45- A-3105

46.Banks face the following main risks:

I. The risk that counterparties in loan/derivative transactions will default

The types of risks described here are:

B. Operational risk, market risk, and credit risk respectively

C. Market risk, operational risk, and credit risk respectively

D. Credit risk, market risk, and operational risk respectively

Credit risk refers to the possibility that the bank’s loan recipients and counterparties in derivative
contracts such as futures and swaps will fail to meet financial contractual agreements. For example,
a borrower may default on a loan half way through the prepayment period. Alternatively, the
counterparty in an interest rate swap arrangement may fail to make the required payments when the
interest rate changes.

Market risk has much to do with the possibility that the value of assets and financial instruments
might be revised downwards. For example, a bank offering securitized instruments faces the risk
that the primary asset, such as a house, might decline in value.

Operational risk, widely considered to be the main type of risk facing banks, refers to the possibility
of internal failures or external events leading to losses. For example, if a popular rival bank happens
to declare bankruptcy, other banks may experience “runs” where depositors rush to withdraw their
funds out of fear that they might lose their money as well.

47.Prime Bank, a recently licensed deposit-taking Sacco, is considering raising capital to fund an
ambitious expansion plan aimed at transforming it into a “tier one” bank within the next five years.
Which of the following statements best explains why the bank’s directors might prefer a rights issue
as opposed to subordinated long-term debt?

A. Subordinated long-term debt is more expensive than equity finance

B. Existing shareholders might block attempts to increase debt capital

C. Equity finance provides more protection against extreme events, compared to debt finance

D. Existing shareholders have pre-emptive rights

Subordinate debt is debt that ranks below some other senior debt and depositors, but above
shareholders (equity financiers) in the event of default. For this reason, this type of debt might be
cheaper than equity in the long-term, since the bank will be obligated to meet both capital and
interest payments before shareholders receive a single penny. However, that’s partly why the
directors might prefer equity since debt finance will put the bank under considerable pressure,
particularly if some extreme events occur. In fact, shareholders would only be entitled to dividends,
which would be issued at the bank’s discretion.

48.Distinguish between regulatory capital and economic capital.

A. Regulatory capital is the amount of capital a bank is required to hold in accordance with regulatory
guidance to sufficiently mitigate against the risk of failure, whereas economic capital is the amount of
capital a bank needs as prescribed by its own (risk) models

B. Regulatory capital is the amount of capital a bank needs as prescribed by its own (risk) models,
whereas economic capital is the amount of capital a bank is required to hold to sufficiently mitigate
against the risk of failure

C. Regulatory capital is the amount of capital a bank needs to hold in accordance with stipulated rules
and regulations while economic capital is the amount of capital every bank needs to deposit at the
Federal Reserve Bank

D. Regulatory capital is the amount of capital a bank needs to hold in cash at any given time whereas
economic is the total amount of capital held, including cash deposits and tangible/intangible financial
assets
The correct answer is: A).

In most countries, there’s an amount of capital that every deposit-taking bank must hold, in line with
regulations and rules established by the regulatory authority in charge. This is called regulatory
capital. Economic capital is the amount of capital a bank chooses to hold, as prescribed by its own
risk models.

49.Following several high-profile bank failures, the Central Bank of a certain Asian country is advocating
the creation a deposit insurance corporation to protect depositors in the event that banks fail in future.
How might the establishment of the corporation create a moral hazard?
A. Banks might refuse to make premium payments to the corporation, crippling it financially in the
process

B. Depositors might channel more of their savings to banks, reducing investments in other sectors of the
economy

C. Banks may increasingly venture into risky businesses that would not otherwise be feasible

D. The corporation may encourage banks to manipulate accounts so as to appear healthier than they
actually are, hence be eligible for lower premium payments
The correct answer is: C).

Establishment of deposit insurance is, on one hand, good since depositors are assured of a certain
percentage of their deposits in the event that their preferred bank fails. For example, the
establishment of the Federal Deposit Insurance Corporation in the U.S. brought about remarkable
relief to depositors, guaranteeing a high of $250,000 per depositor per bank by the year 2008.
However, banks might start to take on risky strategies which they would otherwise turn down. For
example, they might use unusually higher interest rates to entice a bigger number of depositors and
ultimately channel the money into risky ventures, some of which might lead to heavy losses. Without
deposit insurance, banks would not make such a move since depositors might see through the
rogue strategy and withdraw their money en masse. The possibility of such behavior on the part of
banks is called moral hazard.

