Stress Testing
Anurak argues that the advantage of the single-factor sensitivity stress tests is their easy implementation, but Chantana states that the advantage of these tests is their flexibility to do reverse engineering. What do you think?
(a) Anurak is correct and Chantana is wrong
(b) Anurak is wrong and Chantana is correct
(c) Both Anurak and Chantana are correct
(d) Both Anurak and Chantana are wrong
(c) Both Anurak and Chantana are correct
What is credit risk?
(a) The risk of extending credit beyond the regulatory limits
(b) The potential that the counterparty will fail to repay the debt
(c) The risk of deposit withdrawals
(d) The risk for the bank of not securing adequate funding
(b) The potential that the counterparty will fail to repay the debt
Why do we say that the LCR is the result of a stress test?
The LCR is computed as the ratio of High-Quality Liquid Assets (HQLA) to the outflows experienced during a 30-day stress scenario.
That is, you are testing whether there is sufficient HQLA to confront a stressed outflow. That is a stress test.
If a bank has a negative repricing gap over one year, what would be the impact of an increase in interest rates on its income?
(a) It will drop
(b) It will increase
(c) It will remain unchanged
(d) There is not enough information to determine this
(a) It will drop
It will drop since the time to reprice bank assets is longer than the time to reprice bank liabilities
Bank Pedri has $60 billion in assets while Bank Vitinha has $180 billion in assets. Therefore, Bank Vitinha is systemically more important than Bank Pedri.
True or False? Explain.
False. Even though Bank Vitinha is three times the size of Bank Pedri, Bank Pedri may be systemically more important. This could be because Bank Pedri could be more interconnected with other banks that Bank Vitinha so that the failure of Bank Pedri could lead to a cascade of failures.
The first step in running macro stress tests is identification of major risks and exposures. What is the second step?
(a) Discussion with the industry
(b) Collection of the data
(c) Calibration of the shocks and scenarios
(d) Defining the coverage of the tests
(c) Calibration of the shocks and scenarios
Bank Diaz has a loan to AAA-rated company Yamal which has NOT been in default. Is there a credit risk related to that loan?
(a) No, there is no credit risk because Yamal is AAA-rated company
(b) No, there is no credit risk because the loan has not been in default
(c) Yes, there is credit risk related to that loan
(d) The available information is not sufficient to determine
(c) Yes, there is credit risk related to that loan
Explain what is meant by the "haircut" related to wholesale repo funding (use an example). Why does it exist and what causes it to rise or fall?
Does a bank using repo funding prefer a high or low haircut?
The haircut is like a discount that the repo lender sets on the collateral provided by the borrower. For example, if the borrower posts $100 in collateral, the lender can set a haircut of 5%, meaning that it will only lend $95 based on that amount of collateral.
It is set to protect the borrower from risk of the collateral losing value.
The haircut rises when market conditions become more uncertain (higher risk). Leading up to the GFC, haircuts rose for all kinds of assets posted as collateral in repo markets.
The collapse of Silicon Valley Bank was caused by depositor run, driven by irrational fear of uninformed depositors. Rather than expanding its portfolio of loans, the bank had been buying US Government Bonds, with very little credit risk on its balance sheet.
True or False? Explain.
False
The second part of the statement is correct. There was little credit risk on its balance sheet, but it was subject to large market risk because of the high duration of its government securities portfolio.
When interest rates increased sharply in 2022, the market value of these securities fell to a point that equity was wiped out. Thus, the deposit run was not irrational.
Amit argues that financial interconnectedness can help dampen shocks by dispersing their impact but can also propagate shocks beyond their original impact. Priya disagrees. What do you think?
(a) Amit is correct
(b) Priya is correct: financial interconnectedness does not disperse the impact of shocks
(c) Priya is correct: financial interconnectedness does not propagate shocks beyond their original impact
(d) The available information is not sufficient to determine
(a) Amit is correct
Explain the difference between physical and transition climate stress tests.
Give an example of each.
Physical risk: the potential impact of natural disasters on the balance sheet of financial institutions.
Example: a flood affects multiple sectors of the economy and therefore affects the banking system to the extent that it is exposed to those sectors.
Transition: the potential impact of the transition away from fossil fuels and toward renewable energy sources on bank balance sheets.
If policy induces such a shift in economic activity, banks will be affected to the extent that they are exposed to the declining sector.
Chen claims that EAD and PD are the only two key parameters to measure credit risk, but Zhang argues that LGD is also very important. Choose one of the following:
(a) Chen is correct
(b) Zhang is correct
(c) Zhang is correct but only if EAD is very small
(d) Zhang is correct but only if PD is very small
(b) Zhang is correct
A measure of credit risk should necessarily incorporate the loss given default.
Explain how liquidity risk can translate into solvency risk
(Two main elements must be present)
When funding dries up (either there is a deposit run or a restriction in wholesale funding), once liquid assets are exhausted the bank has to sell illiquid assets. Because they are illiquid, there will be a loss of value in selling them.
If the loss of value is large enough, then assets will decline to a point where capital is exhausted; solvency is endangered.
Two elements: (1) Large decline in funding, (2) Large loss of value in assets to cover the loss in funding.
Lionel is considering investing in one of two securities:
- A 5-year corporate bond paying a 3% coupon
- A 10-year sovereign bond paying a 3% coupon
Which of the two would have greater market risk?
(a) The corporate bond
(b) The sovereign bond
(c) They have the same market risk
(d) It depends on the credit rating
(b) The sovereign bond
The sovereign bond has greater duration and therefore greater market risk (although it may have lower credit risk).
