PROFESSIONAL LEVEL EXAMINATION

BUSINESS PLANNING: BANKING

SAMPLE PAPER

(2.5 hours)

BUSINESS PLANNING: BANKING

SAMPLE PAPER - ANSWERS
1.1
All of FBs loans and advances are classified as loans and receivables or held to
maturity. The classification is in accordance with IAS 39 as the loans and advances
are non-derivative financial assets with fixed or determinable payments and the bank
does not intend to sell them in the near term.

The loans are originally recognised at fair value being the purchase price plus any
transaction costs and are subsequently measured at amortised cost. Interest income
is recognised in the statement of profit or loss using the effective interest rate applied
to the carrying amount of the loan at the start of the period. The coupon received is
deducted from the carrying amount of the loan.

Argyle Bank (Argyle)

FB shall assess at the end of each reporting period whether there is any objective
evidence that the loan, measured at amortised cost, is impaired. If any such
evidence exists the amount of the impairment loss needs to be determined.
The downgrading of Argyles loan notes from a credit rating of ABB to BBB is an
indicator of impairment as the recovery of interest and principal amount is less
certain. The information from the Argyle board that no further interest will be paid
and that only 70% of the capital will be paid is a further, and much stronger, indicator
of impairment.

In order to determine if there is any impairment loss the carrying amount must be
compared to the present value of the estimated future cash flows (excluding future
credit losses that have not been incurred) discounted at the loans original effective
annual interest rate of 4.2%.

Carrying amount (amortised cost) of investment in Argyles 3% loan note:

Year ended Balance Effective Coupon Balance
brought interest at (3% x 5m) carried
forward 4.2% forward
30 Sep 2013 4,518,150 189,762 (150,000) 4,557,912
30 Sep 2014 4,557,912 191,432 (150,000) 4,599,344
30 Sep 2015 4,599,344 193,172 (150,000) 4,642,516

Note: IAS39 AG84 requires the use of original effective interest rate of 4.2% for
discounting to determine impairment, as the use of the market interest rate would in
effect impose fair value measurement.

Present value of estimated future cash flows of Argyles 3% loan note:

70% x 5m x 1/(1.0427) = 2,624,182
Individual impairment provision = 4,642,516 2,624,182 = 2,018,334
The loans and advances should be reduced by 2,018,334 and the impairment loss
recognised in the statement of profit or loss.
This impairment may be reduced if there is good security and the bank expects to be
able to foreclose on the loan at or near the nominal value.
(6 marks)
1.2
Key audit risks and related procedures
UK Banks
Audit risk
Argyle Bank loan:
Financial assets recognised at
amortised cost are overstated due to
unrecognised impairments*.
Other UK banks:
Financial assets recognised at
amortised cost are overstated due to
unrecognised impairments*.
Audit procedures
Obtain renegotiation of loan
correspondence between FB and Argyle
to confirm the redemption amount and
date.
Confirm receipt of interest for 30
September 2015 to bank statement.
Perform analytical procedures on
Argyles financial statements, if
available, before audit sign off for
indications of likelihood of meeting
redemption terms.
Ensure impairment has been adjusted
correctly and is recognised in profit or
loss for the period.
Inspect loan documentation to
understand the loan security and obtain
a valuation of the security held.
Examine forecasts of future cash flows
by management to support the
calculation of impairment, evaluating the
assumptions and comparing estimates
with any available external evidence.
Assess and test the design and
operating effectiveness of the controls
over impairment data and calculations.
Discuss with management the credit
risk assessment procedures for
robustness. Attend key meetings that
form part of the approval process for
loan impairment allowances to assess
governance controls.
Assess and test key controls over the
credit grading process to assess
reasonableness of risk grades allocated

Other loans to UK banks may not be
sufficiently impaired.
Mortgage book
Audit risk
The portfolio of assets may have
suffered impairment losses*.
to counterparties.
Examine a sample of loans and
advances which have not been
identified by management as impaired
and ascertain whether impairment is
required, including inspecting external
evidence for relevant counterparties.
Examine board minutes, credit
committee minutes and credit watch list
for discussions of any other loans with
possible default.
Test a sample of performing loans with
characteristics that might imply an
impairment event had occurred e.g.
customer with financial difficulties or
approaching a refinancing deadline, to
assess whether all impairment events
had been identified.
Where impairment was calculated for
loans, test a sample to ascertain
whether the loss event had been
identified in a timely and appropriate
manner.
Test key inputs to the impairment
calculation including expected future
cash flows and valuation of collateral
held.
Consider using other specialists to
assess valuation of collateral, for
example real estate valuation experts.
Compare the impairment allowance to
gains or losses crystallized when
impaired loans have been sold after the
reporting date.
Audit procedures
Obtain an analysis of the mortgage
book to evaluate exposure by time
period.
Identify whether any mortgages have
been assessed as individually
significant and if so ensure that they
have been removed from the portfolio.

Forbearance policies have been applied
to avoid provisions.
Impairments recognised are insufficient.
Segment loans by industry sector in
addition to credit rating if appropriate to
assess probability of default.
Ascertain and evaluate the firms
forbearance policy statement.
Obtain a breakdown of the portfolio on
which forbearance has been applied
(especially payment holidays and
interest only concessions) and check
whether forbearance has been applied
consistently in line with the firms policy
statement.
Appraise economic data for house price
movements and forecasts and perform
analysis to ensure FBs models are in
line with these forecasts.
Where impairment was calculated using
models, test the operation of those
models and the underlying data and
principal assumptions used.
Test inputs to the collective impairment
allowance calculation to ensure it is
based upon historic loss experience for
assets with credit risk characteristics
similar to those in the portfolio.
Benchmark using audit firm knowledge
of other practices in the industry and
actual experience. Apply this
benchmarking to accounting policies,
modelling assumptions, provision
coverage and treatment of specific
exposures.
Test the operation of some models used
to calculate the impairment including
rebuilding the models or building own
models independently and comparing
the results. Perform sensitivity analysis
on the key assumptions.
Consider using IT experts within the
audit firm to carry out in-depth IT testing
techniques such as code review to
analyse managements extraction and
manipulation of data for statistical
purposes.

