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Bionic Turtle FRM Practice Questions
P1.T3. Financial Markets and Products
Chapter 1. Banks
By David Harper, CFA FRM CIPM
www.bionicturtle.com
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CHAPTER 1. BANKS ................................................................................................................ 3
P1.T3.700. MAJOR RISKS FACED BY BANKS ............................................................................... 3
P1.T3.701. BASIC BANK FUNCTIONS AND DEFINITIONS ............................................................... 8
CHAPTER 2 END OF CHAPTER QUESTIONS & ANSWERS ............................................................12
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Chapter 1. Banks
P1.T3.700. Major risks faced by banks
P1.T3.701. Basic bank functions and definitions
P1.T3.700. Major risks faced by banks
Learning Objectives: Identify the major risks faced by a bank. Distinguish between
economic capital and regulatory capital.
700.1. Below is a hypothetical summary income statement for Deposits and Loans Corporation
(DLC):
Risks can affect any line in the income statement, but according to Hull, each major risk
category tends to be primarily associated with certain activities as they manifest on the financial
statements. In regard to this association between a major risk type and its primary income
statement impact, each of the following statements is true EXCEPT which is inaccurate?
a) Credit risk primarily affects loan losses
b) Liquidity risk primary affects non-interest expense
c) Operational risk primarily affects non-interest expense
d) Market risk affects net interest income and/or non-interest income
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700.2. Below are a summary balance sheet and income statement for Deposits and Loans
Corporation (DLC):
Each of the following statements is true EXCEPT which is false?
a) Before-tax return on equity (ROE) is 12.0%
b) Leverage is 19.0 or 20.0 (depending on our definition of leverage)
c) If loan losses jump to 6.0% of assets next year, and nothing else changes, this will
completely wipe out the equity shareholders
d) If DLC had borrowed $10 million (+$10.0 to Sub Long term debt) to buyback shares (-
$10.0 equity) during 2016, its ROE would triple (3x)
700.3. Banks must manage both economic capital and regulatory capital. Each of the following
statements is true EXCEPT which is false?
a) If corporations rated "AA" have a one-year default probability of 0.03%, then a
reasonable economic capital confidence level is 99.97% for a financial institution with an
objective of maintaining a "AA" rating
b) Economic capital is also called risk capital and can be regarded as a sort of "currency"
for risk-taking within a financial institution; a business unit can take a certain risk only
when it is allocated the appropriate economic capital for that risk.
c) Because sharing information about regulatory capital among divisions of the bank is a
conflict of interest, banks construct a so-called Chinese Wall to keep the regulatory
capital separate from the economic capital each division, and to separate economic
capital among divisions within the bank
d) Economic capital is often less than regulatory capital, but it is also different than
regulatory capital (which is prescribed by regulators); banks have no choice but to
maintain their capital above the regulatory capital level, although in order to avoid having
to raise capital at short notice, banks often maintain capital comfortably above the
regulatory minimum
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Answers:
700.1. B. False. Liquidity risk is generally a balance sheet phenomenon, which certainly
impacts the income statement but it most likely to manifest "above" the non-interest
expense line.
In regard to (A), (C) and (D), each is TRUE.
Hull: "2.8 THE RISKS FACING BANKS: A bank's operations give rise to many risks. Much of
the rest of this book is devoted to considering these risks in detail. Central bank regulators
require banks to hold capital for the risks they are bearing. In 1988, international standards were
developed for the determination of this capital. These standards and the way they have evolved
since 1988 are discussed in Chapters 15, 16, and 17. Capital is now required for three types of
risk: credit risk, market risk, and operational risk.
Credit risk is the risk that counterparties in loan transactions and derivatives transactions will
default. This has traditionally been the greatest risk facing a bank and is usually the one for
which the most regulatory capital is required. Market risk arises primarily from the bank's
trading operations. It is the risk relating to the possibility that instruments in the bank's trading
book will decline in value. Operational risk, which is often considered to be the biggest risk
facing banks, is the risk that losses are made because internal systems fail to work as they are
supposed to or because of external events. The time horizon used by regulators for considering
losses from credit risks and operational risks is one year, whereas the time horizon for
considering losses from market risks is usually much shorter. The objective of regulators is to
keep the total capital of a bank sufficiently high that the chance of a bank failure is very low. For
example, in the case of credit risk and operational risk, the capital is chosen so that the chance
of unexpected losses exceeding the capital in a year is 0.1%."
