Chapter 17
Banking and the Management of Financial Institutions
◼ Multiple Choice Questions
1. Which of the following statements are true?
(a) A bank’s assets are its sources of funds.
(b) A bank’s liabilities are its uses of funds.
(c) A bank’s balance sheet shows that total assets equal total liabilities plus equity capital.
(d) Each of the above.
2. Which of the following statements is true?
(a) A bank’s assets are its uses of funds.
(b) A bank’s assets are its sources of funds.
(c) A bank’s liabilities are its uses of funds.
(d) Only (b) and (c) of the above are true.
3. Which of the following statements is false?
(a) A bank’s assets are its uses of funds.
(b) A bank issues liabilities to acquire funds.
(c) A bank’s assets provide the bank with income.
(d) Bank capital is an asset on the bank balance sheet.
4. A bank’s balance sheet
(a) shows that total assets equal total liabilities plus equity capital.
(b) lists sources and uses of bank funds.
(c) indicates whether or not the bank is profitable.
(d) does all of the above.
(e) does only (a) and (b) of the above.
5. Which of the following are reported as liabilities on a bank’s balance sheet?
(a) Reserves
(b) Checkable deposits
(c) Loans
(d) Deposits with other banks
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6. Which of the following are reported as liabilities on a bank’s balance sheet?
(a) Discount loans
(b) Cash items in the process of collection
(c) State government securities
(d) All of the above
(e) Only (b) and (b) of the above
7. The share of checkable deposits in total bank liabilities has
(a) expanded moderately over time.
(b) expanded dramatically over time.
(c) shrunk over time.
(d) remained virtually unchanged since 1960.
8. Checkable deposits and money market deposit accounts are
(a) payable on demand.
(b) liabilities of the banks.
(c) assets of the banks.
(d) only (a) and (b) of the above.
(e) only (a) and (c) of the above.
9. Which of the following statements is false?
(a) Checkable deposits are usually the lowest cost source of bank funds.
(b) Checkable deposits are the primary source of bank funds.
(c) Checkable deposits are payable on demand.
(d) Checkable deposits include NOW accounts.
10. In recent years, the interest paid on checkable and time deposits has accounted for around
_________ of total bank operating expenses, while the costs involved in running the bank have been
approximately _________ of total operating expenses.
(a) 50 percent; 50 percent
(b) 50 percent; 25 percent
(c) 25 percent; 50 percent
(d) 25 percent; 75 percent
Chapter 17 Banking and the Management of Financial Institutions 211
11. Because checking accounts are _________ liquid for the depositor than passbook savings, they earn
_________ interest rates.
(a) less; higher
(b) less; lower
(c) more; higher
(d) more; lower
12. Because passbook savings are _________ liquid for the depositor than checking accounts, they earn
_________ interest rates.
(a) less; higher
(b) less; lower
(c) more; higher
(d) more; lower
13. Which of the following are transaction deposits?
(a) Savings accounts
(b) Small-denomination time deposits
(c) Money market deposit accounts
(d) Certificates of deposit
14. Which of the following are nontransaction deposits?
(a) Savings accounts
(b) Small-denomination time deposits
(c) Negotiable order of withdrawal accounts
(d) All of the above
(e) Only (a) and (b) of the above
15. Which of the following are transaction deposits?
(a) Savings accounts
(b) Small-denomination time deposits
(c) Negotiable order of withdrawal accounts
(d) Certificates of deposit
16. Large-denomination CDs are _________, so that like a bond they can be resold in a _________
market before they mature.
(a) nonnegotiable; secondary
(b) nonnegotiable; primary
(c) negotiable; secondary
(d) negotiable; primary
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17. Bank loans from the Federal Reserve are called _________ and represent a _________ of funds.
