Chapter 04 Testbank Student: ___________________________________________________________________________ 1. If an FI is long-funded it means that the:
A. B. C. D.
maturity of assets equals the maturity of liabilities bank holds more long-term assets than short-term assets maturity of liabilities is less than the maturity of assets maturity of liabilities is longer than the maturity of its assets
2. An FI that invests $100 million into corporate bonds is exposed to the following risks:
A. B. C. D.
credit and interest rate risk liquidity and technology risk solvency and technology risk off-balance-sheet and interest rate risk
3. An FI that holds more short-term assets relative to long-term liabilities is:
A. B. C. D.
exposed to refinancing risk exposed to restructuring risk exposed to reinvestment risk not exposed to any risks
4. An example of refinancing risk is a case in which an FI:
A. B. C. D.
funds two-year maturity assets with one-year maturity liabilities funds one-year maturity assets with two-year maturity liabilities funds two-year maturity assets with two-year maturity liabilities None of the listed options are correct.
5. A decrease in interest rates means that the discount rate on cash flows is:
A. B. C. D.
decreased and thus the market value of an FI's assets and liabilities decreases. increased and thus the market value of an FI's assets and liabilities decreases. increased and thus the market value of an FI's assets and liabilities increases. decreased and thus the market value of an FI's assets and liabilities increases.
6. An increase in interest rates means that the discount rate on cash flows is:
A. B. C. D.
decreased and thus the market value of an FI's assets and liabilities decreases increased and thus the market value of an FI's assets and liabilities decreases increased and thus the market value of an FI's assets and liabilities increases decreased and thus the market value of an FI's assets and liabilities increases
7. Market risk is defined as the risk:
A. B. C. D.
incurred by granting loans to companies that do not hold a large market share incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices that an FI loses market share
8. The market risk of an FI increases with:
A. B. C. D.
increasing volatility of asset prices increasingly large unhedged short positions in bonds, equities and other commodities increasingly large unhedged long positions in bonds, equities and other commodities All of the listed options are correct.
9. Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed funds and general insurance companies?
A. B. C. D.
Because the average maturities of their assets are longer than those of money market managed funds/general insurance companies. Because the average maturities of their assets are shorter than those of money market managed funds/general insurance companies. They are not exposed to more risk. Because they are not specialised in credit risk management.
10. Non-performing loans are defined as loans that:
A. B. C. D.
are either in default or close to being in default and are at least 90 days in arrears have been written off and loans that are at least 80 days in arrears are either in default or close to being in default and are at least 60 days in arrears have been written off and loans that are at least 60 days in arrears
11. What does systematic credit risk mean?
A. B. C. D.
The risk of default of the borrowing firm that arises from the borrowing firm's specific projects. The risk of default associated with microeconomic conditions affecting some borrowers. The risk of default associated with general macroeconomic conditions affecting all borrowers. The risk of default associated with general macroeconomic conditions affecting some borrowers.
12. The major difference between firm-specific credit risk and systematic credit risk is that:
A. B. C. D.
FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified. FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified. None of the listed options are correct, as FIs can diversify both types of credit risk. None of the listed options are correct, as FIs cannot diversify either type of credit risk.
13. can be reduced by diversification.
A. B. C. D.
Firm-specific credit risk Systematic credit risk Firm-specific and systematic credit risks None of the listed options are correct.
14. A high-quality loan book for Australian banks during the global financial crisis (GFC) meant that:
A. B. C. D.
their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the GFC Australian banks' profitability fell and Australian FIs were severely impacted by the GFC Australian banks' profitability was maintained and Australian FIs were not severely impacted by the GFC
15. Which of the following are typical off-balance-sheet activities?
A. B. C. D.
letters of credit loan commitments forward contracts, swaps and other derivative securities All of the listed options are correct.
16. What are the major objectives of technological expansion?
A. B. C. D.
To lower operating costs, increase profits and capture new markets. To stabilise operating costs, increase profits and capture new markets. To lower operating costs, stabilise profits and capture new markets. To lower operating costs, increase profits and stabilise the existing market share.
