banking final

How accurate is the Z-Score model?

-Found to be an accurate predictor of Bankruptcy up to 2 years prior to experiencing financial distress -predicts bankruptcy with 95% accuracy within one year and 70% accuracy within 2 years for PTMF

EAR = What 3 things?

-Market value of the position -A measure of the price sensitivity of the security to a change in market conditions -potential adverse move in market conditions

Scores reflect...

-Probability of borrower default -key quantitative measures that are statistically correlated with default -statistically based decision rules

To build a scoring model, developers utilize:

-Quantitative and statistical techniques -historical information from loan applications and credit bureaus to determine which borrowers characteristics are most useful in predicting whether a loan is repaid or not

Regulatory Capital2

-Regulators are most concerned with the safety and soundness of banks and the banking system (rather than losses to stakeholders) of individual bank -Optimum amount of capital may differ between banks and their regulators since they have different motivations and intentions

Decision rules in the expert systems approach:

-Rubics/Scoring guides that identify the standards and criteria to be used in classifying the credit risk of a loan -Designed to be more objective

What should a bank be able to do in mitigating their credit risk?

-Screening credit risks -Mitigating potential losses -Price provision to cover expected losses -Hold capital to cover unexpected losses

Loan Pricing and Credit Administration

-The appropriate mark-up should increase as: 1. the probability of default increases 2. the loss given default increases -Most banks utilize a pricing matrix that takes these two factors into account

How do bank's typically assign risk ratings and mark-ups today?

-The determination of the appropriate risk premium depends on the bank's ability to evaluate the credit risk of the customer -Mark-Up should increase as PD and LGD increase -Most banks utilize a pricing matrix that takes these two factors into account

Altman's Z-Score

-Uses statistical techniques called multiple discriminant analysis or MDA -Identifies a set of variables that best discriminate between the two- chooses weights for the financial ratios that maximize the similarity between numbers of the same group AND minimizes the similarity between members belonging to different groups

Quantitative credit scoring models and hard to quantify risk factors

-Zone of ignorance can lead to misclassification -Weights used to compute Z-scores can change through time -Not useful for new companies -Can be influenced by accounting practices

Characteristics of the profit/loss distribution for a loan?

-not normally distributed, highly skewed towards large losses, fat tails-higher probability of large losses than would be expected from normal distribution -this affects: how much to place in its RLLL (to recover expected losses) and how much capital to hold (to cover unexpected losses)

What should a bank be able to do in managing their credit risk?

-screening credit risks (underwriting criteria) -mitigate potential losses using collateral, covenants, guarantees -price and provision to cover expected losses -hold capital to cover unexpected losses

How are decision rules for qualitative credit scoring models arrived at?

-they focused on specific factors that are intended to capture important information pertaining to the 5 Cs of credit -points were awarded based off this information -credit decisions are made based upon the borrower's total points, and the loan policies established by the bank's management -based primarily on lender experience and trail/error

Which risks are the most important?

1. Financial Risk (70% of Total Risk) - Credit Risk (45%) 2. Non-Financial/ Business Risk (30% of total risk)

Quantitative credit scoring models and internal risk ratings:

1. Z-Score model, statistical modeling, A.I. modeling 2. IRR- grades assigned to the different loans and loan types by the bank

Which of the following alternatives is better/worse? A. Rejecting a loan that if accepted would be paid in full B. Accepting an applicant and making a loan that will end up in default in the future

B is worse, A is better

Secondary Reserves

Cash reserves in excess of reserve requirements held in the form of securities that can be quickly and easily converted into cash to meet unexpected liquidity needs

What does the Z-Score measure?

Measures how closely a firm "resembles" other firms that have filed bankruptcy in the past (correlation)

How is expected loss on a loan computed?

PD x LGD x Exposure at Default

Economic Capital

The bank's internal estimate of the amount of capital it needs for the various risks it is taking

Mark-Up (Credit Spread, Risk Premium)

The determination of the appropriate risk premium depends on the bank's ability to evaluate the credit risk of the customer. APR = Base Rate + Mark-Up

Economic Capital Part2

The less economic capital the bank holds, the greater the probability that the bank will experience an unexpected loss that exceeds its capital cushion and becomes insolvent

Type1 vs Type 2 errors on a loan

Type 1: accepting a loan in which the applicant will default (MORE COSTLY) Type2: Rejecting a loan in which the applicant will pay in full (not default)

Which type of error is likely to be most costly?

