Faculty of Foreign Languages – Department of Business English Banking & Finance
Full Name: ..................................... Class: .................................. Student Code: .............................
Mark:
TEST 10
TOPIC 10: RISK MANAGEMENT IN FINANCIAL INSTITUTIONS
SECTION 1: Fill in the gaps
Task 1: Fill in the gaps in the text below using the correct terms from the given table. Each term can
only be used once, and five terms will not be used.
loans credit risk judgment assets information
default moral hazard industries liabilities finances
borrowers high-risk income competition adverse selection
screening credit score lenders operations creditworthiness
monitoring diversification profitable consumer loan business loan
Financial institutions like banks, insurance companies, pension funds, and finance companies are
heavily involved in making (1) ____. To achieve high profits, these institutions need to ensure that
their loans are repaid in full and have low (2) ____. Understanding the principles of (3) ____ and (4)
____ is crucial for financial institution managers to minimize credit risk and make successful loans.
Adverse selection occurs in loan markets because those most likely to (5) ____ on their loans are the
ones who seek them out. Borrowers with very risky projects are eager to obtain loans because they
stand to gain much if successful. However, they are the least desirable (6) ____ due to the higher
likelihood of being unable to repay their loans.
Moral hazard exists because borrowers might engage in activities undesirable to the lender once they
have secured a loan. Borrowers are more likely to invest in (7) ____ projects that offer high returns if
successful but also increase the risk of loan default.
To remain (8) ____, financial institutions must tackle the adverse selection and moral hazard issues
that increase the probability of loan defaults. They employ several strategies to manage credit risk,
including (9) ____ and (10) ____, long-term customer relationships, loan commitments, collateral,
compensating balance requirements, and credit rationing.
Asymmetric (11) ____ in loan markets arises because lenders have less information about borrowers'
investment opportunities and activities. This leads financial institutions to engage in two key
activities: screening and monitoring.
When applying for a (12) ____ like a car loan or a mortgage, you must provide detailed information
about your (13) ____, such as salary, bank accounts, and other (14) ____ like cars and insurance
policies. Lenders use this information to assess your credit risk by calculating a “(15) ____,” which
predicts the likelihood of you having trouble with loan repayments.
Deciding on loan approval involves more than just scientific methods; it also requires (16) ____.
Loan officers may call your employer or check personal references to gather more insights. They
might even base their decisions on your demeanor or appearance.
The process is similar for (17) ____ loans, where financial institutions collect information on a
company’s profits and losses (income), (18) ____, and liabilities. Loan officers evaluate the
company's future success, asking about future plans, the purpose of the loan, and the (19) ____ in the
industry. They may visit the company to gain firsthand insights into its (20) ____.
Task 2: Fill in the gaps in the text below using the correct terms from the given table. Each term can
only be used once, and five terms will not be used.
Faculty of Foreign Languages – Department of Business English Banking & Finance
loans default moral hazard successful personal finances
repayments judgment credit risk lender consumer loan
monitoring loan payments diversification income business loan
screening assets credit card bad adverse selectio
borrowers long-term high-risk profitable creditworthiness
A major part of the business of financial institutions, such as banks, insurance companies,
pension funds, and finance companies, is making (1) ____. For these institutions to earn high
profits, they must make successful loans that are paid back in full and have low (2) ____. The
concepts of (3) ____ and (4) ____ provide a framework for understanding the principles that
financial institution managers must follow to minimize credit risk and make successful loans.
Adverse selection in loan markets occurs because (5) ____ credit risks, those most likely to
(6) ____ on their loans, are the ones who usually line up for loans. Borrowers with very risky
investment projects have much to gain if their projects are (7) ____, so they are the most
eager to obtain loans. Clearly, however, they are the least desirable (8) ____ because of the
greater possibility that they will be unable to pay back their loans.
Moral hazard exists in loan markets because borrowers may have incentives to engage in
activities that are undesirable from the lender’s point of view. Once borrowers have obtained
a loan, they are more likely to invest in (9) ____ investment projects—projects that pay high
returns to the borrowers if successful. The high risk, however, makes it less likely that they
will be able to pay the loan back.
To be (10) ____, financial institutions must overcome the adverse selection and moral hazard
problems that make loan defaults more likely. The attempts of financial institutions to solve
these problems help explain several principles for managing credit risk: (11) ____ and (12)
____, establishment of (13) ____ customer relationships, loan commitments, collateral,
compensating balance requirements, and credit rationing.
When you apply for a (14) ____, such as a car loan or a mortgage to purchase a house, the
first thing you are asked to do is fill out forms that elicit a great deal of information about
your (15) ____. You are asked about your salary, your bank accounts and other (16) ____
(such as cars, insurance policies, and furnishings), and your outstanding loans; your record of
loan, (17) ____, and charge account (18) ____; and the number of years you’ve worked and
who your employers have been. You also are asked personal questions such as your age,
marital status, and number of children. The (19) ____ uses this information to evaluate how
good a credit risk you are by calculating your credit, a statistical measure derived from your
answers that predicts whether you are likely to have trouble making your (20) ____.
SECTION 2: True/False
1. Adverse selection in loan markets occurs because bad credit risks are the ones who usually line up
for loans; in other words, those who are most likely to produce an adverse outcome are the most
likely to be selected.
