FIN 129
FINAL STUDY GUIDE
FALL 2006
THE FINAL IS MONDAY DECEMBER 18TH FROM 7:30 AM – 9:20 AM IN OUR REGULAR CLASSROOM.
There are 300 points on the final 100 points of the final will be comprehensive and are covered at the end of the
study guide. The other 200 points are a third midterm over the material covered since the last exam.
YOU CAN BRING ONE SHEET OF PAPER WITH INFORMATION ON ONE SIDE OF IT TO THE TEST – JUST LIKE
THE OTHER EXAMS
NON COMPREHENSIVE PORTION
CHAPTER 14 TECHNOLOGY AND OPERATIONAL RISK
CALCUALTIONS:
CONCEPTS AND IDEAS: Be able to explain the concepts of operational risk. Be able to explain the 7 different
definitions or types of operational risk discussed in the notes (be able to classify examples of operational risk as
falling into one of the categories and or be able to provide examples of each of the types and explain differences
between the different definitions of operational risk). Be able to discuss the different business lines which Basle
requires to be measures for operational risk and the frequency and severity of each operational risk int eh
business line. How can technology impact the net interest margin of a FI? How can technology impact the non
interest income and expense of a FI? What is the difference between wholesale banking and retail banking?
Explain how a wholesale lockbox can be used to improve cash management. Be able to identify and explain at
least 5 ways that wholesale banking can be impacted through improved technology. Be able to identify and
explain at least 5 ways that retail banking has been impacted by technology. Explain how technology can bring
about economies of scale. How do economies of scale relate to the average cost of the FI? What are economies
of scope? What is meant by diseconomies of scale or diseconomies of scope? Be able to explain the use of
technology in the evolution of the electronic payment system used by FI’s. What risks are associated with using
the wire transfer system? Be able to explain the basic indicator approach to measuring operational risk. What
are the problems with the basic indicator approach? Be able to explain the standardized approach to measuring
operational risk, does it solve the problems associated with the basic indicator approach? What problems exist
with the standardized approach?
CHAPTER 17 LIQUIDITY RISK
What is liquidity risk? Does liquidity risk create solvency risk? How do loan commitments result in liquidity
risk? What are meant by fire sale prices for assets and how does it relate to liquidity risk? How is a liability
approach to managing liquidity risk different than an asset approach? What are net deposit drains? What does it
mean if net deposit drains are negative? What if they are positive? What are some examples of predictable
changes that impact net deposit drains and how are net deposit drains impacted? What are some tings that
unpredictable that impact net deposit drains? Be able to show on a simple balance sheet the impact of net
deposit drains and explain the impact on the institution. What are some of the ways that the firm can “purchase
liquidity?” How does it impact the institutions cost of borrowing funds? Does managing liquidity with
liabilities impact the asset side of the balance sheet? For each f the following sources of borrowed funds,
explain the tradeoff associated with their cost vs. the risk of increasing net deposit drains (withdraw risk)
Federal Funds borrowing, Time Deposits and CD’s Now Accounts, Passbook savings, Money Market Accounts,
(this is also discussed at the end of the next chapter). What are the advantages and disadvantages to using
borrowed funds to manage liquidity? How can liquidity be managed from the asset side of the balance sheet?
How does the use of cash to manage liquidity impact a simple balance sheet? What is the difference between
cash and liquid assets? What are the costs of using liquid assets to manage liquidity? How do loan
commitments and other off balance sheet items impact liquidity management? How can you use ratio analysis to
compare your liquidity position to that of the industry? What is the financing gap? How is it used? What is a
bank run? How does it relate to systematic or market risk? Explain the sources of liquidity risk for non
depository institutions such as life insurance companies and mutual funds.