Further, Hull's end-of-chapter Question #6: Which items on the income statement of DLC bank
in Section 2.2 are most likely to be affected by (a) credit risk, (b) market risk, and (c) operational
risk? Answer: "Credit risk primarily affects loan losses. Non-interest income includes trading
gains and losses. Market risk therefore affects non-interest income. It also affects net interest
income if assets and liabilities are not matched. Operational risk primarily affects non-interest
expense."
700.2. C. False. 6.0% implies loan losses of $18.00 and pretax operating income of -
$13.80 which is a pre-tax operating loss of -4.60%, but an after-tax loss of -3.22%; not
enough to wipe out the 5.0% equity buffer.
In regard to (A), (B) and (D) each is TRUE.
In regard to true (A), ROE = pretax operating income/equity = $1.80/$15.0 = 12.0%
In regard to true (B), leverage can be defined as assets/equity or debt/equity; in this
case, assets/equity = 300.0/15.0 = 20, and debt/equity = (270.0 deposits + 15.0
debt)/15.0 = 19.0
In regard to true (D), the recapitalization leads to $1.80/5.0 = 36.0%
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700.3. C. False. Conflicts of interest pertain to completely different issues (for example,
the bank generally wants to aggregate economic capital such that privacy or conflicts
simply do not pertain here).
In regard to (A), (B) and (D), each is TRUE.
Hull on the difference between economic and regulatory capital (emphasis ours): "In addition to
calculating regulatory capital, most large banks have systems in place for calculating what is
termed economic capital (see Chapter 26). This is the capital that the bank, using its own
models rather than those prescribed by regulators, thinks it needs. Economic capital is
often less than regulatory capital. However, banks have no choice but to maintain their
capital above the regulatory capital level. The form the capital can take (equity, subordinated
debt, etc.) is prescribed by regulators. To avoid having to raise capital at short notice, banks try
to keep their capital comfortably above the regulatory minimum. When banks announced huge
losses on their subprime mortgage portfolios in 2007 and 2008, many had to raise new equity
capital in a hurry. Sovereign wealth funds, which are investment funds controlled by the
government of a country, have provided some of this capital. For example, Citigroup, which
reported losses in the region of $40 billion, raised $7.5 billion in equity from the Abu Dhabi
Investment Authority in November 2007 and $14.5 billion from investors that included the
governments of Singapore and Kuwait in January 2008. Later, Citigroup and many other banks
required capital injections from their own governments to survive."
In regard to conflicts of interest, Hull gives several examples including
1. "When asked for advice by an investor, a bank might be tempted to recommend
securities that the investment banking part of its organization is trying to sell. When it
has a fiduciary account (i.e., a customer account where the bank can choose trades for
the customer), the bank can “stuff” difficult-to-sell securities into the account.
2. A bank, when it lends money to a company, often obtains confidential information about
the company. It might be tempted to pass that information to the mergers and
acquisitions arm of the investment bank to help it provide advice to one of its clients on
potential takeover opportunities.
3. The research end of the securities business might be tempted to recommend a
company's share as a “buy” in order to please the company's management and obtain
investment banking business.
4. Suppose a commercial bank no longer wants a loan it has made to a company on its
books because the confidential information it has obtained from the company leads it to
believe that there is an increased chance of bankruptcy. It might be tempted to ask the
investment bank to arrange a bond issue for the company, with the proceeds being used
to pay off the loan. This would have the effect of replacing its loan with a loan made by
investors who were less well-informed.
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... How are the conflicts of interest [above] handled? There are internal barriers known as
Chinese walls. These internal barriers prohibit the transfer of information from one part of the
bank to another when this is not in the best interests of one or more of the bank's customers.
