Examiners commentaries 2008

Examiners commentary 2008

29 Financial intermediation
Specific comments on questions Zone B
Question 1
Explain the functions of financial intermediaries, and analyse the theory of
delegated monitoring.
This question relates to the readings from Matthews and Thompson
(2008), Diamond (1984, 1996) and Bhattacharya and Thakor (1993),
which are referred to in Chapter 1 of the subject guide.
The question clearly comprises two elements, with the latter requiring
a more detailed and technical discussion.
The first part of the answer should focus on the main activities of
financial institutions in their provision of brokerage and asset
transformation functions (which is covered in the early part of Chapter
1 in the subject guide). In brokerage, they match surplus and deficit
units, and thus reduce transaction costs and information costs. In asset
transformation, they issue claims that are far more attractive to savers
than the claims issued directly by corporations. The asset
transformation function includes an asset diversification function and
an asset evaluation function. The most important contribution of
intermediaries is a steady flow of funds from surplus to deficit units.
Key reading on this from Matthews and Thompson (2008) and
Saunders and Cornett (2006) is identified in the subject guide.
The second part of the question relates to one of the key learning
objectives of Chapter 1 of the subject guide. The bulk of the answer
should focus upon this aspect, namely the theory of financial
intermediation as delegated monitoring. Defined broadly, monitoring
of a borrower by a bank refers to information collection before and
after a loan is granted, including screening of loan applications,
examining the borrowers ongoing creditworthiness and ensuring that
the borrower adheres to the terms of the contract. This section could
initially address information costs and monitoring costs, which would
then serve as a foundation to proceed to a discussion of the Diamond
(1984) model. Delegated monitoring is one of the key reasons for the
dominance of intermediation over direct financing. An important
constraint on direct investment by households in the financial claims of
corporations is the cost of information collection. Failure to monitor in
a timely and complete manner exposes a supplier of funds to agency
costs. Financial institutions provide a solution to these problems by
pooling funds from suppliers (e.g. household savers) and investing in
the financial claims of corporations. The financial institution has an
incentive to collect information and monitor, which also alleviates
potential free rider problems with direct financing. The average cost

29 Financial intermediation

of collecting information is also reduced. It is thus argued that

suppliers of funds appoint banks as delegated monitors (to act on their
behalf). Better answers should proceed to analyse the costs and
benefits of monitoring.
Generally, there is much scope in this question for you to demonstrate
rigorous analysis drawn from the textbook and journal readings as
suggested above.
Question 2
Explain the nature of liquidity risk, and discuss the insights from the theory
of bank runs.
This question primarily relates to the readings from Matthews and
Thompson (2008), Bhattacharya and Thakor (1993) and Diamond and
Dybvig (1983), which are referred to in Chapter 2 of the subject guide.
The question relates to one of the key learning objectives mentioned in
Chapter 2.
Similar to question 1, there are two elements to this question, with the
latter requiring a more detailed and technical discussion.
Your answer should begin with a concise explanation of liquidity risk
and its implications for banks. Liquidity risk is often an inevitable
outcome of banking operations. Since a bank typically collects deposits
that are short term in nature and lends long term, the gap between
maturities leads to liquidity risk and a cost of liquidity. This section can
be supported by your reading from Chapter 3 of the subject guide and
from Saunders and Cornett (2006). A very good answer would
illustrate the importance of the lack of liquidity in the interbank market
during the recent credit crunch (e.g. see the early section of Chapter 2
of the subject guide).
The bulk of your answer should discuss insights from theory, which are
expected to focus mainly on the Diamond and Dybvig (1983) model.
You should include a clear definition of a bank run. Financing longterm assets through short-term deposits is a source of potential fragility
of banks because they are exposed to the possibility that a large
number of depositors will decide to withdraw funds for reasons other
than liquidity needs. This results in a vulnerability to bank runs.
A strong answer would link the theory of bank runs to regulation. This
is a key insight as expected in the question. An important reason for
bank regulation is that uninsured depositors are likely to cause a bank
run when faced with information of an adverse shock to bank balance
sheets. This argument has support both in history and in theory. The
bank run on Northern Rock in September 2007 is a recent historical
example. Although depositors in this bank had some protection from
deposit insurance, they still preferred to run on the bank in the light of
uncertainty regarding the banks viability because it had been forced to
rely on the lender of last resort facility. There was also a lack of
appreciation (or confidence) by depositors that the bank was initially
suffering from a liquidity problem rather than a solvency problem. This
and other historical cases support the argument that a deposit
insurance scheme reduces the danger of bank runs and the potential
systemic effects of a run.

