EXAM 2 - Commercial Bank

What are the three types of interest rate risk?

Refinancing risk, Reinvestment risk, Price risk

What is refinancing risk?

Risk that the cost of rolling over or reborrowing funds will rise when liabilities mature and interest rates increase.

What is reinvestment risk?

Risk that cash flows received from assets must be reinvested at lower interest rates.

What is price risk?

Risk that the market value of assets will fall when interest rates rise.

What are the two measures of market risk discussed in Chapter 20?

Value at Risk (VaR) and Daily Earnings at Risk (DEAR)

What is Value at Risk (VaR)?

Measures the maximum expected loss over a given time period at a specified confidence level.

What is Daily Earnings at Risk (DEAR)?

Measures the potential daily loss from adverse market movements.

What is foreign exchange risk?

The risk that exchange rate changes affect the value of an FI's assets and liabilities denominated in foreign currencies.

What is a net long position?

Foreign currency assets are greater than foreign currency liabilities.

What happens to profits when a net long position currency appreciates?

Profits increase.

What happens to profits when a net long position currency depreciates?

Profits decrease.

What is a net short position?

Foreign currency liabilities are greater than foreign currency assets.

What happens to profits when a net short position currency depreciates?

Profits increase.

What happens to profits when a net short position currency appreciates?

Profits decrease.

What is the Nonperforming Asset Ratio?

Nonperforming Assets ÷ Total Assets

What does the Nonperforming Asset Ratio measure?

The proportion of assets that are not generating income.

What two measures are used in real estate credit analysis?

Gross Debt Service (GDS) and Total Debt Service (TDS)

What is the acceptable range for GDS?

25%–30%

What is the acceptable range for TDS?

35%–40%

What are the major components of corporate credit analysis?

Ratio Analysis, Z-Score, and Expected Default Frequency (EDF)

What is time-series analysis?

Examines the applicant's business over time.

What is cross-sectional analysis?

Compares the applicant's ratios to those of its competitors.

What do liquidity ratios measure?

Express the variability of liquid resources relative to potential claims.

What do asset management ratios measure?

Give clues as to how well the applicant uses its assets relative to its past performance and the performance of the industry.

What do debt and solvency ratios measure?

Give an idea of the extent to which the applicant finances its assets with debt versus equity.

What do profitability ratios measure?

Express the profitability of the firm.

Who developed the Z-Score model?

E.I. Altman.

What is the purpose of Altman's Z-Score?

An overall measure of the borrower's default risk classification.

What Z-Score indicates a high default risk firm?

Z < 1.81

What Z-Score indicates an indeterminate default risk firm?

1.81 < Z < 2.99

What Z-Score indicates a low default risk firm?

Z > 2.99

What does a Z-Score of 3.22 indicate?

Low default risk.

What is Expected Default Frequency (EDF)?

A market-based estimate of the probability that a borrower will default.

What are the advantages of credit scoring systems such as FICO?

Improved accuracy, fewer resources required, and faster decisions.

What are the disadvantages of credit scoring systems such as FICO?

May overlook borrower-specific information, depends on historical data, and may be less useful for borrowers with limited credit history.

What are the five FICO score components and weights?

Payment History (35%), Amounts Owed (30%), Length of Credit History (15%), New Credit (10%), Types of Credit Used (10%).

What FICO factor carries the greatest weight?

Payment History (35%).

What FICO factor carries the second greatest weight?

Amounts Owed (30%).

What is a bank run?

Large number of depositors withdraw funds from a single bank because they fear the bank will fail.

What is a bank panic?

Large number of depositors withdraw funds from many banks because they fear the banking system is unstable.

What is the difference between a bank run and a bank panic?

Bank run = withdrawals from one bank. Bank panic = withdrawals from many banks.

What are the three regulatory mechanisms used to deter bank runs and bank panics?

Deposit insurance, discount window, and liquidity plans.

What is deposit insurance?

Protects insured deposits and reduces incentives for depositors to withdraw funds.

What is the discount window?

Allows banks to borrow from the Federal Reserve during liquidity shortages.

What is a liquidity plan?

A bank strategy for maintaining sufficient liquidity during periods of stress.

Why is deposit insurance effective at reducing bank runs?

Depositors know their insured funds are protected even if a bank fails.

Why is the discount window important during a liquidity crisis?

It provides emergency funding to banks experiencing short-term liquidity shortages.

What is the purpose of a liquidity plan?

To ensure a bank can meet its cash obligations during periods of unexpected withdrawals or funding stress.