Just for learning

1. EMBF Group 4, Financial Institutions and Markets Group Assignment
1
Question 9. What steps were taken in the FDICIA legislation of 1991 to improve the functioning
of federal deposit insurance?
Solution
The Federal Deposit Insurance Corporation Improvement Act was passed in 1991, during the
height of the consequences of the Savings and Loan Crisis that began in the 1970s. Several
acts, reforms, bailouts, and mergers were implemented during the 1980s. However, none of
these measures was sufficient to restore the financial stability of commercial banks and savings
and loan associations.
The directives requested that federal financial agencies implement remedial and oversight
measures.
The agencies should allocate their resources among different categories, namely well
capitalised, sufficiently capitalised, critically undercapitalized, significantly undercapitalized, and
undercapitalized.
Despite having a substantial amount of assets, some banks nonetheless fell into the last three
categories. The failure of these banks would have compromised public confidence in the
banking system.
They were deemed "too large and systemically important to be allowed to fail." Consequently,
they were granted bail. The federal government allocated resources to the Bank Insurance
Fund.
The banks were mandated to provide data on loans extended to small companies and small-
scale farms.
Insured depository institutions, whether founded or assisted, must comply with the minimum
capital standards.
The Federal Deposit Insurance Corporation should abstain from buying assets from struggling
institutions.
The new investors should assume the risks associated with the corporation.
The senior leadership of the institution should possess a high level of qualifications in order to
effectively carry out their responsibilities.
—------------------------------------------------------------------------------------------------------------------------
Question 10. What are the risk management activities undertaken by central banks to sustain
economic growth?
Solution
Central banks are essential in supporting economic growth through their involvement in various
risk management operations. The purpose of these actions is to uphold price stability,
guarantee the stability of the financial system, and promote an environment that supports
sustainable economic growth. A crucial risk management task that central banks carry out is the
implementation of monetary policy. Central banks employ several instruments, including interest
rates, open market operations, and reserve requirements, to manipulate the money supply and
manage inflation. Central banks can eliminate a significant risk to economic growth by

2. EMBF Group 4, Financial Institutions and Markets Group Assignment
2
effectively regulating inflation. High and volatile inflation can diminish purchasing power,
undermine consumer confidence, and disrupt long-term corporate planning.
Another crucial risk management task includes overseeing and regulating financial institutions.
Central banks collaborate with regulatory authorities to create and enforce sensible criteria for
banks and other financial institutions. This omission serves to mitigate the occurrence of
financial crises and systemic hazards, which can have profound ramifications for economic
expansion. Central banks contribute to the stability of the financial system and support
sustained economic growth by ensuring that financial institutions retain sufficient capital buffers,
handle risks responsibly, and follow sound lending practises.
Central banks also partake in currency management to protect against exchange rate volatility
that can disrupt global trade and investment. They may intervene in the foreign exchange
market to maintain stability in the value of their national currency or to control its exchange rate
relative to other currencies. This facilitates the preservation of export competitiveness and
promotes economic growth by guaranteeing a stable atmosphere for global trade.
In addition, central banks hold foreign exchange reserves as a precautionary step to reduce the
impact of external shocks and strengthen the country's capacity to fulfil its international financial
commitments. Reserves serve as a cushion during periods of economic instability, playing a role
in maintaining the stability of the exchange rate and guaranteeing the country's ability to get
foreign currency when necessary.
In addition, central banks diligently oversee and evaluate a range of risks in the financial
markets, such as those linked to asset bubbles, excessive leverage, and market volatility. In
order to avoid these risks from growing into systemic crises, authorities can employ
macroprudential instruments such as capital adequacy rules and loan-to-value ratios.
To summarise, central banks engage in a wide range of risk management actions to maintain
and support economic growth. The activities include the implementation of monetary policy,
monitoring and regulation of financial institutions, management of currency, and preservation of
foreign exchange reserves. Through competent risk management, central banks play a crucial
role in maintaining the stability of the economy, which is essential for achieving long-term and
robust economic growth.
—-------------------------------------------------------------------------------------------------------------------------