17. What type of risk focuses upon future contingencies?
A. B. C. D.
liquidity risk interest rate risk credit risk off-balance-sheet risk
18. Which of the following is a suitable description of the term 'economies of scope'?
A. B. C. D.
the use of several inputs to produce one common output the ability to generate cost savings by producing more than one output with the same inputs the ability to lower average operating costs by expanding its output of financial services the ability to lower average operating costs by lowering its output of financial services
19. Which of the following is a suitable description of the term 'economies of scale'?
A. B. C. D.
the use of several inputs to produce one common output the ability to generate cost savings by producing more than one output with the same inputs the ability to lower average operating costs by expanding its output of financial services the ability to lower average operating costs by lowering its output of financial services
20. Which of the following are typical operational risk sources?
A. B. C. D.
employee fraud back-office failures general technological glitches All of the listed options are correct.
21. In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar?
A. The FI holds €00 million in assets and €70 million in liabilities.
B. The FI holds €100 million in assets and €100 million in liabilities.
C. The FI holds 70 million in assets and €100 million in liabilities.
D. The FI does not hold any assets or liabilities in euros, but considers doing so in the future.
22. An Australian FI that invests €50 million in three-year maturity loans and partially funds these loans with €30 million one-year deposits is exposed to the following risks.
A. A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. C. A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing interest rates in the Eurozone. D. A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the Eurozone. 23. Sovereign risk refers to the risk that repayments from:
A. B. C. D.
local borrowers are interrupted because of interference from foreign governments foreign borrowers are interrupted because of interference from local governments foreign borrowers are interrupted because of interference from foreign governments None of the listed options are correct.
24. Which of the following is an effective measure for claimholders if a foreign government prohibits repayment of debt obligations to an international lender?
A. The claimholder can recover its outstanding debt through local courts. B. The claimholder can recover its outstanding debt through international courts C. The claimholder cannot do anything. D. The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future loans or supply of funds. 25. Unanticipated diseconomies of scale and scope are a result of:
A. B. C. D.
technology risk interest rate risk foreign exchange risk credit risk
26. The major source of risk exposure resulting from issuance of standby letters of credit is:
A. B. C. D.
technology risk interest rate risk credit risk off-balance-sheet risk
27. Politically motivated limitations on payments of foreign currency may expose the FI to:
A. B. C. D.
sovereign or country risk interest rate risk credit risk foreign exchange risk
28. The risk that a debt security's price will fall, subjecting the investor to a capital loss is:
A. B. C. D.
credit risk political risk currency risk market risk
29. The risk that interest income will increase at a slower rate than interest expense is:
A. B. C. D.
credit risk political risk currency risk interest rate risk
30. The risk that borrowers are unable to repay their loans on time is called:
A. B. C. D.
credit risk sovereign risk currency risk liquidity risk
31. A letter of credit is:
A. B. C. D.
a credit guarantee issued by an FI's customer to pay a predetermined amount of money to the FI at a future point in time an on-balance-sheet transaction for the issuing FI a credit guarantee issued by an FI on which payment is contingent on some future event occurring None of the listed options are correct.
32. A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 per cent annually. It has assets of $5 million with an average maturity of five years earning interest rates of 6 per cent annually. To what risk is the bank exposed?
A. B. C. D.
reinvestment risk refinancing risk interest rate risk refinancing risk and interest rate risk
33. Matching the foreign currency book protects the FI from:
A. B. C. D.
sovereign country risk interest rate risk liquidity risk foreign exchange risk
34. An FI that finances a German euro loan with US dollar deposits is exposed to:
A. B. C. D.
technology risk interest rate risk credit risk foreign exchange risk
35. An example of a discrete risk is sudden changes in:
A. B. C. D.
the interest rate banking regulations foreign exchange rates commodity prices
36. Event risks such as earthquakes, fraud and theft:
A. B. C. D.
do not have an impact on an FI's performance are easy to measure and to predict form a normal cost of doing business for FIs may have a significant and negative impact on an FI's performance but are difficult to measure and to predict
37. During periods of high and volatile inflation, an FI's:
A. B. C. D.
interest rate risk exposure and credit risk exposure tends to decrease interest rate risk exposure and credit risk exposure tends to increase interest rate risk exposure and credit risk exposure tends to be unaffected None of the listed options are correct.
