Question 1

Economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the equity holders' stake in an FI.

Accepted Answer

Contingent assets and liabilities are contractual claims that have the potential to either increase or decrease the economic value of the equity holders' stake in a financial institution (FI). These claims are not certain, and their occurrence depends on the outcome of a future event. Examples of contingent assets include loans that have not yet been disbursed (but are approved) and unused lines of credit, while examples of contingent liabilities include loan commitments and warranties on products sold.

Question 2

The Reserve Bank of Australia believes that operational risk could lead to severe financial distress for FIs.Outline what is meant by operational risk and how it can impact on a financial institution.In particular, illustrate your answer with recent cases of bank operational risk, for example: retail bank system failures, trading loss fraud and Ponzi scheme fraud.

Accepted Answer

The answer of The Reserve Bank of Australia believes that...

Question 3

Economically speaking, contingent assets and liabilities are not contractual claims that directly impact the economic value of the equity holders' stake in an FI.

Accepted Answer

Contingent assets and liabilities are potential future gains or losses that may affect an FI's financial performance and, subsequently, impact the economic value of equity holders' stake. They are not contractual claims, but their impact on financial statements can have significant effects on investor confidence and market perception.

Question 4

Technological failure, employee fraud and employee errors are all sources of operational risk.

Accepted Answer

Technological failure, employee fraud and employee errors are all sources of operational risk that can cause financial losses and harm to reputation.

Question 5

Assume that you are a financial advisor to ABC Bank.The bank wishes to invest $50 million in loans with an average maturity of three years.The average interest rate on these loans is 12 per cent per annum.The bank can either grant the loans at a variable rate or at a fixed rate for the time of the investment.ABC Bank has the choice of funding these loans through either at-call deposits or through five-year maturity term deposits.Explain the different types of risks that ABC Bank faces when funding its loans.

Accepted Answer

The answer of Assume that you are a financial advisor...

Question 6

Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the foreign government that are out of the control of the foreign corporation.

Accepted Answer

Sovereign risk is indeed the risk of a foreign government imposing certain regulations or actions that may prohibit a foreign corporation from being able to repay principal or interest on a loan.

Question 7

FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.

Accepted Answer

The answer of FIs that make loans or buy bonds...

Question 8

Based on the case of Indymac Bank, explain how liquidity risk and insolvency risk caused a bank failure despite deposit insurance.Outline the chain of events that led to this financial institution's illiquidity and eventual closure.

Accepted Answer

The answer of Based on the case of Indymac Bank,...

Question 9

Systematic credit risk can be reduced by diversification.

Accepted Answer

Systematic credit risk, also known as market risk, affects the entire market or asset class and cannot be reduced through diversification, which is more effective against unsystematic or specific risk.

Question 10

One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-balance-sheet risk.Explain what is meant by off-balance-sheet activities and the risk associated with it using an example.

Accepted Answer

The answer of One of the most striking trends for...

Question 11

Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.

Accepted Answer

Credit risk is the risk associated with the possibility of non-payment of promised cash flows on loans and securities.

Question 12

If the difference between an FI's contingent liabilities and contingent assets is positive then there is an additional obligation, or claim, on the FI's net worth.

Accepted Answer

A positive difference between contingent liabilities and contingent assets implies that the FI has more liabilities than assets that may or may not become payable in the future. This creates an additional obligation or claim on the FI's net worth, reducing its overall equity position.

Question 13

A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.

Accepted Answer

A fire-sale refers to a situation where an FI sells its assets at significantly discounted prices in order to quickly raise cash to meet liquidity needs. The assets are not sold at their fair market values, but rather at prices that may be below their true worth.

Question 14

Many of the various risks, such as interest rate risk, market risk, credit risk and off-balance-sheet risk, faced by an FI often are interrelated with each other.

Accepted Answer

This is true. For example, changes in interest rates may affect market values of assets and liabilities, which can lead to credit risk if the value of collateral declines or if borrowers are unable to pay their debts. Off-balance-sheet activities, such as derivative transactions, can also expose FIs to market and credit risk.

Question 15

An Australian FI that holds a net short asset position in $US is exposed to foreign exchange rate risk if the $US appreciates against the $A over the investment period.

Accepted Answer

When an Australian financial institution holds a net short position in $US, it means that it owes more $US than it holds. If the $US appreciates against the $A over the investment period, the FI will have to pay back more $A to settle its $US obligation, resulting in foreign exchange rate risk.

Question 16

Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.

Accepted Answer

Economies of scope refer to a firm's ability to lower its average cost by producing two or more products together rather than separately, not specifically by expanding its output of financial services.

Quiz 4: Risks of Financial Institutions