FINM3006 Notes on Past Exams

2016 Test 1

QUESTION 1

a) What is the percentage of ADI branches in rural vs. metropolitan

areas?

Rural = 7.8%

Metro = 92.2%

b) What is the percentage of other face-to-face points of presence in

rural vs. metropolitan areas?

Rural = 10.7%

Metro = 89.3%

c) Comment on the difference between the market structures for

metropolitan vs. rural areas.

The physical (i.e. face-to-face) access to banks is very different between rural
and metro areas. All else equal, competition is likely to be much weaker in rural
areas. In other words, rural banking appears much more concentrated than
metro banking.

However, concentration is not a measure of the relative size of rural and metro
banking markets. Therefore, local banks may have local monopolies even in the
presence of online banking.

d) Based on your answer to (c) and what you have learnt in class about
the key roles that banks play in an economy, what can you say about
the potential differences in:

i. Access to finance in rural vs. metropolitan areas;

Access to finance in rural areas is likely to be more restricted relative to metro
areas. This could include: (1) higher costs of borrowing; (2) decreased amount of
borrowing; (3) both.

There are two reasons for this:

Firstly, a lack of physical access increases the cost of monitoring for banks.
Proximity to borrowers is an important determinant of monitoring costs. For most
retail borrowers, a mortgage is the most common form of borrowing. This process
requires, at the very least, an inspection of the property that is being used as
collateral. Other examples include personal loans which may require face-to-face
contact with a loan officer which is harder with fewer and more distant branches.
In summary, the few points of access, the higher the cost of monitoring and the
lower the access to finance.

Secondly, a lack of competition (concentration) will exacerbate the above

problem. Since banks do not compete as much in rural areas, access may be
lower. This is even the case for online competition. Online banks typically require
a minimum of 20% deposit (decreases the amount borrowed) and less prudent
banks charge much higher interest rates/fees (high cost of borrowing).

Other reasons for the lack of access in rural areas include:

 Real estate prices are more volatile in rural areas

 Some banks will not lend to certain post codes or will only lend with a
significant deposit

ii. Stability of the banks in rural vs. metropolitan areas

Higher costs of monitoring imply a higher cost of borrowing (all else equal). So, if
banks continue to lend but do less monitoring, this may lead to higher instability.

On the other hand, a lack of competition means that banks do not need to be as
competitive to maintain local profitability so rural banks may not be as inclined
as metro banks to make risky loans.
QUESTION 2

We have learnt in class about two types of ownership structure for

deposit taking institutions. Mutual Ownership (i.e. credit union) versus
Private Ownership (i.e. bank). In this question, we will consider other
ownership structures.

a) In Japan, there is a unique ownership structure known as a banking

cooperative. These types of banks are called Shinkin Banks. In these
institutions, a group of small firms (i.e. members or owners  hold
equity) set up the bank, which can then accept deposits from any
source. The funds are then lent only to the members of the Shinkin
bank.

i. In three separate diagrams, draw a simple balance sheet for

each of the different ownership structures as well as the flow
of funds between borrowers, depositors, and owners which
make up the balance sheet. (6 marks)

Mutual: depositors are members who are also the owners of the institutions.
Funds are typically lent to members
Private Bank: owners provide equity/capital, raise deposits from lenders and lend
to

borrowers

Shinkin Bank:

ii. With reference to the key functions the banks play in an

economy, discuss whether you think Shikin Banks are likely to
be riskier than a bank or a mutual. Be sure to provide and
economic argument for your answer.

The key issue here are incentives to monitor. Monitoring and screening are both
important functions that banks play in an economy.
However, the Shinkin structure is unique in that the members provide equity to
the bank, then raise deposits from outside lenders. The funds are then lent to
members/owners. Since the member/owners are lending to themselves, how
strong are their incentives to screen and monitor these loans? Akin to “letting
the fox look after the henhouse”.

A breakdown of monitoring can lead to excess risk in these banks.

b) In many countries, the government still plays a major role in the

provision of credit. This is typically done via State Owned Banks. In this
ownership structure, the government is the owner of the bank (i.e.
equity holder) which can raise deposits from any source and then lend
to any source. Recall we discussed in class during the “In the News”
section how the new President of the Fed Reserve of Minneapolis
thought that big banks should either be broken up into smaller banks or
be regulated so heavily that it would be akin to the bank being a state
run enterprise. Now, read attachment 2, which is an article discussing
the current problems in the Indian banking sector and answer the
following:

i. What are the economic reasons for the President of the Fed
Reserve of Minneapolis to suggest moving toward a state-run
banking system be a solution to the too big to fail problem? (6
marks)

The TBTF problems refers to the situation where an ADI is so large that it
believes, in the event of a failure, that the government will have no choice but to
rescue/bailout the bank. Knowing this before the fact, these banks will take
excessive risk because they know the government is a backstop if they fail.

This is a problem because, if the bank performs well, profits go to the private
owners. If the bank performs poorly, the losses are borne by the taxpayer.

Therefore, if the government owns the bank then the taxpayer benefits when the
bank is performing well. Since taxpayers also wear the costs in the event of a
failure, the more hazard incentives are diminished.
 ii. Does it appear the state-owned banks in India are currently
performing very well? Are banks any less risky? Explain your
answer.

No, not at all. The article suggests that state-owned banks are substantially
underperforming. The article sites the profits of the two largest banks fell by 62%
and 93%. The cause of the underperformance is staggeringly high NPL (the NPLs
are crippling the banking sector).

Accordingly, the central bank governor is demanding the banks raise their
provisioning to shore up their balance sheets. This will drive profits down further,
all else equal.

iii. If the answer to (ii) is no. Outline and discuss the economic
reasons as to why you think state runs banks may be no less
risky (or even riskier) than privately run banks.

The main problem with state-owned banks is lack of accountability and efficiency.
Lending decisions may not reflect sensible economic decisions but rather reflect
incumbent politician’s desire to direct credit towards certain areas of the
economy (for political reasons). The worst-case scenario is credit extended on
favourable terms to political supports of the incumbent rather than the most
efficient use of funds.

Even with regulators (i.e. the central bank), political concerns may lead
politicians to interfere with the regulatory process this making regulation less
efficient.

2016 Test 2

QUESTION 1

Development Finance Institutions (DFIs) are an alternative financial

institution (including microfinance institutions, community
development financial institution and revolving loan funds). These
institutions play a crucial role in providing credit in the form of higher
risk loans, equity positions and risk guarantee instruments to private
sector investments in developing countries and are usually backed by
various government agencies. A crucial shift in focus in the last few
years for DFIs and Aid Agencies around the world has been to think
about ways to increase the involvement of the private sector in funding
development. The thinking is by doing so, it would allow aid funding to
be expanded (or leveraged) through financial markets. Below is an
actual transaction which recently occurred. (12 marks)

The Copperbelt Energy Corporation (CEC) transmits power to all mines

in Zambia’s Copperbelt region. The transmission infrastructure is CEC’s
primary asset dates to 1956, and has passed in and out of private and
government ownership. Re-privatization in 1997 marked the first time
the power supply to the mines was fully separated from the mines
themselves, and the official creation of CEC as it is today.

a) Recently, CEC applied for a $25 million CAPEX loan from Citibank.
Initial calculations from Citi estimated that the maximum income (fee
and interest) generated from the loan per annum is $476,000. The
analysts also estimated that the maximum change in the credit risk
premium for CEC over a year is 5%. If the minimum loan duration in 10
years and the internal benchmark return is 10%, show that Citi would
have rejected this application. Market yields are also 10%.

Net Income on Loan

RAROC=
−Duration∗∆ m
∗Loan Value
( 1+ R )

476,000
RAROC=
10∗0.05
∗25,000,000
(1+ 0.1 )

RAROC=4.2 %<10 %

b) It turns out that this loan was approved with the help of DIFs. Short
of providing the loan in full to CEC, come up with two different
strategies the DFIs may have used to structure the deal such that Citi
would approve a loan.

Making a risky project bankable amount to either:

i. Increasing the income from the loan (numerator)

ii. Decreasing the risk from the loan (denominator)

Therefore, the FDI could provide:

 A partial loan (reduces loan exposure) for Citi

 A partial guarantee (reduces risk exposure) for Citi

Solving RAROC for 10%, the DFI would provide 58.1% of the loan.

c) Given the goal of expanding (or leveraging) the total amount of aid
funding available, which of the two options that you have outline is
preferred?

The guarantee. This is because the DFI would commit zero funds so it can
potentially make many of these guarantees and increase aggregate funding.

d) Do DFIs expose themselves to any risks in your preferred deal

structure? If so, how would the DFIs manage this risk?

Yes, they are absorbing the risk for Citi. This is OBS so in the event losses occur,
the DFI will need to compensate Citi. The DFI needs to manage these contingent
credit risks but possibly setting aside capital against potential losses.

e) Do you see any problems/inconsistencies with this type of deal

structure and the stated goals of expanding aid funding?
Yes. The DFIs now expose themselves to these losses. Who wears these losses?
Taxpayers usually.

If DFIs set aside capital to buffer for losses, given these loans are so risky and
losses are likely, this implies an undoing of the ‘leverage effect’.

QUESTION 2

Read the article “What negative interest rates mean for savers and
investors” below and answer the following questions:

a) We learnt in class that banks are typically short-funded implying that

they are exposed to rising interest rates. Why then, do most
commentators believe progressively negative interest rates is a
problem for banks?

Because banks are worried that savers will pull their deposits out of the bank and
store it under their mattress.

If banks fear this, they will not pass on negative rates to depositors. Negative
rates will have a negative effect on profitability since banks do not charge
depositors to deposit money with them, however, the central banks charges
them for any excess reserves they have (which is likely to be a lot given no one
wants to borrow).

b) Given you answer in (a), is the risk to banks from progressively

negative interest rates a cash-flow risk or market value (discount rate)
risk? Explain your answer.

The problem appears to be a cash flow effect rather than a discount rate/market
value effect. The inability of banks to charge depositors to deposit while at the
same time having to pay to deposit reserves at the central bank implies a
negative cash flow effect.

The effect on market value equity seems to be an unlikely channel because

negative rates reduces the discount rate, and this reduction is greater for long-
dated assets so one might expect asset values to rise > liabilities resulting in an
increase in equity value.
So here, we have a situation where the cash flow effect works in the opposite
direction as the market value effect. The fact that market commentators have
stated negative rates are bad for banks implies that they must view the negative
cash flow effect to outweigh the positive market value effect.

c) What is the one other major risk you think that banks face due to
progressively negative rates? Be sure to provide justification for your
answer.

Liquidity risk. If banks pass on the negative rates to savers or if corporate

depositors get sick of paying to park money at their bank, we might see a drain
on deposits leading to a funding problem for banks.

