Answers to End of Chapter Questions
1. High financial leverage magnifies the profitability or loss of a bank. The owner’s portion of
financing is relatively small, yet the owner reaps the profits. Debt, although a cheaper source
2. Existing risk-based capital requirements focus on credit risk. The risk classes used, for
example, are determined by a relative ranking of default risk on the underlying assets. The
percentage requirements, which indicate how much capital a bank must hold in support of
risk assets, increase as perceived default risk increases. The formal percentages ignore all
3. Bank capital reduces risk by 1) absorbing losses in an accounting framework so that banks
can remain technically solvent, 2) providing access to financial market when liquidity needs
4. If management were to target a 16% ROE, its net income would have to equal 16% of
6. An increase in capital requirements raises operating costs, but enables banks to assume
more of the other types of risk, such as credit, interest rate, and liquidity risk. Small banks do
7. CuBng dividends signals that the bank’s earnings prospects are poor, at best. Stockholders
8. If asset quality is the same, the bank with 10% capital faces lower solvency risk. This bank
9. Small- and medium-sized banks do not have the name recognition needed to obtain funds
10. Change in asset composition:
a. 1-4 family mortgages are in the 50% risk class while consumer loans are in the 100%
b. If the same proceeds are allocated to construction loans, required capital will increase
c. FNMA-sponsored mortgage-backed securities are in the 20% risk class while
municipal revenue bonds are in the 50% risk class. This shi$ will increase a bank’s risk
11. External capital
a. Subordinated debt is the cheapest of the three, but it does not qualify as tier 1
b. Preferred stock is not as expensive as common equity, but significantly more
12. The leverage capital ratio compares a bank’s equity capital to its adjusted total assets and
13. If a bank is undercapitalized, the likelihood of failure increases and the bank insurance fund
is at risk. The mandatory restrictions are designed to ensure that managers and regulators
14. If the Basel II standards allow the largest institutions to reduce required capital by 20%,
these firms will have the capacity to i) grow assets internally, ii) buy other firms, iii) pay down
Problems
I. First Student Bank
1. It must meet risk-based capital standards if it is chartered and subject to federal or state
banking regulations.
2. Common equity and tier I capital equal $73 ($5+$48+$5+$15).
II. One-Year Bank Growth
EQ/TA
ΔEC/TADR)ROA(1
ΔTA/TA