Examiners commentaries 2008

An excellent answer would provide a full analysis of the implications of

the theory, and include discussion of the relevance of the design of
deposit contracts.
Generally, there is much scope in this question for you to demonstrate
rigorous analysis drawn from textbook and journal readings as
suggested above.
Question 3
Banks increasingly focus on the expected loss given default. Explain the
constituents of this measure, and comment on its implications for risk
management.
This question relates to the readings from Bessis (2002) and Saunders
and Cornett (2006), which are referred to in Chapters 3 and 4 of the
subject guide. The question relates to key learning objectives noted in
Chapters 3 and 4.
The question is focused on the equation L = D . X . (1 R).
This is Equation (4.1) in the subject guide. The expected loss given
default (L) is the product of the loss given default and the default
probability (D). The loss given default is comprised of an uncertain
exposure (X) and an uncertain recovery rate (R).
Your answer should thus initially present a detailed explanation of the
three elements: default risk, exposure risk and recovery risk.
The default risk is measured by the probability of default. It is
important to note that default can be defined in several ways. Your
answer should highlight the factors that will influence the probability
of default, and the possibility of mapping default probabilities from
historical data linked to rating systems.
Exposure risk needs to be explained very clearly. This is an issue which
many past candidates have struggled to tackle satisfactorily in this type
of question. Exposure is the amount at risk in the event of default
(excluding recoveries). Since default occurs at an unknown future
date, the risk is generated by the uncertainty regarding future amounts
at risk.
Recoveries in the event of default are unpredictable and depend on the
type of default and the guarantees received from the borrower.
Recoveries involve legal procedures, expenses and a significant lapse of
time.
In addressing the final element of the question relating to risk
management, a key issue is that the expected loss given default goes
beyond the probability of default, which might be viewed as a more
traditional measure. Therefore, risk management needs to focus
beyond seeking to control default probabilities through selection and
diversification (see Chapter 3 of the subject guide). Exposure needs to
be properly managed. The potential for recoveries needs to be
addressed, e.g. through the use of collateral, guarantees and
covenants. The latter issues are covered thoroughly in the suggested
readings from Chapter 4 of the subject guide.

29 Financial intermediation

Generally, there is much scope in this question to demonstrate rigorous

analysis drawn from suggested textbook readings, most particularly
Bessis (2002).
Question 4
Assess the merits of internal and external credit rating systems, and analyse
their role in the Basle II capital adequacy accord.
This question relates to the readings from Bessis (2002), Saunders and
Cornett (2006) and Matthews and Thompson (2008), which are
referred to in Chapters 2 and 4 of the subject guide. The question
relates to key learning objectives from Chapters 2 and 4.
The question clearly comprises two elements, with the latter focused
towards the application of rating systems in banking regulation.
The first part of the question requires a comparison of internal and
external ratings systems. A strong answer would provide full discussion
of the main categories of internal ratings systems, the criteria
employed in assigning ratings and the scope of rated entities. A very
good answer would highlight criticisms of rating agencies in relation to
the early stages of the recent credit crunch (in the context of
securitisation and sub-prime mortgages).
Your answer could address four aspects of the syllabus where ratings
systems are important. First, there is significant correlation between
ratings and default frequencies, and external ratings are positively
correlated with borrowing costs (e.g. bond yields). Secondly, rating
systems often serve as a tool for credit policy within banks, whereby a
minimum rating level is required for granting a loan. Thirdly, ratings
have a key role in the process of dis-intermediation. Finally, in passthrough securitisation transactions, ratings of the originating bank and
of the securitised assets play a crucial role.
However, within this syllabus, the most substantive aspect of the value
of rating systems is the regulatory use of credit ratings. Specifically, the
latter part of the answer should focus on the acceptance of the role of
credit ratings in the Basel II capital adequacy accord (Pillar 1
protection against credit risk). Your answer should differentiate
between the role of external ratings under the standardised approach
and the internal ratings (IRB) approach. In the latter case, there should
be analysis of both the Foundations approach and the Advanced
approach. Benchmark risk weights should be noted as a key output.
You should not mention the Basel I accord in depth, nor do you need
to compare Basel I and Basel II in detail, as these elements are not
required by the question. In the context of your time constraints in the
examination, inclusion of peripheral material in an answer can be
costly.
This question requires you to draw analysis from different chapters of
the subject guide. You need to prepare for questions of this nature, by
becoming aware of the cross-referencing between chapters in the
subject guide. In a case like this, if your answer convincingly links the
two elements of the question, it will be well rewarded by the
Examiners.

