Financial Institutions Study Guide of Quiz 1
Financial Institutions Study Guide of Quiz 1 BU.231.710.W4.SP16
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This 4 page Study Guide was uploaded by Kwan on Thursday March 31, 2016. The Study Guide belongs to BU.231.710.W4.SP16 at Johns Hopkins University taught by Roger Staiger in Spring 2016. Since its upload, it has received 76 views. For similar materials see Financial Institutions in Finance at Johns Hopkins University.
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Date Created: 03/31/16
QUIZ 1 1. CHAPTER 1,2,7,16,17 Why Are Financial Institutions Special? This chapter described various factors and forces impacting financial institu tions and the specialness of the services they provide. These forces have resulted in FIs, which have historically relied on making profits by performing traditional special functions (such as asset transformation and the provision of liquidity ser vices), expanding into selling financial services that interface with direct security market transactions, such as asset management, insurance, and underwriting ser vices. This is not to say that specialized or niche FIs cannot survive but rather that only the most efficient FIs will prosper as the competitive value of a specialized FI charter declines. The major theme of this book is the measurement and management of FI risks. In particular, although we might categorize or group FIs and label them life insur ance companies, banks, finance companies, and so on, in fact, they face risks that are more common than different. Specifically, all the FIs described in this and the next five chapters (1) hold some assets that are potentially subject to default or credit risk and (2) tend to mismatch the maturities of their balance sheets to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all are exposed to some degree of saver withdrawal or liquidity risk depending on the type of claims sold to liability holders. And most are exposed to some type of underwriting risk, whether through the sale of securities or by issuing various types of credit guarantees on or off the balance sheet. Finally, all are exposed to operating cost risks because the production of financial services requires the use of real resources and backoffice support systems. In Chapters 7 through 26 of this textbook, we investigate the ways managers of FIs are measuring and managing this inventory of risks to produce the best return risk tradeoff for shareholders in an increasingly competitive and contestable market environment. Financial Services: Depository Institutions This chapter provided an overview of the major activities of commercial banks, savings institutions, and credit unions. It also described the agencies that regulate these depository institutions. The Federal Reserve System, the FDIC, the OTS, and the Office of the Comptroller of the Currency, in conjunction with state regulators, are the agencies that oversee the activities of these institutions. Each of these insti tutions relies heavily on deposits to fund its activities, although borrowed funds are becoming increasingly important for the largest institutions. Historically, commercial banks have concentrated on commercial or business lending and on investing in securities, while savings institutions have concentrated on mortgage lending and credit unions have concentrated on consumer lending. These differ ences are being eroded as a result of competitive forces, regulation, and changing financial and business technology. Risks of Financial Institutions This chapter provided an introductory view of 10 major risks faced by modern FIs. They face interest rate risk when the maturities of their assets and liabilities are mismatched. They face credit risk or default risk if their clients default on their loans and other obligations. They encounter liquidity risk as a result of excessive withdrawals or problems in refinancing liabilities. If FIs conduct foreign business, they are subject to additional risks, namely, foreign exchange and sovereign risks. They incur market risk on their trading assets and liabilities if adverse movements in interest rates, exchange rates, or other asset prices occur. Modernday FIs also engage in significant offbalancesheet activities that expose them to offbalance sheet risks: contingent asset and liability risks. The advent of sophisticated technol ogy and automation exposes FIs to both technological and operational risks. FI’s face insolvency risk when their capital is insufficient to withstand the losses that they incur as a result of such risks. The interaction of the various risks means that FI managers face making trade offs among them. As they take actions in an attempt to affect one type of risk, FI managers must consider the possible impact on other risks. The effective management of these risks determines a modern FI’s success or failure. The chapters that follow analyze each of these risks in greater detail. OffBalanceSheet Risk This chapter showed that an FI’s net worth or economic value is linked not only to the value of its traditional onbalancesheet activities but also to the contingent asset and liability values of its offbalancesheet activities. The risks and returns of several offbalancesheet items were discussed in detail: loan commitments; com mercial and standby letters of credit; derivative contracts such as futures, options, and swaps; forward purchases; sales of whenissued securities; and loans sold. In all cases, it is clear that these instruments have a major impact on the future profitability and risk of an FI. Two other risks associated with offbalancesheet activities—settlement risk and affiliate risk—were also discussed. The chapter concluded by pointing out that although offbalancesheet activities can be risk increasing, they can also be used to hedge onbalancesheet exposures, resulting in lower risks as well as generating fee income to the FI. Technology and Other Operational Risks This chapter analyzed the operating cost side of FIs’ activities, including the effects of the growth of technologybased innovations. The impact of technology was first examined separately for wholesale and retail services before an analysis was presented of its impact on costs and revenues. Technologybased investments can potentially result in new product innovations and lower costs, but the evi dence for such cost savings is mixed. Moreover, new and different risks appear to have been created by modern technology. These include settlement or daylight overdraft risk, international technology transfer risk, crime or fraud risk, regula tory avoidances risk, taxation avoidance risk, and competition risk. Nevertheless, although the chapter focuses on the cost and benefits of technology to an FI, a more fundamental issue may not be technology’s costs and benefits but the need to invest in technology to survive as a modern fullservice FI. 2. CHAPTER 8,9 Interest Rate Risk I This chapter introduced a method of measuring an FI’s interest rate risk exposure: the repricing model. The repricing model looks at the difference, or gap, between an FI’s ratesensitive assets and ratesensitive liabilities to measure interest rate risk. The chapter showed that the repricing model has difficulty in accurately measuring the interest rate risk of an FI. In particular, the repricing model ignores the market value effects of interest rate changes. More complete and accurate measures of an FI’s exposure are duration and the duration gap, which are explained in the next chapter. Interest Rate Risk II This chapter analyzed the duration gap model approach to measuring interest rate risk. The duration gap model is superior to the simple repricing gap model in that it incorporates the timing of cash flows as well as maturity effects into a simple measure of interest rate risk. The duration gap measure could be used to immunize a particular liability as well as the whole FI balance sheet. However, as the concluding section of the chapter indicates, a number of potential problems exist in applying the duration gap model in realworld scenarios. Despite these weaknesses, the duration gap model is fairly robust and can deal with a large number of realworld complexities, such as credit risk, convexity, floating interest rates, and uncertain maturities.
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