CHAPTER 18 LIABILITY AND LIQUIDITY MANAGEMENT
What characteristics are desirable for a liquid asset? What are some examples of liquid assets? Explain the
impact of reserve requirements on liquidity management. How do required reserves relate to the amount of
liquidity a bank has? What are the regulatory reasons that reserve requirements are set? Why have required
reserves been used less as a monetary policy tool recently? (What changes in the goals of the Fed Res have
caused this to happen?) Explain what a sweep account is and how a sweep account impacts the level of required
reserves. What is the difference between a weekend sweep program and a threshold sweep program? Explain
how the use of sweep accounts changes the level of required reserves for the bank. (How does it impact the
calculation of reserves?) Explain the process of Lagged Reserve Accounting. Why do banks prefer Lagged
reserve accounting over other types of reserve calculations? What happens if a bank does not meet its required
reserves? Explain the allowance for undershooting reserves. How does the next reserve period get impacted by
a period of undershooting? What impact does frequent undershooting have in relation to regulator? What are
the explicit costs of undershooting? What are the implicit costs of undershooting? What are the opportunity
costs of undershooting? What options exist for a firm that has been short reserves, but hopes to make it up
during the last few days of the reserve period? What is “gaming” the discount window? Is gaming consistent
with the original goals of the discount window? Why do most institutions rarely overshoot reserves? What is
the weekend game? How does it impact the amount of reserves a depository institutions has? What is the
difference between an automatic transfer to savings account and a sweep account? How is a retail or business
sweep account different from an individual sweep account? How can liquidity be managed from both an asset
and liability perspective?
CHAPTER 20 CAPITAL ADEQUACY
What role is played by capital in financial institutions? What is meant by capital adequacy? Explain the
importance of capital adequacy and how it impacts the firm. What is the cost of using equity capital? How does
capital relate to insolvency risk and net worth? Be able to illustrate on a simple balance sheet the impact of loan
defaults on the net worth (assuming that liabilities do not change). Use the simple balance sheet to illustrate
how this can translate to insolvency risk. Why are banks not forced to mark to market their assets? What are
the arguments for and against using book value versus market value in calculating the balance sheet? How does
the ability to use discretion in writing down the value of troubled loans change the impact of nonperforming
loans on the balance sheet? What are the problems associated with using the book value of capital instead of the
market value? What are the arguments against using market value accounting and the counter arguments that
support use of market value? How is the capital asset ratio used in measuring the capital adequacy of banks?
What problems are associated with using the leverage ratio? What are the three pillars that the Basel Accords
are based upon. What are the goals of the Basel Accords? What is the difference between tier I and tier II
capital? Explain how risk based capital ratios are calculated and used. What criticisms of Basel I prompted the
second Basel agreements (Basel II). How are off balance sheet items accounted for? What is the difference
between potential exposures and current exposures? What is a credit equivalent amount of a derivative
instrument? What are the problems with using risk based capital requirements? How do capital requirements
impact institutions other than depository institutions?
CHAPTERS 15, 16 AND 23 INTERNATIONAL RISKS
What are the sources of foreign exchange risk? What is the difference between a net long and net short position
in a foreign currency? Does matching foreign currency assets and liabilities completely eliminate foreign
exchange risk? What are the characteristics of the market for foreign currency trading? What trading activities
are the primary ones it he market? Explain the tradeoff between risk and return with foreign investments. How
do multi currency positions impact the financial institution? What is the difference between sovereign risk and
credit risk? How are they related and how are the different? What is the difference between debt repudiation
and debt rescheduling? How is country risk evaluated? Be able to explain the different ratios used to evaluate
country risk and how they relate to the level of sovereign risk in a country. What problems exist with using
ratios to measure sovereign risk? What are MYRAs? Explain the idea of Brady bonds. What are three ways a
financial institution can expand its international presence? What factors have encouraged US banks to invest
abroad? What factors have deterred US banks from expanding abroad? How has regulation of foreign banks in
the US changed since 1978? What is the rationale for these changes? What are the advantages and
disadvantages of international diversification?
Be sure to review the extra readings relating to international risks from the syllabus:
Reforming China’s Banking System FRBSF Economic Letter 2002-17
http://www.frbsf.org/publications/economics/letter/2002/el2002-17.pdf
What if Foreign Governments Diversified Their Reserves?
http://www.frbsf.org/publications/economics/letter/2005/el2005-17.pdf
FINAL STUDY GUIDE – COMPREHENSIVE PORTION
The comprehensive portion of the final will consist of 100 points from the questions below. 60 points will come
from Parts I through Part II and are A TAKE HOME PORTION OF THE EXAM. Turn in your answers (typed) to the
questions at the final examination – NO LATE SUBMISSIONS WILL BE ACCEPTED. You can use up to one page
of paper for each of the three questions (but you do not need to necessarily fill the page to receive full credit).