Funding and liquidity risks might also arise in the wholesale funds market due to
the impact negative rates have on bank cash flows.
2016 Test 3

QUESTION 1

Ekspo is a NON-BANK financial (factoring) company located in Turkey.

Moody’s investor services (one of the major ratings companies) recently
downgraded Ekspo’s credit rating and also put it on a negative outlook.
You can read the ratings announcement below in Attachment 1. After
reading the ratings announcement carefully, answer the following
questions.

NOTE: What factoring is exactly is not important to the question, but a

description of the process is below in Attachment 2 for those who are
interested. Ekspo is essentially in the business of making short-term
loans, but since it is not funded by retail deposits, it is not considered
to be a bank and thus is NOT subject to standard bank regulations
(capital, liquidity, funding etc.). Since Ekspo is not a bank, it does not
have access to the liquidity services of the central bank in Turkey.

a) As best you can, summarize Ekspo’s balance sheet information (in a

balance sheet if you wish). Be as detailed as possible.

Assets:

 Cash = 0.3%
 Loans = 99.7%

Asset Notes:

 52.9% of lons are to only 3 industries (textiles, construction and financial

instututions)
 NPL have increased (2.8% in 2012 to 3.7% in 2014) mainly due to big
ticket exposures
- Implication is large concentration risk
- NPLs are increasing faster than industry average (11.4% vs. 5.4% for
industry)
  Coverage for losses (i.e. provisions) fell from 100% in 2013 to 92% in 2014
 Average asset maturity is 3 months

Liabilities:

 Equity = 30.9%
 Debt = 69.1%

Liabilities Notes:

 57% of the company’s liabilities had a maturity of 3 months and the

remaining 43% between 3 and 6 months
 Short-term, volatile funding

b) As best you can, summarize Ekspo’s off-balance-sheet information, if

any. Be as detailed as possible.

OBS Assets: There are no details of OBS assets.

OBS Liabilities:

 The amount of bank lines (lines of credit) is fairly ample compared with
usage (unused debt capacity)
- i.e. a source of liquidity
- They are OBS liabilities because the debt does not appear on the BS
until it draws down the commitment

 The three largest couterparties accounted for a high 76% of total bank
lines
- That is, off all the credit lines Eskpo has, more than 75% are from only
3 banks
- This means that if these 3 banks start having liquidity problems at the
same time as Eskpo, these credit lines will not be particuarly helpful
c) You are advising a client who has a significant proportion of his
portfolio invested in Ekspo, he has read Moody’s announcement and
says to you “I understand that declining profitability and rising costs
are bad, but I don’t understand why credit concentration matters, and
how is it related to the declining asset quality?” Help your client
understand by clearly explaining to him in as much detail as possible
what the issues are.

There has been a general upward trend in NPL from 2.8% in 2012 to 3.7% in
2014. Further coverage for losses (i.e. provisions) have fallen from 100% to 92%.
The announcement suggests that this has been due to ‘big ticket’ names which
suggests that concentration risk might be an issue.

The report notes concentration in 3 industries (textiles, construction and financial

instutitions) has increased from 40.7% to 52.9%. This is a heavy concentration
(lack of diversification). A downturn in any of these industries (which are said to
be particuarly volatile) will lead to higher NPLs and losses for Eskpo in contract to
if it were more diversified.

Example: assuming that NPL of 3.7% leads to 3.7% in charge-offs in these 3

industries, the hit to equity would be:

52.9% * 3.37% = 1.96%

or

1.96% / 30.9% = 6.3% of equity

Therefore, a lack of diversification increases risk exposure.

d) Your client now asks: “What does all this funding structure stuff
mean? I don’t understand why it matters where they raise funds from…I
learnt at university that all you need to do is match the maturities of
your assets and liabilities to immunize the balance sheet of a financial
firm against risk…and doesn’t the announcement say the maturities of
assets and liabilities are relatively similar?” Help your client
understand by clearly explaining to him in as much detail as possible
what the issues are.

The analysis mentiones that Eskpo’s loan portfolio (assets) maturity is about 3
months. It also states that its 57% of its debt (liabilities) is less than 3 months
and the remaining 43% of its liabilities is between 3 and 6 months maturity. That
is, the maturity of the assets vs. liabilities is about the same. This is a pretty
close maturity/duration match so interest rate risk exposures should be minimal.

However, maturity mismatches is different to liquidity mismatches of assets vs.

liabilities. Eskpo’s assets are short-term (3 month) loans. Ekspo has close to zero
cash and loans (assets) are illiquid compared to the short-term wholesale funding
(liabilities) used. More than half of its debt has a maturity of less than 3 months
which means there is a constant need to refinance (i.e. raise more funds). This is
a source of liquidity risk as each time Eskpo refinances, there is a chance that
there will be no funding made available. If this is the case, then Eskpo might be
forced to sell its assets at fire-sale prices resulting in losses to equity capital.

e) Your client continues: “OK, I see… so how is this related to asset

quality and credit concentration risk?” Help your client understand by
clearly explaining to him in as much detail as possible what the issues
are.
As mentioned above, Eskpo’s has a short maturity profile of liabilities (debt) so
there is a constant need to refinance. Each time that Eskpo enters the market,
there is risk that creditors will not provide funding.

Asset quality and concentration risk is very important in determining potential

future losses. Losses increase the likelihood defaulting. Creditors therefore care
about asset quality in determining the cost of funds but also whether or not to
extend funding at all. We noted above that NPL ratios have increased at a
greater pace than the industry average.

Another concern is that the coverage for losses (provisioning) is failling and so
equity is more exposed to losses. If equity is more exposed to losses then the
buffer for debt holders falls and thus their financial risk increases. Deteriorating
asset quality is exacerbated by the fact that credit risks are so concentrated in a
handful of volatile industries.

All else equal, deteriorating asset quality increases the likelihood that creditors
will so no when Eskpo tries to refinance. If this happens, they will be fored to sell
their assets since they have no cash for coverage. The fact that they are selling
poorly performing assets will also result in huge discounts and thus potentially
lead to insolvency.

f) Your client continues: “Hmmm…I think I understand, but why then

does Moody’s talk about concentration risk again in the funding section
of the report…what is this about, and why is this a risk?” Help your
client understand by clearly explaining to him in as much detail as
possible what the issues are.

The fact that Eskpo does not hold any cash for liquidity purposes can be off-set if
it has an alternate source of liquidity. One potential alternative is to have lines of
credit that you can draw down in the event of liquidity needs (noted earlier in
OBS liabilities section).

The analysis notes that there is concentration risk in terms of who and how many
banks are providing Eskpo with credit lines. It notes that the 3 largest
banks/counterparties accounted for 76% of total credit lines. The problem here is
that if these 3 banks get into liquidity problems at the same time as Eskpo, these
credit lines won’t be particuarly helpful.
This is a real issue. Suppose that the 3 banks providing the credit lines are all
Turkish and Turkey suffered a major economic shock leading to tightening of
credit and economy-wide liquidity problems. If the banks cannot provide the
promised liquidity when Eskpo demands it, they themselves are constrainted.

g) Your client continues: “I also learnt at university that lending

institutions are usually highly levered…you know…equity-to-assets
ratios of 3-5%...how come Eskpo has an equity-to-assets ratio of over
30%?” Help your client understand by clearly explaining to him in as
much detail as possible what the issues are.

Eskpo is not a bank. It is not funded by retail deposits, subject to regulations and
most importantly, does not have access to the liquidity services of the central
bank of Turkey.

Because Eskpo does not have access to the lender-of-last-resort function, it will
have big problems if it has unexpected liquidity demands. Eskpo can estimate its
liquidity and financing needs and do things like hold enough cash or make
arrangements with other banks to have access to large credit lines (as is the
case here). However, if there is a large negative liquidity shock, Eskpo cannot
simply go to the central bank to raise any short-fall in funds. If this happens, the
only and last line of defence against insolvency is how well capitalised it is.
Having more equity in place significantly reduces bankruptcy risk associated with
liquidty squeezes.

Market discipline might be forcing Eskpo to hold more capital. The fact that there
is no lender-of-last-resort means that it needs to provide its own insurance by
have a more prudent capital strucutre with less debt.

h) Your client continues: “I’m going to keep my holdings in Eskpo for

now and monitor their activity over the next 6-12 months, so that I
know what to look out for…what changes (and why) do you think Eskpo
should/will be making to improve its financial position and minimize
these risks moving forward?” Help your client understand by clearly
explaining to him in as much detail as possible what the issues are.
Eskpo could do some or all of the follwing. The key issues are concentration
risk/asset quality and liquidity risks so let’s think about how to fix it.

 If high and growing NPLs pose a direct risk AND increase liquidity risks, we
can do the following:
- Provision more
- Sell off NPLs today and wear the losses today but reduce liquidity risk

 Concentration risk
- Limit growth of loans in the industries it already has large exposures to
(i.e. textiles, construction and financial instututions)
- Diversify into other industries
- Sell loans made to highly exposed industries (could sell to other
factoring companies)

 Liquidity risk
- Diversify bank funding sources (i.e. set up lines of credit with different
banks)
- Increase cash holdings
- Issue longer dated debt (but this means increasing interest rate risk
exposure)
- Try to match liquidity profiles of assets and liabilities better

 Increase equity to increase the buffer against unexpected losses

2016 Final Exam

SECTION A – QUESTION 1

You are a bank analyst working for a large mutual fund. The fund
manager wants to increase her exposure to regional Australian banks
and has identified Bank of Queensland and Bendigo & Adelaide Bank as
the best buys of the regionals. The stock market and key financials she
has based this decision on (see below) appear to be nearly identical for
the two banks. She calls you in to help her get a better understanding
about these banks before making her decision. Suppose she wants to
allocate $10 million to purchasing regional bank shares.

Examine Attachments 1 and 2 (the 2015 annual reports for Bendigo &
Adelaide Bank, and Bank of Queensland, respectively) and write a
report to make a recommendation as to how to invest the funds in
these two banks. Gather any additional information necessary to help
you make your recommendation.

