Bank - credit risk, liquidity

CFA Level III
#1

EOC Q

The ALCO decides to increase Winthrop Bank’s credit standards for loans although Winthrop Bank’s overall risk tolerance is unchanged.

A:Winthrop Bank should have more leeway to invest in below-investment-quality debt in its bond portfolio as a result.

If the ALCO increases credit standards doesnt it mean that the bank has to invest in higher credit quality debt?

Other Q: Winthrop decides to sell its mortgage loans as soon as they are booked.

A: Winthrop’s decision decreases the need for liquidity in its securities portfolio.

Why should it decrease liquidity? I would have said it decreases risk given that default risk is removed.

#2

By selling mortgage loans as soon as they book them, they are loaning money out and then immediately getting it back (likely at a small gain).

#3

This is a very badly worded question (though I’m not English).

Based on the answers given in the curriculum, I guess for question B they wanted to say “lift credit standards” instead of “increase credit standards”.

For the liquidity: if they don’t hold mortgage loans, they need less liquidity because mortgage loans are prepayable by the borrowers. Most probably they will offer loans with no early repayment option instead.

#4

Increasing the credit standards means borrowers need a higher credit rating to qualify for a loan. This will decrease the banks provisions for credit losses as they’re loaning money to better qualified applicants.

if their overall risk appetite hasn’t changed, and they’ve now reduced the risk of credit loss by increasing the lending standards, they can pick up the lost risk by investing in below investment grade securities.