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.1. Discuss different types of risks faced by banks and financial institutions.Critically
examine why regulating banks and financial institutions activities are so important.
(4 Marks)
Q.2. Outline the basis of the evolution of international banking regulation under Basel I
(4 Marks)
Q.3. Describe the key deficiencies in bank regulation and risk management in financial
institutions that led to Basil III. (4 Marks)
Q.4. Explain the Capital Asset Pricing Model (CAPM). (
Q1:
Banks and financial institutions are exposed to various types of risks, including credit risk, market risk, operational risk, and liquidity risk. Credit risk arises when a borrower fails to make loan payments, while market risk refers to the potential loss due to changes in the value of financial instruments. Operational risk refers to the risk of losses due to inadequate or failed internal processes, systems, or human errors. Liquidity risk is the risk that a financial institution may not be able to meet its financial obligations as they come due.
Regulating the activities of banks and financial institutions is important because these institutions play a vital role in the economy. They provide a range of financial services, including lending, deposit-taking, and payment processing, and are an essential source of funding for businesses and households. If banks and financial institutions are not well-managed and regulated, it can lead to financial instability and can have negative consequences for the economy as a whole. For example, if a bank fails, it can disrupt the flow of credit and lead to a loss of confidence in the financial system, which can have a knock-on effect on the wider economy.
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Q.2. Outline the basis of the evolution of international banking regulation under Basel I
The evolution of international banking regulation began with the adoption of the Basel I framework in 1988. This framework established minimum capital requirements for banks and aimed to ensure that banks held enough capital to cover the risks associated with their operations. It established three pillars: minimum capital requirements, supervisory review, and market discipline. The minimum capital requirements set out the amount of capital that banks were required to hold to cover the risks they faced, while the supervisory review process allowed regulators to assess the adequacy of a bank’s capital and its risk management practices. The third pillar, market discipline, relied on the market to discipline banks by rewarding those with strong risk management practices and punishing those with weak practices.
Q.3. Describe the key deficiencies in bank regulation and risk management in financial
The key deficiencies in bank regulation and risk management that led to the development of Basel III included a lack of transparency and consistency in the measurement of risks, inadequate capital and liquidity buffers, and a lack of attention to operational risks. The financial crisis of 2007-2008 exposed these deficiencies and highlighted the need for stronger regulatory frameworks to better manage and mitigate the risks faced by banks and financial institutions. As a result, the Basel III framework was introduced in 2010 to address these issues and improve the resilience of the financial system. It included measures such as higher minimum capital and liquidity requirements, the introduction of a leverage ratio, and the introduction of a framework for dealing with failing banks.
The Capital Asset Pricing Model (CAPM) is a model used to determine the expected return of an asset based on its risk level. It states that the expected return of an asset is equal to the risk-free rate plus a risk premium, which is determined by the asset’s beta. Beta is a measure of the asset’s volatility compared to the overall market. The higher the beta, the higher the expected return. The CAPM is commonly used in finance to calculate the required rate of return for a particular asset in order to determine whether it is a good investment. It is also used to price assets in capital budgeting and to evaluate the performance of mutual funds and other investment portfolios.
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