There have been some well-publicized violations of conflict-of-interest rules by large banks.
These have led to hefty fines and lawsuits. Top management has a big incentive to enforce
Chinese walls. This is not only because of the fines and lawsuits. A bank's reputation is its most
valuable asset. The adverse publicity associated with conflict-of-interest violations can lead to a
loss of confidence in the bank and business being lost in many different areas."
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-700-major-risks-
faced-by-banks-hull.10232/
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P1.T3.701. Basic bank functions and definitions
Learning objectives: Explain how deposit insurance gives rise to a moral hazard
problem. Describe investment banking financing arrangements including private
placement, public offering, best efforts, firm commitment, and Dutch auction
approaches. Describe the potential conflicts of interest among commercial banking,
securities services, and investment banking divisions of a bank and recommend
solutions to the conflict of interest problems. Describe the distinctions between the
banking book and the trading book of a bank. Explain the originate-to-distribute model of
a bank and discuss its benefits and drawbacks.
701.1. Below are displayed the loans account in the Balance Sheet of Deposits and Loans
Corporation (DLC) for the year ending December 31st, 2016. Also shown is the breakdown of
the Allowance for loan losses. (Please note this format is realistic and mimics the presentation
given by, for example, Bank of America's annual report).
About these accounts, each of the following statements is true EXCEPT which is false?
a) The actual (not expected) loan losses for DLC during 2016 were $195.0 million before
netting any recoveries
b) The book value (aka, carrying value) of loans which contributes to DLC's reported Total
Assets is $12,451.4 million
c) The most direct impact on DLC's 2016 Income Statement is "Net Charge Offs" which
reduced DLC's reported Pre-tax Operating Income by $175.0 million
d) If the 2016 "Provision for loan losses" had increased from $120.0 million to $200.0
million (i.e., nearer to loans charged off) then reported Assets and Equity (as of
December 31st, 2016) would have both decreased
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701.2. Regulators estimate that Deposits and Loans Corporation (DLC) will report a profit that is
normally distributed with a mean of $1.30 million and a standard deviation of $3.0 million. Below
is displayed the summary Balance Sheet for DLC:
How much equity capital IN ADDITION to DLC's current equity position should regulators
require for there to be a 99.9% chance of the capital not being wiped out by losses? (this is a
variation on Hull's EOC Question 2.15)
a) None
b) About $1.50 million
c) About $3.97 million
d) About $14.46 million
701.3. Hull's Chapter 2 introduces several key banking definitions. Consider the definitions
below:
I. Moral hazard: Moral hazard is the possibility that insurance itself motives the insured
party to engage is riskier behavior
II. Firm commitment IPO: Faced with a choice between "firm commitment" versus "best
efforts," an investment bank underwriting an initial public offering (IPO) is more likely to
prefer the firm commitment if (i) the bank is more confident in obtaining a higher public
sale price and (ii) the bank has a greater risk appetite
III. Trading book: Assets in the trading book are market to market daily, or if they do not
have a market, marked according to a model ("marking to model"); but loans in the
banking book are not marked to market, they are recorded in the books as principal
amount owed plus accrued interest
IV. Originate-to-distribute: Originate-to-distribute refers to the business model that has the
intention to securitize
V. Poison pill: An example of a poison pill is when a potential acquisition target grants to
its key employees stock options that vest in the event of a takeover
VI. Market maker: A market maker facilitates trading by always being prepared to quote a
bid (the price at which it is prepared to buy) and an offer (the price at which it is prepared
to sell)
Which of the above definitions is CORRECT?
a) None of these definitions are correct
b) II., IV, and VI are accurate (but I., III., and V. are incorrect)
c) I., III., and V. are accurate (but II., IV, and VI. are incorrect)
d) All of these definitions are accurate
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Answers:
701.1. C. False. Pre-tax Operating Income (on the income statement) is reduced by the
"Provision for Loan Losses" which is an accounting expense, not charge-off (and
recoveries) which impact the cash flow statement. In this way, loan loss provisions involve
some degree of management discretion.
In regard to (A), (B) and (D), each is TRUE.