Professional scepticism is applied
Non-UK corporate lending
Audit risk
Lending in new markets requires
enhanced credit risk procedures.
Foreclosure costs may be
underestimated
Consider the potential for impairment to
be impacted by events not captured by
management models.
Ascertain how management dealt with
events not captured by models by
examining adjustments made to reflect
current market conditions, with
reference to audit firm knowledge and to
market and economic conditions.
Evaluate the governance controls to
ensure a continuous re-assessment of
impairment models to ensure they are
still appropriate.
Models must consider the loss
emergence/ discovery period to ensure
a reasonable allowance is applied. This
must reflect the length of time between
the loss event occurring for the
borrower and the lender obtaining
sufficient information about it.
Ensure audit teams apply an
appropriate degree of challenge and
professional scepticism rather than
seeking to corroborate managements
views.
Audit procedures
Request the credit risk assessment
procedures for these new geographical
regions.
Discuss a sample of loans with the
relevant Credit Controller to understand
whether balance should be impaired.
Evaluate macro-economic conditions in
non-UK geographical regions and use
in-country teams local knowledge to
assess trends in the local credit
environment.
Ascertain and evaluate the firms
assumptions relating to the amount and
timing of cash flows resulting from
foreclosure including costs for obtaining

Regular reviews of collateral valuation
may not be possible
and selling the collateral.
Evaluate the last independent third
party valuation of collateral for a sample
of loans and the basis on which the
valuations were performed and the
basis for any indexation applied.

*Also relevant for non UK corporate lending

(17 marks)
1.3
Treatment of impairments under IFRS 9
IAS 39 uses the incurred loss model where impairment is recognised if there is
objective evidence of a loss event.

IFRS 9 will use the expected loss model where future credit losses are considered in
calculating impairment allowance. This involves use of more judgement and earlier
recognition of impairment allowance compared to IAS 39. The loans and advances
will be classified into one of the three stages under IFRS 9:

Stage 1: Loans and advances on origination and those with low credit risk (12 month
expected credit losses are recognised)

Stage 2: Loans and advances where the credit risk has increased significantly since
origination (lifetime expected credit losses are recognised)

Stage 3: Loans and advances on which credit loss is incurred (lifetime expected
credit losses are recognised)

12 months expected credit losses in stage 1 are calculated by multiplying the

probability of a default occurring in the next 12 months by the total lifetime credit
losses that would result from that default.

Argyle Bank (Argyle)

The impairment in Argyle would have been recognised earlier (on initial recognition
in 2012) under IFRS 9 based on 12 month expected credit losses. Impairment losses
may be subsequently increased to reflect the changes in probability of default and
credit quality. The present value of future cash flows would be discounted at 6.5%
under IFRS 9 on 30 September 2015.

Under IAS 39 the entire loss is recognised only in 2015.

(3 marks)

1.4

Analysis of non-performing loans

Asset quality is monitored by looking at the non-performing loan (NPL) ratio,

calculated as gross non-performing loans divided by the total gross loan book.

Loans and Mortgage Loans and

advances loans to advances to
to UK UK retail non UK
banks customers corporates Total
000 000 000 000
Total non-performing 3,899 25,350 58,271 87,520
loans: gross
Gross loans and
advances 125,987 433,001 123,576 682,564
NPL % 3.1% 5.9% 47.2% 12.8%

The overall non-performing portfolio amounts to 87,520,000, representing 12.8% of

the gross loan book. This ratio is overall rather high. Segmental analysis indicates
that the non-performing loan ratio is very moderate for loans to UK banks (3.1%) and
low also for UK retail mortgages (5.9%). On the other hand, the most recent
business of lending to non-UK customers has a very high non-performing loan ratio,
at 47.2%, indicating that FB is taking on significant credit risk.

Non-performing loans are expected to generate credit losses, i.e. the bank will most
likely be unable to recover the full amount of loans outstanding, owed by customers
to the bank. Banks therefore need to make sufficient impairment allowances to cover
the credit losses to be incurred in the non-performing loan book. Banks calculate and
disclose their non-performing loan coverage ratio, which divides the total impairment
allowance (individual and portfolio impairments) by the non-performing loans. The
non-performing loan coverage ratio does not need to be 100%, since some
recoveries are expected. However, it should be sufficient to cover losses given the
defaults expected from the non-performing loan book.

In the case of FB, the non-performing loan coverage ratio is as follows:

Loans and Mortgage Loans and

advances loans to UK advances to
to UK retail non UK
banks customers corporates Total
000 000 000 000
Individually assessed
impairment allowance 2,152 1,605 12,975 24,168
Collectively assessed
impairment allowance 0 15,353 2,022 9,939
Total impairment
allowance 2,152 16,958 14,997 34,107
Non-performing loans
gross 3,899 25,350 58,271 87,520
NPL coverage % 55.2% 66.9% 25.7% 39.0%

Overall, the non-performing loan coverage ratio is 39% which is not very high.
However, the ratio is rather different across the 3 segments. The coverage ratio
seems adequate for loans and advances to UK banks and for UK retail mortgages,
at 55.2% and 66.9% respectively. However, at 25.7%, the coverage ratio is very low
for loans and advances to non-UK customers.
A combination of very high non-performing loan ratio and insufficient NPL coverage
seems to indicate that FB is taking excessive risk in the non-UK segment and that
this risk is not adequately covered by existing impairment allowances. If the
impairment allowance is insufficient, then equity is over-stated. In other words, there
is an unreported significant loss in the loan book and ultimately in the equity and
regulatory capital of the bank.
(6 marks)

1.5 (a)

Credit risk disclosures

LTV and credit risk concentration:
FB will need to revise its disclosure of average LTVs and incorporate
house price increases in the indexation.
Credit concentration should be split geographically and by industry for
both UK and non-UK exposures. For loans to UK banks, a breakdown
of exposures by credit rating should be provided.

Impaired loans and arrears:

Analysis of movements in impaired loans to include opening balance,
impaired during the year, transfer to not impaired, repayments,
amounts written off, exchange adjustments, closing balance.
Age analysis by past due status of loans collectively impaired and
individually impaired loans.
Include the impact of interest rate rises on arrears and impairments
[banks currently perform this sensitivity as part of FSA017 return which
measures the impact of a 2% +- interest rate movement].
A comparison of arrears to Council of Mortgage Lenders average.
Details of hedging arrangements and their effectiveness in relation to
non UK exposures.