50.As the chief officer in charge of bank risk monitoring at the Federal Reserve Bank, Peter Musk is
asked to advise the regulator on the best strategy to curb moral hazards among banks after the
establishment of a deposit insurance agency. Mr. Musk could most likely advice the regulator to:

A. Crackdown on banks caught engaging in unduly risky strategies so as to deter others from doing the
same

B. Direct the agency to demand all details of each bank’s transactions on a regular basis

C. Direct the agency to tailor premiums payable according to each bank’s risk level

D. Abolish the deposit insurance agency altogether

By taking into account the risk level of a bank while calculating premiums payable, the agency would
discourage the banks from taking part in excessively risky strategies that in turn put depositors’
funds at risk. Each bank would pay a premium proportional to the amount of the inherent risk.

51.Losses resulting from employee fraud form part of:

A. Market risk

B. Liquidity risk

C. Credit risk

D. Operational risk
The correct answer is: D).

Employee fraud results from internal flaws in the system and therefore forms part of operational risk.

52.In today’s market, banks have come up with several ways to deal with credit losses, including stricter
lending standards and post-issuance follow-up to monitor the borrower’s spending habits. In addition,
banks should:

A. Reduce interest rates to reduce chances of borrower default

B. Increase interest rates to offset losses

C. Make provision for bad debt in financial statements

D. Always demand security for every single facility

Provision for bad debt entails trying to estimate the percentage of loans that are not likely to be
repaid (usually by looking at past repayment records) and deducting that amount as an expense on
the income statement.

53.Which of the following is the main activity of investment banks?

A. To offer credit to large institutional investors and financial magnates

B. To raise debt/equity financing on behalf of corporations or governments

C. To invest in government bonds and T-bills

D. To serve as clearing parties in derivative contracts

Investment banks mainly help institutions or governments to raise funds by originating securities,
underwriting them, and then placing them with investors. They also help to market the securities and
paint the client in a good light so as to woo potential investors.

54. An investment bank is approached by a manufacturing company that wishes to raise funds to
finance an ambitious factory expansion plan. If the bank decides to raise the required funds via a private
placement, this means that:

A. The bank will provide the funds itself without enlisting any third party investor

B. The bank will sell the desired security to a few large investors such as insurance companies

C. The manufacturing company will only accept proposals/bids from privately owned limited liability
companies

D. The bank must sell the securities to one and only one investor
The correct answer is: B).

A private placement refers to the selling of securities to a small number of large institutional
investors such as pension funds, insurance companies or mutual funds. The investment bank
underwriting the arrangement receives a fee negotiated with the issuer, in this case, the
manufacturing company. The bank need not find just one investor – It may be possible, and other
times, the issuer may prefer more than one financier.

55. The management of XYX Inc. wishes to raise some $50 million via a public offering. Which of the
following methods would be most appropriate, given that the total amount MUST be raised?

A. Private placement

B. Best efforts

C. Firm commitment

D. Introduction
The correct answer is: C).

56.A public offering involves offering securities, usually shares, to the general public. In the case of a
firm commitment public offering, an investment bank agrees to buy a specified amount of securities
from the issuer and then attempts to sell them to the public, promising to own any securities which
might not be taken up by the public. Thus, the issuer is completely certain that they will raise the
amount specified.

A public offering on a best efforts basis is a security sale whereby:

A. The issuer works with multiple investment banks as underwriters

B. The underwriter does as well as they can to place securities with investors and get’s paid a fee
commensurate with the extent of its success

C. The underwriter buys the securities and then sells them to investors at a premium

D. The issuer does not enlist the services of an underwriter but instead offers securities to investors
directly
The correct answer is: B).