(a) discount loans; use
(b) discount loans; source
(c) fed funds; use
(d) fed funds; source
18. Which of the following would substitute for discount loans?
(a) Loans to businesses
(b) Repurchase agreements
(c) Investing in Eurodollars
(d) Loans to bank holding companies
(e) Reverse repurchase agreements
19. Which of the following are reported as assets on a bank’s balance sheet?
(a) Discount loans from the Fed
(b) Loans
(c) Borrowings
(d) Only (a) and (b) of the above
20. Which of the following are reported as assets on a bank’s balance sheet?
(a) Cash items in the process of collection
(b) Deposits with other banks
(c) Checkable deposits
(d) Bank capital
(e) Only (a) and (b) of the above
21. Which of the following are reported as assets on a bank’s balance sheet?
(a) Borrowings
(b) Reserves
(c) Savings deposits
(d) Bank capital
(e) Only (a) and (b) of the above
22. Which of the following are not reported as assets on a bank’s balance sheet?
(a) Cash items in the process of collection
(b) Deposits with other banks
(c) U.S. Treasury securities
(d) Checkable deposits
Chapter 17 Banking and the Management of Financial Institutions 213
23. Which of the following are not reported as assets on a bank’s balance sheet?
(a) Cash items in the process of collection
(b) Borrowings
(c) U.S. Treasury securities
(d) Reserves
24. Because of their _________ liquidity, _________ U.S. government securities are called secondary
reserves.
(a) low; short-term
(b) low; long-term
(c) high; short-term
(d) high; long-term
25. Secondary reserves are so-called because
(a) they can be converted into cash with low transactions costs.
(b) they are not easily converted into cash and are, therefore, of secondary importance to banks.
(c) 50 percent of these assets count toward meeting required reserves.
(d) of none of the above.
26. The most important category of assets on a bank’s balance sheet is
(a) discount loans.
(b) securities.
(c) loans.
(d) cash items in the process of collection.
27. Which of the following bank assets is the least liquid?
(a) Reserves
(b) Secondary reserves
(c) Cash items in process of collection
(d) Deposits with other banks
28. Which of the following bank assets is the most liquid?
(a) Consumer loans
(b) Reserves
(c) Cash items in process of collection
(d) U.S. government securities
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29. Loans
(a) are the largest category of bank assets.
(b) provide most of the bank’s revenues.
(c) earn the highest return of all bank assets.
(d) do each of the above.
(e) do only (a) and (b) of the above.
30. A bank’s largest source of funds is its
(a) nontransaction deposits.
(b) checking deposits.
(c) borrowing from the Fed.
(d) federal funds.
31. Banks earn profits by selling _________ with attractive combinations of liquidity, risk, and return,
and using the proceeds to buy _________ with a different set of characteristics.
(a) loans; deposits
(b) securities; deposits
(c) liabilities; assets
(d) assets; liabilities
32. In general, banks make profits by selling _________ liabilities and buying _________ assets.
(a) long-term; shorter-term
(b) short-term; longer-term
(c) illiquid; liquid
(d) risky; risk-free
33. When you deposit $50 in the First National Bank,
(a) its liabilities decrease by $50.
(b) its assets increase by $50.
(c) its reserves increase by $50.
(d) only (b) and (c) of the above occur.
34. When you deposit $50 in the First National Bank,
(a) its liabilities decrease by $50.
(b) its assets increase by $50.
(c) its reserves decrease by $50.
(d) only (b) and (c) of the above occur.
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35. When you deposit $50 in currency at Old National Bank,
(a) its assets increase by $50.
(b) its reserves increase by less than $50 because of reserve requirements.
(c) its liabilities decrease by $50.
(d) only (a) and (b) of the above occur.
36. When you deposit $50 in currency at Old National Bank,
(a) its assets increase by less than $50 because of reserve requirements.
(b) its reserves increase by less than $50 because of reserve requirements.
(c) its liabilities increase by $50.
(d) only (a) and (b) of the above occur.
37. When a $10 check written on the First National Bank is deposited in an account at the Second
National Bank, then
(a) the liabilities of the First National Bank decrease by $10.
(b) the reserves of the First National Bank increase by $10.