701.2. C. True. About $3.97 million: As 3.09 is the one-tailed normal deviation at 99.90%
confidence, the worst expected loss is given by: µ 1.30 - 3.0 * 3.09 = - $7.97 which requires
$3.97 in addition to the current equity of $4.0 million.
701.3. D. All of these definitions are accurate. Please consider the following notes by Hull
(selected):
Moral hazard: "Moral hazard is the possibility that insurance itself motives the insured
party to engage is riskier behavior"
Firm commitment IPO: "There are a number of different types of arrangement between
the investment bank and the corporation. Sometimes the financing takes the form of a
private placement in which the securities are sold to a small number of large institutional
investors, such as life insurance companies or pension funds, and the investment bank
receives a fee. On other occasions it takes the form of a public offering, where securities
are offered to the general public. A public offering may be on a best efforts or firm
commitment basis. In the case of a best efforts public offering, the investment bank does
as well as it can to place the securities with investors and is paid a fee that depends, to
some extent, on its success. In the case of a firm commitment public offering, the
investment bank agrees to buy the securities from the issuer at a particular price and
then attempts to sell them in the market for a slightly higher price. It makes a profit equal
to the difference between the price at which it sells the securities and the price it pays
the issuer. If for any reason it is unable to sell the securities, it ends up owning them
itself. " [Please see Hull's Example 2.1 for an illustration]
Trading book: "For other banking activities, there is an important distinction between
the banking book and the trading book. As its name implies, the trading book includes all
the assets and liabilities the bank has as a result of its trading operations. The values of
these assets and liabilities are marked to market daily. This means that the value of the
book is adjusted daily to reflect changes in market prices ... Often a model has to be
assumed. The process of coming up with a market price is then sometimes termed
marking to model. The banking book includes loans made to corporations and
individuals. These are not marked to market. If a borrower is up-to-date on principal and
interest payments on a loan, the loan is recorded in the bank's books at the principal
amount owed plus accrued interest. If payments due from the borrower are more than 90
days past due, the loan is usually classified as a non-performing loan. The bank does
not then accrue interest on the loan when calculating its profit. When problems with the
loan become more serious and it becomes likely that principal will not be repaid, the loan
is classified as a loan loss."
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Originate-to-distribute: "The originate-to-distribute model is also termed securitization
because securities are created from cash flow streams originated by the bank. It is an
attractive model for banks. By securitizing its loans it gets them off the balance sheet
and frees up funds to enable it to make more loans. It also frees up capital that can be
used to cover risks being taken elsewhere in the bank ... As we will explain in Chapter 6,
the originate-to-distribute model got out of control during the 2000 to 2006 period. Banks
relaxed their mortgage lending standards and the credit quality of the instruments being
originated declined sharply. This led to a severe credit crisis and a period during which
the originate-to-distribute model could not be used by banks because investors had lost
confidence in the securities that had been created."
Poison pill: "In addition to assisting companies with new issues of securities, investment
banks offer advice to companies on mergers and acquisitions, investments, major
corporate restructurings, and so on. They will assist in finding merger partners and
takeover targets or help companies find buyers for divisions or subsidiaries of which they
want to divest themselves. They will also advise the management of companies which
are themselves merger or takeover targets. Sometimes they suggest steps they should
take to avoid a merger or takeover. These are known as poison pills. Examples of
poison pills are ..."
Market maker: "A broker assists in the trading of securities by taking orders from clients
and arranging for them to be carried out on an exchange. Some brokers operate
nationally, and some serve only a particular region. Some, known as full-service brokers,
offer investment research and advice. Others, known as discount brokers, charge lower
commissions, but provide no advice. Some offer online services, and some, such as E*
Trade, provide a platform for customers to trade without a broker. A market
maker facilitates trading by always being prepared to quote a bid (the price at which it is
prepared to buy) and an offer (the price at which it is prepared to sell). When providing a
quote, it does not know whether the person requesting the quote wants to buy or sell.
The market maker makes a profit from the spread between the bid and the offer, but
takes the risk that it will be left with an unacceptably high exposure."