Forbearance:
Quantitative disclosure could include balances on forbearance
programmes to include by reasons stated and type e.g. retail loans,
bank loans and non UK as well as by product e.g. home loans, credit
cards/unsecured, commercial loans etc.
FB should list out all the forbearance activities that are being
undertaken by the bank across the three asset classes [candidates
should mention some common practices like payment holidays, term
extensions, payment concessions and permanent interest only
conversions].
(5 marks)
1.5(b)
Expected Loss (EL)

Calculations:
EL = Exposure *Loss given default (LGD)1* Probability of default (PD)

UK banks: EL = 125,987,000 * (1-0.6) * 0.001= 50,400

UK retail mortgages: EL = 433,001,000 * (1-0.6) * 0.003 = 519,600
Non UK corporates: EL = 123,576,000 * (1-0.4) * 0.005= 370,700
Impact on capital resources:

If the increase in allowances is equal to the increase in expected losses then there
will be no impact on capital resources.

If the increase in allowances is lower than the increase in EL then capital resources
will decrease and vice versa. This is because under CRD IV, the net regulatory
capital expected loss in excess of accounting impairment allowances is deducted
from CET1 capital, gross of tax.

Comparison of expected loss with IAS 39 and IFRS 9:

Under IAS 39 allowances are recognised using incurred loss model where a trigger
event has occurred whereas regulatory EL is calculated on every exposure
regardless of a trigger event occurring and is based on PD and LGD.

Under IFRS 9, the standard allows entities to make the assessment of changes in
credit risk by using a 12 month PD. This may mean that the 12 month PD used for
regulatory purposes can be used without adjustment.
However, there may be differences in that the PD used for regulatory purposes can
often be based on through the cycle (TTC) assessment (that is, probability of
default in cycle-neutral economic conditions). For IFRS 9 however, PD should be
point in time (PiT) assessment (that is, probability of default in current economic
conditions).

This means that PD calculated for regulatory purposes based on TCC methodology
(feeding into the calculation of EL) are less sensitive to changes in economic
conditions and reflect longer-term trends as compared to IFRS 9 under which PD are
point in time assessments and can be higher than regulatory PD during a financial
crisis.
(6 marks)

Total: 43 marks

1
LGD= 1-recovery rate
2.1

Working paper

To: Credit sanction department: First Bank

From: Relationship manager: First Bank
Date: 27 July 2015
Subject: Aardvark Bicycle Company Ltd Loan application

Introduction

The purpose of this working paper is to evaluate the loan application from ABC Ltd.
The company is seeking a loan of 1million from First Bank to fund the setting up of
a shop in Bristol. It is a successful business with over 15 years of track record and a
strong asset base.

Analysis of application
1) Loan suitability
2) Affordability
3) Viability
4) Security
5) Financial Stability
6) Capital structure
7) Track record of management

(1) Suitability of the loan

Loan suitability is considered in a separate section below.

(2) Affordability

The ability of ABC to repay the requested loan relates to the company as a whole,
rather than the specific Bristol project which is the purpose of the loan. Nevertheless,
consideration needs to be given to the impact of the project on the future
creditworthiness of the company and on the affordability of the loan.

Ability to service interest payments

The interest payments are 40,000 per annum (1m x 4%). This is a fairly modest
commitment given the cash generating ability of the company. By comparison, the
forecast cash generated from operating activities after interest and tax is for the year
ending 31 December 2016 is 2.743m.

The total interest payment forecast for the year ending 31 December 2016 is
617,000. This gives a comfortable interest cover ratio (APPENDIX 2) of 5.5.

Repayment of principal

The repayment of the principal of 1 million is due in 2020. There appear to be more
concerns in this respect than with the repayment of interest.
The forecast cash position at 31 December 2016 is an overdraft of 389,000. The
ability to generate enough cash to repay the 1 million loan in 2020 comes primarily
from:
Cash generated from operations
Ability to refinance the loan
Improved working capital management

Cash generated from future operations has already been discussed above.

However, a further measure which indicates the ability of ABC to repay debt from
earnings is the debt to income ratio. For ABC, this has increased significantly from
2.67 in 2015, to 4.96 in 2016 (APPENDIX 1). Based on the 2016 data, it would take
almost 5 years to repay the debt even if all of the profit after tax were to be set aside
to repay the loans. Some caution is needed with this ratio as it is based on profit
rather than cash. Nevertheless, a further deterioration in earnings would imply that
the 5-year loan period of the 2014 Lander Bank loan and of the proposed First Bank
loan (with other loans repayable in 2021) might mean it would be challenging for
ABC to repay these loans on time solely from earnings.

The ability to refinance the loan has some concerns. The gearing is reasonably high
as demonstrated by the following:

2016 2015
Debt/equity (APPENDIX 2) 46.9% 46.1%
Debt ratio (APPENDIX 1) 27.8% 29.1%

Whilst the above ratios are stable they demonstrate a reasonably high level of
gearing for a manufacturer/retailer. Given this high level, the ability to engage in
further borrowing may be restricted. If the financial performance of ABC declines in
future then the ability even to finance existing loans may be restricted.

Some unexplained issues in the cash flow statement may place further doubt over
borrowing. There is forecast significant additional investment of 3.816m in PPE in
2016. This is significantly in excess of depreciation and impairment and thus implies
further expansion, rather than asset replacement. Part of the financing of this
commitment is further borrowing of 530,000 and cash reduction to overdraft of
543,000. It needs to be unclear about the nature and source of this financing and
whether ABC plans to approach First Bank for further loans in 2016.

An additional concern for repayment of the principal based on further borrowing is

that the loan of 3.4 million taken out from Lander Bank plc in January 2014
becomes repayable on 31 December 2018. This is shortly before the First Bank loan
would be repayable in 2020. Payment of the Lander Bank loan may reduce the
ability to repay the First Bank loan. Moreover, even if the Lander Bank loan can be
refinanced it may make refinancing the First Bank loan from other sources less likely.

The fact that the 2014 Lander Bank loan was at 3% and the application for the First
Bank loan is at 4% may indicate firstly that Lander Bank was unwilling to extend a
further loan to ABC and that an increase in perceived credit risk by other banks has
increased the interest rate being demanded.

Moreover the interest rate using the financial statement information gives an implied
rate of 7.1% (617k/(8,300k+389k)). This seems high compared to the interest rates
provided by ABC on existing loans and this requires further investigation.

Further pressure on creditworthiness occurs in 2021 when the other pre-2014 loans
become repayable.

Forecast working capital management seems to be poor in 2016 and is to consume

significant cash resources. Whilst issues may unexpectedly arise in cash recovery,
the fact they are planned in for next year is a matter of concern and needs to be
understood.