You report should:

 Be concise, she is a busy woman so does not want to read a long

report. That is, the report needs to be short but contain all the
relevant information.
 NOTE: please follow the instructions in the answer booklet
regarding length and formatting
 Identify the key challenges to sustained growth and risks facing
the economy and the banking sector in general
 Identify how the challenges/risks above impact on these banks
differently and why
 Provide some measure and comparison of risk/return

You report should NOT:

 Simply regurgitate parts from of the annual reports. Your fund

manager has already read the reports so telling her something
she already knows will get you fired. You are an analyst so
analyse!
 NOTE: citing data/information from the reports in order to do
additional calculations or to combine with other sources of

information so you can form and opinion is not considered

regurgitation.
Key Issues Facing the Australian Economy and Banking Sector:

1. Slowed/falling earnings growth

a) Slowing Australian economy due to the fall in commodities prices
(slowing China) which is slowing the demand for credit (why the RBA
dropped rates)

2. Rising credit risk

a) Loan losses are rising, linked to the slowing economy
b) Problems are in commercial and residential portfolios
c) Rising problems with mortgage fraud

3. Tighter regulatory oversight

a) Potentially increased the cost of funding
b) Reducing ROE (more of a severe problem for the big 4 banks)

4. Funding risks seem under control with the impending Net Stable Funding
Ratio. We need to focus on lengthening the maturity profile of wholesale
funding and expanding the depositor base

5. Two industries at the most risk:

a) Real Estate: a lot of discussion about property being overvalued and
the problems seem the most severe in Melbourne and Sydney.
Indirectly linked to China to the extent that Chinese demand has
contributed to rising prices
b) Mining: the mining sector is slowing which impact loans directly linked
to mining but also loans to businesses that support the mines as well
as individuals whose income is derived from the mines. This is linked to
Chinese demand for commodities

(5) is the main one.

Each of the banks have different exposures and strategies. While their numbers
look very similar, their risk exposures and operations are totally different (need
to state how the above problems relate to each bank individually).
Key Differences Between the Two:

1. Concentration risks differ

a) Geographic: BoQ is more concentrated in QLD while Bendigo is
concentrated in VIC. BoQ’s concentration risk is more severe
b) Industry: BoQ is more exposed to mining than Bendigo. Bendigo is
more exposed to real estate than BoQ

2. Funding differs
a) BoQ is more reliant on wholesale funding
b) Bendigo has been growing its depositor base

3. Growth strategies differ

a) BoQ:
i. Through acquisitions
ii. Increasing real estate exposure via mortgage brokers
b) Bendigo:
i. More organic growth. Leveraging existing relationships and
increasing real estate exposure through new products
ii. Investing in an advanced internal model for estimating credit
risk. If approved by APRA, can slash the average risk-weight of
the banks assets and free up a lot of capital so the bank can
aggressively lend

Overall, the biggest risk for the banks is concentration risk (regional banks are
normally like this). Given the different exposures, which bank will succeed
depends on which of the potential economic shocks come to fruition.

 Mining bust vs. real estate bubble burst

One technique is using the big 4 banks as a benchmark for geographic diversity
to estimate the concentration risk of the other banks. Could come up with a
weighting scheme across the two banks such that you minimise deviations from
the big 4 benchmark. You could then recommend the manager split the $10m
according to those weights.

SECTION B – QUESTION 1

With concerns over global warming in recent years, many ‘green’

initiatives have been proposed. One such initiative is Green Bonds. The
basic idea behind green bonds is to raise cheaper funding for green
projects, that is, projects that reduce emissions or develop new
technologies and alternative energy sources. Attachments 3A and 3B
provide information about World Bank Green Bonds. World Bank Green
Bonds were the first of their kind to be issued. Attachment 3C is an
article detailing the issue of one of the very first ever private Green
Bond issues (by Deutsche Bank), i.e. the PACE bond. Read these
attachments carefully and answer the following questions.

1. Are these green bonds examples cash or synthetic transactions?

Justify your answer.

Cash as we are trying to raise funding for green projects (not just transfer risk).

2. Consider the World Bank Green Bonds.

a. Where does the underlying risk and return come from?

The risk and return comes from the green projects in the World Bank portfolio.

b. From the investor’s point of view, who has made a promise of

repayment?

The World Bank.

c. Can the issuer (i.e. World Bank) default on Green Bonds?

Explain your answer.
Yes. Since the World Bank made the promise, it can break it by defaulting. Similar
to an SIV

d. The World Bank’s credit rating is AAA and the World Bank
Green Bonds are also issued with a AAA rating. However, the
World Bank invests in extremely risky development projects such
as those highlighted in Attachment 3A and 3B. How then can the
World Bank maintain such a high credit rating? Can you say
anything about what the likely funding (capital) structure for the
World Bank might be?

The World Bank does not have much debt. Most of its funding comes from
member nations governments across the world and has a backstop from them
too. Like an emergency LoC.

e. Draw and label a diagram of the flow of funds, risk and return
from the ultimate user of funds to the Green bond investor.

3. Consider the Deutsche Bank Green (PACE) Bonds.

 a. Where does the underlying risk and return come from?

Households doing the upgrade.

b. From the investor’s point of view, who has made a promise of

repayment?

Since payments on these loans are collected from future rates (taxes), these
households can default if they fail to make payments on their future taxes.

c. Can the issuer (i.e. Deutsche Bank) default on these PACE

Bonds? Explain your answer.

No, DB has not made any promises.

d. Deutsche Bank’s credit rating is A. However, the PACE bonds

were issued with a AA (higher) rating. How is this possible?

DB has not made the promise so their credit rating is irrelevant. The credit rating
is based on the likelihood of default of the pool of loans to households doing the
upgrades. The loans are secured by the property (collateral) so can attract a
higher rating.

e. Draw and label diagram of the flow of funds, risk and return
from the ultimate user of funds to the Green bond investor.
SECTION B – QUESTION 2

Read Attachment 3D. This case study is an example of how the

International Finance Corporation (IFC) which is an arm of the World
Bank works with private banks to provide loans to extremely poor
individuals in developing countries (who would otherwise not have
access to finance). In this case the IFC is working with Nib International
Bank to provide loans to coffee farmers in Ethiopia. The IFC and Nib
entered into a risk-sharing agreement whereby the IFC has set up a
$10m facility to cover any loses up to 75% of loans made by Nib to
farming cooperatives. To date, there have been 62 loans made to
cooperatives benefiting more than 45,000 farmers.
1. Is this a cash or synthetic transaction? Is the transaction, fully,
partially or un-funded?
This is a partially-funded synthetic transaction.

It is partially-funded because NIB is insured for 75% of defaults (not 100%) so is

still exposed to the top 25% of the portfolio. There is no note/debt issue by the
IFC to fund the guarantee. The facility is simply funded by the IFC.

It is a synthetic transaction because NIB is getting ‘insurance’ from IFC rather

than selling the loans.

2. What type of instrument can be used to structure such a risk-sharing

facility?
A CDS or similar derivative contract.

3. Draw and label a diagram of the flow of funds, return and risk
between the
ultimate user
of funds, Nib
and the IFC.

4. The details of the facility are not clear. In particular, we cannot tell if
the IFC guarantee is 75% per loan or 75% of the loan portfolio. For the
purposes of this question, assume that Nib has made 60 loans valued at
$200,000 each. Consider the following scenarios (1) 60 loans lose 75%;
and (2) 45 loans lose 100%
a. Calculate the loss to the loan book under each case in the
absence of the guarantee
(1) Loss = (60 * 200,000) * 0.75 = $9,000,000

(2) Loss = (45 * 200,000) = $9,000,000

b. Calculate the loss under each case to Nib if the IFC guarantee
was 75% per loan
(1) Loss = (60 * 200,000) * 0.75 = $9,000,000
Insurance = (60 * 200,000) * 0.75 = $9,000,000  $0
total loss

(2) Loss = (45 * 200,000) = $9,000,000

Insurance = (45 * 200,000) *0.75 = $6,750,000 
$2,250,000 loss

c. Calculate the loss under each case to Nib if the IFC guarantee
was 75% of the loan portfolio
(1) Loss = (60 * 200,000) * 0.75 = $9,000,000
Insurance = (60 * 200,000) * 0.75 = $9,000,000  $0
total loss

(2) Loss = (45 * 200,000) = $9,000,000

Insurance = 45 / 60 = 75% of total portfolio  $0 loss

d. Which scheme does Nib prefer?

NIB would prefer the portfolio guarantee (insurance for 75% of the loan portfolio)
because under both scenario (1) and (2), they are covered for 100% of their
losses.

e. Suppose the guarantee is 75% of the loan portfolio and

suppose 0% of the loans Nib has made thus far have defaulted.
The facility is nearing maturity. If you were the CEO of Nib, what
 could you do to extract as much benefit from the facility as
possible in the remaining time?
I would start extending loans to riskier farms with higher yields since I don’t bear
the cost of risk taking, I might as well extract as much as I can from the IFC.

SECTION C – QUESTION 2

Read Attachment 3E “Goldman Sachs Hawks CDOs tainted by credit

crisis under new name”. These new products called Bespoke Tranche
Opportunities (BTOs) allow investors to tailor the securitization
however they want, but the two key dimensions are: (1) what credit
risks are included in the pool of reference entities; and (2) how the deal
is structured (tranched). Banks have learnt one thing since the crisis,
and that is, unfunded issues can be very problematic, and so most of
these deals appear to be fully funded. Using the information in the
article and any other information you may find about BTOs (HINT: do
not waste too much time looking, there is not much as these are too
new) to answer the following.
Consider the following different parties: the borrowing firms (F), the
lenders who want credit protection (L), the “speculators” (S), the
intermediary i.e. Goldman Sachs (GS), and the investors who buy BTOs
(I).

1. In any given deal of this nature we know that we need at least two of
the above counterparties to take part, but of course, there can be many
more than two. For the following three scenarios, please draw and label
a diagram of the flow of funds, risk and return from the ultimate user of
funds to the BTO investor:
a. Ethical Goldman Sachs creates BTOs to hedge insurance written
for clients who have credit exposures to various firms.
 b. Ethical Goldman Sachs creates BTOs to hedge insurance written
for clients who do not have credit exposures to various firms.

c. Unethical Goldman Sachs creates BTOs to bet against its own

clients
2. Now consider that you are a hedge fund manager searching for yield
and think that these BTOs are a great option. You approach Goldman to
strike a deal. You want to create two new funds to invest in BTOs, one
fund that uses structural leverage to capture yield and the other will
use financial leverage to increase dollar profits on the spread pickup.
Goldman offers you 1000 different credit risk exposures to choose. You
are allowed to choose up to 100 to include in your securitization pool.
Finally, assume that except for the credit exposure and the return (i.e.
credit default swap spread) offered on each contract, the contracts are
all similar in other dimensions (i.e. same notional value, credit event
trigger, maturity etc.)
a. How would you go about choosing which 100 reference entities
to include in the pool? What are you looking for? What
information might you need? Outline step by step how you would
do this.
The HF wants to pick the right credit risks. To do this, the HF needs some way of
estimating the credit risks associated with each of the 1,000 entities. For
example, you could build a quantitative model to predict default using historical
data on loans that have been issued to various firms. You could regress loan
performance (default/no default) on various predictors to predict the default
probabilities.