The page numbers referred to are from the UBPR. This is not intended to be a group project (although some of
the questions are very similar – even identical – to parts of your group project). YOU ARE EXPECTED TO
PREPARE YOUR ANSWERS ALONE – WITHOUT ANY DISCUSSION WITH YOUR CLASSMATES. ANY EVIDENCE
OF COLLUSION WILL RESULT IN A ZERO ON THE ENTIRE FINAL, NOT JUST THIS PORTION. I will answer
general questions about the problems both in class and in office hours, but I do not have time to read through
entire answers for the entire class so I will keep the playing field level and not read through any answers. Part
III will consist of the remaining points and are more general questions not referring to the bank in Parts I or the
reading in Part II. Two of the questions in part III will be on your final and answered during the “in-class” final
period.
You have been hired as an analyst to perform an in depth risk analysis of Waukee State Bank, Waukee, Iowa.
You can access the information for the bank from the FDIC website, the certificate number for the bank is
34185. Use the information provided to answer the questions that follow.
Part I Basic Financial Information
a) Perform a decomposition of the banks Return on Equity (ROE) using the data for 12/31/05. You only
need to break the ROE into its main three components. Along with the calculation of each of the three
components, include an explanation of how you could use each in an analysis of the bank. According to
page 1 (ratios) of the handout the banks annualized ROA for the first 9 months of 2003 is 1.18%
compared to 0.98% for its peer group. This places the bank in the 26th percentile in terms of ROA. Use
your decomposition to explain the performance of the banks ROA. (20 points)
b) Obviously if the ROA is low it implies that the firm has a lower net income relative to assets than its
peers. The net income of the firm can be broken down into two main parts net interest income and net
non interest income. What is the Net Interest Margin (Net Interest Income / Total Assets) of the bank
and how does it compare to the banks peers? It looks like the Bank is below the average of the peer
group in net interest margin. It appears that the bank is low compared to average in interest income, but
much higher in interest expense when compared its peers. Look at the liability mix on page 4 and page 6
to determine what choices the bank is making compared to its peers that cause it to have a higher
interest expense than its peers. Explain in detail how its choice of liabilities decreases its net interest
margin (in other words: what are the bank’s sources of funds, how expensive are they) (20 points)
Part II The Big Picture
As an analyst with Bulldog National Bank you have been given the task of predicting the path of future
interest rates and advising the bank on any possible changes it makes in its asset and liability mix. In the
past two years you correctly predicted the inversion in the yield curve and the bank decreased it holdings of
long term assets and increased its holding of short term assets. This changed the bank from being short term
liability sensitive and long term asset sensitive to a point where the both the long term and short term static
gap was zero. Unfortunately this also decreased the interest margin of the bank. The bank is currently
considering changing its asset and liability mix again and would like to provide a one page memo outlining
your forecast of changes in both short and long run interest rates, as well as the slope of the Yield curve over
the next 12 months. Given your predictions (which need to be supported briefly explain why you expect the
changes you do) you need to provide a discussion of if it should change its GAP (both long term and short
term). To help out, the CFO has suggested you read the following FRBSF Economic Letter: “Is a Recession
Imminent?” http://www.frbsf.org/publications/economics/letter/2006/el2006-32.pdf and look at recent
comments by Ben Bernanke, the chairman of the Federal Reserve Board (see the Wall Street Journal).
Part III General Questions (20 points each)
a) Be able to calculate the duration of a bond and explain the how convexity impacts the estimate of the
impact of interest rate changes on the value of a bond.
b) Explain what is meant by consolidated risk management. Why is it difficult for a financial institution to
develop a consolidated risk management plan (review readings from the first part of the class)? Discuss
the problem associated with developing a consolidated risk management plan in detail including a
discussion of the different types of risk
c) Explain briefly what is meant by Value at Risk analysis and how and why you would conduct a value at
risk analysis on the assets held by a financial institution.