38. An FI with a low level of leverage, such as a high level of capitalisation:
A. B. C. D.
is generally less profitable is better able to withstand losses has improved ability to remain solvent All of the listed options are correct.
39. Credit risk puts both the principal loaned and expected interest payments at risk. As a result, FIs issue financial claims that have a risk–return profile with:
A. high probability of fixed upside return B. high probability of large downside risk C. low probability of large downside risk D. both high probability of fixed upside return and low probability of large downside risk 40. The collapse of the US bank IndyMac Bank was an example of:
A. B. C. D.
market risk operational risk insolvency risk insolvency and liquidity risk
41. Technological risk:
A. can only lead to an FI's short-term distress B. refers to the scenario that technological investments produce the anticipated cost savings C. can result in major losses and the long-term viability of the FI D. refers to the scenario that technological investments do not produce the anticipated savings, and can cause major losses and impact on the viability of the FI 42. The Bank for International Settlements:
A. defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events B. does not include technology risk in its categorisation of operational risk C. is the principal organisation of central banks in the minor economies of the world D. All of the listed options are correct. 43. A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for one of her friends. The loan was subsequently added to a loan pool, securitised and sold. Which of the following risks applies to the false documentation by the employee?
A. B. C. D.
market risk credit risk operational risk technological risk
44. Which function of an FI involves buying primary securities and issuing secondary securities?
A. B. C. D.
brokerage asset transformation investment research trading
45. Which of the following may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus causing an FI's equity to approach zero?
A. B. C. D.
insolvency risk sovereign risk currency risk liquidity risk
46. The BIS definition 'the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events' encompasses which of the following risks?
A. B. C. D.
credit risk and liquidity risk operational risk and technology risk credit risk and market risk technology risk and liquidity risk
47. The increased opportunity for a bank to securitise loans into liquid and tradable assets is likely to affect which type of risk?
A. B. C. D.
sovereign risk market risk insolvency risk technological risk
48. Which of the following situations pose a refinancing risk for an FI?
A. An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity. B. An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-year maturity. C. An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-year maturity. D. An FI matches the maturity of its assets and liabilities. 49. The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:
A. B. C. D.
liquidity risk reinvestment risk credit risk foreign exchange risk
50. The major source of risk exposure resulting from issuance of standby letters of credit is:
A. B. C. D.
interest rate risk credit risk foreign exchange risk off-balance-sheet risk
51. The positive difference between an FI's contingent liabilities and contingent assets represents:
A. B. C. D.
an additional obligation, or claim, on the FI's net worth an additional profit for the FI an increase in assets None of the listed options are correct.
52. The potential exercise of unanticipated contingencies can result in:
A. B. C. D.
technology risk interest rate ris. credit risk off-balance-sheet risk
53. Matching the foreign currency book does not protect the FI from:
A. B. C. D.
sovereign country risk interest rate risk liquidity risk foreign exchange risk
54. A small local bank failed because of a housing market collapse following the departure of the area's largest employer. What type of risk applies to the failure of the institution?
A. B. C. D.
firm-specific risk technological risk operational risk insolvency risk
55. Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.
True
False
56. An FI that only operates domestically is never exposed to foreign exchange rate risk.
True
False
57. An FI that matches the maturities of its assets and liabilities is perfectly hedged against interest rate risk.
True
False
58. A short-funded FI is exposed to increasing interest rates.
True
False
59. When analysing an FI's performance, it is not important to consider its off-balance-sheet activities as they have no current or future impact on the FI's financial standing.
True
False
60. Firm-specific credit risk can be reduced by diversification.
True
False
61. Systematic credit risk can be reduced by diversification.
True
False
62. Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.
True
False
63. Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.
True
False
64. Technological failure, employee fraud and employee errors are all sources of operational risk.
True
False
65. 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.
True
False
66. A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.
True
False
67. 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.
True
False
68. 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.
True
False
69. 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.
True
False
70. 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.
True
False
71. Economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the equity holders' stake in an FI.
True
False
72. Economically speaking, contingent assets and liabilities are not contractual claims that directly impact the economic value of the equity holders' stake in an FI.
True
False
73. 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.
74. 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.
75. 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.