Factors that might influence default include:

1. Financial ratios from historical accounting statements

2. Geographic area
3. Industry
4. Economic factors

Once the HF is confident it can predict the likelihood of default, it would then
compare this with the return (CDS spread/premium) on the contracts for each
entity. You should target the highest return per unit of credit risk.
You would also need to consider the correlation of credit risks (VERY DIFFICULT).
If default is clustered within industry or geography, you might want to diversify
along these dimensions.

b. Is the process in (a) more important for your structural

leverage fund or your financial leverage fund? Explain your
answer.
Structural leverage is a way to increase returns by slicing up the pool of CDS
contracts into tranches to increase yield. The further down the payment waterfall
– the higher the yield (high risk = high reward).

Using structural leverage implies buying the residual tranche or something

similarly far down the payment waterfall (e.g. even a AAA in a JPM Bistro
Structure has a lot of structural leverage as it is further down the waterfall).

The process in part (a) is more important for the structurally leveraged fund
since this is the first loss tranche, choosing the best credit exposures is
extremely important.

c. Suppose that you can tranche the issue into three slices: Senior
(AAA), Mezzanine (BBB) and Residual. Which tranche do you buy
for your structural leverage fund?
Residual (see answers to b).

d. Suppose you are choosing between the following distributions:

(1) 60% Senior (AAA), 20% Mezzanine (BBB) and 20% Residual; OR
(2) 60% Senior (AAA), 35% Mezzanine (BBB) and 5% Residual.
Which would you choose if you are trying to maximise yield for
your structurally levered fund? What is the risk-return trade-off
 for you under each structure? What is the major risk(s) that your
structural leverage fund faces?
Choose the second option because it has high structural leverage and thus
higher yield. Credit risk is the biggest problem here.

e. Which tranche do you buy for your financially leverage fund?

Does it matter whether you choose structure (1) or (2) from above
for your financially leverage fund? Where will you likely raise debt
financing from? What is the major risk(s) that your financially
leveraged fund faces?
Senior AAA tranche – it doesn’t really matter which one you choose but given I
am setting up 2 funds and one is using structural leverage; I would opt for the
second option and raise funds in the short-term money markets.

I would use either repo financing (using the AAA tranche as collateral) or issue
short-term ABCP. Suppose I could borrow at LIBOR – 20bps and the AAA tranche
paid LIBOR + 30bps, I would pick up a 50bps spread per dollar borrowed. Then I
can lever up 20x-25x to increase dollar profits to increase return on capital.

The issue of credit risk is less of an issue compared to the structurally leverage
fund as I am holding the top 60% of credits. However, there is a constant need to
refinance so if short-term money markets dry up there could be solvency issues.

I am a shadow bank!

3. Goldman Sachs closes the deal with you buying two tranches from
the three created. What do you suppose Goldman will do with the left
over tranche?
REPACKAGE IT AND SELL IT AS A BTO2!

Goldman could create these by taking all of the unwanted tranches from other
deals and packaging them up into a portfolio to do another round of
securitisation.
2017 Test 1

QUESTION 1

Tables 1 through 3 in the attachments are excerpts from Westpac’s

2016 annual report. Examine these tables and answer the following:

a) Using the 2016 numbers, rank the industries from least risky to
riskiest from Westpac’s point of view. Explain your answer.

Need to use the table that contains information on provisions. This tells how
much WBC expects to lose from every dollar loaned to a given industry.
b) Given what we have discussed in class regarding the performance of
various industries reported in the press, do you find this ranking
surprising? That is, has media reporting suggested any industry as
being particularly risky, and is this different from Westpac’s ranking?

The media has talked a lot about the risks of an over-heated property market due
to the high and increasing level of household debt.

These factors are very important in determining potentially losses to WBC from
retail lending. Therefore, one might expect to see retail lending (mortgages) to
be ranked as riskier. On face value, it is surprising that this category is ranked as
the least riskiest.

c) Can you reconcile any differences in parts (a) and (b)? Explain your
answer.

Loan loss provisions are made based on a bank’s view of the potential
for future losses (expected losses). Expected losses are determined by the
probability of loss (riskiness of a loan) and the loss given default.

The media reporting on centres on risk or probability of loss but says little about
the loss given default. Retail mortgages are secured so in the event of default
banks can sell the house and recover a lot of the loan through collateral.

Therefore, even if the probability of loss is high-ish, the loss given default is very
low so the expected loss is still low compared to other types of loans that are
unsecured or secured by collateral which is harder to sell off.

d) What do you think the single most important factor in determining

Westpac’s rankings is, and why?

It appears whether or not a loan is secured with collateral and the quality of the
security is the most important factor in determining the ranking.
e) Now examine the time series between 2012 and 2016. Which
industry has become the riskiest over this period according to Westpac?
Can you explain what underlying economic factors contribute to
Westpac’s view?

Again, looking at Table 3 is the relevant table. We can rank the

industries according to the percentage change in loss provisions as a
faction of lending and get the following ranking:

Industries which have become riskier receive more provisioning over time (i.e.
WBC expects to lose more per dollar lent). These industries are manufacturing
and mining. Mining is a clear outlier with a massive increase in the provisions to
loans ratio between 2012 and 2016. The underlying factor contributing to this is
the recent sharp decline in commodity prices after many years of record highs
and the mining boom. The fall in commodity prices subsequently reduced the
profitability of the mining sector and increases the change that loans to the
sector will make losses.

f) Given your answers above, name three (3) important factors Westpac
include in their modelling of future loan losses.

1. Whether or not the loan is secured

2. Value and quality of collateral
3. Risks that impact the probability of default (e.g. household debt, real
estate prices)
4. Macro factors (e.g. commodity prices)
QUESTION 2

On November 8 2016, Prime Minister Narendra Modi of India, in a

sudden television address to the nation, announced that Rs 500 and Rs
1,000 denomination notes are being withdrawn from midnight (known
as demonitization). He said that such notes will become “mere paper”.
You can read more about his unexpected announcement below in the
article “Rs500 and Rs1,000 notes pulled out of circulation immediately:
PM Narendra Modi”, then answer the following:

a) What kind of economic shock did the citizens of India experience on

November 8 2016? Explain your answer.

This is an unexpected liquidity shock. Anyone holding these notes are suddenly
without a liquid asset (cash) that they could use for everyday transactions.

b) Is this shock idiosyncratic or systematic? Explain your answer.

Systematic. Everyone experienced the same shock.

c) The Indian government also closed the banks on November 9 and

shut down ATMs for a few days. Why do you think they did this? Do you
think this was a sensible response by the government?

This makes sense. If people now have no cash and need it, then you would
expect withdrawals to increase. A sudden surge in demand can be a problem for
banks because they hold so little cash.

One obvious solution is to close banks and ATMs.

d) Of the many important functions banks play in the economy, which

one in particular was disrupted by demonitization and its associated
policies?

The liquidity creation role of banks was hampered by this policy.

Consumers who hold deposits to hedge against liquidity shocks found their
hedge ineffective when banks and ATMs closed.
e) Do you think that demonitzation affected metropolitan or rural areas
more? Explain your answer.

Rural. The article states that electronic funds transfers/purchases will be

unaffected. Since metro areas are more likely to facilitate electronic purchases,
the liquidity problems will be worse in rural areas as they may rely solely on
physical access to banks.

Rural banks are also more likely to be underbanked (i.e. have no access to formal
banks) so are more likely to be hoarding cash. This change will impact these
banks disproportionately.

f) Can you think of a way for the citizens of India to get around the
potential economic problems created by demonitization?

Money is disappearing.

If there is no money to exchange for goods, the people can resort to trading in
physical goods and services (i.e. barter).

g) What do you think the impact on investment in India will be in (i) the
short-run; and (ii) in the long run as a result of demonitization? Explain
your answer.

Short-Run: the liquidity shock will likely dampen investment. Withdrawals will
reduce the funds available to be lent out (reduce the amount of liquidity banks
can create).

Long-Run: over time, deposits will grow because consumers can deposit old
notes at their banks for no cost. This may result in more lending and investment
since banks have a larger asset base.
h) You are tasked by the Indian government to measure the impact of
demonitization on investment at the bank level. Can you come up with a
financial ratio that you can use to compare bank performance in this
regard? Explain your answer.

Change in Loans / Change in Deposits

Higher values imply more liquidity creating and lending which drives investment.

2017 Test 2

QUESTION 1

Exhibit 1 is taken directly from the 2016 Annual reports for two
Australian banks: the ANZ and Westpac. Study Exhibit 1 and use the
figures for the average interest rate risk exposures to answer the
following questions.

a) Which bank has a larger interest rate risk exposure, related to cash
flow risk? Justify your answer.

ANZ. For the same +1% movement in interest rates, ANZ experiences a larger
impact on its NII as a % of NII.

b) Which bank has a larger interest rate risk exposure, related to

market value risk? Justify your answer.

WBC (in absolute terms). WBC has a larger exposure ($39.4m vs. ANZ’s $36.6m
reduction in net worth). However, we cannot say which bank has a larger
exposure without more information such as information about the size of the
bank or the size of the equity base. We would need to scale these numbers by
the size of the equity or asset base.

c) Write down in a concise sentence how to interpret the repricing gaps

for each of the banks?

ANZ has a positive repricing gap. For a +1% change in interest rates, NII
increases by 0.40%.

WBC has a negative repricing gap. For a +1% change in interest rates, NII
decreases by 0.23%.

d) Without any additional information and holding other factors

constant, which bank do you think is more reliant on deposits? Justify
your answer.

This depends how one views deposits. That is, should they be considered as rate
sensitive liabilities over the 12-month horizon?
Over a 12-month horizon, deposits (or a good fraction) are most likely to be rate
sensitive. This is because, even though most deposits are core and do not move
in the short run, over 12 months, have the potential to “run off” if rates in the
economy increase. This potential run-off means that if banks want to maintain a
stable source of deposit funding, they will have to pass on the interest rate
increase to depositors.

Other things equal, a larger deposit base increases the value of rate sensitive
liabilities and thus reduces the repricing gap. Therefore, since WBC’s repricing
gap is lower than ANZ’s I would guess that WBC has a larger deposit base.

e) Without any additional information and holding other factors

constant, which bank do you think is exposed to more liability side
liquidity risk? Justify your answer.

Liability side liquidity risk comes from unexpected cash demands from either
deposits or wholesale funding.

From (d) we established that WBC has a larger deposit base. Accordingly, is less
reliant on wholesale funding. The answer then depends on whether one feels
that wholesale funding is less or more volatile than deposit funding. As discussed
in class, wholesale funding is much more volatile than deposit funding, especially
during times of market stress. This is even more true given Australian banks
have access to a deposit guarantee. Thus, ANZ, being more reliant on this type
of funding suffers higher liability side liquidity risk.

f) Without any additional information and holding other factors

constant, which bank do you think is exposed to more asset side
liquidity risk? Justify your answer.