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functions-and-definitions-hull.10242/
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Hull RMFI1 Chapter 2 End of Chapter Questions & Answers
Question 2.1
How did concentration in the U.S. banking system change between 1984 and 2014?
Answer:
The banking system became more concentrated, with large banks having a bigger share of the
market. The total number of banks reduced from 14,483 to 5,809.
Question 2.2
What government policies led to the large number of small community banks in the United
States?
Answer:
In the early twentieth century, many states passed laws restricting banks from opening more
than one branch. The McFadden Act of 1927 restricted banks from opening branches in more
than one state.
Question 2.3
What risks does a bank take if it funds long-term loans with short-term deposits?
Answer:
The main risk is that interest rates will rise so that, when deposits are rolled over, the bank has
to pay a higher rate of interest. The rate received on loans will not change. The result will be a
reduction in the bank’s net interest income.
1
John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John Wiley & Sons,
2018).
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Question 2.4
Suppose that an out-of-control trader working for DLC bank (see Tables 2.2 and 2.3) loses $7
million trading foreign exchange. What do you think would happen?
Answer:
DLC’s loss is more than its equity capital, and it would probably be liquidated. The subordinated
long-term debt holders would incur losses on their $5 million investment. The depositors should
get their money back.
Question 2.5
What is meant by net interest income?
Answer:
The net interest income of a bank is interest received minus interest paid.
Question 2.6
Which items on the income statement of DLC bank in Section 2.2 are most likely to be affected
by (a) credit risk, (b) market risk, and (c) operational risk?
Answers:
Credit risk primarily affects loan losses. Non-interest income includes trading gains and losses.
Market risk therefore affects non-interest income. It also affects net interest income if assets and
liabilities are not matched. Operational risk primarily affects non-interest expense.
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Question 2.7
Explain the terms “private placement” and “public offering.” What is the difference between “best
efforts” and “firm commitment” for a public offering?
Answer:
A private placement is a new issue of securities that is sold to a small number of large
institutional investors. A public offering is a new issue of securities that is offered to the general
public. In a best efforts deal, the investment bank does as well as it can to place securities with
investors, but does not guarantee that they can be sold. In a firm commitment deal, the
investment bank agrees to buy the securities from the issuing company for a particular price and
attempts to sell them in the market for a higher price.
Question 2.8
The bidders in a Dutch auction are as follows:
The number of shares being auctioned is 150,000. What is the price paid by investors? How
many shares does each investor receive?
Answer:
The bidders when ranked from the highest price bid to the lowest are: H, C, F, A, B, D, E, and
G. Bidders H, C, and F have bid for 140,000 shares. A has bid for 20,000. The price that clears
the market is the price that was bid by A or Answers to Questions and Problems 631 $100. H,
C, and F get their orders filled at this price. Half of A’s order is filled at this price.
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Question 2.9
What is the attraction of a Dutch auction over the normal procedure for an IPO? In what ways
was Google’s IPO different from a standard Dutch auction?
Answer:
A Dutch auction potentially attracts a wide range of bidders. If all interested market participants
bid, the price paid should be close to the market price immediately after the IPO. The usual IPO
situation where the price turns out to be well below the market price should therefore be
avoided. Also, investment banks are not able to restrict purchasers to their best current and
potential clients. The Google IPO was different from a standard Dutch auction in that Google
reserved the right to choose the number of shares that would be issued, and the percentage
allocated to each bidder, when it saw the bids.
Question 2.10
Management sometimes argues that poison pills are in the best interests of shareholders
because they enable management to extract a higher price from would-be acquirers. Discuss
this argument.
Answer:
Poison pills can give management a negotiation tool, particularly if the board has the right to
overturn a poison pill or make it ineffective. When it is confronted with a potential acquirer, the
poison pill can buy the company time to bargain for a better purchase price or find other bidders.
However, there is the danger that the poison pill will discourage potential buyers from
approaching the company in the first place.
Question 2.11
Give three examples of the conflicts of interest in a large bank. How are conflicts of
interest handled?