In a best efforts offering, investment banks (working as agents/underwriters) agree to do their best to
place an issue in the hands of investors. It differs from a firm commitment offering in that the bank
does not buy the securities so as to resell them to investors. However, they may negotiate an option
giving them the right but not an obligation to buy a given amount of the securities, even as they try to
maximize sales to other investors.

57.ABC Company Limited is not publicly traded, but its directors contend the company cannot self-fund
further expansion. Directors approach an investment bank intending to create 50 million shares but
haven’t yet settled on an appropriate price per share. Under these circumstances, the company is most
likely to issue a:

A. Best efforts IPO

B. Rights issue

C. Firm commitment

D. Private placement

The correct answer is: A).

A firm that’s not publicly traded issues shares in form of an initial public offering. In most cases, there
will be considerable uncertainty regarding the public’s willingness to acquire some stake in such a
company. As such, most investments prefer to issue a best effort IPO since it carries less risk. In
general, underwriters are usually wary of firm commitments in such cases particularly because they
might be forced to own a large number of shares in the event that the public’s response falls short.

58.A company intends to employ the Dutch Auction Approach (DAA) to sell 1 million shares. It receives
the following bids:

Bidder Number of shares Price per share

A 200,000 $40.50

B 150,000 $39.50

C 400,000 $41.00

D 100,000 $39.40

E 300,000 $39.00

F 50,000 $38.75

G 120,000 $37.00

Which of the following is closest to the price all successful buyers will pay per share?

A. 37
B. 41
C. 40.5
D. 39
The correct answer is: D).

Under the DAA, potential investors enter their bids quoting the number of shares they intend to
purchase and the price they are willing to pay per share. Once the bids have been submitted, the
allotment is done starting from the highest bid down, until all the allotted shares have been assigned.
However, the final price paid per share is that which has been quoted by the last successful bidder –
the buyer whose bid coincides with the end of the intended allotment.

Following the methodology outlined above, here’s what would happen in this scenario: First, 400,000
shares would be allocated to C, 200,000 shares to A, 150,000 shares to B, and 100,000 shares to D.
At this point, only 150,000 shares remain out of the planned 1 million shares allotment. This means
the next highest bid of 300,000 shares at $39 each can only be half filled. As such, $39 is the price
that would be paid by all the other successful bidders.

59.The Kings Bank located in State A wishes to establish its footing in State B, by acquiring The Queens
Bank. Employees and senior management of the latter do not want their business to be enjoined to that
of the former in part because they feel their bank’s future is bright. In particular, the directors of The
Queens Bank fear that the new owners may opt to kick them out in favor of new management. The
directors decide to seek advice from a reputable investment bank on how to fend off the takeover.
Assuming you were one of the advisory panel members, which of the following would likely not form
part of your advice?

A. That The Queens Bank add to its charter a provision that if another company acquires one-third of the
shares, other shareholders have the right to sell their shares to that company for twice the recent
market price

B. That the Queens Bank grant its employees stock options that can be exercised in the event of a
takeover

C. That the Queens Bank add to its charter a provision making it impossible for any new owners to
terminate the contracts of existing directors

D. That the Queens Bank should go to court and block the move

The correct answer is: D).

A, B, and C are all possible and realistic actions that The Queens Bank can take to discourage other
companies from acquiring the bank. Going to court might have little or no impact in light of the
information given in the question. Takeover bids are legal procedures between a willing buyer and a
willing seller. Legal proceedings would work only if the potential owners engage in outlawed
activities in an attempt to pull off the acquisition.

60.Which of the following is the most realistic source of conflict of interest when all of commercial
banking, investment banking, and securities services are conducted under the same corporate umbrella?

A. The three units might not get along, particularly if one or two perform very poorly compared to the
other
B. The investment segment might work with competitors to paint the commercial segment in a bad light
and therefore obtain preferential treatment from shareholders

C. In the process of lending money to a company, the commercial segment may be tempted to share
confidential information about the borrowing company with the investment segment which may, in
turn, forward the information to a potential takeover bidder

D. None of the above

Conflicts of interest might emerge whenever investment banking, commercial banking, and
securities services all share the same platform. For example, the banking segment may unlawfully
pass confidential information about one of its clients to the investment segment to help it provide
crucial advice to one of its clients regarding takeover opportunities.