76. 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.
Chapter 04 Testbank Key 1. If an FI is long-funded it means that the:
A. B. C. D.
maturity of assets equals the maturity of liabilities bank holds more long-term assets than short-term assets maturity of liabilities is less than the maturity of assets maturity of liabilities is longer than the maturity of its assets
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
2. An FI that invests $100 million into corporate bonds is exposed to the following risks:
A. B. C. D.
credit and interest rate risk liquidity and technology risk solvency and technology risk off-balance-sheet and interest rate risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
3. An FI that holds more short-term assets relative to long-term liabilities is:
A. B. C. D.
exposed to refinancing risk exposed to restructuring risk exposed to reinvestment risk not exposed to any risks
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
4. An example of refinancing risk is a case in which an FI:
A. B. C. D.
funds two-year maturity assets with one-year maturity liabilities funds one-year maturity assets with two-year maturity liabilities funds two-year maturity assets with two-year maturity liabilities None of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
5. A decrease in interest rates means that the discount rate on cash flows is:
A. B. C. D.
decreased and thus the market value of an FI's assets and liabilities decreases. increased and thus the market value of an FI's assets and liabilities decreases. increased and thus the market value of an FI's assets and liabilities increases. decreased and thus the market value of an FI's assets and liabilities increases.
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
6. An increase in interest rates means that the discount rate on cash flows is:
A. B. C. D.
decreased and thus the market value of an FI's assets and liabilities decreases increased and thus the market value of an FI's assets and liabilities decreases increased and thus the market value of an FI's assets and liabilities increases decreased and thus the market value of an FI's assets and liabilities increases
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
7. Market risk is defined as the risk:
A. B. C. D.
incurred by granting loans to companies that do not hold a large market share incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices that an FI loses market share
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.2 Understand the significance of market risk for FIs
8. The market risk of an FI increases with:
A. B. C. D.
increasing volatility of asset prices increasingly large unhedged short positions in bonds, equities and other commodities increasingly large unhedged long positions in bonds, equities and other commodities All of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.2 Understand the significance of market risk for FIs
9. Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed funds and general insurance companies?
A. B. C. D.
Because the average maturities of their assets are longer than those of money market managed funds/general insurance companies. Because the average maturities of their assets are shorter than those of money market managed funds/general insurance companies. They are not exposed to more risk. Because they are not specialised in credit risk management.
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
10. Non-performing loans are defined as loans that:
A. B. C. D.
are either in default or close to being in default and are at least 90 days in arrears have been written off and loans that are at least 80 days in arrears are either in default or close to being in default and are at least 60 days in arrears have been written off and loans that are at least 60 days in arrears
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
11. What does systematic credit risk mean?
A. B. C. D.
The risk of default of the borrowing firm that arises from the borrowing firm's specific projects. The risk of default associated with microeconomic conditions affecting some borrowers. The risk of default associated with general macroeconomic conditions affecting all borrowers. The risk of default associated with general macroeconomic conditions affecting some borrowers.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
12. The major difference between firm-specific credit risk and systematic credit risk is that:
A. B. C. D.
FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified. FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified. None of the listed options are correct, as FIs can diversify both types of credit risk. None of the listed options are correct, as FIs cannot diversify either type of credit risk.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
13. can be reduced by diversification.
A. B. C. D.
Firm-specific credit risk Systematic credit risk Firm-specific and systematic credit risks None of the listed options are correct.
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
14. A high-quality loan book for Australian banks during the global financial crisis (GFC) meant that:
A. B. C. D.
their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the GFC Australian banks' profitability fell and Australian FIs were severely impacted by the GFC Australian banks' profitability was maintained and Australian FIs were not severely impacted by the GFC
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
15. Which of the following are typical off-balance-sheet activities?
A. B. C. D.
letters of credit loan commitments forward contracts, swaps and other derivative securities All of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
16. What are the major objectives of technological expansion?
A. B. C. D.
To lower operating costs, increase profits and capture new markets. To stabilise operating costs, increase profits and capture new markets. To lower operating costs, stabilise profits and capture new markets. To lower operating costs, increase profits and stabilise the existing market share.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
