29 Financial Intermediation

Examiner’s report 2007

Zone B

General remarks
The paper comprised eight questions, with candidates required to answer
four questions. Questions on this paper will often contain multiple
elements. In such cases, the primary element often requires an explanation
or description of theoretical concept(s), with the secondary element
requiring application of such information to a specific issue of theoretical
importance or practical relevance. More complete answers to this style of
question should seek to ensure that the answers to the two elements are
well integrated.
Candidates should be able to demonstrate their understanding of theory,
and to be able to cite appropriate models, arguments and examples.
Conceptual terms and definitions should always be clearly explained.
Answers should be constructed in a logical and coherent manner, and
must always address the question as posed. Some questions allow an
element of independent thought and reasoning. However, where personal
opinions or experiences are offered, their relevance should be fully
explained and justified, and they should not comprise the major part of
the answer provided. The outstanding answers are those that are able to
reflect knowledge and understanding obtained from following the
suggested readings given in the subject guide.
Candidates must prepare sufficiently thoroughly to be able to make a
serious attempt at four questions on the paper. Endeavour to allow an
approximately equal time for each question, and attempt all parts or
aspects of a question. It is a common failing for candidates to be unable to
provide four adequate answers in the time permitted, due to either an
inappropriate revision strategy or ineffective time management during the
examination itself. The impact of a very low mark for the fourth answer
does severe harm to the overall script average mark.
When reading an examination question, it is important first to identify key
words. To begin, identify the words in the question which indicate the
depth required in each part of the answer, e.g. ‘analyse’, ‘assess’, ‘explain’
will require greater depth than ‘define’, ‘describe’ or ‘outline’. Then identify
the scope of the question, i.e. what content must be included in the
answer. It is equally important to identify what should be excluded from
the answer, i.e. marks will not be gained for information which is
irrelevant to the question posed. If the question is in multiple parts, note
the mark allocation to each part and use this as a guide for time
management.
It should be noted that some questions may require breadth across the
syllabus. It will be common for questions to require the synthesis of topics
from different chapters of the subject guide. Therefore, it is important to
appreciate that different topics within the subject guide are not self-

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contained, and candidates are guided in this respect by the cross-

referencing between different chapters of the subject guide. For
examination purposes, candidates need to have an understanding of the
subject as a whole, and the examination seeks to cover the entire breadth
of the syllabus. In this examination, many candidates provided good or
excellent answers to individual questions but were unable to maintain a
high standard across four questions. Further, many candidates were able
to convincingly address one aspect of a question but unable to tackle other
aspects of the same question.
A small number of candidates did not write clearly and legibly, and all
candidates must make efforts to structure and present their answers to an
appropriate standard. Many candidates failed to provide clear
introductions and conclusions to their answers.

Specific comments on each question

The following comments on specific questions should not be regarded as
model answer outlines. They are suggestions as to how a particular
question may be addressed, and of the principal elements to which an
answer should relate. There is more than one valid way of using subject
material, and therefore more than one way of approaching any given
question.

Question 1
Explain how financial intermediation and delegated monitoring address the
problems of information imperfection between the suppliers and users of funds.
Answers needed to begin with a statement of the nature of the
information imperfection and asymmetry between the ultimate suppliers
and users of funds (subject guide Chapter 1). A full discussion would
address the problems of differential requirements, moral hazard and
adverse selection. The answers should have proceeded to focus on the
main activities of financial institutions in their provision of brokerage and
asset transformation functions. This meant directly addressing transaction
costs, information costs and monitoring costs. The latter point should then
serve as a link to the theory of delegated monitoring of borrowers. An
important constraint on direct investment by households in the financial
claims of corporations is the cost of information collection. Failure to
monitor in a timely and complete manner exposes a supplier of funds to
agency costs. Financial institutions provide a solution to these problems by
pooling funds from suppliers (e.g. household savers) and investing in the
financial claims of corporations. The financial institution has an incentive
to collect information and monitor, which also alleviates potential ‘free
rider’ problems with direct financing. The average cost of collecting
information is also reduced. It is thus argued that suppliers of funds
appoint banks as delegated monitors (to act on their behalf). Better
answers proceeded to analyse the costs and benefits of monitoring. The
best answers reflected reading on delegated monitoring (especially
Diamond (1984) and/or (1996)).