Asset side liquidity risk comes from unexpected cash demands on the asset side
(i.e. drawdowns of contingent assets like loan commitments). While we do not
know the size of the commitments that each bank has made, one thing that we
have discussed in class is how in the presence of deposit insurance, the cash
demands on the asset side and liability side are likely to be negatively
correlated. That is, during times of market stress, it is likely that households and
firms drawdown commitments, but at the same time deposits are likely to flow
into banks (flight to safety). Thus, banks can use the deposit inflows to fund the
commitment drawdowns. So banks can use deposits to hedge asset side liquidity
risk. Thus discussion implies that ANZ being more reliant on wholesale funding is
exposed to higher asset side liquidity risk.

g) Without any additional information and holding other factors

constant, which bank do you think is more likely to satisfy the net
stable funding ratio requirement from APRA? Justify your answer.

Deposits are viewed as more stable sources of funds (and are encouraged by
APRA). Especially in the presence of deposit insurance. This, since WBC has a
larger deposit base, it is more likely to satisfy this ratio.

h) Without any additional information and holding other factors

constant, which bank do you think is more likely to satisfy the liquidity
ratio requirement from APRA? Justify your answer.

The liquidity coverage ratio is the ratio of HQLA to an estimate of net outflows
under scenario conditions similar to a crisis. During a crisis, it is typical that there
is a withdrawal of wholesale funding. There is also potential for some deposit
drains. However, as pointed out above since under the presence of deposit
insurance (as is the case for Australian banks), deposits are much more stable
during times of stress. Thus the net cash out flow would be less for a bank with a
larger reliance on deposits. Other things equal, this implies that WBC is more
likely to satisfy the LCR.

An alternative answer could be that since the stock of HQLA is insufficient in

Australia, no bank can satisfy this requirement without the committed liquidity
facility set up by the RBA.

QUESTION 2

Read the article in Exhibit 2 and combine it with information in Exhibit 1

to answer the following questions.

a) We learned in class that rising interest rates are usually bad for
banks because it results in a reduction in net worth. Explain why this is
the case? Is this the case for ANZ and Westpac? Why then does the
article claim rising interest rates are good for bank net worth? Justify
your answer.

As discussed in class, banks are typically short funded which means that the
maturity of assets exceed that of liabilities. As rates rise, the value of both assets
and liabilities fall, but since the discounting is heavier on assets the fall in asset
value exceeds the fall in liability value. Thus net worth must fall.

Discount Rate ↑ Asset ↓ > Liability ↓ due to higher xn (heavier

discounting)  Equity ↓

Discount Rate ↑ Equity ↓ due to A = L + E

The discussion above is under ceteris paribus conditions, i.e. all other things
equal. We know however that all other things rarely remain equal. Since the
value of as asset or liability is simply the discounted sum of future cash flows,
the above reasoning assumes that future cash flows stay constant, and we are
increasing the discount rate. Of course, if cash flows increase sufficiently, the
positive cash flow effect might outweigh the discount rate effect and so value
may actually increase. The article explicitly says that rising rates were expected
to “favourably impact bank earnings.”

b) The article says: "A rise in short-term interest rates is expected to

favourably impact earnings, through a higher net interest margin,
which should lead to higher stock prices." Is this statement inconsistent
with the interest rate exposures for ANZ and Westpac observed in
Exhibit 1? Justify your answer.

No not necessarily, as above the actual impact on value depends on the relative
size of the cash flow versus the discount rate effect. It is possible that value
increases if the CF effect is > the discount rate effect. In the case of ANZ we can
see that rising rates are associated with a positive cash flow effect however this
effect obviously does not dominate the discount rate effect for value to fall with
rising rates.

Therefore, it depends if CF effect > discount rate effect.

c) The article then says: "Using each bank's assumption for the net
interest revenue increase resulting from a 100 or 200 basis point
increase in interest rates we calculate that the top 20 banks would on
average see an increase in net interest revenue equivalent to 7.1% of
2017 estimated earnings." For the banks that this article is referring to,
do you think the interest rate risk modelling is done so using the
repricing model (i.e. as in Exhibit 1)? Justify your answer.

The article also says: “higher interest rates are expected to improve bank
margins by improving lending rates” and "A rise in short-term interest rates is
expected to favourably impact earnings, through a higher net interest margin,
which should lead to higher stock prices,"

In other words, spreads are increasing: lending rates are increasing but not
borrowing rates. At least in the short run. However, the repricing model assumes
parallel shifts in the yield curve—that is, both borrowing and lending rates
increase by the same amount.

So there are two possible conclusions: (1) the banks in the article are not using a
repricing model to estimate the impact on NII; and (2) the banks in the article do
use a simple repricing model however the analysts quoted in the article have
incorrectly interpreted and thus misused the estimates from the banks (because
in the LR the borrowing and lending costs should be similar).
2017 Test 3

QUESTION 1

From the 2016 annual reports of The Commonwealth Bank of Australia

(CBA) and Westpac, we can obtain the following information regarding
home loans:

CBA has a stock of home loans valued at $409,452 million with total
provisions for non-performing loans of $193 million. On the other hand,
Westpac holds home loans valued at a total of $418,729 with total
provisions of $57 million. Use this information to answer the following:

a) Australians prefer variable rate mortgages. In fact, only about 12-

15% of all home loans have been fixed in the last 25 years. Given what
we know about the future direction interest rates in Australia, and
assuming other factors between CBA and Westpac are the same, which
bank do you think has originated more variable rate loans? Explain your
answer.

Discussed in class: interest rates are expected to rise

Fixed rate mortgages hedge against interest rates increasing. However, variable
rate mortgages pass on interest rate risk to the borrowers. Banks are therefore
less exposed to interest rate risk on variable loans.

In saying this, this does not make variable loans less risky. This is because, when
interest rate increases are passed onto the consumer, they are more likely to
default. Thus, the reduction in interest rate risk is offset by an increase in credit
risk for the bank.

Banks manage credit risk, in part, by provisioning for expected losses. Higher
provisions imply a higher expected loss. If borrowers are exposed to interest rate
risk, they are more likely to default which increases expected losses and thus
increases provisions.

CBA: 193/409,452 = 0.0004714

WBC: 57/418,729 = 0.0001361

Therefore, CBA has a higher provision/loan ratio which implies more variable rate
loans.

b) Is duration matching a more effective method for controlling interest

rate risk for the CBA or for Westpac? Explain your answer.

Higher variable rate loans make duration matching more difficult. Thus, duration
matching would be less effective for CBA given a).

This is because the duration model assumes constant cash flows. Recall the
duration relation between price changes and interest rate changes is derived
from the price of a FI product which, by definition, has fixed cash flows. Variable
rate loans’ cash flows change with interest rates so it violates this assumption.

The duration model works better for banks with balance sheets that look like FI
portfolios (i.e. banks with more fixed rate loans).

c) Suppose that interest rates change via parallel shifts in the yield
curve. In addition to matching the duration of assets with the (leverage
adjusted) duration of liabilities, what other measures must these two
banks take to minimise interest rate risk exposure? Are these additional
steps more challenging for CBA or Westpac? Explain your answer.
Matching the duration of assets with the (leverage adjusted) duration of liabilities
accounts for market value effects that occur due to interest rate changes – that
is, discount rate effects, holding cash flows constant (as above).

However, as we have already discussed, cash flows change with interest rate
changes with variable rate mortgages. Thus, in order to minimise interest rate
risk banks also need to try to keep cash flows constant when interest change. To
do this, a bank will need to match cash flowing in and with those flowing out
when rates change. For example, if rates increase, the banks will have to match
the increase in cash flows from the assets with the increase in outflows from
higher liability payments.

Since CBA has more variable rate loans, its cash flows are more sensitive to
changing interest rates and thus this process will be more challenging for CBA.

QUESTION 2

Recall from class that the FICO scoring system is the most widely used
credit risk scoring system in the US for retail lending. Typically, higher
FICO scores are associated with lower credit risk and result in better
borrowing terms for the customer. Read Exhibit 1 “Will change to credit
reports change how banks vet borrowers” and answer the following
questions.

a) Do you think that this change is a good idea? Explain your answer.

On one hand, observers note that tax lien and civil judgment information is
sometimes attached to the wrong consumer’s file due to a lack of identity
information. This inaccuracy was the catalyst for the change in the first place.
Using inaccurate information may unfairly penalise some borrowers and thus
should not be used.

On the other hand, it can be argued it’s important for lenders to know if
consumers have had a lien on their taxes or a civil judgment against them,
because their risk of defaulting on a new loan is much higher (since this reduces
their disposable income). That is, it is a bad idea to remove anything from a
credit report that's predictive of future credit risk and is accurate.

Overall, the issue is whether the inaccuracy is severe enough to make using the
information pointless and unfair. If only a small fraction of the population is
impacted, from a credit scoring perspective, the improvement in credit scoring
one gets from including the information outweighs any unfair treatment of
prospective borrowers.

b) Will this change result in an increase or decrease in average FICO

scores? Explain your answer.

All else constant, this change will increase FICO scores. The information
discussed is reflective of bad credit risk (tax liens and civil judgements reduce
the amount of disposable income available to service debt payments  higher
chance of default). Its removal will mean a credit score will contain less negative
information, leading to an increase in the score.

c) Holding other factors constant, in the context of the RAROC model,

do you think that more loans will be approved after this change?
Explain your answer.

RAROC = Loan Income / Loan Risk

If RAROC > benchmark rate, approve loan.

An increase in FICO scores equates to a reduction in measurable credit risk (i.e.

loan risk) this leading to an increase in the RAROC. All else equal, you will
approve more loans.

d) Given your answers above, has credit risk increased or decreased?

Explain your answer.

The changes only impact how credit is measured. Nothing else. The underlying
risk still remains as risk doesn’t just disappear. Accordingly, the credit risk hasn’t
changed at all.
e) If you are operating a bank without capacity to build and update your
own credit risk model (and thus reliant on the FICO system), how would
you update your loan underwriting (i.e. screening and pricing) to reflect
this change?

I would improve my screening and monitoring of loan application or somehow

discount observed FICO scores.

To do this, I would need to reprice loans. For example, if a FICO score of 600 was
charged 5%, I may reprice it to 5.5%. Alternatively or in addition, I may request
more information from the borrower at the time of application or more frequently
monitor the borrower.

f) Given your answer in (e), in the context of the RAROC model, what
changes will you make, if any, to the parameters in the model? Explain
the answer.

Should increase the benchmark/hurdle rate required to approve loans of a given

FICO score (measurable risk).

Since the underlying risk has not changed, if we were prepared to make the loan
prior to the regulatory change, then any adjustment we make to the parameters
in our model should result in us still wanting to approve the loan after the
regulatory change.

