64. A bank that cannot meet its loan commitments is experiencing the results of:
a. interest rate risk.
b. credit risk.
c. trading risk.
d. liquidity risk.
65. Many people believed that when the calendar changed from December 31, 1999 to January
1, 2000, many bank records were going to be wiped out, so many people planned on
withdrawing their funds. If this were to happen, this would be an example of:
a. credit risk.
b. operational risk.
c. interest rate risk.
d. liquidity risk.
66. The difference between a bank’s reserves and its required reserves is:
a. profits.
b. net interest income.
c. excess reserves.
d. vault cash.
67. If a bank has $200 million in deposits, the required reserve rate is 10 percent and the bank
has $23 million in reserves:
a. the bank is short of required reserves.
b. the bank has excess reserves of $21 million.
c. the bank has excess reserves of $13 million.
d. the bank has excess reserves of $3 million.
68. If a bank has deposits of $250 million, reserves that total $30 million and has a required
reserve rate of 10 percent:
a. the bank is short of required reserves.
b. the bank has excess reserves of $27.5 million.
c. the bank has excess reserves of $5 million.
d. the bank has excess reserves of $3 million.
69. If a bank has customer deposits of $150 million, $15 million in reserves and the amount of
excess reserves equals 0 (zero):
a. the required reserve rate is 15 percent.
b. the required reserve rate is 10 percent.
c. the required reserve rate is 1 percent.
d. the bank’s net interest margin is zero (0).
70. Regulators require a bank to hold some of its assets as reserves mainly to address:
a. liquidity risk.
b. trading risk.
c. credit risk.
d. operational risk.
71. A bank that does not want to hold a lot of excess reserves but wants to manage liquidity risk
is likely to:
a. hold a lot in highly liquid securities.
b. make sure that most of its assets are in small business loans.
c. have a high ratio of loans to securities.
d. limit withdrawals by customers.
72. If Bank A sells some its loans to Bank B for cash, everything else equal:
a. Bank A’s assets decrease and Bank B’s assets increase.
b. Bank A becomes less liquid while Bank B becomes more liquid.
c. Banks A’s total assets do not change, but Bank A is more liquid.
d. Bank A’s liabilities decrease by the amount of the loans that are sold.
73. A bank that meets deposit withdrawal by borrowing additional funds will alter:
a. the asset side of their balance sheet.
b. the liabilities side of the balance sheet.
c. the amount of bank capital.
d. the asset and liabilities side of the balance sheet.
74. The credit risk a bank faces is the risk resulting specifically from:
a. the economy entering a recession.
b. interest rates falling.
c. some of the bank’s loans not being repaid.
d. the bank experiencing a decrease in deposits.
75. A bank that specializes in granting loans to firms in a specific line of business:
a. may decrease its operating cost and decrease its credit risk.
b. may increase both its operating cost and its credit risk.
c. may increase its operating cost and decrease its credit risk.
d. may decrease its operating costs and increase its credit risk.
76. One way for a bank to deal with credit risk is to:
a. charge all borrowers from the same industry an average rate for that industry.
b. add a mark-up for a specific borrower based on the borrower’s credit history to the cost of
funds.
c. avoid making loans to borrowers from a broad spectrum and to specialize geographically and
in specific industries.
d. increase the number of loans made in any year.
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77. The fact that a bank’s assets tend to be long-term while its liabilities are short-term creates:
a. interest-rate risk.
b. credit risk.
c. lower risk for the bank, this is why they follow this strategy.
d. trading risk.
78. A bank’s assets tend to be long-term while its liabilities are short-term. Therefore, when
interest rates rise, the value of the bank’s assets:
a. increases by more than the value of its liabilities.
b. will decrease by more than the value of its liabilities.
c. increases and the value of its liabilities decreases.
d. decreases and the value of its liabilities increases.
79. When interest rates fall a bank’s capital will usually:
a. not change.
b. decrease.
c. turn negative.
d. increase.