The significance of planned working capital movements in 2016 can be seen from
the statement of cash flows at 965,000 (257k + 741k - 33k). This is most
obviously reflected in the receivables days and the inventory days as follows:

2016 2015
Receivables days 63 days 50 days
Inventories days 125 days 137 days

The receivables days has increased by 26% which is a matter of concern that
requires investigation and explanation. Additionally however the absolute level of the
receivables ratio seems extremely high. Whilst 63 days might not initially appear
excessive the structuring of the business means that half the sales are in the UK
which are with individuals paying by credit card, which is unlikely to generate more
than minimal receivables. In contrast, the B2B foreign sales are generating almost all
the receivables giving an effective receivables days ratio on these sales of about 126
days.

Inventory days have decreased, per the above table, from 137 days to 125 days.
However the absolute level of inventories has increased by 257,000. Some
increase may have been expected due to the requirements of the new Bristol shop.
The key factor affecting the inventory days has been the increase in the cost of
sales. A more detailed understanding of cost of sales is needed (eg is it due to price
increases; volume increases; a change in mix; exchange rate movements).

Poor working capital management can affect ABCs ability to recover cash from its
operations which in turn will damage its ability to service the loans. It may also be
indicative more general poor financial controls and weak management.

(3) Viability

The business is well placed to repay the loan within the 5 years. The repayment of
the principal of 1 million is due in 2020.

The company is well established and has grown to be profitable over 15 years as
evidenced by the scale of the retained earnings. The retained earnings average a
little under 1 million per annum over the first 15 years, although the early years
were likely to be much lower. Economic conditions have therefore been favourable
over a long period.

The racing bicycle market is growing, but this growth has more recently attracted
new entrants from abroad with competitively priced products and therefore increased
competition. More evidence from market research is needed to substantiate these
claims (see assurance section below) and ascertain the supply-demand balance in
this market.

Regarding the Bristol project, it is clear that it will not, based on the projections
provided, generate sufficient cash flows within the period of the 5-year loan
agreement to repay interest and capital.

Projected operating cash flows for the Bristol shop

Years ending 2016 2017 2018 2019 2020

31 December

Sales revenue 225,000 375,000 675,000 550,000 400,000

Costs
(includes fixed (180,000) (255,000) (405,000) (342,500) (267,500)
and variable)

Working (60,000) (5,000) (20,000) - -

capital

Interest (40,000) (40,000) (40,000) (40,000) (40,000)

Net cash flow (55,000) 75,000 210,000 167,500 92,500

Cumulative
cash flow (55,000) 20,000 230,000 397,500 490,000

The cumulative figure shows that the Bristol project after interest generates less than
half the cash necessary to repay the 1m loan over 5 years. Tax would reduce the
cash generated further.

This shows that repayment of the loan is heavily dependent on cash flows from other
aspects of the business. This is not entirely unexpected as five years is a short
period to repay a loan to acquire property and the business needs to go through a
start-up phase in that period.

Of more concern is that, while the net cash flows are forecast to increase in 2018,
they are forecast to decline in 2019 and again in 2020, such that the 2020 level is
little above the 2017 level which could be regarded as part of the start-up period.
This may be because of expected long term adverse economic conditions, but more
detailed explanations are required for the forecast decline and some indication of
post 2020 cash flows is needed.
Sensitivity analysis on a spreadsheet should be carried out for the Bristol project and
for the business as a whole. This should consider a range of possible future
scenarios and should model their outcomes for future cash flows.

Projections provided for the business as a whole need to go beyond 2016.

(4) Security (Collateral)

Collateral comprises assets pledged to secure a loan or guarantees to repay the

loan. These are required for a secured loan, but not for an unsecured loan. For
financing an asset such as the Bristol building a fixed charge is most likely on that
building, but this does not exclude an additional floating change on other assets.

A number of issues arise for First Bank in obtaining appropriate assets to provide
security.

Other property owned by ABC may be a reasonable alternative/additional security for

the First Bank loan. However, it seems likely that Lander Bank has a first charge
over other properties in respect of the existing loans. Nevertheless, the properties in
the statement of financial position have a value of 16.231m with long term loans of
only 8.3m so there appears to be equity in the properties over and above the loan
values which could form a reasonable basis for a floating charge over these
properties. In this respect, however, it would be subordinated debt with greater risk
than the fixed charge.

A further issue with respect to property values is that ABC uses the historic cost
model for financial reporting purposes, so the fair value may be greater than the
carrying amount to provide additional security. A valuation should be obtained prior
to any charge being taken.

Conversely, there is an impairment charge in the financial statements. It needs to be

ascertained the causes and the assets to which it relates. It may imply there is a
concern over the fair value of properties which would need to be considered in the
context of taking a charge over these assets.

Further collateral could be obtained from ABCs current assets through securitisation
of receivables/invoices or inventories.

It may also be possible to effectively increase the collateral by requiring personal

guarantees from the shareholders, possibly secured on the equity of their homes.
Loans were taken out by the two shareholders to finance their initial share capital
investment and they also supplied personal guarantees for ABCs initial borrowing. It
needs to be ascertained whether these loans have been redeemed or, if not,
whether there is sufficient equity to justify a second charge over the homes.

(5) Financial stability

It is important that the company demonstrates continued financial stability after

taking out the loan.
Whilst the current interest cover ratio shows a reasonable current ability to repay
interest, there are some concerning trends.

The 2016 interest cover was 8.4 so there is a forecast steep decline over the year to
5.5.

More generally the table below (APPENDIX 1) shows that while revenues have
increased by 4% in 2016, compared with 2015, operating profit has decreased by
24.2%.

Moreover, the forecast figures for 2016 include the cash flows from the Bristol project
to enhance growth, whereas the revenue and operating costs in 2015 are unaffected
by the Bristol project. Stripping out the Bristol project data from the 2016 forecasts,
the underlying core business can be compared on a like-for-like basis.

Specifically:

2016 2016
Actual Bristol* adjusted 2015 %
000s 000s 000s 000s change
Revenue 18,178 225 17,953 17,464 +2.8%
Operating profit 3,385 45 3,340 4,463 (25.2%)

* The Bristol project figures are cash flows rather than profit, but are assumed to be
comparable.

The above figures show there is a significant decline in the operating profit of the
business (25.2%) despite a modest increase in revenues (2.8%). Further
explanations of this outcome are required to understand why this trend has occurred
(see section below on further information) and whether it is likely to continue to the
point where ABC may be unable to service its future loan interest payments.