Question 2
‘A bank run can cause a solvent bank to default’. Critically analyse this
statement in the context of liquidity transformation by banks.
The statement is based on Diamond and Dybvig (1983), see Chapter 1 of
the subject guide. It was essential for candidates to cite this article as the
source of the theoretical ideas within their essays. It was appropriate to

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open the essay with a discussion of the nature of liquidity transformation

by banks, and to subsequently develop an analysis of the resultant risks to
which the bank becomes exposed. Financial institutions issue claims that
are attractive to savers due partly to the lower liquidity costs compared
with the claims issued directly by corporations. Intermediaries hold the
long-term, high-risk claims issued by borrowers and finance this by issuing
short-term low-risk claims. They manage such positions by diversification
of their portfolio risks. Financing long-term assets through short-term
deposits is a source of potential fragility of banks because they are
exposed to the possibility that a large number of depositors will decide to
withdraw funds for reasons other than liquidity needs. This results in a
vulnerability to bank runs. Candidates should have ensured that a clear
definition of ‘bank run’ was included within the essay.
Diamond and Dybvig (1983) provide insights on the problematic nature of
bank runs when depositors with imperfect information run on banks
which are not (pre-run) insolvent. A run in itself can cause a bank to
default that would not otherwise have defaulted. This is in stark contrast
with the potential disciplinary benefit of runs in providing an incentive to
avoid insolvency or an appearance of insolvency. The best answers
provided a full analysis of the implications of this theory, and included
discussion of the relevance of the design of deposit contracts.

Question 3
Explain the nature of market risk and operational risk, and discuss how these
risks are addressed in the Basle II capital adequacy accord.
This question required synthesis across the ‘risks’ and regulatory elements
of the syllabus (with relevant material in Chapters 2 and 5 of the subject
guide). Answers needed to begin with clear and detailed explanations of
the nature of market and operational risks. Discussion of operational risks
should encompass both technical and organisational aspects. The answer
should have then proceeded to address the regulatory aspect in depth. A
brief synopsis of the aims of the Basel II capital adequacy accord would be
a desirable starting point. Following a 1998 revision to the Basel I accord,
market risk was incorporated into risk-based capital in the form of an
‘add-on’ to the minimum required ratio for credit risk (and this remains in
Pillar 1 of the Basel II accord). Banks in BIS member countries can
calculate market risk exposure using either a standardised framework (the
regulatory model) or their own internal models (if approved by
regulators). Value at Risk (VaR) is a popular tool, but the better answers
also referred to RiskMetrics (variance/covariance approach), historic/back
simulation and Monte Carlo simulation. A candidate’s ability to tackle this
aspect convincingly reflected reading from the recommended textbooks.
The incorporation of operational risk is a new element introduced in the
Basel II accord (also under Pillar 1). The accord proposed three methods
by which banks can calculate their required capital to protect against
operational risk. Answers should have explained these alternative methods
and the best answers reflected reading beyond the subject guide on this
aspect.

Question 4
Analyse the value of rating systems as a means of evaluating credit risk quality.
The question required analysis of the ‘value’ of rating systems. This implies
that answers which merely described the features and characteristics of
ratings systems did not attract high marks. Nevertheless, comparison of
internal and external ratings systems, and analysis of the main categories

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of internal ratings systems were essential elements of a complete answer.

There also needed to be a discussion of the criteria employed in assigning
ratings and the scope of rated entities.
The question required synthesis across different elements of the syllabus
(with relevant material appearing in Chapters 1, 3 and 5 of the subject
guide). Within this syllabus, the most substantive aspect of the ‘value’ of
rating systems is the regulatory use of ratings. Specifically, answers should
have focused on the acceptance of the role of ratings in the Basel II capital
adequacy accord (Pillar 1 – protection against credit risk). The answer
should have differentiated between the role of external ratings under the
standardised approach, and the internal ratings (IRB) approach. In the
latter case, there should have been analysis of both the Foundations
approach and the Advanced approach. Benchmark risk weights should
have been noted as a key output.
Answers should have also addressed four other aspects of the syllabus
where ratings systems are important. Firstly, there is significant correlation
between ratings and default frequencies, and external ratings are strongly
correlated with borrowing costs (e.g. bond yields). Secondly, in pass-
through securitisation transactions, ratings of the originating bank and of
the securitised assets play a crucial role. Thirdly, rating systems often serve
as a tool for credit policy within banks, whereby a minimum rating level is
required for granting a loan. Finally, ratings have a key role in the process
of dis-intermediation.