80. If a bank has more interest-rate sensitive liabilities than interest-rate sensitive assets, an
increase in the interest rate will cause profits to:
a. increase.
b. decrease.
c. remain constant.
d. be negative, meaning there will not be profits, only losses.
81. For every $100 in assets, a bank has $30 in interest-rate sensitive assets, and the other $70 in
non-interest-rate sensitive assets. The same bank has $60 for every $100 in liabilities in interest-
rate sensitive liabilities, the other $40 are in liabilities that are not interest-rate sensitive. If the
interest rate on assets decreases from 6 to 5 percent, and the interest rate on liabilities decreases
from 4 to 3 percent, the impact on the bank’s profits per $100 of assets will be:
a. a reduction of $0.30.
b. an increase of $0.30.
c. a reduction of $3.00.
d. zero since the interest rates on assets and liabilities fell by the same amount.
82. For every $100 in assets, a bank has $40 in interest-rate sensitive assets, and the other $60 in
non-interest-rate sensitive assets. The same bank has $50 for every $100 in liabilities in interest-
rate sensitive liabilities, the other $50 are in liabilities that are not interest-rate sensitive. If the
interest rate on assets increases from 5 to 6 percent, and the interest rate on liabilities increases
from 3 to 4 percent, the impact on the bank’s profits per $100 of assets will be:
a. an increase of $0.10.
b. a decrease of $0.10.
c. a reduction of $1.00.
d. zero since the interest rates on assets and liabilities increased by the same amount.
83. The procedure that estimates the interest-rate sensitivity of a bank’s assets and liabilities is
called:
a. managing credit risk.
b. estimating operating risk differential.
c. trading risk minimization.
d. gap analysis.
84. A bank that makes most of its long-term loans at adjustable interest rates is:
a. reducing both interest rate and credit risk.
b. increasing credit risk and reducing interest rate risk.
c. reducing credit risk and increasing interest-rate risk.
d. increasing both interest-rate and credit risk.
85. Trading risk faced by U.S. banks results from:
a. the free-rider problem.
b. changes in regulations.
c. adverse selection.
d. moral hazard.
86. A bank faces foreign exchange risk when:
a. it has assets denominated in one currency and liabilities in another.
b. it lends to foreign borrowers because they are less likely to repay a U.S. bank.
c. foreign governments restrict dollar-denominated payments.
d. it has branches in other countries.
87. Mergers resulting from the financial crisis of 2007-2009 have left what percentage of
deposits in the hands of 4 banks?
a. 10%
b. 30%
c. 40%
d. 60%
88. One of the lessons from the 2007-2009 financial crisis regarding the management of risk by
financial institution is that:
a. many banks lacked real-time information that would allow them to assess their various risk
exposures at the bank-wide level.
b. some banks, especially large ones, overestimated the trading risk associated with mortgage
backed securities.
c. banks were holding too much capital as a protection against market risk.
d. many of the usual mechanisms for managing liquidity risk actually worked pretty well.
Short Answer Questions
89. What is the equation that reflects a bank’s balance sheet?
90. If a bank has a net worth that is negative, what do you know about the relationship between
the amounts the bank has in assets and liabilities?
91. Identify the four broad categories that make up the asset side of the balance sheet for banks
and which category is usually the largest.
92. One of the cash items included on the asset side of banks’ balance sheets is reserves. What
makes up reserves and what is their purpose?
93. What are the securities that U.S. banks own and why are they often referred to as secondary
reserves?
94. Explain why non-transactions accounts have become a more important source of funds for
the bank than transaction accounts over the past thirty years?
95. Why would a bank usually want to minimize the amount of excess reserves it has on hand?
96. A bank has a need for cash for a short period of time to meet its liquidity needs. The bank
has significant holding of U.S. treasury securities. The bank really does not want to sell the
securities, realizing the liquidity need is a temporary problem. A pension fund has significant
cash holdings and would like to earn some return on part of these holdings. The problem is the
fund will need this cash in a few days to honor a purchase agreement it made for municipal
bonds being issued. Is there any way these two organizations can work together to solve each
other’s problem?
