Week 6

Question 1

What are a bank’s key financial statements?

Answer 1

1. Balance sheet (stocks)
2. Income / P/L statement (flows)

Question 2

Why are retail banks exposed to liquidity risk?

Answer 2

Because their liabilities are more liquid than their assets

Question 3

What characterises an investment bank’s balance sheet?

Answer 3

Securities make up most assets and liabilities

Question 4

What is the difference between revenues & costs?

Answer 4

• Revenues generated by assets
• Costs generated by liabilities

Question 5

What are the main costs for a bank?

Answer 5

• Interest paid on deposits & debts
• Provision for loan losses & taxes
• Dividends to shareholders
• Staffing & operating costs

Question 6

What is ‘reclassifying’ an income statement?

Answer 6

Scaling / adjusting it for the size of the bank

Question 7

How do you reclassify an income statement?

Answer 7

1. Subtract PLL to get net interest income after PLL
2. Calculate net non-interest income
3. Combine to get pre-tax net operating profit
4. Add/subtract securities gains/losses to get profit before taxes
5. Account for extraordinary items e.g. M&As
6. After tax you get net profit
7. After dividends you get retained prodit

Question 8

What is PLL?

Answer 8

Provision for loan losses

Question 9

What are the categories of financial ratios?

Answer 9

1. Profitability
2. Asset quality
3. Liquidity
4. Solvency
5. Efficiency

Question 10

What ratios measure profitability?

Answer 10

1. ROE
2. ROA
3. NIM

Question 11

What ratios measure asset quality?

Answer 11

NPL

Question 12

What ratios measure liquidity?

Answer 12

Liquidity ratio

Question 13

What ratios measure solvency?

Answer 13

Capital ratio / EM

Question 14

What ratios measure efficiency?

Answer 14

C/I

Question 15

What is ROE?

Answer 15

• Return on equity
• Profitability measure for shareholders
• ROE = net income/total equity

Question 16

What is ROA?

Answer 16

• Return on assets
• General profitability measure
• ROA = net income/total assets

Question 17

What is EM?

Answer 17

• Equity multiplier/capital ratio
• Solvency/leverage measure
• EM = total assets/total equity

Question 18

What is NIM?

Answer 18

• Net interest margin
• Profitability ratio
• NIM = net interest income/earning assets

Question 19

Should NIM ideally be high or low?

Answer 19

High

Question 20

What is C/I?

Answer 20

• Cost to income ratio
• Efficiency measure
• C/I = non-interest expenses/total income

Question 21

What is the liquidity ratio?

Answer 21

core deposits/total assets

Question 22

What is NPL?

Answer 22

• Non-performing loans
• Not yet written off
• But in doubt/problematic

Question 23

What is capital adequacy?

Answer 23

• Total risk-based capital ratio
• Measures soundness

Question 24

What is the difference between liquidity & solvency?

Answer 24

• Liquidity = cash flow
• Solvency = stock

Question 25

What is ALM?

Answer 25

Asset & liability management

Question 26

What is the purpose of ALM?

Answer 26

Maximise profits & shareholder value

Question 27

What is included in ALM?

Answer 27

- Investment (asset) decisions - Financing (liability) decisions - Monitoring performance

Question 28

Why is ALM different for banks than other companies?

Answer 28

Loans & deposits are more complex than other assets & liabilities

Question 29

When is shareholder value created?

Answer 29

When ROC > cost of capital

Question 30

What is one measure of shareholder value?

Answer 30

EVA (economic value added)

Question 31

How is EVA calculated?

Answer 31

NOPAT - (CI x K) - net op profit after tax - capital invested - cost of capital

Question 32

In ALM, what is included under asset management?

Answer 32

- Maximise loan/security returns - Minimise risks - Adequate liquidity

Question 33

In ALM, what is included under liability management?

Answer 33

- Maximise interbank market returns - Minimise cost of deposits

Question 34

What must be balanced in ALM?

Answer 34

- Long-run (2-5yr) strategic objectives - Flexibility to respond to shocks

Question 35

Why is flexibility especially important for global banks?

Answer 35

Shocks could come from anywhere in the world

Question 36

What are the types of reserves?

Answer 36

- Required reserves - Excess reserves

Question 37

If banks are illiquid, what steps do they take, in order?

Answer 37

1. Borrow from other banks 2. Sell securities 3. Sell loans 4. Borrow from central bank (if solvent)

Question 38

Why was Northern Rock nationalised?

Answer 38

It was still solvent despite liquidity crisis

Question 39

Why do shareholders prefer low capital?

Answer 39

high leverage = low capital = high ROE

Question 40

What are the advantages of holding capital?

Answer 40

- *ex ante* - can loan when demand is high - *es post* - protects bank when it incurs losses