(6) Capital structure

The forecast gearing ratio at 31 December 2016 is 46.9% (APPENDIX 2). Whilst this
is reasonably high it shows that over two thirds of the financing is capital from the
shareholders (equity). This is at risk to the owners if the business fails and provides
a significant incentive to succeed. This reasonable level of owner capital reduces
First Banks risk from volatility and improves ABCs creditworthiness.

The equity is primarily retained earnings (15.8m) with only 2.7m as share capital.
As there is no share premium account, this looks as though it could be the initial
capital invested in the business, but this needs to be ascertained.

If there were significant concerns over the amount of capital, the shareholders could
be asked to subscribe for additional shares as a condition of the loan.
The fact that the change in retained earnings equals the profit for the year
(1.674m), shows that no dividends have been paid to shareholders in the year to
31 December 2016 to extract cash from the business or reduce capital.

Covenants restricting future dividend payments and directors remuneration may

help prevent the two director-shareholders subsequently reducing capital after the
loan has been granted.

(7) Management track record

This section concerns the management track record, business continuity and key
human resource risk management. It also includes an assessment of the owners
competence and trustworthiness, including borrowing history.

The management seems to be committed to the business. The business is owned by

the two founders who are working full time in the business. They are technically
sound professionals as they are both engineers. They have made significant
personal investment in the business.

The director-owners are not existing customers of First Bank so there is no

established credit history from internal sources. Some evidence is therefore needed
to establish their character and competence.

The 15-year history of successfully running of the business is a good track record
and is evidence of competence. Audited financial statements will be required to
substantiate this.

Ages and retirement plans of the two directors are needed to ensure they will be
engaged in active management of ABC over the 5-year loan horizon.

Both shareholder-directors have a professional engineering background (to be

verified) which gives evidence of some professional integrity and competence.

Credit references can be obtained as evidence of credit history. Documentary

evidence of repayment of existing loans on time with Lander Bank will be required.
In this respect the reasons for not applying to Lander Bank for this loan will need to
be explained.

One piece of contrary evidence of competence is that working capital management

appears to be poor and explanations will be required.

Further information

A full business plan

Historic audited financial statements
Extended forecasts for the company beyond 2016 (perhaps 3 years)
Sensitivity analysis on forecasts
Details of directors background and skills
Market analysis including market research undertaken on the Bristol project
Strategy plan
 Investment budget
Copies of existing loan agreements including covenants
Budgets
Property valuations
Tax
Detailed budgets and plans for the Bristol project

APPENDIX 1 Key credit analysis ratios

Workings

2016 2015 2016 2015

Revenue growth 4% n/a =(18,178/17,464)/100 n/a
Operating profit
growth/(decline) (24.2%) n/a =(3,385/4,463)/100 n/a
Net Margin 9.2% 16.7% =(1,674/18,178)*100 =(2,911/17,464)*100
Payables days 54.3 63.5 =(1,218/8,180)*365 =(1,185/6,811)*365
Current Ratio 1.96 1.80 =(5,926/3,023) =(5,082/2,817)
Quick Ratio 1.03 0.90 =(5,926-2,812)/3,023 =(5,082-2,555)/2817
PAT / equity
(ROE) 6.6% 12.6% =(1,674/25,518) =(2,911/23,144)
=(4,463/(26,731-
ROCE 12.6% 18.1% =3,385/(29,841-3,023) 2,117)
Debt/income 4.96 2.67 = 8,300/1,674 = 7,770/2,911
Debt Ratio 27.8% 29.1% =8,300/29,841 =7,770/26,731

APPENDIX 2 (ratios given in the question not required)

2016 2015 2016 2015

Gross margin 55.0% 61.0% =(8,180/18178)*100 =(10,653/17464)*100
Operating margin 18.6% 25.6% =(3,385/18,178)*100 =(4,463/17464)*100
Inventory days 125.47 136.92 =(2,812/8,180)*365 =(2555/6,811)*365
Receivables days 62.5 49.6 =(3,114/18,178)*365 =(2,373/17,464)*365
Debt / equity 46.9% 48.1% =(8,300+389)/18,518 =7,770/16,144
Interest Cover 5.49 8.44 =3,385/617 =4,463/529

(13 marks)
(2) Key terms and conditions

Purpose

The loan should only be used for the stated purpose of building the shop in Bristol
and working capital requirements for that shop. As it is being built, and is not
therefore a single purchase transaction, appropriate internal controls and reporting
should be in place with the loan funds ring-fenced for this purpose. A plan of when
the loan will be drawn down needs to be set out in the agreement.

Amount

1 million (see below)

Period

Despite the loan being to finance the acquisition of property, a long-term loan (eg 15
to 25 years) to a small company is unlikely given the economic risks arising typically
from lack of resources, lack of diversification and dependence on a few key
individuals.

The proposal for a 5-year loan is relatively short for property finance, but it gives
some protection to First Bank as repayment occurs before the repayment of the
Lander Bank pre 2014 loans which may cause pressure on ABCs liquidity.

Security

The Bristol property alone is not enough as if it is valued at its cost of about 1
million this would be 100% loan to asset value (even then some of the loan is for
working capital). A maximum of loan to value of around 75% would be appropriate.

Other security is therefore necessary. As already noted above this may include a
floating charge; factorisation of receivables; and securitisation inventories. A floating
charge would be the most straightforward of these.

Interest rate

A fixed annual interest rate of 4% seems reasonable in current market conditions.

This is greater than the 3% in 2014 for Lander Bank. This may reflect a higher risk
(eg due to inferior collateral or a worsening of ABCs performance and position) or a
change in market interest rates over time.

Repayment terms

The proposal is for a bullet repayment of the principal at the end of 5 years. This
helps ABCs cash flow, but the bank may be better protected by an amortised
repayment loan where repayments are part principal and part interest. This would
recover some principal prior to repayment of the 3.4m loan to Lander Bank at the
end of 2018, which may cause ABC some liquidity issues if it is not refinanced.
Covenants

Covenants may be useful:

As an early warning signal (enabling early repayment) if ABCs performance
continues to deteriorate.
To prevent excessive subsequent borrowing after the loan is taken out from First
Bank thereby exposing the bank to risks that were not envisaged at the time the
loan was granted (eg by limiting gearing).
To protect First Bank vis a vis other lenders (ie Lander Bank). For example, if a
Lander Bank covenant crystallised this could automatically trigger a First Bank
covenant requiring immediate repayment of its loan.
To prevent the two shareholder-directors acting in their own interests (eg by
making distributions) thereby reducing the capital and liquidity of ABC and
increasing the risk to lenders. Covenants restricting dividend payments and
directors remuneration may help prevent such actions.