97. Explain why a bank manager and a bank regulator would likely view the timing at which a
loan should be charged to the loan loss reserve differently.
98. You are provided with the following information: a bank has a net income after taxes of
$3.5 million; it has assets of $150 million; and bank capital of $12.5 million. What is the bank’s
return on assets; its return on equity, and its debt-to-equity ratio?
99. Explain why a bank with a high debt-to-equity ratio may be more profitable than a bank with
a lower ratio but would also have a higher level of risk.
100. Considering that, on average, the return on assets is the same for small and large banks, and
the return on equity is higher for large banks than small banks, what can be one of the
explanations for the trend toward bank mergers?
101. We saw in Chapter 12 that initially savings and loans were created to make home
mortgages, and their main source of funds was deposits from savers. In the late 1970’s and into
the 1980’s, the U.S. experienced rising interest rates that had depositors looking for higher
returns. Congress quickly removed the interest rate ceilings that savings and loans could offer.
Explain the initial impact this had on the interest rate spread and the net interest margin for the
savings and loans.
102. As the end of the year 1999 approached, many people worried that banks and more
specifically the banks’ computers would not be able to read the year 2000 correctly. This was
commonly known as the Y2K problem. Many people were concerned that their bank would lose
the record of their deposits etc., and made plans to take most of their funds out of the bank.
Address the potential Y2K problem from the standpoint of bank risk. What two types of risk
potentially could have been involved?
103. If the Federal Reserve were to do away with the required reserve regulation, do you think
banks would stop holding reserves? Explain.
104. A bank has the following assets: Reserves of $15 million; Loans of $150 million; and
Securities of $50 million. Their liabilities include Deposits of $150 million; Borrowed funds of
$35 million and Bank Capital of $30 million. If the required reserve rate is 10 percent, answer
the following: What is the amount of excess reserves the bank is currently holding? What are the
options available to the bank if customers decide to withdraw $10 million in deposits?
105. Information asymmetry that exists in lending creates what type of risk for banks? Discuss
the ways for a bank to handle or minimize this risk.
106. If you focus on interest-rate risk, can you explain why banks offer higher interest rates on
longer-term CDs than they do on short-term CDs?
107. A bank has $100 million in assets and 50 percent of its assets are interest sensitive. The
bank has $75 million in liabilities, 50 percent of which are interest sensitive. What is the bank’s
gap between interest-sensitive assets and liabilities?
108. A home buyer is presented with two options for financing the purchase of a home: a 20
year fixed rate mortgage or a 20 year adjustable-rate mortgage, where the rate adjusts once a
year. Which mortgage would you expect to start at the lowest interest rate and why?
109. The trading losses that some banks incurred could be thought to be from trading risk, but in
many cases the real cause of the losses could be attributed to moral hazard. Why was this the
case?
110. Why are U.S. banks prohibited from owning stocks?
111. What should be the impact on a bank’s return on assets and return on equity from increased
use of off-balance-sheet activities?
112. A bank develops specialized skills in analyzing companies from one specific industry. This
contributes significantly to the bank achieving economies of scale because a large portion of its
total loan portfolio is made up of companies in this industry. What are the long-run profit
prospects for this bank? Explain.
Essay Questions
113. An argument that comes up from time to time is that credit unions have an advantage over
other financial depository institutions in the sense that they are non-profit institutions and,
therefore, are exempt from taxes on income that other private depository institutions pay. As a
result, credit unions may be able to charge lower rates of interest to borrowers and pay a higher
rate to depositors than these other institutions. What do you think of this argument?
114. We have discussed the principal-agent problem as a form of moral hazard. Discuss the
unique problems a bank manager faces in terms of trying to please the owners of the bankand at
the same time trying to appease regulators.
115. Bank managers seem to have to walk a tightrope between managing risk and earning a
profit. Explain.
116. The primary difference among various kinds of depository institutions is in the composition
of their loan portfolios. Agree or disagree? Explain.