2. Moral hazard exists in loan markets because borrowers may have incentives to
engage in activities that are undesirable from the lender’s point of view.
3. Adverse selection in loan markets requires that lenders screen out the bad credit risks from the
good ones so loans are profitable to them.
4. Credit risk is the risk that the value of an asset will decrease due to changes in market conditions.
5. Credit risk can only be managed by collateralizing loans.
Faculty of Foreign Languages – Department of Business English Banking & Finance
6. Stress testing is a tool only used to manage interest rate risk.
7. Effective screening and information collection together form an important principle of credit risk
management.
8. A positive duration gap means that a bank’s assets have longer durations than its liabilities.
9. Gap analysis is used to assess interest rate risk by examining mismatches between rate-sensitive
assets and liabilities.
10. Credit risk management only involves loan approvals.
11. The probability of default is irrelevant in risk management.
12. A high positive GAP is riskier than a high negative GAP.
13. To reduce moral hazard, financial institutions must adhere to the principle for managing credit
risk that a lender should write provisions (restrictive covenants) into loan contracts restricting
borrowers from engaging in risky activities.
14. One way for financial institution managers to obtain information about their
borrowers is through long-term customer relationships, another important principle of credit risk
management.
15. Long-term relationships benefit the customers as well as the financial institution.
16. If a borrower defaults on a loan, the lender cannot sell the collateral and use the proceeds to make
up for its losses on the loan.
17. Credit rationing occurs when a lender is willing to make a loan without restricting the size of the
loan to less than the borrower would like.
18. Collateral worsens the consequences of adverse selection and moral hazard.
19. Liquidity is variable, depending on the nature of the asset.
20. Credit risk is the risk that a borrower will default on a loan.
21. A loan commitment is a bank’s commitment (for a specified future period of time) to provide a
firm with loans up to a given amount at an interest rate that is tied to some market interest rate.
22. Adverse selection in loan markets occurs because good credit risks are the ones who usually line
up for loans.
23. Collateral, which is property promised to the borrower as compensation if the borrower defaults.
24. Adverse selection exists in loan markets because borrowers may have incentives to
engage in activities that are undesirable from the lender’s point of view.
25. Collateral, which is property promised to the lender as compensation if the borrower defaults.
26. Collateral lessens the consequences of adverse selection because it reduces the lender’s losses in
the case of a loan default, and also reduces moral hazard because the borrower has more to lose from
a loan default.
27. Loan covenants are restrictions placed on borrowers to limit risk exposure.
28. Moral hazard in loan markets requires that lenders screen out the bad credit risks from the good
ones so loans are profitable to them.
29. Long-term relationships benefit the customers, but the financial institution.
30. If a borrower defaults on a loan, the lender cannot sell the collateral and use the proceeds to make
up for its losses on the loan.
31. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up
for its losses on the loan.
32. Credit rationing occurs when a lender refuses to make a loan of any amount
to a borrower, even if the borrower is willing to pay a higher interest rate.
33. Credit rationing occurs when a lender is willing to make a loan but restricts the size of the loan to
less than the borrower would like.
34. The first step in assessing interest-rate risk is for the bank manager to decide which
assets and liabilities are rate-sensitive, that is, which have interest rates that will be reset
(repriced) within the year.
Faculty of Foreign Languages – Department of Business English Banking & Finance
SECTION 3: Answer the questions
Task 1:
Question 1: Why is being nosy a desirable trait for a banker?
Because it helps bankers identify credit risks (avoiding adverse selection) and monitor
borrowers (reducing moral hazard). Being inquisitive supports risk management and
strengthens client relationships.
Question 2: Can a financial institution keep borrowers from engaging in risky activities if there are
no restrictive covenants written into the loan agreement?
Not fully, but they can manage risk via higher interest rates, ongoing credit monitoring,
requiring collateral, and strong borrower relationships
Question 3: How can a bank apply credit risk mitigation techniques in its lending practices?
By using: collateral, credit guarantees, covenants in loan contracts,and
credit derivatives like CDS
Task 2:
Question 1: “If more customers want to borrow funds at the prevailing interest rate, a financial
institution can increase its profits by raising interest rates on its loans.” Is this statement true, false, or
uncertain? Explain your answer.
True
Question 2: A bank almost always insists that the firms it lends to keep compensating balances at the
bank. Why?
They reduce credit risk and provide low-cost funds for the bank to invest, while also
improving liquidity.
Question 3: “Because diversification is a desirable strategy for avoiding risk, it never makes sense
for a financial institution to specialize in making specific types of loans.” Is this statement true, false,
or uncertain? Explain your answer.
False: Specialization can improve risk assessment and efficiency, despite reducing
diversification. It can be strategic in niche markets.
Task 3:
Question 1: Dong A bank has to rely heavily on short-term borrowing to finance long-term assets,
and interest rates suddenly rise. How can Dong A bank mitigate the risk it faces in this case?
Use interest rate swaps/futures or match asset-liability maturities more closely.
Question 2: VP bank has a high concentration of loans in the real estate sector, and property values
begin to decline. What type of risk is VP bank exposed to, and how can it manage this risk?
It faces credit risk. It can manage this by diversifying the loan portfolio and using credit
derivatives to hedge losses