(c) the liabilities of Second National Bank decrease by $10.
(d) the assets of Second National Bank decrease by $10.
38. When a $10 check written on the First National Bank is deposited in an account at Second National
Bank, then
(a) the liabilities of the First National Bank decrease by $10.
(b) the liabilities of Second National Bank increase by $10.
(c) the reserves of the First National Bank increase by $10.
(d) all of the above occur.
(e) only (a) and (b) of the above occur.
39. Holding all else constant, when a bank receives the funds for a deposited check,
(a) cash items in process of collection fall by the amount of the check.
(b) bank assets increase by the amount of the check.
(c) bank liabilities decrease by the amount of the check.
(d) all of the above.
40. Holding all else constant, when a bank receives the funds for a deposited check,
(a) cash items in process of collection fall by the amount of the check.
(b) bank assets remain unchanged.
(c) bank liabilities decrease by the amount of the check.
(d) all of the above.
(e) only (a) and (b) of the above.
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41. A bank manager has which of the following concerns?
(a) To acquire funds at low cost
(b) To minimize risk by diversifying asset holdings
(c) To have enough ready cash to meet deposit outflows
(d) All of the above
42. Which of the following are primary concerns of a bank manager?
(a) Maintaining sufficient reserves to minimize the cost to the bank of deposit outflows
(b) Extending loans to borrowers who will pay high interest rates, but who are also good credit risks
(c) Acquiring funds at a relatively low cost, so that profitable lending opportunities can be realized
(d) All of the above
43. Bankers’ concern regarding the optimal mix of excess reserves, secondary reserves, borrowings
from the Fed, and borrowings from other banks to deal with deposit outflows is an example of
(a) liability management.
(b) liquidity management.
(c) managing interest-rate risk.
(d) none of the above.
44. When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank
chooses not to hold any excess reserves but makes loans instead, then, in the bank’s final
balance sheet,
(a) the assets at the bank increase by $200,000.
(b) the liabilities of the bank increase by $200,000.
(c) reserves increase by $200,000.
(d) each of the above occurs.
45. When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank
chooses not to hold any excess reserves but makes loans instead, then, in the bank’s final
balance sheet,
(a) the assets at the bank increase by $800,000.
(b) the liabilities of the bank increase by $1,000,000.
(c) the liabilities of the bank increase by $800,000.
(d) reserves increase by $160,000.
46. If a bank has $1 million of deposits, a required reserve ratio of 20 percent, and $300,000 in reserves,
it need not rearrange its balance sheet if there is a deposit outflow of
(a) $50,000.
(b) $75,000.
(c) $150,000.
(d) either (a) or (b) of the above.
Chapter 17 Banking and the Management of Financial Institutions 217
47. If a bank has $100,000 of deposits, a required reserve ratio of 20 percent, and $40,000 in reserves,
then the maximum deposit outflow it can sustain without altering its balance sheet is
(a) $30,000.
(b) $25,000.
(c) $20,000.
(d) $10,000.
48. If a bank has $200,000 of deposits, a required reserve ratio of 20 percent, and $80,000 in reserves,
then the maximum deposit outflow it can sustain without altering its balance sheet is
(a) $50,000.
(b) $40,000.
(c) $30,000.
(d) $25,000.
49. If a bank has $10 million of deposits, a required reserve ratio of 10 percent, and $2 million in
reserves, then it does not have enough reserves to support a deposit outflow of
(a) $1.2 million.
(b) $1.1 million.
(c) $1 million.
(d) either (a) or (b) of the above.
50. Banks can protect themselves from the disruption caused by deposit outflows by
(a) holding excess reserves.
(b) selling securities.
(c) “calling in” loans.
(d) doing all of the above.
(e) doing only (a) and (b) of the above.
51. In general, banks would prefer to meet deposit outflows by _________ rather than _________
(a) selling loans; selling securities.
(b) selling loans; borrowing from the Fed.