Thus, if we increase the hurdle rate, then we should find a way to increase the
RAROC. We can do this by increasing the numerator (i.e. charge a higher rate of
interest) or decrease the denominator (i.e. loan risk). If we think of loan risk =
duration x measured credit risk (i.e. FICO) x loan amount, for any given FICO
score, we can reduce the duration (i.e. increase monitoring) or ration credit
(increase screening).

2017 Final Exam

QUESTION 1
Read Attachment 1 “ANZ capital ratio trimmed after APRA review” and
answer the following questions.

a) The article says “ANZ said the 26-basis-point erosion of its capital
ratio due to the APRA review translated to an average risk-weight for
its domestic mortgage portfolio of a little over 28.5 per cent”. Explain
what this statement means and what the implications for ANZ are if it is
aiming to keep is capital ratio fixed?

Under Basel III, two of the regulatory ratios are calculated as the amount of
capital banks hold relative to risk-weighted assets.

A higher ratio can result from higher levels of capital of lower risk-weighted
assets. Here the article says that the ratios fell and later the article states “more
capital will have to be held against mortgage portfolios because of the higher
risk…” which implies that risk weights on mortgages must have increased to “a
little over 28.5 per cent” leading to a fall in regulatory ratios by 26 basis points.

b) What does the article suggest the impact of the APRA review will be
on mortgage pricing? What are the implications for mortgage margins,
bank profitability and shareholder returns as a result of the APRA
review.

The article suggests that to avoid regulatory capital ratios from falling that ANZ
will likely need to raise additional capital. This will increase its costs of funds and
so ANZ will likely reprice its mortgage products (i.e. increase the cost of
mortgages) in an attempt to preserve margins and profitability.

However, the article also says that this strategy is limited given the enhanced
competition in the sector and so margins and profitability may well fall as a
result. Other things equal, if profitability falls then so does shareholder returns.

c) If you are the CEO of ANZ and maintaining current profitability

(growth) was an imperative, what changes to your lending practices are
you likely to take?

Start shifting the lending portfolio into riskier parts of the economy (high risk,
high reward).
For example, if mortgage risk weights are attached to the Loan to Value Ratio
(LVR), then for two loans of equal value and the same LVR, ANZ will hold the
same amount of capital to support either loan. The ANZ could then choose to
fund the riskier loan of the two and charge a risk premium.

Alternatively, ANZ may direct lending to riskier industries where regulators have
yet to adjust risk weights.

QUESTION 2

Study Attachment 2A-2C (ME Bank’s balance sheet from its latest
annual report) and Attachment 2D (ME Bank’s latest APRA Regulatory
Disclosure) to answer the following questions. Note: the balance sheet
is in thousands and the regulatory report is in millions.

a) What is the growth rate in ME Bank’s total asset base between 2013
and 2014?

24.4%

b) What is the growth rate in ME Bank’s investment assets between

2013 and 2014?

70.2%

c) What is the growth rate in ME Bank’s loan book base between 2013
and 2014?

18.9%

d) Has growth been stronger in the investment book or loan book?

Which of the investment assets has seen the most growth? Why do you
think that growth has been strongest in the areas that you have
identified?

Investment book. Growth in the investment book has been strongest in

Treasuries and then corporate floating. This massive growth is because of the
new regulatory rules around asset liquidity. Specifically, banks now have to hold
a stock of HQLA sufficient to cover a 30-day net liquidity drain. This is known as
the LCR. The principle form of assets used to meet this regulatory requirement
are government securities and other high-grade debt with liquid markets. Some
corporate debt is also included.

e) Which type of loans has seen the most growth? Why do you think
that growth has been strongest in the area that you have identified?

Growth has been strongest in commercial and then residential home loans. Note
however that home loans dwarf the other categories in comparison. So what is
happening here matters a lot as this is where ME needs to raise funds to support
its activities.

There are 2 reasons why growth has been so strong here.

1. First, super low interest rates

2. Second, ME banks has been aggressively growing their interest-only and
investor residential mortgage business segment

We have covered several articles that have talked about this strategy during the
semester.

f) Classify the liabilities into the following groups: (1) retail customer
deposits; (2) all other unsecured borrowings; (3) secured borrowing; (4)
equity. How has ME Bank funded its expansion over the last year? Do
you see any potential problems with how ME bank is funding its
expansion? What risks does this pose to ME bank?

Secured (wholesale funding) has been growing the fastest. So this is the principle
source of funds for ME bank’s recent expansion. Essentially, this means that ME
bank is making loans and then securitizing these loans to raise more funds to
issue more loans.

The risk the MA bank faces is that it now relies on the securitization market to
fund its activities. Should this market dry up, like it did in the lead up to and
during the GFC then ME banks will not be able to fund its operations and will run
into liquidity problems.
These wholesale liquidity problems might lead to other problems, like a run on
ME deposits and ultimately failure. This is exactly what happened to Northern
Rock in 2007.

g) From ME Bank’s regulatory disclosure, we can see its capital charge

for market risk is nil. Provide two possible reasons as to why ME Bank
does not have to hold capital for market risk exposures.

1. ME might not have a trading desk

2. ME does have a trading desk but only trades standardised contracts (no
counterparty risk)
- Market risk is only calculated on OTC contracts

h) Comparing risk-weighted assets to total assets, what is the average

risk-weight for ME Bank’s asset base?

RWA = 5,684,700 found in capital adequacy table

Assets = 14,368,088

RWA / Assets = 5,684,700 / 14,368,088 = 39.6%

i) Given ME Bank’s total capital ratio, how much tier 2 capital must ME
be holding? Give one example of a liability on ME Bank’s balance sheet
that would count towards tier 2 capital.

Total CAR = 16.24% = T1 / RWA + Tier 2 / RWA

So T2 = (16.24 - T1 / RWA) * RWA = 327,444

ME has 32,903 of subordinated debt which is one thing that can be used as T2
capital. Basically anything that absorbs losses and protects depositors.

j) What is ME Bank’s leverage ratio as defined under Basel III?

LR = Equity / Total Credit Exposure (Assets) = 808,149 / 16,515.1 = 48.9%

k) Considering what you have learnt about ME Bank in this question

(along with what you have learnt this semester about ME Bank), what
strategies would you put in place to maximise short-term profitability if
you were the CEO of ME Bank? What if you were trying to maximise
long-term profitability? Contrast these two scenarios with what you
would do if you were the chairman of APRA. In answering your question
consider the current economic and regulatory climate.

To increase profit I can do the following.

1. Increase revenue
2. Decrease costs, and/or
3. Reduce provisioning.

Or some combination of the above. Each combination has in good/bad points

since there is a trade-off between risk and return. Reducing provisions, other
things equal, implies banks are more exposed to credit and bankruptcy risk.
Decreasing costs might be good but this might come at the expense of reduced
monitoring which might see a fall in lending standards.

Short-Term: If the focus is on short-term profits then I do not care about these
trade-offs. I maximise profit and ignore risk. I am risk-neutral. So ME can increase
revenue, decrease costs and decrease provisioning. Note that a reduction in
provisioning to extreme levels might attract regulatory scrutiny. So increasing
revenues is the most straight forward way. ME can do this by competing for new
loans/business by reducing price. ME can also get cheaper funding via using the
securitization market to pay for the expansion. The business model is originate
and distribute. Since ME is not hanging onto any loans then it may cut staff costs
by reducing the amount of screening and monitoring. ME looks to be doing this
right now.

Long-Term: If the focus is on long-term profits then I care about risk, because
excessive risk taking can ultimately lead to lower profits/failure in the long run.
So the strategy is very different. ME should pursue expansion while continuing to
screen and monitor loan quality regardless of its intension to securitize. ME
should also think about diversifying its funding and loan portfolio. Heavy reliance
on the securitization market can lead to problems if loan performance starts to
fall. And a heavy concentration in residential real estate can lead to big problems
for ME if the hot housing market and low interest rate environment reverses. Two
key issue here is that long-term success involves risk-taking but also balancing
the potential pitfalls associated with that risk taking. ME’s CEO is risk-averse.

APRA primary goal to have a well-functioning banking system such that there are
no (or few) bank failures. APRA’s key concern is therefore risk minimisation, not
profit. In that sense, what regulators want banks to do is most likely quite
inconsistent with what the banks want. E.g. higher capital ratios, more liquid
assets, more stable funding etc. is all aimed at reducing risk. Lower risk tends to
be associated with a lower return for the banks. Regulators are very-risk averse.

QUESTION 3

Read Attachment 3 “IFC, EIB, and AFD Support Small Businesses and
Mobilize Investment in Middle East and North Africa (MENA)” which is a
World Bank announcement of a new risk sharing facility to help fund
loans to small-medium sized enterprises (SMEs) in MENA, and then
answer the following:

a) What is the total estimated amount of funds available to be lent to

SMEs under this facility? Explain your answer. (3 marks)

Total Funds = 150 + 150 + 50 + 24 + 400 = $774m

b) For every dollar of loan to SMEs, calculate the average guarantee

amount local banks are able to receive from the facility. Explain your
answer (3 marks)

If banks make $774m in loans, $374m is guaranteed.

Guarantee = 374 / 774 = 48.3%

c) In the context of the RAROC model, what factor has this facility
changed to make commercial banks willing to lend to SMEs? Explain
your answer. (2 marks)

RAROC = Loan Income / Loan Risk

Here, the guarantee is lowering the loan risk that banks face.

d) There are at least 2 different ways to structure this facility: a cash

facility or a synthetic facility. Explain how risk can be “shared” between
local banks and the program sponsors in this deal under the alternative
structures. (10 marks)

1. Reduce the amount banks lend out (cash transaction)

 A cash transaction involves the sponsors providing actual money for the
loans (buying) which reduces the amount that the banks have to lend out
 To protect the banks, the loans would need to be structured so that any
losses are absorbed by the sponsor
- This can be achieved with a clear payment waterfall

Suppose a firm in MENA wants to borrow $100. The facility will offer $48.3 and
the bank will provide the additional $51.7. The contract will clearly outline that
the sponsor will be the subordinate lender. The payment waterfall would be:

i. Local banks
ii. IFC, EIB and AFD
iii. NIF (because the article states they are the junior tranche)

Summary: a cash transaction involves the sponsors providing partial funds for
the loans and being the subordinated lender.

2. Reduce the risk banks are exposed to (synthetic transaction)

  Banks provide the full $100 loan and then part of the risk of the loan can
be transferred to the sponsor via a credit derivative like a CDS

Banks provide the $100 and receive a guarantee from the sponsors for losses up
to $48.3.

e) Is the synthetic deal structure you outlined above, fully, partially or

un-funded? Explain your answer. (2 marks)

Partially funded. The $374m in funds committed by the sponsors is enough to

cover the guarantee they provide but does not cover the entire size of the loan
pool ($774m).

f) Draw and label a diagram of the flow of funds, return and risk
between the ultimate user of funds (i.e. SMEs), the local banks and the
program sponsors (i.e. IFC, EIB, AFD and NIF) under each of the two
structures you outlined above. (7 marks)
g) In terms of implementation, which deal structure is preferable? I.e.
which structure from the two you have discussed will be least costly to
run and also allow lending by the commercial banks to occur more
promptly? Explain your answer. (3 marks)

Synthetic is preferable.