Answer:
The brokerage subsidiary of a bank might recommend securities that the investment banking
subsidiary is trying to sell. The commercial banking subsidiary might pass confidential
information about its clients to the investment banking subsidiary. When a bank does business
with a company (or wants to do business with the company), it might persuade the brokerage
subsidiary to recommend the company’s shares as a “buy.” The commercial banking subsidiary
might persuade a company to which it has lent money to do a bond issue because it is worried
about its exposure to the client. (It wants the investment banking subsidiary to persuade its
clients to take on the credit risk.) These conflicts of interest are handled by what are known as
Chinese walls. They prevent the flow of information from one part of the bank to another.
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Question 2.12
A loan for $10 million that pays 8% interest is classified as nonperforming. What is the impact of
this on the income statement?
Answer:
The interest is no longer accrued. The before-tax income will be reduced by 8% of $10 million or
$800,000 per year.
Question 2.13
Explain how the loan loss provision account works.
Answer:
The provision for loan losses reflects the losses the bank expects in the future. It is updated
periodically. When the provision is increased in a year by X, there is a charge to the income
statement of X. Actual loan losses, when they are recognized, are charged against the balance
in the loan loss provision account
Question 2.14
What is the originate-to-distribute model?
Answer:
In the originate-to-distribute model, a bank originates loans and then securitizes them so that
they are passed on to investors. This was done extensively with household mortgages during
the seven-year period leading up to July 2007. In July 2007, investors lost confidence in the
securitized products, and banks were forced to abandon the originate-to-distribute model, at
least temporarily.
Question 2.15
Regulators calculate that DLC bank (see Section 2.2) will report a profit that is normally
distributed with a mean of $0.6 million and a standard deviation of $2 million. How much equity
capital in addition to that in Table 2.2 should regulators require for there to be a 99.9% chance
of the capital not being wiped out by losses?
Answer:
There is a 99.9% chance that the profit will not be worse than 0.6 − 3.090 × 2.0 =
−$5.58 . Regulators will require $0.58 million of additional capital.
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Question 2.16
Explain the moral hazard problems with deposit insurance. How can they be overcome?
Answer:
Deposit insurance makes depositors less concerned about the financial health of a bank. As a
result, banks may be able to take more risk without being in danger of losing deposits. This is an
example of moral hazard. (The existence of the insurance changes the behavior of the parties
involved with the result that the expected payout on the insurance contract is higher.)
Regulatory requirements that banks keep sufficient capital for the risks they are taking reduce
their incentive to take risks. One approach (used in the U.S.) to avoiding the moral hazard
problem is to make the premiums that banks have to pay for deposit insurance dependent on an
assessment of the risks they are taking.
Question 2.17
The bidders in a Dutch auction are as follows:
The number of shares being auctioned is 210,000. What is the price paid by investors? How
many shares does each investor receive?
Answer:
When ranked from highest to lowest the bidders are B, H, C, A, E and F, D, and G. Individuals
B, H, C, and A bid for 160, 000 shares in total. Individuals E and F bid for a further 80,000
shares. The price paid by the investors is therefore the price bid by E and F (i.e., $42).
Individuals B, H, C, and A get the whole amount of the shares they bid for. Individuals E and F
gets 25,000 shares each.
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Question 2.18
An investment bank has been asked to underwrite an issue of 10 million shares by a company.
It is trying to decide between a firm commitment where it buys the shares for $10 per share and
a best efforts where it charges a fee of 20 cents for each share sold. Explain the pros and cons
of the two alternatives.
Answer:
If it succeeds in selling all 10 million shares in a best efforts arrangement, its fee will be $2
million. If it is able to sell the shares for $10.20, this will also be its profit in a firm commitment
arrangement. The decision is likely to hinge on a) an estimate of the probability of selling the
shares for more than $10.20 and b) the investment banks appetite for risk. For example, if the
bank is 95% certain that it will be able to sell the shares for more than $10.20, it is likely to
choose a firm commitment. But if assesses the probability of this to be only 50% or 60% it is
likely to choose a best efforts arrangement.
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