17. What type of risk focuses upon future contingencies?
A. B. C. D.
liquidity risk interest rate risk credit risk off-balance-sheet risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
18. Which of the following is a suitable description of the term 'economies of scope'?
A. B. C. D.
the use of several inputs to produce one common output the ability to generate cost savings by producing more than one output with the same inputs the ability to lower average operating costs by expanding its output of financial services the ability to lower average operating costs by lowering its output of financial services
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
19. Which of the following is a suitable description of the term 'economies of scale'?
A. B. C. D.
the use of several inputs to produce one common output the ability to generate cost savings by producing more than one output with the same inputs the ability to lower average operating costs by expanding its output of financial services the ability to lower average operating costs by lowering its output of financial services
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
20. Which of the following are typical operational risk sources?
A. B. C. D.
employee fraud back-office failures general technological glitches All of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
21. In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar?
A. The FI holds €00 million in assets and €70 million in liabilities.
B. The FI holds €100 million in assets and €100 million in liabilities.
C. The FI holds 70 million in assets and €100 million in liabilities.
D. The FI does not hold any assets or liabilities in euros, but considers doing so in the future.
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
22. An Australian FI that invests €50 million in three-year maturity loans and partially funds these loans with €30 million one-year deposits is exposed to the following risks.
A. A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone. C. A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing interest rates in the Eurozone. D. A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the Eurozone. AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
23. Sovereign risk refers to the risk that repayments from:
A. B. C. D.
local borrowers are interrupted because of interference from foreign governments foreign borrowers are interrupted because of interference from local governments foreign borrowers are interrupted because of interference from foreign governments None of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers
24. Which of the following is an effective measure for claimholders if a foreign government prohibits repayment of debt obligations to an international lender?
A. The claimholder can recover its outstanding debt through local courts. B. The claimholder can recover its outstanding debt through international courts C. The claimholder cannot do anything. D. The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future loans or supply of funds. AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers
25. Unanticipated diseconomies of scale and scope are a result of:
A. B. C. D.
technology risk interest rate risk foreign exchange risk credit risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
26. The major source of risk exposure resulting from issuance of standby letters of credit is:
A. B. C. D.
technology risk interest rate risk credit risk off-balance-sheet risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
27. Politically motivated limitations on payments of foreign currency may expose the FI to:
A. B. C. D.
sovereign or country risk interest rate risk credit risk foreign exchange risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers
28. The risk that a debt security's price will fall, subjecting the investor to a capital loss is:
A. B. C. D.
credit risk political risk currency risk market risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.2 Understand the significance of market risk for FIs
29. The risk that interest income will increase at a slower rate than interest expense is:
A. B. C. D.
credit risk political risk currency risk interest rate risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
30. The risk that borrowers are unable to repay their loans on time is called:
A. B. C. D.
credit risk sovereign risk currency risk liquidity risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
31. A letter of credit is:
A. B. C. D.
a credit guarantee issued by an FI's customer to pay a predetermined amount of money to the FI at a future point in time an on-balance-sheet transaction for the issuing FI a credit guarantee issued by an FI on which payment is contingent on some future event occurring None of the listed options are correct.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
32. A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 per cent annually. It has assets of $5 million with an average maturity of five years earning interest rates of 6 per cent annually. To what risk is the bank exposed?
A. B. C. D.
reinvestment risk refinancing risk interest rate risk refinancing risk and interest rate risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
33. Matching the foreign currency book protects the FI from:
A. B. C. D.
sovereign country risk interest rate risk liquidity risk foreign exchange risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
34. An FI that finances a German euro loan with US dollar deposits is exposed to:
A. B. C. D.
technology risk interest rate risk credit risk foreign exchange risk
AACSB: Analytic Bloom's: Application Difficulty: Easy Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
35. An example of a discrete risk is sudden changes in:
A. B. C. D.
the interest rate banking regulations foreign exchange rates commodity prices
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs
36. Event risks such as earthquakes, fraud and theft:
A. B. C. D.
do not have an impact on an FI's performance are easy to measure and to predict form a normal cost of doing business for FIs may have a significant and negative impact on an FI's performance but are difficult to measure and to predict
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs
37. During periods of high and volatile inflation, an FI's:
A. B. C. D.
interest rate risk exposure and credit risk exposure tends to decrease interest rate risk exposure and credit risk exposure tends to increase interest rate risk exposure and credit risk exposure tends to be unaffected None of the listed options are correct.
