ADVANCED CREDIT RISK MANAGEMENT APRIL 2023 PAST PAPER

MONDAY: 24 April 2023. Afternoon Paper. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Do NOT write anything on this paper.

QUESTION ONE

BANK RUN AND STABILITY OF SILITON VALLEY BANK (SVB)

Siliton Valley Bank (SVB) was a bank whose target clients were tech start-ups and their founders. It started between 2019 and 2021. The level of venture capital funding exploded during this time, meaning that start-ups were getting tonnnes of cash, and subsequently depositing this with SVB. SVB’s deposits went from roughly $60 billion in 2019 to $189 billion in 2022. SVB made money through what is known as ‘net interest margin.’ SVB would offer customers 0.2% on their savings account, and they would take that money and place it in a different form of investment that gave them a return of 1% – keeping the 0.8%. SVB had all of these deposits, and in order to generate a return (with interest rates still at almost 0% at this point) they placed reportedly $80 billion of the $189 billion into long term mortgage backed securities. These were reportedly paying a yield of around 1.5%, leaving SVB with a healthy net interest margin.

Unlike 2008, the viability of these mortgage securities was not the problem. The issue was the fact that they were long term liabilities that were being used to secure short term deposits, purchased at a time when interest rates were at all time lows. The risk of ‘safe’ mortgage bonds While there was no problem with the mortgage bonds that were purchased, they are still sensitive to interest rates. The reason for that is that bond prices move inversely to interest rates. If rates go up, bond prices fall and vice versa.

Why did Siliton Valley Bank collapse?
This was simply an old-school liquidity crisis. SVB’s underlying investments had not failed. The prices went down. Because of the uncertain economic conditions, SVB saw a lot of their clients looking to get their hands on their money. Facing $80 billion of their assets being held in securities which had fallen in value, SVB started looking for ways to raise cash.

This made markets a little nervous, but it went into overdrive when they announced a sale of stock at a loss of $1.8 billion. This came just days after crypto-focused bank Salivate failed, and the announcement was made with little attempt at calming investors. A number of deposit holders turned into a tidal wave, as prominent Venture Capitalists (VC’s) called their portfolio companies and told them to get out as fast as they could. This type of bank run would be a problem for any bank. SVB did not have enough liquid cash at hand at that given time for every account holder to redeem at once. It was an especially big problem for SVB, with their liquidity profile as it was.

The bottom line
It was the first time in a long time that such a bank run was seen. It highlighted the importance of understanding counterparty risk. Even organisations that appear stable and secure can be undone, in a matter of hours, given how fast information travels in 2023. Diversification is the best way to limit your risk, whether you are talking about investments or savings accounts. Hedging can be a powerful tool to protect against volatility, but it is not easy to do. These unprecedented withdrawals caused a strain on daily operations of SVB, necessitating the bank under the guidance of the regulator to limit some services, the bank management said in a statement. The regulator while commenting on the troubled bank was quoted as saying “the point is that all banks are working to deal with any liquidity issues or any of those challenges that may happen from one day to the next. This showed how regulators play behind scenes in bank trouble situations that it is difficult to determine if they are acting or not.

Strong interventions often have negative and far-reaching consequences for the many stakeholders involved and so bank supervisors should use them carefully. However, hesitation in using these tools could lead to an even worse outcome. In the case of the Banking Supervisory Authority (BSA), both the early detection mechanisms and intervention powers were lacking, which made it impossible to react at a sufficiently early stage.

Willis Otieno is the new head of the Banking Supervisory Authority (BSA). He has been hired to strengthen the bank supervision and reform the supervisory system to meet international standards and best practice. You have recently joined the BSA’s Policy Department, and Willis Otieno has asked you to do some research with the aim of fulfilling these objectives.

Required:

1.  Describe the term “bank run”. (2 marks)

Propose FOUR bank run mitigation measures that SVB would have considered. (8 marks)

2. Apart from falling prices of the bonds, list SEVEN warning indicators that the Bank Supervisory Authority should have focused their attention on to avoid future bank runs. (7 marks)

3. Describe FOUR supervisory tools that the Supervisory Authority should have used to gather information to detect potential problems. (8 marks)

4.  Identify FIVE factors the Supervisory Authority could have used to rate the bank’s liquidity. (5 marks)

5.  Highlight FOUR risk types that the Supervisory Authority could have monitored to avoid future bank runs. (4 marks)

6. State SIX sources of funding that SVB could have considered to avoid liquidity crisis. (6 marks)

(Total: 40 marks)

 

QUESTION TWO

1.  Enumerate THREE reasons why banks measure the cost of funds. (3 marks)

2. Explain THREE methods of taking a loan security. (6 marks)

3. Assess THREE strategies for managing concentration risk. (6 marks)

(Total: 15 marks)

 

QUESTION THREE

1. Outline THREE assumptions of Modern Portfolio Theory (MPT) with reference to credit risk modelling. (3 marks)

2.  Explain the following types of credit risk models:

Structural models. (3 marks)

Reduced form models. (3 marks)

3. Summarise THREE credit events upon whose occurrence a firm may suffer default risk. (6 marks)

(Total: 15 marks)

QUESTION FOUR

1.  State THREE shortcomings of Basel I Accord. (3 marks)

2. List FIVE objectives that credit portfolio management models seek to achieve. (5 marks)

3. Explain the following types of project finance bonds as used in managing project finance credit risks:

Performance bond. (2 marks)

Payment bond. (2 marks)

Retention bond. (3 marks)

(Total: 15 marks)

 

QUESTION FIVE

1. With reference to prudential guidelines, enumerate THREE conditions that should be satisfied for a loan to be reclassified as performing. (3 marks)

2.  Outline FOUR features of financial crises. (4 marks)

3.  Discuss FOUR causes of overtrading. (8 marks)

(Total: 15 marks)

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