Chat with AIExam 19: Types of Risks Incurred by Financial Institutions
What is insolvency risk?
How can liquidity risk and credit risk cause insolvency?
What are the two best protections against insolvency at an FI?
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VerifiedInsolvency occurs when equity becomes zero or negative. Hence,one of the best protections against insolvency is equity capital. The more equity an FI has,the lower the insolvency risk. The second-best protection is prudent management. The job of an FI manager is to decide how much risk is appropriate. Too much risk can cause an institution to fail. Liquidity risk can cause insolvency when a bank's creditors refuse to renew deposits or other borrowings; this may force the bank to have to liquidate assets at fire sale prices. The loss in value of the assets sold would reduce equity and could cause insolvency. Credit risk occurs when money invested in loans or securities is not paid back to the lending institution. These losses reduce equity capital and can lead to insolvency.
The terrorist attacks on the World Trade Center in 2001 are an example of ______________.
(82) VerifiedE
In general terms explain why certain types of derivatives such as options,futures,swaps,and other exotic contracts can generate such catastrophically large losses and even insolvency for users at times. Does this mean that corporate or institutional use of derivatives should be limited or otherwise regulated?
Explain.
(87) VerifiedDerivatives are complex instruments that can be difficult to price and difficult to estimate the payouts that can occur if market conditions change. The user has the responsibility to understand the risks involved. They also involve large amounts of leverage. This means that a small investment can give the user the gains or losses of a much larger investment. These large losses can cause insolvency as in the cases of Societe Generale,Barings,and Orange County. It is debatable whether derivatives usage should be limited to certain parties. One could make a case for limiting derivatives usage to those who have demonstrated the knowledge,skill,and financial resources needed to be able to take on the risks associated with these contracts. In fact,we already do this for individual investors. More disclosure of the risks involved in certain OTC derivatives is probably needed because in many cases the bank sellers know more about the risks than the buyers of these contracts. Problems like those at Societe Generale,Barings,and Sumitomo were really internal control problems,however,not problems with derivatives per se,although the magnitude of losses was certainly exacerbated by the use of derivative contracts. Former Fed Chairman Alan Greenspan has argued that derivatives help complete the market (i.e.,allow better hedging)and that their usage should not be burdened with excessive regulations.
Rank order the net charge-off rates from high to low for the following loan types:
I. C&I loans.
II. Credit card loans.
III. Real estate loans.
(60) Why do banks continue to make credit card loans even though credit card default rates are often at least twice as high as other loan types?
(90) A bank has on-balance-sheet assets with a book value of $940 million and a market value of $985 million and on-balance-sheet liabilities with a book value of $900 million and a market value of $930 million. The bank also has off-balance-sheet assets currently valued at $150 million and off-balance-sheet liabilities worth $160 million. Stockholders' net worth should be valued at _________________ million.
(80) A U.S. bank has £900 million in loans it has made to corporate customers and it has £750 million in deposits when the exchange rate is £1 = $1.98. The bank will have a net foreign exchange loss on these accounts if the exchange rate moves to £1 = $1.95.
(77) Argentina has refused to pay loans made to it by foreign institutions three times. This is an example of
(95) A guarantee issued by an FI that obligates the FI to pay if the purchaser of the letter defaults on a debt is called a
(94) Breakdowns of ATMs and fraudulent use of information stored on a bank's computer system are examples of operational risk.
(68) The risk that an unanticipated increase in liability withdrawals may cause an FI to have to sell assets at fire sale prices is an example of
(89) A bank has total assets of $620 million and $68.2 million in equity. The managers of the bank realize that $18.6 million of its $372 million loan portfolio will not be repaid. After the bank charges off these unexpected bad loans the bank's equity to asset ratio will be __________________.
(91) If a bank is exposed to refinancing risk,its profitability is reduced if interest rates __________________ and if it is exposed to reinvestment risk,its profitability is reduced if interest rates ________________.
(75) Repurchase agreements (repos)are used extensively to finance security holdings. In 2007,many investment banks and other financial institutions were unable to roll over their maturing repurchase agreements during the subprime mortgage crisis. This inability to get new repo financing is an example of
(72) The Fed allowed nonbank financial institutions to borrow money from the discount window during the mortgage crisis and even allowed nonbanks to swap mortgages for Treasury securities. This was an attempt by the Fed to reduce ________________ at institutions.
(77) Assets in a bank's trading book tend to be held for a longer time than assets held in the banking book.
(76) Why would an FI be willing to issue a letter of credit guarantee to a municipal bond issuer?
(91) Second Bank now offers web banking services. Last week a computer glitch posted all web deposit transfers to the wrong accounts. This is an example of
(64) Loan charge-offs do not lead to insolvency risk because when loans are written off both loans and liabilities are reduced.
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