Understanding Banking: Class Activities and Key Concepts

Class Activity 1: Transmission Mechanism of Monetary Policy

Q1: Impact of Interest Rates on Loans

• FALSE – Higher interest rates make it less attractive to take out loans for financing cars.
• TRUE – Higher interest rates make it less attractive to take out loans in general.
• TRUE – Higher interest rates make it more difficult to repay loans.
• Lower interest rates boost investments and economic activity.

Q2: The Wealth Channel

• TRUE – The wealth channel typically affects consumption.
• FALSE – The wealth channel impacts various segments of the population, not just the wealthy.
• TRUE – The wealth effect leads households to increase consumption as asset values rise.
• TRUE – As a consequence of the wealth effect, higher equity prices generally lead to higher consumption levels.

Q3: Credit Standards and Interest Rates

• FALSE – High interest rates usually lead to a tightening of credit standards by banks.
• Low interest rates increase loan demand.
• TRUE – High interest rates increase the risk of default for borrowers.
• The recent increases in ECB interest rates aim to control inflation.

Q4: Inflation Expectations

• If inflation expectations are high, workers may demand higher wages, leading to a wage-price spiral.
• FALSE – High inflation expectations are generally seen as negative by households and companies.
• TRUE – The lower the volatility of inflation, the higher the confidence of households and businesses in making decisions.
• FALSE – Anchoring inflation expectations means maintaining a stable medium- to long-term inflation rate.

Q5: Price Stability and the ECB

• FALSE – The EU treaty does provide a definition of price stability.
• Huge positive deviations from the inflation target are undesirable.
• FALSE – Huge positive deviations from the target are seen as negative, while negative deviations are seen as positive.
• The ECB’s Governing Council defined price stability as an inflation rate of below, but close to, 2% over the medium term.

Q6: Monetary Policy Strategies of Central Banks

• TRUE – The ECB’s mandate is twofold: price stability and financial stability.
• FALSE – The ECB has a single monetary policy objective: price stability.
• All central banks have mandates related to price stability and often have additional objectives.
• TRUE – The Federal Reserve’s strategy considers financial stability among its monetary policy objectives.

Class Activity 2: From Products to Balance Sheet

• LIABILITIES – A bank takes deposits from its customers.
• ASSETS – Purchase of government bonds.
• NONE – Selling mutual funds to customers is not reflected on the balance sheet.
• ASSETS – Granting loans to corporate clients.
• LIABILITIES – Issuing debt to institutional investors.
• LIABILITIES – A bank enters into a repo to fund its short-term lending activity.
• ASSETS – A bank has derivative exposures.
• NONE – Selling insurance products to bank’s clients is not reflected on the balance sheet.
• ASSETS – A bank places its excess liquidity in the repo market.
• LIABILITIES – A bank borrows money from central banks’ facilities.
• NONE – A bank asks a client to post more collateral to secure a derivative’s exposure.
• ASSETS – A bank purchases a portfolio of loans.
• ASSETS – Bank A sells a loan to Bank B.

Class Activity 4: Staging Requirements under IFRS 9

• TRUE – Exposures identified as having experienced a significant increase in credit risk (SICR) are transferred to Stage 2.
• FALSE – Exposures transferred to Stage 2 or 3 can be transferred back to Stage 1 if credit risk improves.
• TRUE – For Stage 2 and 3 exposures, ECL are calculated based on a lifetime PD.
• TRUE – ECL are recognized in profit or loss.
• FALSE – Interest revenue is calculated based on the amortized cost of the exposure, which considers expected credit losses.
• FALSE – 30 days past due exposure may be allocated to Stage 1 if there is no significant increase in credit risk.
• FALSE – IFRS 9 requires a recognition of impairment based on an ‘expected loss’ perspective.
• FALSE – When a loan exposure is granted, an impairment should be recognized based on 12-month expected credit losses, even without objective evidence of impairment.
• FALSE – An exposure for which the probability of default has increased from 1.5% to 20% should be classified as Stage 2 or 3, depending on the severity of the increase and other factors.
• FALSE – A loan exposure to a ‘small and medium enterprise’ with negative EBITDA and equity, but that is up to date with payments, may be classified as Stage 3 if there is objective evidence of impairment.
• FALSE – The estimations of impairments under the IFRS 9 model require the estimation of expected credit losses for groups of similar exposures, not necessarily for each individual exposure.
• FALSE – An exposure with sufficient collateral to cover credit risk may still be classified as Stage 2 or Stage 3 if there is a significant increase in credit risk or objective evidence of impairment.
• TRUE – Trading book exposures are not subject to staging requirements.

Class Activity 5: Credit Risk

• FALSE – Counterparty credit risk typically emerges in derivative and trading exposures, not just loan exposures.
• FALSE – The EAD (Exposure at Default) is a dynamic parameter that estimates the amount the bank would lose if the obligor defaulted, considering factors such as potential changes in exposure.
• FALSE – A bank should still be concerned about default risk even if the exposure is fully collateralized, as collateral valuation and liquidation can be uncertain.
• TRUE – A recovery rate of 60% means that the bank would recover 60% of the exposure in the event of a default.
• TRUE – The probability of default (PD) is a time-dependent variable, as the likelihood of default can change over time.
• FALSE – The loss distribution for credit risk is typically skewed, not a normal distribution.
• TRUE – Expected credit losses are covered by means of accounting provisions, while unexpected losses have to be covered via own funds (capital).
• FALSE – Own funds held by banks allow them to withstand a range of potential losses, but not necessarily any scenario of losses.
• FALSE – The LGD (Loss Given Default) denotes the severity of the loss if a default occurs, not the probability of default.
• FALSE – The expected/unexpected loss of a portfolio of loans is not simply the sum of expected/unexpected losses of each loan exposure, as diversification and correlation effects need to be considered.
• TRUE – The ASRF (Advanced Supervisory Formula for Regulatory Capital) model can be used only when the loan portfolio is sufficiently granular.
• TRUE – According to the ASRF model, the higher the PD of the loan portfolio, the higher the capital required.