Question 5
Analyse the application of gap analysis and Value at Risk (VaR) for risk
management in banks.
The question required discussion of the application of liquidity gap
analysis, interest rate gap analysis, and Value at Risk (VaR) (with relevant
material appearing in Chapters 2 and 4 of the subject guide). To achieve
this, answers should have provided numerical examples for each of the
three cases. A good starting point would have been to explain the aims of
asset and liability management within banks prior to the discussion of gap
analysis. Answers should be clear about how these techniques are
designed to manage liquidity risk and interest rate risk. Under interest rate
gap analysis, it is important to discuss the identification of rate-sensitive
assets and liabilities. Discussion of VaR should have begun with a brief
commentary on market risk, before proceeding to define VaR, and answers
needed to provide an illustration of the technique. Better answers
convincingly analysed the limitations of these techniques. For example,
obtaining accurate VaR estimates is somewhat hampered by the
technique’s need to estimate extreme events within a distribution of
returns. The best answers reflected reading beyond the subject guide on
these issues.

Question 6
Explain the benefits and costs associated with different forms of securitisation.
The question required analysis of the benefits and costs associated with
different forms of securitisation (see Chapter 5 of the subject guide and
the suggested readings). It was important that the answer should not be
restricted solely to pass-through securitisation, although this was expected
to represent a substantial portion of the discussion. Other types of
securitisation which are addressed in the subject guide and suggested
readings include collateralised loan obligations (CLOs), collateralised debt
obligations (CDOs), collateralised mortgage obligations (CMOs), and

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mortgage-backed bonds (MBB). For pass-through securitisation, a

relatively brief explanation of the mechanics of this process was desirable.
Much greater focus needed to be placed on the costs and benefits, and the
influences upon these costs and benefits. Capital management and
reduced funding costs are two crucial benefits. On the other hand, there
are significant costs in setting up the pass-through structure. Identification
of appropriate packages of assets has an important impact on the
cost–benefit calculation. In extending the discussion to CLOs and CDOs,
answers should have commented on the increased difficulties and costs
associated with securitising lower quality assets (e.g. credit insurance,
over-collateralisation). CMOs are created either by packaging and
securitising mortgage loans, or by placing existing pass-through securities
in a trust. MBBs differ from the above in that MBBs normally remain on
the balance sheet, and there is no direct link between the cash flows on
the mortgages backing the bond and the interest and principal payments
on the MBB. Better answers on the costs and benefits of these latter
approaches were able to draw on the suggested readings from the subject
guide.

Question 7
Analyse the processes of risk measurement, risk management and performance
measurement within banks.
The question required a synthesis of different elements within the syllabus
(see Chapters 2 and 6 of the subject guide, and potentially Chapter 7 for
illustrations). Firstly, a discussion of risk measurement should have
highlighted the recent advances in the quantitative techniques applied to
risk management within banks. Different measurement approaches should
be noted, along with comments on how they address different dimensions
of risk. Secondly, the answer should identify key elements in the process of
risk management, and the importance of the outcomes of this process. To
achieve greater depth on these elements, answers should have drawn on
illustrations of hedging or risk management (e.g. derivatives) available
from multiple areas of the syllabus. Such examples should be concise and
targeted toward the question’s requirements. Thirdly, the answer should
have proceeded to discuss the process of performance measurement. This
element should focus on the aims and outcomes of the performance
measurement process. Although examples of the range of possible
performance measurement techniques should have been included, such
discussion should primarily identify the managerial insights available
through their use. It was important to link performance measurement with
risk. Better answers were able to achieve the above within a coherent
structure and able to provide strong linkages between the different
elements. As with previous questions, the very best answers reflected
additional reading on the topics.

Question 8
Explain the structure of option contracts and analyse the option-based
approach to modelling default risk.
The question required a synthesis of the characteristics of option contracts
with the use of option-based models for credit risk (see Chapters 3 and 7
of the subject guide). It would be appropriate to start by presenting
definitions and payoff structures for the most common varieties of options
contracts, specifically including both buyer and writer positions for both
calls and puts. European-style and American-style exercise should be
explained. The feature of upside potential with limited downside risk for

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buyers should be emphasised. A brief discussion of options pricing issues

would be worthwhile, in order to provide linkage to the next section. The
answer should then turn its attention to modelling default risk, under the
Merton (1974) approach. The payoff function for the stockholders of a
corporate borrower resembles that of holding a call option, thus holding
equity is viewed as analogous to buying a call option on the assets of the
firm. The payoff function for the debt holder resembles that of writing
(selling) a put option on the value of the borrower’s assets, with an
exercise price equal to the face value of the debt and a maturity equal to
the life of the debt. Better answers commented on the theoretical insights
from Merton (1974) in this context, and some candidates were also able
to address the issues of practical implementation. An example of
commercial application of the method (e.g. Moody’s KMV) was also highly
desirable.

Key steps to improvement

The examiners wish to emphasise the importance of following the
suggested readings provided in the subject guide. Also, candidates need to
be prepared to tackle questions which require a synthesis of different
elements within the syllabus.

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