Answers - Reading 11 Analysis of Financial Institutions

Question #1 of 20 Question ID: 1472578 Which of the following is least likely a reason for the establishment of global and regional regulatory bodies? A) To minimize systemic risk. B) To increase harmonization or regulatory rules. C) To increase global opportunities for regulatory arbitrage. Explanation One aim of establishing global regulatory bodies is to reduce, not increase, opportunities for regulatory arbitrage (multinational companies exploiting differences in regional regulations to avoid unfavorable rules). (Module 11.1, LOS 11.b) Question #2 of 20 Question ID: 1472577 Compared to manufacturing or merchandising companies, financial institutions are most likely to have higher direct exposures to: A) inflationary risk, business risk, exchange rate risk, and legal risk. B) market risk, credit risk, liquidity risk, and interest rate risk. C) operational risk, process risk, political risk, and compliance risk. Explanation Because the productive assets of financial institutions are primarily financial assets such as securities and loans, financial institutions are likely to have significant direct exposures to risks such as credit risk, liquidity risk, market risk, and interest rate risk. (Module 11.1, LOS 11.a) Question #3 of 20 Question ID: 1472582 The CAMELS approach to analyzing a bank considers: A) character, ability to pay, market exposure, efficiency, liabilities, and stability. B) capital adequacy, asset quality, management, earnings, liquidity, and sensitivity. C) capacity, appetite for risk, monetary assets, evidence, legislative factors, and structure. Explanation The CAMELS approach to analyzing a bank stands for: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity. (Module 11.2, LOS 11.c) Question #4 of 20 Question ID: 1472585 John Gittens is reviewing his firm's guidance for the application of the CAMELS framework and notices the following two statements: "The mission of a banking entity will affect the way its assets and liabilities Statement 1: are managed, and hence this qualitative impact is usually addressed within the management capabilities section of the CAMELS approach." "The corporate culture may lead to excessive risk taking, or even a high Statement 2: level of risk aversion, and this aspect is not covered in a typical CAMELS analysis." Regarding the two statements made by Gittens, statement 1 is most likely: A) incorrect, and statement 2 is most likely correct B) incorrect and statement 2 is most likely incorrect C) correct and statement 2 is most likely correct Explanation Neither the mission nor the corporate culture are addressed in a typical CAMELS analysis, hence statement 1 is incorrect (stating that the mission is included) but statement 2 is correct (in stating that the corporate culture is not included). (Module 11.5, LOS 11.d) Question #5 of 20 It would be least accurate to state that the Basel Committee: Question ID: 1472580 A) monitors adoption and implementation of standards in member jurisdictions. B) has legal authority to enforce compliance with supervision and accountability standards. C) develops international regulatory framework for banks. Explanation The Basel Committee develops international regulatory framework for banks, and monitors adoption and implementation in member jurisdictions. However, the Basel Committee does not have legal authority (i.e., jurisdiction) to enforce compliance. (Module 11.1, LOS 11.b) Question #6 of 20 Question ID: 1472575 Which of the following statements is least likely correct? Financial institutions differ from other companies: A) due to their balance sheet containing assets that are often measured at fair value. B) due to their assets being predominantly tangible. C) due to their activities giving rise to systemic risk. Explanation Lots of companies have predominantly tangible assets. Financial institutions differ in that their assets are predominantly financial assets. These are often measured at fair value, and financial institutions do give rise to systemic risk. (Module 11.1, LOS 11.a) Question #7 of 20 Question ID: 1472590 Under the Basel III Regulatory Framework, the Net Stable Funding Ratio (NSFR) is most likely to be calculated as: A) highly liquid assets ÷ available stable funding. B) required stable funding ÷ expected cash outflows. C) available stable funding ÷ required stable funding. Explanation The Net Stable Funding Ratio (NSFR) is the percentage of a bank's required stable funding that must be sourced from available stable funding. The numerator (available stable funding) is a function of the composition and maturity of a bank's funding sources (i.e., capital and deposits and other liabilities), while the denominator (required stable funding) is a function of the composition and maturity of a bank's asset base. (Module 11.5, LOS 11.e) Question #8 of 20 Question ID: 1472594 Compared to a life and health (L&H) insurance company, it is most likely that a property and casualty (P&C) insurer's: A) policies’ final cost will typically be known within a year of an insured event. B) claims will be more predictable. C) policies will be longer term. Explanation P&C insurers' final