F446 Exam 1

Chapters 1-11

liquidity

ease of converting an asset to cash

price risk

risk that sale price of an asset will be lower than the purchase price

economies of scale

cost reduction in trading and other transaction services results in increased efficiency when FIs perform these services

asset transformer

FI issues financial claims that are more attractive to house-hold savers than claims issued by corporations

primary securities

issued by corporations and backed by the real assets of the corps

secondary securities

issued by FIs and backed by primary securities

agency costs

risk that owners and managers of firms will receive savers’ funds will take actions with those funds contrary to best interest of savers

delegated monitor

economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds

diversify

reduce risk by holding different securities in a portfolio

negative externalities

action by an economic agent imposing costs on other economic agents

net regulatory burden

difference between private costs of regulations and private benefits for the producers of financial services

outside money

money supply directly produced by government or central bank

inside money

part of money supply produced by private banking system

enterprise risk management

manage the full spectrum of risks in an interrelated risk portfolio

interest rate risk

risk incurred by an FI when maturities of its assets and liabilties are mismatched

refinancing risks

risk that the cost of rolling over or reborrowing funds will rise above returns being earned on asset investments

reinvestment risk

risk that return on funds to be reinvested will fall below cost of funds

credit risk

risk that promised cash flows from loans and securities held by FIs may not be paid in full

firm-specific credit risk

risk of default of borrowing firm associated with specific types of project risk taken by firm

systematic credit risk

risk of default associated with general economy wide or macro conditions affecting all borrowers

liquidity risk

risk that sudden surge in liability withdrawals may leave FI in a position of having to liquidate assets in a very short period of time at low prices

foreign exchange rate

risk that exchange rate changes can affect the value of an FIs assets and liabilities denominated in foreign currencies

country/sovereign risk

risk that repayment from foreign borrowers may be interrupted because of interference from foreign governments

off-balance-sheet risk

risk incurred by an FI due to activities related to contingent assets an liabilities

market risk

risk incurred in trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices

contingent assets and liabilities

assets and liabilities off the balance sheet that potentially produce positive or negative cash flow for an FI

letter of credit

credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring

economies of scale

degree to which an FI’s average unit costs of providing financial services fall as its outputs of services increase

economies of scope

degree to which an FI can generate cost synergies by producing multiple financial service products

technology risks

risks including strategic risk of not embracing new technology, not investing in the right technology, as well as cybersecurity, third-party, and ineffective risk management

operational risk

risk that existing technology or support systems may malfunction or break down

risk of digital disruption and fintech

risk that an FI fails to successfully redefine and innovate how it creates, delivers, and captures value

risk that FI fails to compete against new disruptive players in the sector

insolvency risk

risk that an FI may not have enough capital to offset a sudden decline in the value of assets relative to its liabilities

repricing gap

difference between assets and liabilities whose interest rates will be repriced or changed over some future period

rate sensitive asset/liability

asset/liability that is repriced at/near current market interest rates within a maturity bucket

core deposits

FI’s long-term sources of funds

CGAP effects

relations between changes in interest rates and changes in net interest income

spread effect

effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change

runoff

periodic cash flow of interest principal amortization payments on long-term assets, such as conventional mortgages, that can be reinvested at market rate

book value accounting

accounting method where assets/liabilities are recorded at historic values

market value accounting

accounting method where assets/liabilities are revalued according to current level of interest rates

marking to market

value securities at their current market price

duration

weighted-average time to maturity on an investment

consol bond

bond that pays a fixed coupon each year forever

interest elasticity

percentage change in the price of a bond for any given change in interest rates

modified duration

duration divided by 1 plus the interest rate

dollar duration

dollar value change in a security’s price to a 1% change in the return on security

duration gap

measure of overall interest rate risk exposure for an FI

convexity

degree of curvature of the price-yield curve around some interest rate level

junk bonds

rated as speculative or less than investment grade by bond-rating agencies

syndicated loan

provided by a group of FIs rather than a single lender

secured loan

loan that is backed by a first claim on certain assets of the borrower if default occurs

unsecured loan

loan that has only a general claim to the assets of the borrow if default occurs

spot loan

loan amount withdrawn by borrower immediately

loan commitment

credit facility with maximum size and maximum period of time over which the borrower can withdraw funds

line of credit

adjustable- rate mortgage (ARM)

mortgage whose interest rates adjusts with movements in underlying market index interest rate

revolving loan

credit line on which a borrower can both draw and repay many times over the life of the loan contract

usury ceilings

national-, state-, or city-imposed ceilings on the maximum rate FIs can charge on consumer and mortgage debt

