Questions
1. Bank Balance Sheet. Create a balance sheet for a typical bank, showing its main liabilities (sources
of funds) and assets (uses of funds).
ANSWER:
Liabilities
1. Transaction deposits
2. Savings deposits
Assets
1. Cash
2. Loans
2. Bank Sources of Funds. What are four major sources of funds for banks? What alternatives does a
bank have if it needs temporary funds? What is the most common reason that banks issue bonds?
ANSWER:
1. Transaction deposits
Sources of temporary funds include:
1. Federal funds market
Banks may issue bonds to purchase fixed assets.
3. CDs. Compare and contrast the retail CD and the negotiable CD.
ANSWER: Retail CDs and negotiable CDs (NCDs) both specify a minimum deposit, a stated
4. Money Market Deposit Accounts. How does the money market deposit account differ from other
bank sources of funds?
5. Federal Funds. Define federal funds, federal funds market, and federal funds rate. Who sets the
federal funds rate? Why is the federal funds market more active on Wednesday?
ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository
The federal funds rate is not directly set by anyone, but is determined by the market. The rate changes
The federal funds market is active on Wednesday because depository institutions use the market to
6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations.
ANSWER: The federal funds market is used by depository institutions that experience a temporary
7. Borrowing at the Federal Reserve. Describe the process of borrowing from the Federal Reserve.
What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market
rather than through the Federal Reserve?
ANSWER: “Borrowing at the discount window” represents the borrowing by depository institutions
Banks tend to prefer the federal funds market over the discount window because the Fed may monitor
8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the
federal funds market? Why?
9. Bullet Loan. Explain the advantage of a bullet loan.
ANSWER: A bullet loan represents a loan whose principal is paid off in one lump sum. That is, a
10. Bank Use of Funds. Why do banks invest in securities, even though loans typically generate a higher
return? How does a bank decide the appropriate percentage of funds that should be allocated to each
type of asset? Explain.
ANSWER: Securities provide a bank with liquidity, because they can often be sold easily in the
The optimal allocation of funds is dependent on a bank’s degree of risk aversion and anticipated
11. Bank Capital. Explain the dilemma faced by banks when determining the optimal amount of capital
to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would
compare to that of manufacturing corporations? How would you explain this difference?
ANSWER: Banks may prefer a low level of capital because they can possibly achieve a higher return
Banks are more highly leveraged (less capital and more liabilities) than manufacturing companies
12. HLTs. Would you expect a bank to charge a higher rate on a term loan or a highly leveraged
transaction (HLT) loan? Why?
13. Credit Crisis. Explain how some mortgage operations by some commercial banks (along with other
financial institutions) played a major role in instigating the credit crisis.
ANSWER: There were many defaults on subprime mortgages. Banks and other financial institutions
14. Bank Use of Credit Default Swaps. Explain how banks used credit default swaps.
ANSWER: Some commercial banks and other financial institutions buy credit default swaps in order
to protect their own investments in debt securities against default risk. Other banks and financial
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Lower interest rates may reduce the size of banks.”
Lower interest rates are beneficial because they can increase the spread between the interest
banks earn on their assets versus the interest they pay on their liabilities. However, when interest
b. “Banks are no longer as limited when competing with other financial institutions for funds
targeted for the stock market.”
A bank’s traditional services do not include investing funds for individuals in the stock market.
c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial
banks can accommodate the demand.”
If loan demand rises, interest rates on deposits and loans will increase. Thus, the high deposit
Managing in Financial Markets
As a consultant, you have been asked to assess a bank’s sources and uses of funds, and to offer
recommendations on how it can restructure its sources and uses of funds to improve its performance. This
bank has traditionally focused on attracting funds by offering certificates of deposit (CDs). It offers
checking accounts and money market deposit accounts (MMDAs), but it has not advertised these
accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage
points more on its CDs than on its money market deposit accounts, but the bank prefers knowing the
precise length of time that it can use the deposited funds. (The CDs have a specified maturity whereas the
MMDAs do not.) Its cost of funds has historically been higher than that of most banks, but it has not been
concerned because its earnings have been relatively high. The bank’s use of funds has historically been
focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans
have provided a very high return over the last several years. However, the demand for real estate in the
local area has slowed.
a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other
types of deposits?
It should push its checking accounts and its MMDAs. While the bank does not know the precise
length of time that it can use funds from these accounts, it should have easy access to other funds
b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans,
where should the funds be allocated?
The bank should not focus on real estate loans, because the loan portfolio will be affected by a
c. How will the potential return on the bank’s uses of funds be affected by your restructuring of the
asset portfolio? How will the cost of funds be affected by your restructuring of the bank
liabilities?
The potential return will likely be smaller because the interest rates on real estate loans are
Flow of Funds Exercise
Services Provided by Financial Conglomerates
Carson Company is attempting to compare the services offered by different banks, as it would like to have
all services provided by one bank.
a. Explain the different types of services provided by a financial conglomerate that may allow
Carson Company to obtain funds or to hedge its risk.
b. Review the services that you listed in the previous question. What services could provide
financing to Carson Company? What services could hedge Carson’s exposure to risk?