cost will usually be known within a year of an insured event occurring. P&C insurers' policies are usually short term, and P&C claims are more variable and "lumpier" because they stem from unpredictable events such as accidents. (Module 11.6, LOS 11.f) Question #9 of 20 Question ID: 1472579 Basel III regulation that aims to prevent banks from assuming so much leverage that they are unable to withstand loan losses is most correctly described as the: A) minimum capital requirement. B) minimum liquidity requirement. C) stable funding requirement. Explanation The minimum capital requirement specifies a ratio of assets to risk-weighted assets to ensure the balance sheet is robust enough to cope with loan losses. Stable funding requirements specify the amount of stable funding relative to liquidity needs over a oneyear horizon. The minimum liquidity requirement specifies a minimum level of liquidity to cover a partial loss of funding sources or outflow due to off balance sheet commitments. (Module 11.1, LOS 11.b) Question #10 of 20 Question ID: 1472576 Systemic risk in financial services is least likely to: A) have consequences for the economy as a whole. B) concern the co-movement of an institution’s asset values with the overall market. C) be caused by interdependencies in the financial system. Explanation Systemic risk refers to the risk that impairment in one part of the financial system could spread throughout other parts of the financial system, and then negatively affect the entire economy. Note that systemic risk is distinct from systematic (beta) risk. (Module 11.1, LOS 11.a) Question #11 of 20 Question ID: 1472583 When using the fair value hierarchy as defined by IFRS and US GAAP, a financial asset valuation performed by discounting future cash-flows at a discount rate would most likely be classified as a: A) level 1 valuation B) level 2 valuation C) level 3 valuation Explanation Neither the future cash flows or the discount rate in a PV calculation are directly observable, hence the valuation is level 3. Level 1 valuations are based on observed quoted prices for identical assets. Level 2 valuations are observable but are not quoted prices for identical assets, they may be prices for similar assets. (Module 11.3, LOS 11.c) Question #12 of 20 Question ID: 1472581 When assessing capital adequacy using risk-weighted assets, cash will most likely: A) be weighted over 100%. B) be weighted at 100%. C) not be included in risk-weighted assets. Explanation Cash has zero risk and hence is not included in risk-weighted assets (i.e. is weighted at zero). (Module 11.2, LOS 11.c) Question #13 of 20 Question ID: 1472588 Gert Fonn, CFA, extracted the following information on the regulatory capital and total assets for JJK Inc., a U.S. commercial bank he is considering as an investment. Fonn weights cash at 0%, performing loans at 100% and non-performing loans at 150% when calculating risk-weighted assets, and only considers investing in institutions with a tier 1 capital ratio over 15%. However, he is concerned that JJK has classified $85m of non-performing loans as performing loans. Regulatory Capital 2018 2018 $('000) $('000) Common Equity Tier 1 Capital 80,438 Cash 165,754 Additional Tier 1 Capital 14,294 Performing loans 235,631 Tier 2 Capital 22,395 Non-performing loans 158,654 Using the information in the table, which of the following conclusions is Fonn most likely to make? A) JJK’s current tier 1 capital ratio meets Fonn’s criteria even if the $85m of nonperforming loans were reclassified B) JJK’s current tier 1 capital ratio does not meet Fonn’s criteria C) JJK’s current tier 1 capital ratio meets Fonn’s criteria, but would not if the $85m of non-performing loans were reclassified Explanation Common Equity Tier 1 Capital 80,438 Additional Tier 1 Capital 14,294 Tier 1 Capital 94,732 Pre Adjustment Cash 165,754 0% Performing loans 235,631 100% 235,631 Non-performing loans 158,654 150% 237,981 TotalTotal 0 473,612 Tier 1 Ratio 94,732 473,612 Post Adjustment Cash 165,754 0% Performing loans 150,631 100% 150,631 Non-performing loans 243,654 150% 365,481 Total 0 20.0% 516,112 Tier 1 Ratio 94,732 516,112 18.4% JJK's tier 1 ratio is 20% pre-adjustment and 18.4% post adjustment, both above 15%. (Module 11.5, LOS 11.e) Question #14 of 20 Question ID: 1472589 The following extract shows data prepared by OWB, a financial institution conducting a review of its BASEL III compliance from 2016 to 2018. All data has been prepared in accordance with BASEL III requirements. 