(c) borrowing from the Fed; selling loans.
(d) “calling in” loans; selling securities.
52. Which of the following do banks hold as insurance against the high cost of deposit outflows?
(a) Excess reserves
(b) Secondary reserves
(c) Bank equity capital
(d) Each of the above
(e) Only (a) and (b) of the above
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53. Which is the least costly way for a bank to handle deposit outflow?
(a) Hold excess reserves.
(b) Borrow from other banks.
(c) Sell securities.
(d) Call in loans.
54. The _________ are the costs associated with deposit outflows, the _________ excess reserves banks
will want to hold.
(a) lower; more
(b) higher; less
(c) higher; more
(d) None of the above, since deposit outflows cannot be anticipated.
55. A bank can reduce its total amount of loans outstanding by
(a) “calling in” loans, that is, by not renewing some loans when they come due.
(b) selling loans to other banks.
(c) selling loans to the Federal Reserve.
(d) doing all of the above.
(e) doing only (a) and (b) of the above.
56. Which of the following statements are accurate descriptions of modern liability management?
(a) Greater flexibility in liability management has allowed banks to increase the proportion of their
assets held in loans.
(b) New financial instruments enable banks to acquire funds quickly.
(c) The introduction of negotiable CDs have significantly reduced the percentage of funds that
banks borrow from one another to finance loans.
(d) All of the above have occurred since 1960.
(e) Only (a) and (b) of the above have occurred since 1960.
57. Banks fail when the value of bank _________ falls below the value of _________, causing the bank
to become insolvent.
(a) reserves; required reserves
(b) loans; secondary reserves
(c) assets; liabilities
(d) income; expenses
58. A bank fails when the value of its _________ falls below the value of _________, causing the bank
to become insolvent.
(a) reserves; required reserves
(b) loans; secondary reserves
(c) securities; deposit liabilities
(d) assets; liabilities
Chapter 17 Banking and the Management of Financial Institutions 219
59. Bank failure is less likely to occur when a bank
(a) holds less in U.S. government securities.
(b) suffers large deposit outflows.
(c) holds more excess reserves.
(d) has less bank capital.
60. A bank failure is more likely to occur when
(a) a bank holds less in U.S. government securities.
(b) a bank suffers large deposit outflows.
(c) a bank holds less equity capital.
(d) each of the above occur.
(e) only (a) and (b) of the above occur.
61. The largest source of bank income is
(a) interest on loans.
(b) interest on securities.
(c) service charges on deposit accounts.
(d) noninterest income.
62. The largest operating expense for a bank is
(a) salaries and employee benefits.
(b) interest paid on discount loans.
(c) interest paid on federal funds borrowed from other banks.
(d) interest paid on deposits.
63. On a bank’s income statement the provision for loan losses is an _________ item and represent the
amount of _________ in the bank’s loan loss reserves.
(a) income; decrease
(b) income; increase
(c) expense; decrease
(d) expense; increase
64. On a bank’s income statement, the amount available to keep as retained earning or pay to the
stockholders in dividends is the bank’s
(a) net income.
(b) net operating income.
(c) net extraordinary items.
(d) net interest margin.
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65. Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called
(a) return on assets.
(b) return after taxes.
(c) return on equity.
(d) equity multiplier.
66. Net profit after taxes per dollar of assets is a basic measure of bank profitability called
(a) return on assets.
(b) return on capital.
(c) return on equity.
(d) return after taxes.
67. The amount of assets per dollar of equity capital is called the
(a) asset ratio.
(b) equity ratio.
(c) equity multiplier.
(d) asset multiplier.
(e) return on equity.
68. For a given return on assets, the lower is bank capital,
(a) the lower is the return for the owners of the bank.
(b) the higher is the return for the owners of the bank.
(c) the lower is the credit risk for the owners of the bank.
(d) both (a) and (c) of the above.
69. In the absence of regulation, banks would probably hold
(a) too much capital, reducing the efficiency of the payments system.