More specifically positive covenants could include:

A requirement to provide First Bank with audited quarterly management accounts
to be submitted to the bank within 60 days of end of quarter
Annual audited financial statements to be submitted to the bank within 6 months
of end of the financial year
Key person cover is required for both the directors individually for at least
1million throughout the life of the loan
Disclosure to First Bank of significant contractual agreements
Undertaking to comply with laws and regulations (eg health and safety)
Adequately insure assets (including the Bristol property which is to be used as
the primary collateral)
Make payments of interest and principal on the due dates
Any major business incident which can affect profitability materially needs to be
notified to the First Bank as soon as possible
Any bad debts, of more than 10% of the total outstanding, need to be notified to
First Bank immediately

Negative covenants could include:

Any new directors would require First Banks pre-approval
Any new shareholders would require First Banks pre-approval
No share capital more than 5% can be sold without the express permission of
First Bank
ABC should not assign any interest/option relating to ownership of assets without
the pre-approval of First Bank
Any new loans would require First Banks pre-approval. (It is necessary to check
whether there is a covenant in the Lander Bank loans which requires ABC to
obtain its approval before borrowing from First Bank)
Lease arrangements (eg sale and leaseback on assets) would require First
Banks pre-approval
Any dividend will need to be pre-approved by First Bank
Any increase in directors remuneration will need to be pre-approved by First
Bank
Financial covenants could include:
Interest cover (perhaps limit to no lower than 5 times)
Gearing (limit debt to equity to no greater than 50%)
Operating profit margin (to no lower than 20%)
Gross profit ratio to be maintained at minimum of 40%

The precise numbers of financial covenants could be negotiated with the ABC board
so its financial flexibility is not unduly restricted.

Arrangement fees

Loan arrangement fees charged to ABC by First Bank will be 1% of the loan, payable
on first drawdown of the loan.

(4 marks)

(3) Assurance procedures

The purpose of the assurance procedures is to provide comfort to First Bank that the
loan decision is based on credible information and so the bank is aware of the risks it
is undertaking in making the loan.

The assurance procedures aim to achieve the following:

Attest to the truth and fairness of the historic financial statements
Provide limited assurance that forecast financial statements and other
projections are reasonable and are based on appropriate and reasonable
assumptions
Provide comfort over the existence and value of key assets and liabilities
Gain assurance and understanding over the external economic and
commercial environment for ABC
Provide comfort over the capability and efficiency of internal operations to
deliver the business strategy
Gain assurance over contractual and other legal rights and obligations which
constrain, or enable, ABCs financial and operational activities
Gain assurance over the background, qualifications, competence and
integrity of the two key management personnel (and any additional personnel
who are key to the business)

As the loan is only for 1million the extent of assurance procedures should be
commensurate with this amount and not at disproportionate cost to the benefits that
can be obtained. The extent of the fees from ABC for the loan need to be considered
in this context.

Historic financial statements

For financial statements up to and including the year ended 31 December 2014
reliance should be able to be placed on the audited financial statements, unless
there were any modifications to the audit opinion or audit report.
For the financial statements in the year to 31 December 2015 up to the date the loan
is granted reliance may need to be placed on a review of the management accounts,
which is not a full audit, but is likely to be sufficient and cost effective.

Forecast financial statements and other projections

Providing assurance in respect of forecasts is key to the loan application to ensure

that ABCs creditworthiness is not based on over-optimistic assumptions or
unsubstantiated information.

Some guidance in relation to assurance over forecasts is given by ISAE 3400, The
Examination of Prospective Financial Information.

Prospective financial information means financial information based on assumptions

about events that may occur in the future and possible actions by an entity. This
relates to ABCs forecasts of cash flow and profits to support its application for
finance.

In this respect, a forecast is defined as prospective financial information based on

assumptions as to future events which management expects to take place and the
actions management expects to take (best-estimate assumptions).

The areas where First Bank needs to obtain sufficient appropriate evidence are:
First Bank needs to satisfy itself that ABC managements best-estimate
assumptions on which the prospective financial information is based are not
unreasonable and, in the case of hypothetical assumptions, that such
assumptions are consistent with the purpose of the information, (ie to raise new
finance by a 1m loan). This will require ascertaining that ABCs sales volumes
are realistic for the prices being charged in the markets being accessed (eg
similar bicycles sold by other companies, existing market prices and revenues
generated by retail outlets selling racing and other bicycles). As ABC operates
in an outdoor sports industry this will require evidence on seasonal trends in the
industry. To be able to do this First Bank will need clear evidence (eg market
research) collected by ABC to support the forecasts provided. Given that ABC
is made up of both manufacturing and retail business units then separate
projections and assumptions would be needed for each these. Similarly,
separate projections for B2B foreign sales will be needed. These streams can
then be aggregated.
The prospective financial information is properly prepared on the basis of the
assumptions i.e. that the financial information produced (ie ABCs revenues,
costs, cash flows) is consistent with the assumptions in amount and timing. As
ABC has both manufacturing and retail net income streams, (UK and abroad)
this will need to be done for each separately and then aggregated.
The prospective financial information is properly presented and all material
assumptions are adequately disclosed, including a clear indication as to
whether they are best-estimate assumptions or hypothetical assumptions
(disclose assumptions about timing and level of sales, levels impact of
advertising, costs, number of shops opened each year).
 The prospective financial information is prepared on a consistent basis with
historical financial statements, using appropriate accounting principles (for ABC
profit forecasts).

It is clear that, as prospective financial information is subjective information, it is

impossible to obtain the same level of assurance regarding forecasts for ABC,
as would be applicable to historic financial information for its historic
performance. In particular it covers a 5-year horizon for the Bristol store, but
only one year (2016) for the company as a whole.

Existence and value of key assets and liabilities

Assurance will be needed over the key assets of the business. Documentation
demonstrating ownership or control is important (eg title deeds to property). The fair
value of such property is unlikely to be reflected by the financial statements which
have been prepared under the historic cost model. Professional property valuers will
be needed to determine a fair value of key assets, particularly in relation to assets
that form part of the collateral for the loan.

Similarly, the documentation for key liabilities needs to be reviewed to ensure there
are no clauses that expose First Bank to risk (eg regarding seniority of debt and
charges over assets).