3. EMBF Group 4, Financial Institutions and Markets Group Assignment
3
Quantitative Question
Question 7. Bank regulators force Oldhat to sell its mortgages to recognise their fair market
value. What is the accounting transaction? How does this affect its capital position?
Solution
When Oldhat Financial is compelled by bank regulators to divest its mortgages in order to
acknowledge their fair market value, the accounting transaction will entail the following steps:
Oldhat will debit its mortgage assets, resulting in a drop in their value on the balance sheet. The
sum will correspond to the aggregate book value of the mortgages, which, in this instance,
amounts to $50 million.
Debit Oldhat will classify the funds obtained from selling the mortgages as revenue or gains on
the income statement. The amount credited to this account will be determined by the fair market
value of the mortgages sold. If the fair market value is less than the book value, it would lead to
a loss, and if it is greater, it would lead to a gain.
Debit Capital: In the event of a loss on the mortgage sale, when the fair market value is lower
than the book value, Oldhat's capital position will be directly reduced. In this situation, the $9
million in capital will be decreased by the exact amount of the loss incurred from the sale of the
mortgage.
The impact on Oldhat's capital position will be contingent upon the disparity between the fair
market value and the book value of the mortgages that were sold. If the fair market value is less
than the book value, it will decrease Oldhat's capital, potentially jeopardising its compliance with
regulatory capital requirements. On the other hand, if the fair market value is greater, it could
lead to a profit that would boost Oldhat's capital.
It is essential to emphasise that capital adequacy is a vital component of a bank's adherence to
regulatory requirements. Financial institutions are obligated to uphold a specific threshold of
capital in order to absorb potential losses and guarantee stability in their operations. In the event
that the sale of the mortgages leads to a substantial financial loss and causes Oldhat's capital to
fall below the mandated minimum, the company may be compelled to undertake remedial
measures, such as securing additional funds or making changes to its business activities, in
order to comply with regulatory capital obligations.

4. EMBF Group 4, Financial Institutions and Markets Group Assignment
4
Question 8. . Congress allowed Oldhat to amortize the loss over the remaining life of the
mortgage. If this technique had been used in the sale, how would the transaction have been
recorded? What would be the annual adjustment? What does Oldhat’s balance sheet look like?
What is the capital ratio?
Solution
If Oldhat Financial had been allowed to amortize the loss over the remaining life of the mortgage
in the sale of mortgages, the transaction would be recorded differently. This approach is often
used when a bank is forced to recognize a loss on the sale of financial assets. Here's how the
transaction would have been recorded:
Debit (Decrease) Mortgage Assets: Oldhat would still decrease the value of its mortgage assets
on the balance sheet by the total book value of the mortgages, which is $50 million.
Credit (Decrease) Loan Sales or Mortgage Revenue: Oldhat would recognize the proceeds from
the sale of the mortgages as revenue or gains on the income statement. However, the gain or
loss would not be recognized entirely upfront but rather amortized over the remaining life of the
mortgages. To calculate the annual adjustment, you would need to determine the remaining life
of the 30-year mortgages. Let's assume, for example, that these mortgages were sold with 29
years remaining.
Annual Adjustment = (Total Loss) / Remaining Life of Mortgages
Total Loss = Book Value - Fair Market Value
Total Loss = $50 million (Book Value) - Fair Market Value
Credit (Decrease) Capital: If there is a loss on the sale of the mortgages, this loss will reduce
Oldhat's capital position. However, the annual adjustment to recognize the loss over the
remaining life of the mortgages will be smaller compared to recognizing it entirely upfront.
Now, let's calculate the annual adjustment and how Oldhat's balance sheet and capital ratio
would look like:
Assuming the fair market value of the mortgages is $45 million, the total loss would be $5 million
($50 million - $45 million).
Annual Adjustment = $5 million (Total Loss) / 29 (Remaining years of the mortgages)
Annual Adjustment ≈ $172,414
Oldhat's Balance Sheet:
Mortgage Assets: $50 million (book value) - $172,414 (annual adjustment)
Mortgage Assets = $49,827,586
Loan Sales or Mortgage Revenue: $5 million (initial loss recognized)
Loan Sales or Mortgage Revenue + $172,414 (annual adjustment)
Oldhat's Capital Position:

5. EMBF Group 4, Financial Institutions and Markets Group Assignment
5
Initial Capital: $9 million
Capital Reduction due to the initial loss: -$5 million
Annual Reduction in Capital: -$172,414
The capital ratio can be calculated as:
Capital Ratio = (Total Capital / Risk-Weighted Assets)
Oldhat's Total Capital = $9 million (initial capital) - $5 million (initial loss) = $4 million
Assuming a simplified risk-weighted asset calculation of $75 million (commercial loan +
mortgages):
Capital Ratio = ($4 million / $75 million) * 100% ≈ 5.33%
Please note that the capital ratio calculated here is a simplified example. In practice, banks use
more complex risk-weighted asset calculations to determine their capital adequacy and
regulatory compliance. Additionally, this calculation assumes that no other transactions or
changes have occurred in the bank's operations during this period.