(b) too much capital, reducing the profitability of banks.
(c) too little capital, increasing the return on equity.
(d) none of the above.
70. An argument that supports a regulated minimum capital requirement is that banks that hold too
little capital
(a) are unprofitable.
(b) impose costs on other banks because they are more likely to fail.
(c) have an unfair competitive advantage over savings and loans.
(d) all of the above.
Chapter 17 Banking and the Management of Financial Institutions 221
71. Conditions that likely contributed to a credit crunch in 1990–92 include
(a) a decline in bank capital caused by loan losses due to falling real estate prices.
(b) regulated hikes in bank capital requirements.
(c) falling interest rates that raised interest-rate risk, causing banks to choose to hold more capital.
(d) all of the above.
(e) only (a) and (b) of the above.
72. Conditions that likely contributed to a credit crunch in 1990–92 include
(a) a hike in the equity multiplier caused by loan losses due to falling real estate prices.
(b) regulated hikes in bank capital requirements.
(c) falling interest rates that raised interest-rate risk, causing banks to choose to hold more capital.
(d) all of the above.
(e) only (a) and (b) of the above.
73. Examples of off-balance-sheet activities include
(a) loan sales.
(b) foreign exchange market transactions.
(c) trading in financial futures.
(d) all of the above.
(e) only (a) and (b) of the above.
74. Examples of off-balance-sheet activities include
(a) loan sales.
(b) extending loans to depositors.
(c) borrowing from other banks.
(d) all of the above.
75. The danger of banks engaging in activities such as trading in financial futures and interest-rate
swaps is that these activities allow banks to
(a) increase profits.
(b) decrease risks.
(c) avoid bank regulations.
(d) engage in speculation.
76. When a bank sells all or part of the cash stream from a specific loan,
(a) it thereby removes the loan from its balance sheet.
(b) it usually does so at a loss.
(c) it usually does so at a profit.
(d) both (a) and (b) of the above.
(e) both (a) and (c) of the above.
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◼ True/False
1. Since their introduction in 1961, negotiable CDs have become an important source of bank funds.
2. Deposits that banks keep in accounts at the Federal Reserve less vault cash is called reserves.
3. When a bank receives additional deposits, it gains an equal amount of reserves; when it loses
deposits, it loses an equal amount of reserves.
4. To keep enough cash on hand to meet depositors’ demand for withdrawals, banks must engage in
liquidity management.
5. Required reserves are insurance against the costs associated with deposit outflows. The higher the
costs associated with deposit outflows, the more required reserves banks will want to hold.
6. A bank maintains bank capital to lessen the chance that it will become insolvent.
7. Given a bank’s return on assets, the higher the bank capital, the higher the return for the owners of
the bank.
8. Loan loss reserves are an asset on a bank’s balance sheet.
9. Off-balance-sheet activities consist of trading financial instruments and generating income from fees
and loan sales, all of which affect bank profits but are not visible on bank balance sheets.
10. The value-at–risk method for estimating a bank’s risk exposure measures the losses a bank could
incur under a worst-case scenario.
11. The share of bank operating income earned from off-balance sheet activities has increased over the
past two decades.
12. Since a bank’s assets exceed its equity capital, the return on assets always exceeds the return on
equity.
13. A loan commitment is an agreement to provide a loan up to a certan dollar amount if a customer
requests the loan during a specific time period.
Chapter 17 Banking and the Management of Financial Institutions 223
◼ Essay
1. What is the major focus of each of the following bank management concerns: asset management;
liability management; liquidity management; capital adequacy management?
2. Explain the off-balance-sheet activities banks engage in, the risks they face from undertaking these
activities, and the controls they put in place to restrict bank employees from taking on too much risk.
3. Discuss the recent trends in bank performance measures.
4. What are a bank’s major sources and uses of funds?
5. Distinguish between a bank’s reserves, required reserves, excess reserves, and secondary reserves.
6. What costs do banks hope to avoid by holding excess reserves?