Type I Worse

Z-Score analysis

Uses historical data on actual loan (or bond) performance to determine the performance (default vs. non-default)

Should a loan's expected loss be priced?

YES

______ has been found an accurate predictor of bankruptcy up to 2 years prior to experiencing financial distress

Z-Score Analysis

Do Z-Scores provide a direct estimate of PD?r

Z-Scores do NOT provide a direct estimate of PD

in June of 2013 it was reported that at least $15M was stolen via online infiltration of 15 financial companies, including JP Morgan, Citigroup, E*Trade, TIAA, CREF, and TD Ameritrade, over a two-year period. This is an example of: a. operational risk b. business risk c. Reputational risk d. technological risk e. legal risk

a. operational risk

the use of statistical or mathematical models to perform credit analysis and evaluation is known as: a. quantitative credit scoring b. qualitative credit scoring c. expert systems d. Altman's folly e. none of the above

a. quantitative credit scoring

The sum of a bank's Reserve for Loan and Lease Losses and Capital, to protect the bank against risk of loss is known as its: a. risk funds b. regulatory capital c. economic capital d. tier 1 capital e. tier 2 capital

a. risk funds

Altman selected the critical cut-off Z-scores for automatic acceptance and rejection because they eliminated both type 1 and type 2 errors in his original data a. true b. false

a. true

the profit-and-loss distribution for bank loans indicates that there is positive probability for large losses if a borrower defaults, while also demonstrating that profit opportunities from full repayment are relatively small. therefore banks much effectively screen out those prospective borrowers that pose a significant counterparty credit risk for the bank a. true b. false

a. true

z-scores provide banks with a direct estimate of the borrower's probability of default (PD) a. true b. false

b. false

a bank that undertakes a significant investment in on-line credit application and decision software with the expectation that this technology will increase loan volume and improve cost efficiency is taking which of the following risks? a. operational risk b. technology risk c. software risk d. credit risk e. market risk

b. technology risk

in deciding whether to make a loan to a specific borrower, the bank faces both a type 1 and a type 2 error. which one of the following answers best describes a type 1 error? a. the bank makes a loan to a customer who will ultimately full repay the loan b. the bank makes a loan to a customer who will ultimately fail to repay the loan c. the bank does not make a loan to a customer who will ultimately fully repay the loan d. the bank does not make a loan to a customer who will ultimately fail to fully repay the loan e. none of the above answers describes a type 1 error

b. the bank makes a loan to a customer who will ultimately fail to repay the loan

the zone of ignorance or grey zone refers to: a. the Chief Lending Officer's office b. the range of Z-scores in which misclassification is most likely to occur c. any estimate of the value-at-risk made using a Monte Carlo simulation approach d. credit analysis decisions made using the expert systems approach e. all of the above

b. the range of z-scores in which misclassifications is most likely to occur

credit analysis that relies on banker experience, training, and local knowledge is known as: a. z-score analysis b. artificial intelligence systems c. expert systems or qualitative credit scoring d. knowledge based systems e. structural credit risk modeling

c. expert systems or qualitative credit scoring

the loss in a bank's earnings or its market value of equity resulting from changes in commodity prices, exchange rates and interest rates is known as: a. systemic credit risk b. operational risk c. market risk d. business risk e. none of the above

c. market risk

stress testing by bank regulators is used to help determine whether a bank has sufficient: a. primary capital b. secondary capital c. regulatory capital d. tangible equity capital e. economic capital

c. regulatory capital

the difference between uncertainty and risk is that: a. with risk, the potential outcomes can be identified and measured (while with uncertainty they cannot) b. with risk, the probabilities of potential outcomes can be estimated (while with uncertainty they cannot) c. risk requires both (a) and (b) d. there is no meaningful difference between risk and uncertainty e. none of the above answers are accurate

c. risk requires both (a) and (b)

the legal authority to sign a binding loan contract and the adequacy of the borrower's cash flow available to service the loan falls under which of the 5 C's of credit analysis?

capacity

the assessment of the adequacy of a borrower's net worth available to prevent insolvency falls under which one of the 5 C's of credit analysis?

capital

the assessment of the seriousness of the borrower's intent to repay the loan falls under which one of the 5 C's of credit analysis?

character

the assessment of the adequacy of the liquidation value of a borrower's assets in the case of default falls under which one of the 5 C's of credit analysis?