LIBOR

London Interbank Offered Rate

rate for interbank dollar loans of a given maturity in the offshore or Eurodollar market

prime lending rate

base lending rate periodically set by banks

compensating balance

percentage of a loan that a borrower is required to hold on deposit at the lending contract

default risk

risk that borrower is unable/unwilling to fulfill terms promised under loan contract

credit rationing

restricting quantity of loans made available to individual borrowers

covenants

restrictions written into bond and loan contracts either limiting or encouraging the borrower’s actions that affect the probability of repayment

implicit contract

long-term customer relationship between a borrower and lender based on reputation

leverage

ratio of a borrower’s debt to equity

credit scoring model

mathematical models that use observed loan’s applicant’s characteristics either to calculate a score representing the applicant’s probability of default or to sort borrowers into difference default classes

treasure strips and zero-coupon corporate bonds

bear no coupons and only a face value to be paid on maturity

deep-discount bonds

marginal default probability

probability borrower will default in a given year

cumulative default probability

probability borrower will default over a specified multi-year period

no arbitrage

inability to make a profit without taking risk

forward rate

one-period rate of interest expected on a bond issue at some date in the future

mortality rate

historic default rate of experience of bond or loan

marginal mortality rate

probability of a bond/loan defaulting in any given year after issue

RAROC

risk-adjusted return on capital

brokerage function

agent for the saver by providing information and transaction services

economies of scale

asset-transformer function

finance purchase of primary securities by selling financial claims to household investors

information costs, liability risks, price risks

three costs FIs reduce for savers

information cost

agency costs

delegated monitor or information producer

reduce liquidity and price risk

diversification

reduced transaction costs, maturity intermediation, transmission of monetary policy from federal reserve, credit allocation, intergenerational transfers, payment services, denomination intermediation

7 ways financial institutions are special

safety and soundness, monetary policy, credit allocation, consumer protection, investor protection, entry and chartering

6 types of regulations

safety and soundness

diversify assets

minimum level of capital

provision of guaranty of funds

monitoring and surveillance

monetary policy regulation

implemented through FIS

credit allocation regulation

know what accounts need more to maintain diversity

consumer protection regulation

consumers don’t know intricacies of policies, payment systems, etc

investor protection regulation

where are investors actually investing

risk off loss due to change in interest rates

misunderstanding disclosures/understanding fine print

entry and chartering regulation

any financial institution newly entering the market

must follow array of other issues

3 trends for savers

rise of mutual fund and money market mutual funds

shift from originate and hold to originate and distribute

enterprise risk management: risk culture, risk appetite, risk governance

fintech

global trends and sizes of banks

sub-prime mortgage

people with lower credit scores who want to buy a house

increase in home prices

economic recession typically does NOT cause

sub-prime mortgage market

most often mentioned cause of the financial crisis

brokerage and asset transformation

two most major functions provided by FIs

15%

percent of equity that loans cannot be greater than for a FI

Lehman Brothers

investment bank that failed during the financial crisis

assets

cash and due from

investments

loans

non-earning [term]

liabilities

noninterest bearing deposits

NOW accounts

savings

MMDA

CDs

borrowings

profit margin

net income/operating income

TOI= interest income + noninterest income

Return on Assets (ROA)

net income/TOI * TOI/assets

management efficiency * asset efficiency

Return on Equity (ROE)

net income/TOI* TOI/assets * assets/equity

management efficiency * asset efficiency * leverage