You simply allow the banks to conduct their business as usual and enter into a
contract with them that says you will insure 48% of their losses. The sponsors
(World Bank) do not need to get involved in the business of providing partial
loans which requires expertise in lending in local markets (much more costly to
implement).

QUESTION 4

In a future-flow securitization, a company issues a debt instrument

whose repayment of principal and interest to investors is secured by
payments on future receivables (i.e. cash inflows) the company expects
to generate through its normal course of operation. Study Attachment
4, which provides a detailed description of the process, and answer the
following:

a) What is the main difference between future-flow securitization and

“regular” pass-through securitizations (e.g. CDO, CMO etc.) we have
learnt about in class? Explain your answer. (5 marks)
Regular pass-through securitisation have a defined pool of assets or loans with
cash flows that are known in advance.

Future-flow securitisations rely on generating future cash flows (through

receivables) so there is a dependence on the future performance of the issuer to
perform. Figure 1 shows that Company A is securitising cash flows that have yet
to occur.

b) Are investors of future-flow securitizations exposed to the credit risk

of the customers or the issuing firm? Explain your answer. (5 marks)
The customers are not even know at the time of securitisation so investors do
not bare their risk (this is different to pass-throughs which risk is transferred from
borrowers all the way to investors).

In a future-flow securitisation, the issuing firm is promising a certain level of cash

flows from future sales which act as collateral for the note issue. Thus, investors
are exposed to the risk of the firm.

c) We’ve learnt that one needs to be able to accurately predict

prepayment risk in CMO securitizations, likewise the main risk one
needs to be able to forecast for a CDO securitization is credit risk. What
risk do you think needs to be forecast accurately in order to securitize
future flows successfully? Explain your answer. (7 marks)
Cash flow risk. Investors are entirely depending on the issuing firm actually being
able to generate future cash flows from sales.

The more accurately they can forecast future cash flows, the more likely the
future cash flows can be securitised.

d) Given your answer above in (c) come up with two characteristics of

the issuing company’s customer base that will make forecasting said
risk much easier? Explain your answer. (8 marks)
1. Stable Cash Flows: Stable cash flows are the easiest to forecast. Firms with
large and diversified customer bases reduces idiosyncratic risk which makes
them more predictable. If you have a concentrated customer base, there is more
chance for volatility in CFs which makes them harder to forecast.

2. Long Sales History: more data on customer spending makes forecasting cash
flows easier.
2018 Mid-Semester Exam

QUESTION 1

Marijuana use is legal in some states in the United States (US), however
it remains illegal at the federal level. This tension creates a major
problem for marijuana retailers: since all banks’ deposits are insured by
a federal agency—the Federal Deposit Insurance Corporation—banks
refuse to provide banking services to individuals and businesses
generating income from the sale of marijuana because doing so can
lead the banks to be charged with feral offences related to money
laundering. Read Exhibit 1 “Why marijuana retailers can’t use banks”
for more background and then answer the following questions.

a) What key banking function breaks down when banks refuse to do

business with certain segments of the economy? Explain your answer.

Liquidity creation. These weed operators are not allowed to bank so the banks
cannot use the deposits to fund loans.

b) Other things equal, do you think liquidity risk for banks operating
exclusively in states that have legalized marijuana will be higher, lower
or the same relative to banks in other states? Explain your answer.

If weed state banks take less deposits, they create less liquidity on their balance
sheet and are therefore subject to less liquidity risk from unexpected depositor
withdrawals.
c) Other things equal, do you think interest rate risk for banks
operating exclusively in states that have legalized marijuana will be
higher, lower or the same relative to banks in other states? Explain your
answer.

a) and b) imply that banks get less deposits and therefore do less lending. This
implies less long-term loans. However, the reduction in loans is due to a
reduction in deposits.

Therefore, the answer depends on whether one thinks deposits are on average
long duration relative to loans:

 If loans are thought of as core and therefore do not move very much 
longer duration
- Increases duration gap  increases IR risk

 If deposits are thought of as having zero maturity  shorter duration

- Decreases duration gap  decreases IR risk

d) What do you think the impact on economic growth will be for states
choosing to legalize marijuana? Explain your answer.

Reduced deposits  reduced liquidity creation  less loans  less investment 

less growth.

e) Suppose the Federal Reserve wants to loosen monetary policy and

reduces interest rates. Do you think the impact of the policy change will
be greater, weaker or the same in states that have legalized marijuana
relative to other states? Explain your answer.

The idea behind loosening monetary policy is to increase money supply, reduce
interest rates and stimulate growth.
For this to be successful, banks need to lend and people need to spend money,
others then earn money and deposit money back into banks. This is the deposit
multiplier.

In the marijuana states, banks take fewer deposits and thus money gets drained
out of the banking system. A reduction in the deposit multiplier (i.e. liquidity
creation) leads to less effective monetary policy.

f) Suppose the Federal Reserve’s actions lead to a national boom in

economic activity resulting in high loan demand from the banks. Other
things equal, relative to banks in other states, is the expansion in
lending by banks in marijuana states more risky, less risky, or of similar
risk? Explain your answer.

Riskier. This is because the deposit base is smaller so the expansion will need to
be funded out of wholesale financing. Wholesale financing is, on average, more
volatile and so the banks will be exposed to higher liquidity risk.

g) We learned in class that a new regulatory requirement called the net

stable funding ratio (NSFR) is due for implementation in the next year
or so. Other things equal, are banks in marijuana states more likely,
less likely or as likely to be able to comply with these new rules relative
to other states? Explain your answer.

Less likely. The NSFR encourages and preferences that banks fund their assets
with deposits as a more stable source of funding relative to wholesale financing.

h) Suppose now that the NSFR binds (i.e. all banks across the US meet
the requirement at all times). Now suppose there is another national
boom in economic activity resulting in high loan demand from the
banks. Other things equal, in the presence of the NSFR and relative to
banks in other states, is the expansion in lending by banks in marijuana
states more risky, less risky, or of similar risk? Explain your answer.

If the NSFR binds then banks in weed states will not be able to fund a lending
expansion using wholesale financing.
Since the depositor base in weed states is smaller, banks have to offer higher
interest rates to raise the same amount of deposits.

Higher deposit rates eat into bank margins and profit. One way that banks in
weed states can recoup some lost profit it to lend to riskier borrower whom they
charge a risk premium. In this instance, banks in weed states will be riskier.

QUESTION 2

There has been a lot of action in money markets recently. Read Exhibit
2 “Sea change is underway in money markets for banks, investors” and
answer the following questions.

a) Suppose long-term interests rates are yet to adjust, what does the
movement in money market interest rates imply about the shape of the
yield curve? Explain your answer.

The curve is flattening if SR rates are increasing and LR rates are held constant.

b) Is the “sea change” that is occurring the money markets an example

of interest rate risk or liquidity risk for banks? Explain your answer.

Potentially both. But to begin with, this is mainly an interest rate shock. The 3-
month rate has been increasing for two mains reasons outside of liquidity
problems in money markets. In this instance, the rise in 3-month rates is driven
by:

1. An increase in US government bond issuance to finance the deficit (i.e.

increase in supply)
2. US corporations shifting money away from longer dated instruments (3+
months in maturity) into instruments resembling cash in anticipation of a
tax change that will encourage the repatriation of cash to the US (i.e. a fall
in demand).

Both factors lead to increasing yields. It is very possible that if high interest rates
persist that it might lead to liquidity problems for banks. I.e. if demand falls
significantly, then banks will have no investors to lend at reasonable prices and
this could lead to funding shortages.

c) Do you think this shift in money market rates will impact large banks
or smaller banks more? Explain your answer.

Large. Small banks rely far less on wholesale financing which is where the costs
are increasing the most.

d) Will the introduction of the NSFR exacerbate or dampen the current

interest rate trend in money markets? Explain your answer.

Lessen. The NSFR will force banks to use more deposits to finance their assets.
This means they will demand less wholesale financing (issue less bonds) which
will lower supply in debt markets and decrease yields.

e) Other things equal, will the introduction of the NSFR steepen or

flatten the yield curve? Explain your answer.

Steepen. A reduction in SR rates will steepen the curve (from d).

f) Given the changes in money markets and suppose the long-term

rates remain unchanged, do you think that cash flow risk component or
market value risk component of interest rate risk is more of a problem
for banks? Explain your answer.

Short rates rise, long rates constant.

Assuming bank is short funded, then the interest expenses increase but interest
income is constant.

So cash flow is negative.

Market value effects imply the liability values fall but asset values a (relatively)
constant. So there is an increase in net worth. Cash flow risk is more of a
problem.

g) Suppose the average maturity of assets is 20 years (fixed rate) and

suppose that these assets are funded exclusively with money market
funds. Given the changes in money markets and suppose the long-term
rates remain unchanged does the repricing model predict a positive or
negative impact on income in the next, say, five years? Does the
duration model predict positive or negative impact on net worth (i.e.
equity value)? Overall, what do you expect the impact will be on the
price of bank stock? Explain your answer.

Repricing model predicts a negative impact on income (interest expenses are

rising) but no change in income from assets.

The duration model assumes parallel shifts in interest rates which hasn’t
happened here. With unchanged long rates the value of assets is unchanged,
however the value of liabilities has fallen due to rising short rates, so the
duration approach predicts net worth will rise (lower duration gap).

Overall whether the stock price increases of falls depends on the relative size of
the cash flow risk versus the market value effects.

h) Suppose the average maturity of assets is 20 years (variable rate)

and suppose that these assets are funded exclusively with money
market funds. Given the changes in money markets and suppose the
long-term rates remain unchanged does the repricing model predict a
positive or negative impact on income in the next, say, five years? Does
the duration model predict positive or negative impact on net worth
(i.e. equity value)? Overall, what do you expect the impact will be on
the price of bank stock? Explain your answer.

Since loan rates are variable, banks have the ability to pass on rate changes if
their cost of funds increases. So the repricing model predicts that income from
assets will rise at the same time as expenses are rising. Since the repricing
model calculates the gap as the total value of rate sensitive assets minus the
total value of rate sensitive liabilities then the gap in this instance is zero.
Assuming that banks pass on the full rise in funding costs to borrowers then the
repricing model predicts no impact on cash flows.

The duration model assumes cash flows from assets are fixed, which is not the
case here, so the duration approach starts to break down. With unchanged long
rates and constant cash flows the value of assets is unchanged, however here,
the cash flows are falling so too must the asset values. The value of liabilities has
fallen due to rising short rates, so the duration approach predicts net worth will
rise.