collateral

the assessment of the impact of changing economic activity on the borrower's ability to repay the loan falls under which one of the 5 C's of credit analysis?

conditions

credit risk refers to the potential variation or volatility in net income and the market value of equity resulting from: a. non-payment by the borrower b. partial payment by the borrower c. late payment by the borrower d. all of the above e. none of the above

d. all of the above

the use of expert systems or qualitative credit scoring models for credit evaluation has been criticized for which of the following reasons: a. there is no sound theoretical or statistical basis for model or the decision rules used b. the decision on loan approval is based on the subjective judgement of the analyst using their experience, training and local knowledge, and can lead to inconsistent decisions among analysts c. cut-off scores used to determine whether a loan should be made to a loan applicant are chosen based on trial and error d. all of the above are criticisms of expert systems or qualitative credit scoring e. none of the above are criticisms of expert systems or qualitative credit scoring

d. all of the above are criticisms of expert systems or qualitative credit scoring

the potential for gains or losses resulting from a bank's decision to try to increase their loan volume by offering lower interest rates than their competitors is an example of: a. operational risk b. interest rate risk c. counterparty risk d. business risk e. liquidity risk

d. business risk

the maturity or repricing GAP is a commonly used measure of which of the following types of bank risk? a. liquidity risk b. business risk c. technology risk d. interest rate risk e. operational risk

d. interest rate risk

credit risk may arise from all but which of the following? a. borrower specific or counterparty credit risk b. concentration credit risk from a lack of diversification across the bank's loan and security investments c. systemic credit risk or the spread of defaults across different segments of the bank's assets from the correlation among key underlying risk factors d. systemic credit risk from depositors unexpectedly withdrawing funds or borrowers unexpectedly pre-paying loans e. credit risk may arise from all of the above sources

d. systemic credit risk from depositors unexpectedly withdrawing funds or borrowers unexpectedly pre-paying loans

according to research conducted by financial economists at the Federal Reserve Bank of New York, Financial Risk Factors can explain approximately _____% of the earnings volatility of banks a. 6% b. 18% c. 30% d. 46% e. 70%

e. 70%

credit risk refers to the potential or volatility in net income and the market value of equity resulting from: a. non-payment by the borrower b. partial payment by the borrower c. exceed a particular amount d. the standard deviation or volatility of the risk factor of interest e. all of the above

e. all of the above

quantitative credit scoring models are most often relied upon when: a. banks make real estate, consumer, and small business b. banks make a large number of loans of very similar type c. the dollar amounts of loans of a particular type are generally small d. the information requirements associated with making a particular type of loan are low e. all of the above

e. all of the above

quantitative credit scoring models are most often relied upon when: a. banks make residential real estate, consumer, and small business loans b. banks make a large number of loans of very similar type c. the dollar amounts of loans of a particular type are generally small d. the information requirements associated with making a particular type of loan are low e. all of the above

e. all of the above

to estimate the Daily Earnings at Risk (DEAR) approach to measuring market risk requires: a. the mark-to-market value of the asset, liability or portfolio b. a measure of the price sensitivity of the asset, liability, or portfolio to the risk factor of interest (market return, market interest rate, exchange rate, etc._) c. a z-statistic that captures the probability that a change in the key risk factors of interest will not exceed a particular amount d. the standard deviation or volatility of the risk factor of interest e. all of the above

e. all of the above

the amount of capital that a bank determines that it needs to absorb unexpected losses over a specified time period, given their risk profile and risk tolerance is known as: a. primary capital b. secondary capital c. regulatory capital d. tangible equity capital e. economic capital

e. economic capital

a bank that is funding illiquid assets with volatile liabilities will be exposed to which one of the following risks? a. counterparty credit risk b. solvency risk c. operational risk d. contractual risk e. liquidity risk

e. liquidity risk

what happens when a z-score between 1.81 and 2.99 is computed?

grey zone or zone of ignorance -requires the additional information and involvement of credit analysts/ credit committee input

Qualitative Credit Scoring (analysis models Z-Score/ Logistic-Regression Approach)

most useful for evaluating loan applications for high volume, small denomination loans such as auto, mortgage and consumer loans f

regulatory capital

the amount of capital that banks are required to hold to meet minimum capital requirements as determined by regulators

Earnings at Risk

the estimated potential loss in earnings resulting from an adverse move in market conditions