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Answers to Chapter 11
Questions:
1. A depository institution is a financial intermediary that obtains a significant proportion of its funds from
2. The major sources of funds for commercial banks in the U.S. are reported on the liability side of the balance
sheet:
Deposits: Transaction accounts (demand deposit and NOW accounts); and Time deposits (small savings accounts
and time deposits over $100,000).
3. The principal asset types are securities, business loans, mortgages, and consumer loans. Over the longer term,
there has been a drop in securities and an increase in mortgages. As seen in Figure 11-4, through the mid-2000s,
4. Investment securities consist of items such as interest-bearing deposits purchased from other FIs, federal funds
sold to other banks, repurchase agreements, U.S. Treasury and agency securities, municipal securities issued by
5. According to Table 11-1, the principal sources were deposits, borrowings and other liabilities. Of these, deposits
6. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order
of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts
7. Transaction accounts include demand deposits that may be held by anyone and NOW accounts that may not be
held by businesses. Retail savings accounts include passbook savings accounts and small, nonnegotiable time
9. An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly
accounted for on the bank’s balance sheet. They are often reported in the notes to the financial statement or on a
11. Off-balance-sheet activities include the issuance of guarantees that may be called into play at a future time, and
the commitment to lend at a future time if the borrower desires.
b. The initial benefit is the fee that the bank charges when making the commitment. If the bank is required to honor
c. The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrower. In many
cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may
12. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong
13. Assets Liabilities and Equity
This bank has funded the assets primarily with transaction and savings deposits. The certificates of deposit could be
15. Challenges have come from industrial loan corporations and shadow banks. For example, in mid-2005,
Wal-Mart led an application with the FDIC to open a Utah-based “nonbank” bank (called an
industrial loan bank), stating that it wanted to use the bank to reduce the costs of processing
electronic payments. Target, the retail chain, made a similar banking license application
More recently activities of nonfinancial service firms that perform banking services have been termed shadow
banking. In the shadow banking system savers place their funds with money market mutual and similar funds, which
invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than
16. Money center banks operate in the global banking market. They are active in international lending and lending
Regional banks tend to concentrate more on domestic business than do money center banks. They are often market
Size alone, however, does not distinguish money center banks from regional banks. Money center banks tend to be
located in the major cities and are also net borrowers of funds in the interbank market. Thus, even though Bank of
17. Community banks typically have assets under $1 billion and serve consumer and small business customers in
local markets. In 2013, 91.1 percent of the banks in the United States were classified as community banks. However,
18. Small banks generally concentrate on the retail side of the businessClending and issuing deposits to consumers
and small businesses. In contrast, large banks engage in both retail and wholesale banking and often concentrate on
the wholesale side of the business. Further, small banks generally hold fewer off-balance-sheet assets and liabilities
In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do.
Thus, their noninterest expenses are generally higher than small banks. They also tend to diversify their operations
19. Bank size has traditionally affected the types of activities and financial performance of commercial banks.
Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a
reason for many of these differences. For example, large banks with easier access to capital markets operate with
20. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990s, U.S.
commercial banks have flourished for most of the 1990s. In 1999 commercial bank earnings were a record $71.6
This downturn was short-lived, however. In 2001, net income of $74.3 billion easily surpassed the old record of
$71.6 billion and net income rose further to $106.3 billion in 2003. Moreover, in 2003, both ROA and ROE reached
all-time highs of 1.40 percent and 15.34 percent, respectively. The two main sources of earnings strength in 2003
Several explanations have been offered for the strong performance of commercial banks during the early 2000s.
First, the Federal Reserve cut interest rates 13 times during this period. Lower interest rates made debt cheaper to
As interest rates rose in the mid-2000s, performance did not initially deteriorate significantly. Third quarter 2006
earnings represented the second highest quarterly total ever reported by the industry and more than half of all banks
reported higher earnings in the third quarter of 2006 than in the second quarter. However, increased loan loss
Commercial banks’ performance deteriorated again in the late 2000s as the U.S. economy experienced its strongest
recession since the Great Depression. For all of 2007, net income was $105.5 billion, a decline of $39.8 billion (27.4
percent) from 2006. Less than half of all institutions (49.2 percent) reported increased earnings in 2007, the first time in
23 years that a majority of institutions had not posted full year earnings increases. The average ROA for the year was
As the economy improved in the second half of 2009, so did commercial bank performance. While loan loss
provisions continued to surge, growth in operating revenues, combined with appreciation in securities values, helped
the industry post a net profit. Commercial banks earned $2.8 billion in net income in the third quarter of 2009, more
than three times the $879 million from 2008. Growth in net interest income, lower realized losses on securities and
other assets, higher noninterest income, and lower noninterest expenses, all contributed to the increase in net
As the economy improved in the second half of 2009, so did commercial bank performance.
While loan loss provisions continued to surge, growth in operating revenues, combined with
appreciation in securities values, helped the industry post a net prot. Commercial banks
earned $2.8 billion in net income in the third quarter of 2009, more than three times the
$879 million from 2008. Growth in net interest income, lower realized losses on securities
and other assets, higher noninterest income, and lower noninterest expenses all contributed
As the economy continued to slowly recover in 2010 through 2013, so did bank performance. The 2010 industry
ROA and ROE increased to 0.65 percent and 5.86 percent, respectively. By 2013, industry ROA and ROE increased
to 1.12 percent and 10.06 percent, respectively, the highest since 2007. In first quarter of 2013, increases in
22. The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the
Currency (OCC), the Federal Reserve System (FRS), and state bank regulators.
The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks. In so doing, it levies
insurance premiums on banks, manages the deposit insurance fund, and conducts bank examinations. In addition,
The Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency. Its primary function
is to charter so-called national banks as well as to close them. In addition, the OCC examines national banks and has
the power to approve or disapprove their merger applications. Instead of seeking a national charter, however, banks
In addition to being concerned with the conduct of monetary policy, the Federal Reserve, as this country’s central
bank, also has regulatory power over some banks and, where relevant, their holding company parents. Since 1980,
23. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of member banks.
In so doing, it levies insurance premiums on member banks, manages the deposit insurance fund, and conducts bank
26. International expansion has six major advantages:
Risk Diversification. As with domestic geographic expansions, an FI=s international activities potentially enhance
Innovations. An FI can generate extra returns from new product innovations if it can sell such services
Funds Source. International expansion allows an FI to search for the cheapest and most available sources of funds.
Customer Relationships. International expansions also allow an FI to maintain contact with and service the needs
Regulatory Avoidance. To the extent that domestic regulations such as activity restrictions and reserve requirements
Information/Monitoring Costs. Although global expansions allow an FI the potential to better diversify its
geographic risk, the absolute level of exposure in certain areas such as lending can be high, especially if the FI fails
to diversify in an optimal fashion. For example, the FI may fail to choose a loan portfolio combination on the
efficient portfolio frontier (see chapter 21). Foreign activities may also be riskier for the simple reason that
Nationalization/Expropriation. To the extent that an FI expands by establishing a local presence through investing
in fixed assets such as branches or subsidiaries, it faces the political risk that a change in government may lead to the
Fixed Costs. The fixed costs of establishing foreign organizations may be extremely high. For example, a U.S. FI
seeking an organizational presence in the Tokyo banking market faces real estate prices some five to six times higher
than in New York. Such relative costs can be even higher if an FI chooses to enter by buying an existing Japanese