What is the purpose of network analysis as applied to banking?
(a) To assess the transmission of financial distress within the banking system
(b) To measure the data gaps stemming from the bank network structure
(c) To identify potential adverse shocks to the banking system
(d) To assess the likelihood of failure of individual banks
(a) To assess the transmission of financial distress within the banking system
Can stress test results underestimate the possible impact of adverse shocks?
(a) No, the latest stress testing models are very accurate
(b) No, stress tests never underestimate but may occasionally overestimate the impact of adverse shocks
(c) Yes, stress tests always underestimate the impact of shocks
(d) Yes, stress tests may sometimes underestimate the impact of shocks
(d) Yes, stress tests may sometimes underestimate the impact of shocks
What is evergreening?
(a) A process of replacing bank loans with green bonds
(b) A process of replacing bank loans with perpetual securities
(c) A standard practice used by all banks
(d) A practice of extending loans to delinquent borrowers to hide NPLs
(d) A practice of extending loans to delinquent borrowers to hide NPLs
Bank Mbappe just reported that it has an LCR of 0.85.
(a) What does this mean?
(b) What can and/or should the bank do about it?
(a) In the event of outflows occurring during a 30-day stress event, Mbappe has only 85% of the liquid assets it would need. Therefore, it will incur substantial losses as it would need to sell illiquid assets.
(b) It can either alter the composition of its balance sheet (for example reducing loans in favor of cash or reserves at the central bank), or it can alter the composition of its funding, toward more stable (less likely to flow out) funding.
Note that either of these strategies will imply a cost.
Ganbaatar calculated the daily 95% VaR (in %) for his investment portfolio (-4.8%) and the daily expected shortfall (-7.2%).
However, over the following 100 days, Ganbaatar had losses of 10% on one day, 12% on another day, and 15% on yet another.
Ganbaatar is confused and thinks that there must be something wrong with the calculations.
True or false? Explain.
False
Although there could be something wrong with the VaR calculations, these three observations do not invalidate the VaR or ES.
VaR would predict that 5 days out of 100 you should expect losses of at least 4.8%. The three losses are greater than 4.8%, still within what VaR predicts.
ES says that the returns of the worst 5 days would average 7.2%. Again, these three returns do not contradict this.
Yusuf claims that if a bank undergoes a sharp deterioration in the quality of its credit portfolio, there would be no impact on its liquidity. Fatima disagrees and says that liquidity will deteriorate. What do you think?
(a) Yusuf is correct since loans are not part of short-term liquid assets
(b) Yusuf is correct as long as liquid assets to deposits remain constant
(c) Both Yusuf and Fatima are wrong: liquidity may increase or decrease depending on the size of the loan portfolio
(d) Fatima is correct: liquidity will deteriorate due to an increase in funding costs
(d) Fatima is correct: liquidity will deteriorate due to an increase in funding costs
According to George, stress tests are used for micro-prudential and macro-prudential supervisory purposes, but Maria insists that stress tests can also be used as a crisis management tool. Choose one of the following and explain.
(a) George is wrong
(b) Maria is correct
(c) Maria is wrong
(d) Both George and Maria are wrong
(b) Maria is correct
George is right, stress tests can be used for both micro and macro prudential purposes. But Maria is also right since stress tests can be used for crisis management (as in the case of Greece).
Nikolay is of the view that CreditRisk+ model of CSFB is very effective to determine the appropriate size of provisions only, while RiskMetrics of JPMorgan is used to estimate the size of both provisions and capital. Tatyana is not convinced. What is your opinion?
(a) Nikolay is correct
(b) Nikolay is wrong
(c) Nikolay is correct but only if the data on rating transition matrix are available
(d) Nikolay is correct but only if the data on rating transition matrix are NOT available
(b) Nikolay is wrong
Both credit models can be used to determine the size of expected losses and unexpected losses, or provisions and capital
During the crisis in Argentina in 2000, there was a rapid withdrawal of bank deposits as depositors lost trust in the currency and the banking system.
To avoid a wider and deeper crisis, the government imposed a "corralito", capping the amount that depositors were allowed to withdraw from their accounts.
Explain why this was not a good policy and propose a preferable policy measure.
The corralito amounted to an expropriation -- prevented depositors from having access to their funds. Critically, it undermined trust in the system going forward.
Eventually, the corralito was abandoned, the government committed to covering the public's deposits (deposit insurance). This can be costly in the short run, but is preferable to suspending withdrawals.
The average duration of Bank Levandowsky's securities portfolio is 6.5. Today, the central bank increased interest rates by 200 basis points, from 3% to 5%.
What will be the impact (in $) on the bank's solvency?
Assume that Total Assets = Securities Portfolio = 100
Liabilities = 90
Value of securities portfolio will fall by 2.0 x MD
MD = 6.5/(1+0.03) = 6.31
Percentage fall = 2 x 6.31 = 12.62. Since securities = 100, their value will fall by $12.62
Initial capital = 100 - 90 = $10, therefore capital will be -2.62; Bank Levandowsky will go bankrupt.
What is the best description of the time dimension of systemic risk?
(a) The inherent collective tendency by economic agents to increase risk exposures during booms and to become overly risk-averse during busts
(b) The correction of market imbalances
(c) Joint failures of institutions due to direct interlinkages
(d) Joint failures of institutions due to indirect interlinkages
(a) The inherent collective tendency by economic agents to increase risk exposures during booms and to become overly risk-averse during busts