Examiners commentaries 2008

Question 5
Discuss the rationale for asset and liability management in banks, and
analyse the techniques which are employed.
This question relates to the readings from Saunders and Cornett
(2006) and the further readings, e.g. Sinkey (2002), which are referred
to in Chapter 5 of the subject guide. The question relates to the three
learning objectives of Chapter 5.
The question clearly has two elements, with the latter requiring
discussion of deeper and more technical material.
In addressing the rationale for asset and liability management (ALM),
you should focus on the issues of liquidity risk and interest rate risk in
bank balance sheets. You should also highlight the relevance of net
interest margin and net interest income as target variables, with both
their level and variability being important elements.
The main portion of your answer should consist of a detailed
consideration of liquidity gap analysis and interest rate gap analysis. In
discussing liquidity gap analysis, sources of liquidity and maturity
mismatching should be addressed. Under interest rate gap analysis, it
is important to discuss the identification of rate-sensitive assets and
liabilities. Illustrative examples should be provided in both cases. There
are many examples available in the suggested readings from the
textbooks. Interest margin variance analysis is another technique which
would be covered in a full answer.
The section in Chapter 5 of the subject guide titled Issues associated
with ALM is of limited relevance to the question posed here, and this
material should not constitute a large portion of your answer.
Generally, there is much scope in this question for you to demonstrate
rigorous analysis drawn from the suggested textbook readings.
Question 6
Critically analyse banks use of securitization and credit derivatives in
transferring risk from their balance sheets.
This question relates to the readings from Matthews and Thompson
(2008), Saunders and Cornett (2006) and Neal (1996), which are
referred to in Chapter 6 of the subject guide. The question relates to
the learning objectives of Chapter 6.
This question focuses on risk transfer using the techniques of
securitisation and credit derivatives. A distinction can be made that
securitisation is mostly used for funding purposes whereas credit
derivative transactions have hedging (or trading) motivations. These
financial innovations have changed the landscape of risk by enabling
market participants to trade risk (credit risk in particular) across
financial and non-financial sectors.
Your answer should discuss the characteristics of these instruments,
e.g. by explaining the mechanics of pass-through securitisation, and the
structure of pure credit swaps (credit default swaps). However, a
significant element of the answer should be focused towards the
motivation, merits and drawbacks of banks use of these instruments.

29 Financial intermediation

Credit risk transfer instruments (especially credit derivatives) offer

important diversification benefits for banks with large credit exposures,
and can also act as a stabilisation mechanism for the financial system,
while enhancing efficiency in pricing and intermediation. However,
others would argue that these innovations have also created risks for
financial stability. A key concern is that the pace of innovation may
have exceeded the development of infrastructure and risk management
systems. Any shock to the financial system may be magnified by the
resulting inter-relationships, as witnessed in the recent credit crunch.
Therefore, a complete analysis would draw on different perspectives
expressed in the literature regarding the use of these instruments.
If the answer succeeds to link the two elements of the question
(securitisation and credit derivatives) in a convincing manner, it would
be very well rewarded. Table 6.1 in the subject guide could assist in
this regard. This type of question also highlights the dynamic nature of
some of the more applied subject material contained in the syllabus for
this unit.
Question 7
Compare and contrast the different methods available for analyzing bank
performance.
This question relates to the readings from Bessis (2002) and Matthews
and Thompson (2008), which are referred to in Chapter 7 of the
subject guide. The question relates to the learning objectives of
Chapter 7.
A good answer would begin by identifying the motivation for analysing
bank performance. It would also consider the users of performance
measures, and distinguish between internal (e.g. bank) and external
users (e.g. regulators). A strong answer would set the context whereby
banks are faced with trends (deregulation, innovation, globalisation),
which have a major impact on their performance.
The focus should then turn to the riskreturn trade-off, and this issue
should permeate the remainder of the answer, in the sense of
comparing accounting measures with risk-adjusted measures of
performance.
In addressing the accounting measures of performance, you should
focus the discussion around the du Pont model, which decomposes the
accounting return on equity. You should identify how different
measures of profitability can provide alternative perspectives. Better
answers will analyse the potential for misleading inferences from
accounting measures, e.g. if a bank has inadequate equity capital. Your
answer should proceed to consider market value measures of
performance and to compare these with the accounting measures.
Discussion of risk-adjusted performance measures should then
represent a significant portion of the answer. Better answers will need
to demonstrate reading on this issue, e.g. from Bessis (2002).
Generally, there is much scope in this question for you to demonstrate
deep analysis drawn from the suggested textbook readings.

Examiners commentaries 2008

Question 8
Explain the application of the binomial option pricing model, and illustrate
the technique of delta hedging with options.
This question relates to the readings from Saunders and Cornett
(2006), which are referred to in Chapter 8 of the subject guide. The
question relates to several of the learning objectives for Chapter 8.
A good answer would begin by briefly introducing the characteristics of
option contracts, to provide a foundation for the remainder of the
answer. Before proceeding to discuss the binomial option pricing
model, better answers will highlight the underlying role of the absence
of arbitrage arguments.
The three steps in applying the binomial model should be explained
(see subject guide), with algebraic exposition of the final step in
calculating the price. You should also supplement this with a brief
numerical example, to convince the Examiners of the depth of your
understanding of this application. Good answers will draw attention to
the limitations of the simple single branch binomial process and
highlight how this may be extended in practice.
Your answer should then proceed to discuss delta hedging. An
algebraic representation of the principle of hedging an underlying
portfolio is essential for this element (as demonstrated in the subject
guide). A brief numerical illustration must again be provided to
convince the Examiners of your understanding of how this would be
applied. Better answers will explicitly link delta hedging to the BlackScholes model, by referring to N(d1). In a very good answer, this could
be supplemented by a discussion of the values taken by delta for in-themoney, at-the-money, out-of-the-money call and put options (which is
covered in the textbooks).
An answer which covered all these elements would be well rewarded.