2016 2017 2018 $m $m $m Net Outflows (30 days of stress level cash flows) 70,363 79,454 111,547 Available Stable Funding 337,964 347,945 298,045 Required Stable Funding 327,043 287,953 247,876 High Quality Liquid Assets 82,334 87,677 109,654 Using the data extracted from OWB, which of the following statements is most likely correct? A) B) The number of days of stress level cash flows that OWB can withstand has steadily increased over the period The liquidity coverage ratio meets the standard BASEL III requirements in each of the three years C) The net stable funding ratio was highest in 2017 Explanation 2016 2017 2018 $m $m $m Net Outflows 70,363 79,454 111,547 Available Stable Funding 337,964 347,945 298,045 Required Stable Funding 327,043 287,953 247,876 High Quality Liquid Assets 82,334 87,677 109,654 110% 98% Liquidity Coverage Ratio High Quality Liquid Assets 117% Net Outflows Number of days of stress 30 x 1.17 30 x 1.10 30 x 0.98 level volume of cash outflows OWB can withstand 35.1 33.1 29.5 Net Stable Funding Ratio 103% 121% 120% Available Stable Funding Required Stable Funding The answer "The net stable funding ratio was highest in 2017" is correct, the net stable funding ratio was highest in 2017. The number of days of stress level cash flows OWB can withstand has decreased over the period and is below the BASEL III requirement in 2018. (Module 11.5, LOS 11.e) Question #15 of 20 Question ID: 1472584 Which of the following factors is least likely to be considered during a CAMELS analysis of a financial institution? A) Estimation methods used for the fair value of assets B) Accuracy of accounting estimates C) Levels of government support Explanation The level of government support or ownership is not part of the CAMELS process. The accuracy of accounting estimates and the valuation process used (level 1,2,3) would be considered within the earnings category. (Module 11.5, LOS 11.d) Question #16 of 20 Question ID: 1472592 Which of the following statements comparing Property and Casualty insurers to Life and Health insurers is least likely correct? A) B) C) The calculation of Property and Casualty insurers minimum capital requirements is more likely to factor in exposure to interest rate risk Life and Health insurers typically face more predictable claims than Property and Casualty insurers Property and Casualty insurers typically require a higher equity cushion and hence can have higher capital requirements Explanation Property and Casualty insurers typically face more unpredictable claims and hence have higher capital requirements. Life and Health insurers are more likely to sell products with material exposures to interest rate risk and hence they, not Property and Casualty insurers, are more likely to factor that risk into capital requirements. (Module 11.6, LOS 11.f) Question #17 of 20 Question ID: 1472591 Which of the following statements regarding Property and Casualty insurance institutions is most likely correct? A) The priority in the selection of assets should be liquidity The suitability of assets held can be analyzed by observing the status of the B) assets in the fair value hierarchy. A majority of level 3 reported values indicates an appropriate asset base C) Due to the uncertainty of payout timings and levels, the institution will usually invest in high-risk, longer term assets Explanation Due to the uncertain nature of required payouts, liquidity is the key concern. High-risk, long term assets are therefore not appropriate. Level 1 valuations would suggest liquid assets, as they are priced using identical trading (and hence liquid) assets. (Module 11.6, LOS 11.f) Question #18 of 20 Question ID: 1472586 Important attributes that the CAMELS approach to assessing bank soundness does not address are most likely to include: A) management capabilities, asset quality, and capital adequacy. B) earnings, liquidity, and sensitivity to market risk. C) competitive environment, mission, and support by government. Explanation In addition to the CAMELS components, important attributes deserving analysts' attention include government support, the bank's mission, corporate culture and competitive environment, off-balance-sheet items, segment information, currency exposure, and risk disclosures. CAMELS itself focuses on a bank's: capital adequacy, asset quality, management capabilities, earnings sufficiency, liquidity position, and sensitivity to market risk. (Module 11.5, LOS 11.d) Question #19 of 20 Question ID: 1472593 When analyzing insurance companies, the combined ratio is most likely to: A) indicate an underwriting loss when it is higher than 100%. B) suggest a soft market when it is low. C) equal net premiums earned divided by total insurance expenses. Explanation An underwriting loss is indicated by a combined ratio higher than 100% for a single insurance company. Low prices for premiums leads to a high combined ratio, indicating a soft market. The combined ratio equals the total insurance expenses divided by the net premiums earned. (Module 11.6, LOS 11.f) Question #20 of 20 Question ID: 1472587 When analyzing a bank, important attributes that the CAMELS approach to assessing bank soundness does not address are most likely to include: A) sensitivity to market risk, liquidity, and earnings. B) corporate culture, exposure to currencies, and segment information. C) capital adequacy, asset quality, management capabilities. Explanation In addition to the CAMELS components, important attributes deserving analysts' attention include government support, the bank's mission, corporate culture and competitive environment, off-balance-sheet items, segment information, currency exposure, and risk disclosures. CAMELS itself focuses on a bank's: capital adequacy, asset quality, management capabilities, earnings sufficiency, liquidity position, and sensitivity to market risk. (Module 11.5, LOS 11.d)