External economic and commercial environment

Economic and commercial assurance procedures complement financial assurance

procedures by considering ABCs markets and external economic environment.
Information may come from ABC and its business contacts. Alternatively, it may
come from external information sources. A competitor analysis is a key factor to be
assessed as this is preventing ABC fully exploiting a growing market.

Assurance over the future growth of the racing bicycle market and the level of
competitiveness within that market may form the basis of attesting the
reasonableness of the assumptions underlying the financial forecasts.

Internal operations

Operational assurance considers the operational risks and possible improvements

which can be made by ABC in order to achieve its strategy. In particular it will:
Validate assumed operational improvements in projections
Identify operational upsides/downsides that may increase/decrease the
creditworthiness of ABC

Contractual and other legal rights and obligations

The existing contractual obligations and rights of ABC may affect its creditworthiness
but may also impact on the rights of First Bank in relation to other lenders and
stakeholders.
A review of such documents to understand such rights and obligations may include:

Shareholder agreement
Loan agreements
Articles/memorandum
Director contracts (including remuneration)
Supplier contracts
Foreign customer contracts (France and USA)
Lease documents
Legal title deeds to property

Key management personnel

Obtain documents and ascertain:

Academic and professional qualifications
Additional skills training
Role in the business
Credit references

(11 marks)

(4) Recommendation

There remain a number of unexplained issues; requirements for more information

and the need to evidence the information presented by ABC.

If these issues can be resolved then the key features are that this is a profitable
company that is generating a significant amount of cash that can afford to repay the
loans requested and other loans at current levels of profits. It also has a significant
value of suitable assets available for security for a new loan.

However, key concerns are that:

profits have fallen and may continue to do so
all of the current debt and planned debt is repayable in a concentrated period
from 2018 to 2021 which will put a strain on cash resources if it cannot be
refinanced
working capital management is poor, but conversely an improvement would
generate significant additional cash flow
ABC would be a new client to First Bank with little known credit history
To moderate these risks, there is significant excess value of property over loans
secured on it, which can provide good collateral.

Recommendation

The full 1 million loan can be justified if the required information and evidence is
made available and reveals no additional substantial risks to First Bank. This should
be on condition that adequate security can be obtained, having regard to the terms
of existing loans with Lander Bank and with the protection of covenants to prevent
actions by the two directors which would expose First Bank to unacceptable future
risks.
(3 marks)
2.2

Ethics

Ethics pertains to whether a particular behaviour is deemed acceptable in the

context under consideration. In essence it is doing the right thing.

Situation

The ethical principle in this case is a perceived intimidation threat by the manager
James Brown, and a potential conflict of interest.

The intimidation threat is that, as a line manager, James is putting pressure on me,
as relationship manager, to give a favourable recommendation for the ABC loan,
irrespective of the merits of the application and possibly against my best judgement.
Moreover, there is additional intimidation pressure to make a quick decision in the
next few days so the loan application in processed in July.

The self-interest threat is that achieving the budget target may have personal career
benefits for James, and myself, but may not be in the banks best long term interests,
or indeed in the interests of the ABC shareholders.

There is also an ethical threat for the bank, as an organisation, if it is seen to be

offering loans to companies which are not creditworthy. This may damage the
commercial and ethical credibility of the bank. It may also damage the ABC
shareholders if they are knowingly given a loan which they are unlikely to be able to
pay back, with serious financial consequences for them if and when charges over
assets are ultimately enforced by the bank.

Actions

It may be that my recommendation will finally be to offer the loan to ABC based on
sound commercial reasons. This would be consistent with James wish but would not
be unquestioning and would not be for the same reasons.

In term of timing however it is not credible that this decision can be made by 31 July
2015 as the list of outstanding information required (see above) will take time to
collect, and the assurance procedures on that information (see above) will then need
to take place. The appropriate action is therefore to delay the decision until adequate
and reliable information is available to decide whether to recommend that the loan to
ABC should be made.

An ethical safeguard would be transparency. In the first instance, the matter should
be discussed with James informing him that a final decision before 31 July 2015 is
not possible.
If the intimidation continues, or James tries to overrule my decision to delay the
recommendation, the matter should be communicated to more senior management
to make them aware of the potential intimidation threat and potential poor, or at least
premature, lending decisions.

As a member of the ICAEW, ringing the ethics help line would be a reasonable
action if First Banks more senior management fail to respond appropriately to the
issue.
(5 marks)

Total: 36 marks
3.1

(a)

000
Interest income
Interest on commercial mortgages 24,750
Interest on corporate loans 19,800
Interest expense
Interest on customer deposits 0
Interest on interbank deposits (4,200)
Net interest income 40,350

(2 marks)
(b)

Current LIBOR
LIBOR +1.0%=
Projected for 2016 0.6% 1.60%
000
Interest income
Interest on commercial mortgages 24,750 24,750
Interest on corporate loans 19,800 25,300
Interest expense
Interest on customer deposits 0 0
Interest on interbank deposits (4,200) (11,200)
Net interest income 40,350 38,850
Change in net interest income (3.7%)

A rise in interest rates is damaging to the bank because its assets yield mainly a
fixed rate. In terms of lost net interest income, a 75 basis point increase in the Bank
of England base and a 100 basis point increase in LIBOR generates a 3.7% loss in
net interest income.
(2 marks)

(c)

BritBanks financial assets have on average a materially longer duration than

BritBanks financial liabilities. As a result, BritBank has a material positive net
duration position or duration gap. The duration gap is a measure of interest rate risk
and is used by some banks to estimate the change in the value of banks net worth
(or market value of equity) to changes in interest rates. BritBank has a positive
duration gap, indicating that its net worth would decline in the stress test scenario of
an increase in interest rates.
(2 marks)
(d)
BritBank is heavily exposed to interest rate risk. Interest rate risk arises from the fact
that BritBank is unable to increase interest rate on its commercial mortgage book,
and therefore the increase in the cost of funding (mainly interbank deposit) is higher
than the increase on the interest income.

In addition, BritBank is exposed to the risk of a withdrawal of customer deposits.

BritBank is not paying any interest to customer deposits and it is projecting that it can
rely on this cost-free funding even in the event of a rise in interest rates. However, in
reality there might be some competitive pressure on the rate paid on customer
deposits. If interest rates rise and BritBank does not offer any interest on customer
deposits, then there is a risk of a loss in customer deposits. Therefore, BritBank is
also exposed to significant funding risk in this scenario.

Further, it will be difficult for BritBank to raise long tenor funding as both customers
and others banks would be reluctant to lock in a long term rate in a rising interest
rate environment.

