Question

Define the purpose of the Commercial Bank Stress Tests

a.     Define the credit, default and liquidity risks that commercial banks face.

b.     Is regulation working the same for all banks? Explain.

c.     How financial institution size is correlated with overall uncertainty in the economic and financial landscape?

d.     Define the term “financial uncertainty” and explain how the Too Big to Fail (TBTF) issue may affect it

Answer 1

Stress tests are designed to ensure banks are taking the necessary measures to prevent failure in the event of an economic crisis. These tests are ultimately meant to protect the consumers who place their money in the trust of banks, and to stop a financial crisis from quickly getting worse.

a) A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments

Default risk is the risk that a bond issuer will not make its promised principal and interest payments.

Liquidity risk is the Inability to meet short-term debt due to exceptional losses or damages during Operations.

b) Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. All scheduled commercial banks (except regional rural banks) are required to comply with Basel Regulations and these banks are required to comply with the Basel Regulations both at individual and consolidated level.

c) The primary role of financial institutions is to provide liquidity to the economy and permit a higher level of economic activity than would otherwise be possible.In the financial system funds flow from those who have surplus funds to those who have a shortage of funds, either by direct, market-based financing or by indirect, bank-based finance.

d) Uncertainty simply means the lack of certainty or sureness of an event. In accounting, uncertainty refers to the inability to foretell consequences or outcomes because there is a lack of knowledge or bases on which to make any predictions.The term is often widely used in financial accounting, especially because there are many events that are beyond a company’s control that can greatly affect its transactions.

Too big to fail describes a business or business sector deemed to be so deeply ingrained in a financial system or economy that its failure would be disastrous to the economy. Therefore, the government will consider bailing out the business or even an entire sector such as Wall Street banks or U.S. carmakers to prevent economic disaster.