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Bionic Turtle FRM Practice Questions

P1.T3. Financial Markets and Products

Chapter 1. Banks
By David Harper, CFA FRM CIPM
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Chapter 1. Banks
P1.T3.21.1. RISKS FACED BY BANKS......................................................................................... 3
P1.T3.21.2. INVESTMENT BANKS .............................................................................................. 6
P1.T3.700. MAJOR RISKS FACED BY BANKS ............................................................................... 9
P1.T3.701. BASIC BANK FUNCTIONS AND DEFINITIONS ..............................................................12

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Chapter 1. Banks
P1.T3.21.1. Risks faced by banks
P1.T3.21.2. Investment banks
P1.T3.700. Major risks faced by banks
P1.T3.701. Basic bank functions and definitions

P1.T3.21.1. Risks faced by banks

Learning outcomes: Identify the major risks faced by banks and explain ways in which
these risks can arise. Distinguish between economic capital and regulatory capital.
Summarize the Basel Committee regulations for regulatory capital and their motivations.
Explain how deposit insurance gives rise to a moral hazard problem.

21.1.1. Banks face three major risks: market, credit, and operational risks. Each of the following
is true about these major risks faced by banks EXCEPT which statement is false?

a) Market risk arises from exposure to market variables (aka, risk factors), and banks are
always exposed to some market risk
b) Although credit risk includes unexpected (UL) and expected loss (EL), EL does not meet
the strict definition of a risk; banks typically provision for (i.e., subtract) EL from loan
principal upon transaction initiation (per IFRS 9 or CELC) prior to incurring the losses
c) Operational risk, which does include cyber and legal risk, is the hardest to quantify and
considered by many to be the greatest challenge to banks
d) Derivative contracts should only map to one of the major risk categories (i.e., credit,
market, or operational), but a single contract should never map to multiple categories

21.1.2. When referring to a bank's capital, it helps to be specific because there are different
types of capital. Equity capital (aka, going concern capital) is the bank's essential buffer.
Leverage is a measure of debt-to-equity (or debt-to-assets) such that less equity implies higher
leverage. There is also a key distinction between regulatory and economic capital. Regulatory
capital is a minimum capital requirement that is externally imposed, while economic capital is an
internal measure. In regard to regulatory and economic capital, which of the following
statements is TRUE?

a) Since the crisis, the Basel Committee has increased the reliance on internal models
b) Regulatory capital is the denominator in the risk-adjusted return on capital (RAROC)
metric
c) Regulatory capital for credit risk is designed to cover a loss that is expected to be
exceeded only once every four years
d) From a bank balance sheet perspective, the net stable funding ratio (NSFR) evaluates
the bank's liabilities, while the liquidity coverage ratio (LCR) evaluates its assets

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21.1.3. Peter and Emily are having a friendly debate about regulatory policy and the implications
of moral hazard. Mary contends that deposit insurance gives rise to a moral hazard problem.
Peter asserts that moral hazard is merely theoretical; he says it is an academic concern but not
a realistic concern in the marketplace. Mary points to Acme Bank as evidence of a moral hazard
problem. If it is a true observation, which of the following observations offers the BEST
EVIDENCE in favor of the existence of a genuine moral hazard problem that has not been
addressed or resolved?

a) Acme pays higher premiums to its primary federal regulator due to the higher risk of its
assets
b) Acme bank offers higher interest rates to depositors in order to fund additional loans with
very high yields
c) Acme bank offers lower interest rates to depositors in order to fund additional loans with
very low yields
d) Acme's shareholders decide to increase their cost of equity capital as compensation for
Acme's higher leverage

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Answers:

21.1.1. D. FALSE. Instead, it is often the case that a single contract, exposures, or
position maps to multiple risk categories (or classes of risk). An interest rate swap is a
classic example of a position that maps to market and credit risk. As another example, any
exotic option is likely to map to both market risk (market variables) and credit risk (counterparty
risk). Further, most derivative contracts--especially over-the-counter (OTC) contracts--create
some kind of operational risk(s). An exotic derivative is likely to offer each of market, credit, and
operational risk!

In regard to (A), (B), and (C), each is TRUE.

21.1.2. D. TRUE. From a bank balance sheet perspective, the net stable funding ratio
(NSFR) evaluates the bank's liabilities, while the liquidity coverage ratio (LCR) evaluates
its assets

In regard to (A), (B), and (C), each is FALSE.

 In regard to false (A), instead: after the crisis, the Committee (BIS) reduced the reliance
on internal models in favor of standardized approaches
 In regard to false (B), instead: economic capital (EC) is the denominator in RAROC, as
RAROC = (after-tax expected risk-adjusted net income) / EC.
 In regard to false (C), instead: regulatory capital is calibrated with 99.9% confidence over
a one-year horizon which implies an exception once every thousand years; 1/1,000 =
0.10%.