Information on BritBanks other financial assets and liabilities is needed to have a

more complete picture of the impact of an interest rate change on the bank as a
whole but, based on the schedule of financial assets and liabilities at 31 December
2015 which are of concern to ALCO, there is significant risk exposure in respect of
these assets and liabilities and for net interest income from these assets and
liabilities.
(3 marks)

(e)

Risk management strategies

Interest rate swap

Interest rate futures

BritBank can reduce its duration gap by entering into a pay long-term fixed interest
rate and receive short-term variable rate swap based on a 3-month LIBOR. This
fixed to variable swap would significantly reduce interest rate risk on the commercial
mortgage book;

If interest rate rises, then BritBank would receive a positive cash flow from the
interest rate swap which would more than compensate the higher interest expense
on interbank deposits.

BritBank can hedge interest rate risk with futures: it can sell interest rate futures now
(for example 90 day certificate of deposits futures) and then buy similar futures later
at lower prices if interest rates rise;

The gain on the interest rate futures would compensate the higher interest expense
on bank deposits.

Financial reporting treatment

Derivatives must be measured at fair value in accordance with IAS 39, with changes
in fair value recognised through the statement of profit or loss. When the derivative is
entered into, the derivative fair value must be nil as accounting standards do not
allow for gain/losses on financial derivatives at inception (or day 1).

Over time, depending on the movement of LIBOR, the fair value of both interest
SWAPs or futures would change and become positive if LIBOR increases. An
increase in the fair value of the derivative results in a gain in the statement of profit
or loss. Therefore, derivative accounting means that profit or loss is impacted by any
cash settlement, as well as any gains and losses.

In both risk management strategies, the interest rate derivative (hedge instrument) is
hedging interest rate risk on the commercial mortgage book (hedged item). BritBank
can either:

Apply for hedge accounting treatment, proving that the derivatives are
effective fair value hedges, hedging the change in fair value of the commercial
mortgage book: hedge accounting would link the derivative to the underlying
hedged item (mortgage book) and the mortgage book would then be
measured at fair value with changes through the statement of profit or loss; or

Designate the commercial mortgage book at fair value through the statement
of profit or loss, applying the fair value option. This strategy would achieve the
same accounting result as hedge accounting, without the need to prove
hedge effectiveness.

It should be noted that the bank might consider hedging interest rate risk at portfolio
level, i.e. enter into interest rate swaps or interest rate futures based on the overall
net exposure to interest rate risk, rather than hedging the exposure on the mortgage
book in isolation. In this case, BritBank would reference a smaller net underlying
exposure in structuring the derivative hedge.

It should also be noted that hedging does not completely eliminate risk. It does not
eliminate interest rate risk as there might be outstanding basis risk if the change in
LIBOR is not fully reflected in the pricing of derivatives.

In addition, hedging creates new risks as it exposes BritBank to counterparty risk of

the bank on the other side of the derivative transaction being unable to fulfill its
obligations.
Also, if LIBOR declines instead of increasing, as expected, then the derivative hedge
would generate a loss and BritBank would be expected to post collateral. In this
event, the derivative would expose BritBank to liquidity risk from collateral
requirements.
(6 marks)

3.2

BritBank is exposed to liquidity risk on the asset side, as the assets examined by the
ALCO committee are long term (10 & 3 years maturity) and illiquid (loans rather than
tradable securities). It is also exposed to liquidity risk on the liability side, as the
customer deposits are current and can be withdrawn at any moment. In the event of
a sudden deposit withdrawal increase, the bank would be forced to sell its assets at
distress prices, resulting in potentially large losses and possibly threatening its
solvency and viability. Basel III measures liquidity risk with a liquidity coverage ratio,
defined as highly liquid unencumbered assets / net cash outflows in a regulatory 30
day stress scenario. Under Basel III banks are required to maintain a minimum LCR
of 80% which will transition to 100%.

BritBank is also exposed to funding risk, i.e. it does not have a stable funding
structure. First of all it relies significantly on interbank deposits (70% of total
deposits), which are short-term and need to be rolled over every 6 months. In other
words, every 6 months, BritBank needs to persuade its creditors to renew this
funding line. BritBank has access to customer deposits, representing 30% of total
deposits. They are short term but stable in a normal environment. However, given
the size of the loan book (1.1bn) the customer deposits are insufficient, and
BritBank does not have a stable funding structure.

There are different regulatory reporting requirements for funding risk. First of all,
banks typically report the customer loans to customer deposit ratio, 1,100 m / 300 m
= 367% which is easy to calculate and provides a quick check on the funding
structure of any bank. Loan to deposit ratios of more than 100% are not uncommon,
but they are considered more risky. At 367% loan to deposit ratio, BritBank is clearly
heavily exposed to funding risk.

In addition, under Basel III banks are expected to monitor the net stable funding
ratio, which divides stable funding available / stable funding required. Banks are
expected to report a net stable funding ratio of at least 100% once Basel III is fully
implemented. Any long term funding (equity and funding with more than 1 year
maturity) is 100% stable. Customer deposits are converted into stable funding with a
stable funding coefficient ranging from 80% to 90%. However, with the current asset
/ liability structure it is clear that BritBank is very far from the 100% net stable funding
ratio required.

BritBank is exposed to interest rate risk in the banking book, due to the different
duration and pricing of interest earning assets and interest bearing liabilities. The
increase in LIBOR also widens the basis risk gap.

The risk covered in this scenario is interest rate risk in the banking book, as opposed
to interest rate risk in the trading book or funding / liquidity risk.

Interest rate risk in the banking book is covered by Pillar 2, at present. In other
terms, regulators have the power to supervise the internal risk management models
of BritBank to ensure that interest rate risk in the banking book is at an acceptable
level. Regulators will look to review the firms transfer pricing mechanism to ensure
that it is encouraging the right behaviours. In the event of excessive risk, supervisors
have the power to impose remediation activity (i.e. higher capital requirements).
However, this risk is not covered by Pillar 3 disclosure requirements.
Traditionally banks have published voluntary disclosure of interest rate risk in the
form of maturity gap tables, repricing gap tables and more recently sensitivity of net
interest income to changes in interest rates.

Basel regulators are currently discussing changes to the treatment of interest rate
risk in the banking book both in terms of measurement, debating the benefits of
measures focused on lost interest income or loss of equity value, disclosure, and,
potentially, additional capital requirements.
(6 marks)

Total: 21 marks