Class Activity 6: Market Risk

• FALSE – Market risk stems from positions in a bank’s trading book, not the banking book.
• FALSE – Exposures towards clients can entail market risk, such as interest rate risk or foreign exchange risk.
• FALSE – VaR (Value at Risk) is defined as the maximum potential loss over a given time horizon with a certain confidence level, not the total number of losses.
• TRUE – The VaR is dependent on the time horizon and the confidence level.
• FALSE – The higher the time horizon, the higher the VaR, as there is more time for potential losses to accumulate.
• TRUE – The higher the confidence level (left tail), the higher the potential loss that is covered by the VaR measure.
• TRUE – The daily volatility of an asset is 3%. Using the model-building approach, the 99% 1-day VaR is 6.99%. (Note: the 1% percentile of a normal distribution with mean 0 and variance 1 is -2.33.)
• TRUE – The lower the duration of a bond, the lower the market risk, as the bond’s price is less sensitive to changes in interest rates.
• FALSE – The approximation error using bond duration is higher when interest rates are very high or very low.
• FALSE – The delta of an option is the sensitivity of its price to the underlying asset price, not volatility.

Class Activity 7: Liquidity and IRRBB Risk

• TRUE – An optimal funding structure should not have a strong overreliance on short-term and less stable funding (i.e., wholesale funding).
• FALSE – In global banks, wholesale funding is often a significant source of funding, alongside deposits.
• FALSE – A negative maturity gap does not always signal an imminent risk of a liquidity crisis, but it indicates potential challenges in meeting short-term obligations.
• TRUE – A survival period of 120 days indicates that, according to the current maturity ladder and considering contractual cash flows, the bank will not survive more than 120 days without additional funding.
• TRUE – A loan-to-deposit ratio of 90% indicates that the bank primarily funds its business by means of deposits.
• TRUE – A liquidity coverage ratio above 100% indicates that the bank has sufficient high-quality liquid assets to cover its net cash outflows over a 30-day stress scenario.
• TRUE – Investors in unsecured senior bonds will demand higher returns than investors in covered bonds due to the higher risk.
• TRUE – A bank has a liability repricing at 3 months, and there is a 1% rise in interest rates. The net interest margin of this bank will fall, as the cost of funding will increase.
• TRUE – A bank has an asset repricing at 3 months and a liability maturing in 2 years. The bank expects interest rates to increase in five months. The net interest margin will increase, as the bank will benefit from higher interest income on the repriced asset.
• A bank has an asset repricing at 3 months and a liability maturing in 2 years. There is a 1% interest rate hike at year 3. The net interest margin will remain relatively stable in the short term, as the impact of the rate hike is further in the future.
• FALSE – A floating balance sheet (i.e., assets and liabilities reprice frequently) is still exposed to interest rate risk, as changes in interest rates can affect the spread between asset and liability yields.
• FALSE – A bank funds fixed-rate lending with variable-rate funding. The bank is exposed to the risk of interest rate hikes, which can be hedged by means of an interest rate swap with the bank being the fixed-rate payer (i.e., variable-rate receiver).

Class Activity 8: The Minimum Capital Requirements

• FALSE – EU Directives need to be transposed into Member State’s legislation, while EU Regulations are directly applicable in all EU Member States.
• FALSE – The European Parliament and the Council of the European Union are also involved in legislating banking regulation in the EU.
• TRUE – Pillar 2 requirements, which address institution-specific risks, are covered by the Capital Requirements Directive (CRD).
• TRUE – Pillar 1 requirements, which set minimum capital requirements for credit, market, and operational risk, are covered by the Capital Requirements Regulation (CRR).
• FALSE – AT1 (Additional Tier 1) instruments are more subordinated than Tier 2 instruments, meaning they absorb losses before Tier 2 capital.
• FALSE – Pillar 1 requirements are set by the regulation (CRR), not calibrated by the supervisor.
• TRUE – Macroprudential buffers, which address systemic risks, are imposed by the supervisor.
• TRUE – The minimum Tier 1 capital imposed by the CRR is 4.5%, while the total capital requirement stands at 8%.
• TRUE – Capital requirements are risk-sensitive, meaning they vary based on the risk profile of the bank’s assets and activities, while leverage ratio requirements are not risk-sensitive.
• FALSE – Regulatory own funds may differ from accounting own funds due to adjustments and deductions required by the regulations.
• FALSE – A credit institution may be subject to only consolidated or individual capital requirements, depending on its structure and activities.
• TRUE – Goodwill, an intangible asset, shall be deducted from CET1 capital.
• FALSE – The IRB (Internal Ratings-Based) approach is generally considered more risk-sensitive than the standardized approach, as it allows banks to use their own internal models to assess risk.