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs
38. An FI with a low level of leverage, such as a high level of capitalisation:
A. B. C. D.
is generally less profitable is better able to withstand losses has improved ability to remain solvent All of the listed options are correct.
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks
39. Credit risk puts both the principal loaned and expected interest payments at risk. As a result, FIs issue financial claims that have a risk–return profile with:
A. high probability of fixed upside return B. high probability of large downside risk C. low probability of large downside risk D. both high probability of fixed upside return and low probability of large downside risk AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
40. The collapse of the US bank IndyMac Bank was an example of:
A. B. C. D.
market risk operational risk insolvency risk insolvency and liquidity risk
AACSB: Analytic Bloom's: Application Difficulty: Hard Est time: 1–3 Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks
41. Technological risk:
A. can only lead to an FI's short-term distress B. refers to the scenario that technological investments produce the anticipated cost savings C. can result in major losses and the long-term viability of the FI D. refers to the scenario that technological investments do not produce the anticipated savings, and can cause major losses and impact on the viability of the FI AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
42. The Bank for International Settlements:
A. defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events B. does not include technology risk in its categorisation of operational risk C. is the principal organisation of central banks in the minor economies of the world D. All of the listed options are correct. AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Hard Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
43. A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for one of her friends. The loan was subsequently added to a loan pool, securitised and sold. Which of the following risks applies to the false documentation by the employee?
A. B. C. D.
market risk credit risk operational risk technological risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
44. Which function of an FI involves buying primary securities and issuing secondary securities?
A. B. C. D.
brokerage asset transformation investment research trading
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
45. Which of the following may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus causing an FI's equity to approach zero?
A. B. C. D.
insolvency risk sovereign risk currency risk liquidity risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks
46. The BIS definition 'the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events' encompasses which of the following risks?
A. B. C. D.
credit risk and liquidity risk operational risk and technology risk credit risk and market risk technology risk and liquidity risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: 1–3 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
47. The increased opportunity for a bank to securitise loans into liquid and tradable assets is likely to affect which type of risk?
A. B. C. D.
sovereign risk market risk insolvency risk technological risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.2 Understand the significance of market risk for FIs
48. Which of the following situations pose a refinancing risk for an FI?
A. An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity. B. An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-year maturity. C. An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-year maturity. D. An FI matches the maturity of its assets and liabilities. AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
49. The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:
A. B. C. D.
liquidity risk reinvestment risk credit risk foreign exchange risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
50. The major source of risk exposure resulting from issuance of standby letters of credit is:
A. B. C. D.
interest rate risk credit risk foreign exchange risk off-balance-sheet risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
51. The positive difference between an FI's contingent liabilities and contingent assets represents:
A. B. C. D.
an additional obligation, or claim, on the FI's net worth an additional profit for the FI an increase in assets None of the listed options are correct.
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
52. The potential exercise of unanticipated contingencies can result in:
A. B. C. D.
technology risk interest rate ris. credit risk off-balance-sheet risk
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
53. Matching the foreign currency book does not protect the FI from:
A. B. C. D.
sovereign country risk interest rate risk liquidity risk foreign exchange risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
54. A small local bank failed because of a housing market collapse following the departure of the area's largest employer. What type of risk applies to the failure of the institution?
A. B. C. D.
firm-specific risk technological risk operational risk insolvency risk
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks
55. Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.
TRUE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Easy Est time: <1 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
56. An FI that only operates domestically is never exposed to foreign exchange rate risk.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
57. An FI that matches the maturities of its assets and liabilities is perfectly hedged against interest rate risk.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
58. A short-funded FI is exposed to increasing interest rates.
TRUE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
59. When analysing an FI's performance, it is not important to consider its off-balance-sheet activities as they have no current or future impact on the FI's financial standing.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
60. Firm-specific credit risk can be reduced by diversification.
TRUE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
61. Systematic credit risk can be reduced by diversification.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
62. Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.