21.1.3. B. TRUE. Acme bank offers higher interest rates to depositors in order to fund
additional loans with very high yields

As GARP explains (1.3 Deposit Insurance), "If deposit insurance were provided to a bank
without any other measures being taken, the insurance might encourage banks to take on more
risks than they would otherwise. For example, banks could offer slightly above average interest
rates to depositors and then use the funds to make risky loans at relatively high interest rates to
borrowers. Without deposit insurance, this would not be possible because depositors would
withdraw their money when the risks being taken became apparent. With deposit insurance, the
strategy might be feasible because depositors know that they are protected in the event of bank
failure and will appreciate the above average interest rates they are receiving. This argument is
an example of what is known as a moral hazard, which can be defined as the risk that the
behavior of an insured party will change because of the mere existence of the insurance, and
thus the insurance contract will become riskier. It is a serious consideration in deposit
insurance, because governments certainly do not want to set up a program that encourages a
bank to take larger risks.."1

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P1.T3.21.2. Investment banks

Learning outcomes: 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 these conflict of interest problems. Describe the distinctions between the
banking book and the trading book of a bank. Explain the originate-to-distribute banking
model and discuss its benefits and drawbacks.

21.2.1. Dronedork is planning to go public with the help of their investment bank (IB). The
company plans to sell 10.0 million shares and is exploring three options:
 Their IB will utilize a "best efforts" approach, and the cost will be fixed at $0.40 per share
 Their IB will guarantee a "firm commitment" (aka, bought deal) to sell 10.0 million shares
at $20.00 per share. Due to the bank's optimistic projections and preference for this
approach, the bank will charge no fees under this approach.
 The IB will sponsor a Dutch auction among six major bidders. Because this involves less
work, the cost will be $0.20 per share.
If the firm performs a Dutch auction, the six bidders (A to F) are shown below. Let us assume
that the price determined by the Dutch auction is also a good estimate of the price that would
clear under the other two approaches; i.e., please assume the same selling price achieved via
the Dutch auction is also achieved under best efforts and firm commitment.

The net funds received by the company deduct the underwriter's

cost from gross receipts. Under these assumptions, which
approach raises the highest amount of net funds for the
company?

a) Best efforts raises the most net proceeds for Dronedork

b) Firm Commitment raises the most net proceeds for
Dronedork
c) Dutch auction raises the most net proceeds for
Dronedork
d) The three methods happen to raise equivalent net
proceeds for Dronedork

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21.2.2. In financial services, conflicts of interest are a thematic concern of regulators, and
violations, as GARP says, "are likely to be costly both in terms of fines as well as loss of
reputation." Each of the following scenarios probably is a conflict of interest EXCEPT which is
the LEAST LIKELY to be a conflict?

a) The bank holds a sales contest to encourage the promotion of a new retail product by its
financial planners, but instead of cash, the prize is an all-expenses-paid trip to an exotic
location
b) Advisors are trained to recommend the firm's own product for retirees because the firm's
research department determined the firm's own product happens to be the best product
in the marketplace
c) The brokers' compensation plan includes a 30% variable (bonus) component, but it is
based on customer satisfaction, and the incentive plan is disclosed to customers
d) The investment bank prefers that its sell-side analyst initiate buy recommendations for
stocks where the bank seeks, or already has, an underwriting relationship with the
stock's company but only on the condition that the company meets the bank's minimum
ESG criteria

21.2.3. The originate-to-distribute (OTD) banking model has both advantages and
disadvantages. In regard to the OTD banking model, which of the following statements is
TRUE?

a) OTD depresses the originating bank's reported return on equity (ROE)

b) OTD implies that investors should be aware of the adverse selection problem implied by
information asymmetry
c) OTD has an inherent, unavoidable design bug and public relations problem: mezzanine
and equity tranches absorb losses before senior tranches
d) OTD was banned after the global financial crisis (GFC 2007-08) such that it can no
longer be conducted without incurring grave regulatory risk

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Answers:

21.2.1. C. True: Dutch auction raises the most net proceeds for Dronedork

21.2.2. C. This is the LEAST LIKELY of the scenarios to be a conflict. Variable incentive
(bonus) pay is common and not by itself a conflict, and disclosure (e.g., the Disclosure
Obligation in Regulation Best Interest) is generally the key to avoiding a conflict. Further, in this
scenario, the metric of customer satisfaction is not inconsistent with the customer's best interest
(unlike the promotion of an internal product).

In regard to (A), (B), and (D), each is likely to be a conflict of interest.

21.2.3. B. TRUE: OTD implies that investors should be aware of the adverse selection
problem implied by information asymmetry

In regard to (A), (C), and (D), each is FALSE.

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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 of 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.

 Credit risk primarily affects loan losses
 Operational risk primarily affects non-interest expense
 Market risk affects net interest income and/or non-interest income

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%

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.

 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
 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.
 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

Banks determine their economic capital by developing their own internal models. Economic
capital is often lower than regulatory capital, in which case banks will need to maintain their
capital at (or above) the regulatory capital requirement.

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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 $12,801.4 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)2
a) None
b) About $1.50 million
c) About $3.97 million
d) About $14.46 million

701.3. Hull's Chapter 22 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 in 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. Specifically:

 Moral hazard: the risk that the existence of insurance itself encourages riskier behavior
 Firm commitment IPO: an IPO may be “best efforts” or “firm commitment.” In a firm
commitment IPO, the investment bank commits to purchasing the securities at a
predetermined price and therefore bears the price risk.

 Trading book: the trading book contains positions that are held with the intent to trade
or hedge. See Basel’s note on the boundary between the banking book and the trading
book at https://www.bis.org/basel_framework/chapter/RBC/25.htm

 Originate-to-distribute refers to securitization, where the bank gets loans off its
balance sheet.
 Poison pill: mechanism to avoid acquisition or unwanted merger.
 The market maker is always prepared to quote a bid and/or offer on a security.

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