Overall we have: no impact on net cash flows but both asset and liability values
are falling. So whether the stock price increases of falls depends on the relative
size of the fall in asset and liability values.

2018 Final Exam

QUESTION 1

Study Table 19 on pg. 42 of the 2017 annual report for Laurentian Bank
and answer the following questions.

a) Using the 2017 numbers, provide a risk ranking for the asset classes
in Table 19 from the least risky to the most risky. Justify your answer.

Calculated using risk weights (RWA / Total Assets)

b) Which asset class increased in risk the most between 2016 and
2017?

Retail mortgages

c) What are two reasons that can explain such an increase in risk for
the asset class identified in (b)? Which of the two explanations do you
think is most likely? Justify your answer.
 1. Regulatory risk weights do not change but there is a credit rating
downgrade
2. Regulators increase the risk weights even though underlying credit risk is
unchanged

For sovereign debt (i.e. Canadian government bonds) it is unlikely that the
regulator would have increase the risk weights (it would be very unpopular with
politicians)

QUESTION 2

Examine Tables 24 and 25 (pp. 51-52) of the 2017 annual report for
Laurentian Bank and answer the following questions using the 2017
numbers.

a) When looking at impaired loans for the entire loan portfolio, what
location is the worst performing?

United States (100% of their loans were impaired)

b) Provide an economic rationale/theory to explain your answer in (a)?

This is a Canadian bank, lending outside of Canada would entail larger

information/monitoring costs. This will reduce loan performance all else equal.

c) Which area does Laurentian Bank have the most concertation risk?
What about the second most concentration risk?

Concentration risk = Impaired loans / Total exposure

 1. Ontario (larger loss rate)
2. Quebec

d) Suppose Laurentian wants to reduce its concentration across the two

locations you cited in (c), how should it go about doing this? That is,
which part of its portfolio should it shift, and in which direction? Explain
your answer.

Personal residential: from Quebec to Ontario

Mortgage residential: from Ontario to Quebec

Commercial mortgage: from Ontario to Quebec

Commercial other: from Quebec to Ontario

QUESTION 3

Read section 7 STRUCTURED ENTITIES SECURITIZATION VEHICLES of the

2017 annual report for Laurentian Bank (pp. 97-99) and answer the
following:

a. There are three securitization structures used by Laurentian, for

each structure state whether it is a cash transaction, synthetic
transactions or something else? Explain your answer.
None of these fit into one category.

1. National Housing Act MBS and Canada Mortgage Bond programs

- Combination of securitisation and covered bond

2. Multi-seller conduit
- Closest to a standard cash transaction

3. Structured Entities Securitisation Vehicles

 - Cash transaction (to a shadow bank) which issues its own notes that
are then securitised

b. For each of the structures, draw and label a diagram of the flow of
funds/risk from the borrower to the end investor and all intermediaries
in between.
< not provided >

c. For each of the structures, draw and label a diagram showing the
impact of securitization on a simplified/stylized version of Laurentian
Bank’s balance sheet.

< not provided >

QUESTION 4

Read the article in Exhibit 1 “APRA clamps down on interest-only

mortgage loans” for background information and examine the two
figures in Exhibit 2 (exhibits follow this question). Figure 1 presents
quarterly growth rates in interest only loans taken from APRA’s
quarterly ADI statistics. Figure 2 presents monthly growth rates for
total housing credit for all financial institutions in Australia taken from
the RBA website. The arrows in each figure indicate the date APRA
changed the lending rules for the banks. Now answer the following
questions:

a. Describe any differences you see in the growth rates between Fig. 1
and Fig. 2 after the APRA regulatory change.
IO loans from banks fell while total housing loans didn’t move too much.

b. Do you think the APRA’s new regulatory rule worked? Explain your
answer.
Yes. It exposed bank’s exposures.
c. Do you think that aggregate risk in the economy is now lower
because of this new rule? Explain your answer.
No. Total housing credit looks to be constant. Risky lending likely moved from the
banking sector to the non-bank (shadow banking) sector.

d. Is APRA now more or less informed about aggregate risk in the

economy? Explain your answer.
If lending has shifted into the shadow banking industry, they are less informed
because they have no information or authority.

e. Do you think that banks are able to circumvent the rule in anyway? If
yes, provide some examples of how this might be done.
Yes.

Set up a SIV and shift the risky loans to there (shadow bank). Or given that this is
regulating only IO loans, banks could speed up lending in all other loans in order
to maintain the current relative volume of IO loans being extended.
Practice Exam Question Concepts
2016 Test 1
Question 1: Rural vs. Metropolitan

 Concentration, cost of monitoring, lack of competition

Question 2: Ownership Structures

 Credit union/mutual vs. bank vs. Shinkin bank, Indian state-owned banks
 Monitoring incentives, TBTF, nationalising banks (state-owned)

2016 Test 2
Question 1: RAROC

 Guarantee better than loan (0 funds committed)

Question 2: Negative Interest Rates

 Negative CF effect due to not passing on negative rates to depositors

 Positive MV effect due to lower discount rate
 Liquidity risk if depositors get sick of paying to store money

2016 Test 3
Question 1: Ekspo
  Concentration risk (assets/loans and liabilities/funding), OBS liabilities,
maturity matching, liquidity risk (wholesale refinancing), provisioning,
lender-of-last-resort, capital buffer
 Improving profitability

2016 Final Exam

Question 1: BoQ vs. Bendigo Bank Report

 Mining vs. real estate concentration risk

 Queensland vs. Victoria concentration risk
 Wholesale vs. depositor financing
 Inorganic vs. organic growth strategies
 Use big 4 banks as a benchmark, weighting scheme from deviations

Question 2: Green Bonds

 World Bank Green Project financing – synthetic/cash, deal structure, credit

ratings
 DB PACE bonds – deal structure, credit ratings

Question 3: NIB Ethiopian Coffee Farmers Financing

 Partially-funded, synthetic
 CDS
 Deal structure

Question 4: Goldman Sachs Bespoke Tranche Opportunity

 Varying deal structures

- Credit risk estimation
 Structural vs. financial leveraged hedge funds

2017 Test 1
Question 1: WBC Risk

 Provisions are based on a forecast of future losses (expected losses)

- E(Loss) = Probability of Loss * Loss Given Default
 Mortgages have a low loss given default (LGD) so the expected loss is low
(due to collateral)
  Secured loans are important
 Mining losses from commodity prices (less reliance on China)
 Important factors in modelling future loan losses

Question 2: India Removing Currency

 Liquidity shock hampers liquidity creation function

 Rural vs. metropolitan access to finance
 Impact on investment (SR vs. LR)
 Financial ratio

2017 Test 2
Question 1: ANZ vs. WBC Risk Exposures

 Repricing model (CF risk) vs. duration model (MV risk)

 Deposit vs. wholesale financing reliance
 Deposits as RSL
 Deposit insurance (asset side cash demand is negatively correlated with liability
side cash demand)
 NSFR and LCR
- RBA liquidity facility vs. HQLA

Question 2: Interest Rate Risk (INCREASING IR IMPACT ON NIM)

 Positive CF effect due to larger spread – repricing

 Negative MV effect due to higher discount rate – duration/discount rate

2017 Test 3
Question 1: CBA vs. WBC Provisions

 Fixed vs. variable rate loans

- Variable rate loans aren’t less risky because passing on rates increases
default probability
o Higher Provisions / Loans (credit risk)  more variable rate loans
- Variable rate loans make duration matching impossible
 Ways to reduce interest rate risk exposure
- Duration matching
Question 2: FICO Score Change

 Credit risk model

 Ways to reduce credit risk exposure
- Increase monitoring (reduce duration) or increase screening (ration
credit)
 Unfairly penalise vs. remove predictive information
 RAROC

2017 Final Exam

Question 1: ANZ Capital Requirements

 Raising capital  increase loan pricing

- But high competition
 Improving profitability (similar to Ekspo question)
- Become riskier with loans

Question 2: ME Bank Balance Sheet

 LCR and HQLA  increase investment to meet regulatory requirements

 Financing loan expansion (wholesale financing through securitisation)
 Risk weights, capital ratios and leverage ratio
- Market risk is only calculated on OTC contracts
 Improving profitability (SR vs. LR) – similar to Ekspo and ANZ questions
 “What would APRA do?”

Question 3: Lending to Developing Countries

 Cash vs. synthetic structure

 Partially vs. fully funded
 Deal structures

Question 4: Future-Flow Securitisation

 Future-flow vs. pass-through securitisation

 Future-flow securitisation: cash flow risk
- CMOs: pre-payment risk
- CDOs: credit risk
2018 Mid-Semester Exam
Question 1: Marijuana Use

 Liquidity creation function

 Less deposits  more liquidity risk (less growth)
- Duration gap
 Interest rate risk
- Loosening monetary policy
 Wholesale financing and risk
 NSFR
- Inability to use wholesale financing

Question 2: Money Markets

 Yield curve
 Interest rate risk and liquidity risk
- Increasing yields
- CF vs. MV risk (repricing vs. duration model)
 Wholesale financing
 NSFR
 Variable vs. fixed rate loans

2018 Final Exam

Question 1 and 2: Canadian Bank

 Risk weights
 Concentration risk
 Loan impairment and provisions

Question 3: Canadian Bank Securitisation

 Cash vs. synthetic vs. combination

 Deal structures (not shown)

Question 4: APRA Regulation IO Loans

 Banks just move risky loans to shadow banks when regulated

Tutorial Question Concepts
Tutorial 1: Information Asymmetry and Liquidity Risk
 Solving frictions using intermediated (indirect) financing
- Monitoring and liquidity
 Excel
- Big 4 banks concentration and competition (oligopolies  neobanks)
- Leverage ratio, deposit %, loan growth
- ATMs and branches decline

Tutorial 2: Financial Ratios and Liquidity Risk

 DuPont
 Weaknesses of financial ratio analysis – does not capture risks
- Could also just be leverage
 Measuring liquidity risk from a balance sheet
 Mutual fund went tits up due to liquidity issues
- Deposit insurance

Tutorial 3: Moral Hazard and Deposit Insurance

 FDIC collapse
 Risk-based premiums
 Deposit insurance
 How banks manage their liquidity (surplus/deficit)
- Repos
 Yes Bank failure and TBTF problem
Tutorial 4: Interest Rate Risk
 Repricing model and duration model calculations
 Ways to reduce interest rate risk

Tutorial 5: Interest Rate Risk

 Duration model calculations
 Estimates vs. actual changes in market value
 Building a stress test model for interest rate risk

Tutorial 6: Credit Risk

 RAROC calculations
 Default probabilities calculations
 Ekspo questions on credit risk