TRUE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
63. Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.
FALSE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
64. Technological failure, employee fraud and employee errors are all sources of operational risk.
TRUE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
65. 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.
TRUE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs
66. A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: <1 Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs
67. 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.
TRUE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: 1–3 Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers
68. 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.
TRUE
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Medium Est time: <1 Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs
69. 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.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs
70. 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.
TRUE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
71. Economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the equity holders' stake in an FI.
TRUE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
72. Economically speaking, contingent assets and liabilities are not contractual claims that directly impact the economic value of the equity holders' stake in an FI.
FALSE
AACSB: Analytic Bloom's: Application Difficulty: Medium Est time: 1–3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
73. 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.
In mismatching the maturities of assets and liabilities as part of their asset transformation function, FIs potentially expose themselves to interest rate risk. If ABC Bank finances its loans with average maturities of three years through at-call deposits (which is short term in nature) then the bank can be viewed as being ‘short-funded’. That is, the maturity of its liabilities is less than the maturity of its assets. As a result, it potentially exposes itself to refinancing risk. This is the risk that the cost of rolling over or re-borrowing funds could be more than the return earned on asset investments. In the second case, the bank loans (average three years maturity) are financed through five-year maturity term deposits. Here the bank is exposed to reinvestment risk; by holding shorter term assets relative to liabilities it faced uncertainty about the interest rate at which it could reinvest funds borrowed for a longer period. This exposure is more evident when the bank borrows fixed-rate deposits while investing in floating-rate loans—that is, loans whose interest rates are changed or adjusted in line with market movements in interest rates. In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, ABC Bank faces market value risk as well. Mismatching maturities by holding longer term assets than liabilities means that when interest rates rise, the market value of the FI’s assets falls by a greater amount than its liabilities. This exposes the FI to the risk of economic loss and potentially the risk of insolvency.
AACSB: Analytic Bloom's: Comprehension Difficulty: Medium Est time: 10–15 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
74. 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.
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. An off-balance-sheet activity, by definition, does not appear on an FI’s current balance sheet since it does not involve holding a current primary claim (asset) or the issuance of a current secondary claim (liability). Instead, off-balance-sheet activities affect the future shape of an FI’s balance sheet in that they involve the creation of contingent assets and liabilities that give rise to their potential (future) placement on the balance sheet. Thus, accountants place them ‘below the bottom line’ of an FI’s asset and liability balance sheet. A good example of an off-balance-sheet activity is the issuance of standby letter of credit guarantees by insurance companies and banks to back the issue of a bond issue or a trade contract. Many foreign trade transactions do not take place without bank or insurance company letter of credit guarantees that promise payment to suppliers should the buying organisations default on future obligations. Similarly, many corporate bond issues would not take place without such guarantees. Nothing appears on the FI’s balance sheet today or in the future. However, the fee earned for issuing the letter of credit guarantee appears on the FI’s income statement. As a result, the ability to earn fee income while not loading up or expanding the balance sheet has become an important motivation for FIs to pursue off-balance-sheet business. Unfortunately, this activity is not risk free. Suppose the corporate bond issuer defaults on its bond interest and principal payments. Then the contingent liability or guarantee the FI issued becomes an actual or real liability that appears on the FI’s balance sheet. That is, the FI has to use its own equity to compensate investors in the corporate bonds it guaranteed with its letter of credit.
AACSB: Analytic Bloom's: Knowledge Bloom's: Knowledge Difficulty: Hard Est time: 10–15 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management
75. 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.
In the middle of 2008, the US IndyMac Bank failed, in part due to a bank run that continued for several days, even after it was taken over by the US Federal Deposit Insurance Corporation (FDIC). The events which preceded this were as follows: IndyMac Bank announced on Monday 7 July 2008 that due to its deteriorating capital position its mortgage operations would cease and it would operate only as a retail bank. IndyMac had been operating under close regulatory scrutiny since January 2008. The bank lost US$614.8 million in 2007 and US$184.2 million during the first quarter of 2008, largely as the result of losses on home loans. News reports over the following days suggested the possibility that IndyMac Bank would become the largest bank failure in more than 20 years. Worried that they would not have access to their money, bank depositors rushed to withdraw money from IndyMac, even though their deposits were insured up to US$100 000 by the FDIC. The run on deposits was so large that by the weekend of the week of the original announcement, the FDIC stepped in and took over the bank. Citing a massive run on deposits, regulators shut its main branch three hours early, leaving customers stunned and upset. Further, the bank’s 33 branches were closed over the weekend, and the FDIC advised that the bank would reopen on Monday. Customers were not able to undertake any phone or internet transactions over the weekend but were able to continue to use ATMs, debit cards and cheques. The failure of IndyMac Bank was the second largest FI failure in the US at that time, following only Continental Illinois Bank, which had assets of about $40 billion before it closed in 1984. IndyMac's failure had been widely expected and as the bank was shutting offices and laying off employees, deposit withdrawals amounted to $100 million a day, causing the bank’s share price to plummet to less than $1 as analysts built into the stock price the expected losses. The bank, which had employed 10 000 staff, fell prey to a classic 'run on the bank' and regulators suggested that injudicious reporting of events helped to fuel massive withdrawals. The Office of Thrift Supervision director John M. Reich stated that ‘this institution failed today due to a liquidity crisis. Although this institution was already in distress, the deposit run pushed IndyMac over the edge'.
AACSB: Reflective thinking Bloom's: Knowledge Bloom's: Knowledge Difficulty: Hard Est time: 10–15 Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks
76. 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.
Operational risk is partly related to technology risk and can arise whenever existing technology malfunctions or back-office support systems break down. Even though such computer glitches are rare, their occurrence can cause major dislocations in the FIs involved and potentially disrupt the financial system in general. For example, in March 2011, Commonwealth Bank ATMs allowed customers to overdraw their accounts due to a technical glitch. As customers learned of this, some took advantage of the perceived opportunity to withdraw what they thought was ‘free money’. When the bank requested the return of the funds, many were unable to do so. The opposite happened a few months later when customers were unable to withdraw funds from ATMs, make EFTPOS payments or access their online accounts, during which time many were not paid salaries and other payments owed to them. A similar problem had occurred at National Australia Bank in 2010 and at Westpac later in 2011. Operational risk is not exclusively the result of the failure of technology. For example, employee fraud and errors constitute a type of operational risk that often negatively affects the reputation of an FI. An example of employee fraud was in 2012, where a Sydney woman was convicted of defrauding ING Australia of more than $45 million by siphoning funds from corporate accounts at the bank to her personal account at the ANZ Bank. This was the largest fraud by an individual in Australia. Another example of employee fraud is the trading loss fraud incurred by a trader at the French bank, Société Générale, in February 2008 and resulted in a US$7.2 billion in trading losses. The trader, Jérôme Kerviel, traded futures on the European stock indexes and took large positions on the expectation that European markets would continue to rise. At the end of 2007 the trades were profitable. But at the beginning of 2008 the market turned against him, as the global financial crisis hit, and European markets fell sharply. The result was the largest market-risk related loss by any trader at any time. The operational risk occurred as Mr Kerviel was able to circumvent the bank’s controls because he had previously worked in the bank's 'back office' and had prior knowledge of the processing of trades. Operational risk can occur from external frauds such as the Ponzi scheme fraud committed in the US by Bernie Madoff, a hedge fund manager, in 2009. Bernie Madoff lost US$65 billion in client funds as a part of a giant Ponzi scheme, the largest investor fraud ever committed by an individual in the US.
AACSB: Reflective thinking Bloom's: Knowledge Bloom's: Knowledge Difficulty: Hard Est time: 10–15 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs
Chapter 04 Testbank Summary Category # of Questions AACSB: Analytic 74 AACSB: Reflective thinking 2 Bloom's: Application 36 Bloom's: Comprehension 1 Bloom's: Knowledge 39 Bloom's: Knowledge 39 Difficulty: Easy 15 Difficulty: Hard 12 Difficulty: Medium 49 Est time: 1–3 40 Est time: 10–15 4 Est time: <1 32 Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance 14 Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern 4 FIs Learning Objective: 4.2 Understand the significance of market risk for FIs 4 Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs 13 Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers 4 Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs 8 Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs 3 Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management 12 Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs 12 Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks 5
