Chapter 12
Depository Institutions: Banks and Bank Management
Conceptual and Analytical Problems
1. Explain how a bank manager uses Core Principles 1, 2 and 3 (Time Has Value, Risk
Requires Compensation, and Information Is the Basis for Decisions) to select assets
and issue liabilities consistent with shareholder preferences. (LO1)
Answer: The manager evaluates the return and risk of each asset and liability, as in
core principles 1 and 2, prior to adding it to the balance sheet. These evaluations
preferences. For example, risk-averse shareholders may wish the manager to hold a
relatively large proportion of government securities and a relatively low proportion of
loans.
2. Consider a bank with the following balance sheet. You read in the local newspaper
that the bank’s return on assets (ROA) was 1 percent. What were the bank’s after-tax
profits? (LO2)
Bank Balance Sheet
(in thousands)
Assets Liabilities
Answer: Since the return on assets is defined as
assetsBank
taxesafterprofitNet
ROA
,
with ROA reported as 0.01 and assets of $1.1 million, after-tax net profit would be
ROA × (Bank assets) = 0.01 × ($1,100,000) = $11,000
.
3. Based on the information provided below about banks A and B, compute for each
a. Bank A has net profit after taxes of $1.8 million and the balance sheet below:
Bank A
(in millions)
Assets Liabilities
b. Bank B has net profit after taxes of $0.9 million and the balance sheet below:
Bank B
(in millions)
Assets Liabilities
Securities $23.5 Bank Capital $8.0
Answer: For both banks, we will compute ROA as
assetsBank
taxesafterprofitNet
ROA
and ROE as
capitalBank
taxesafterprofitNet
ROE
As a check, we note that
ROE
CapitalBank
taxesafterprofitNet
CapitalBank
AssetsBank
assetsBank
taxesafterprofitNet
ROA
where
CapitalBank
AssetsBank
is the leverage ratio, the value of assets divided by the
owner’s equity.
a. Bank A has net profit after taxes of $1.8 million. Given assets of $120 million, its
should find that:
ROA × (leverage factor) = ROE
b. Bank B had net profit after taxes of $0.9 million. Its ROA is (0.9 / 86) = .0105 or
4. Banks hold more liquid assets than do most businesses. Explain why. (LO1)
Answer: Banks are required to meet depositors’ demands for cash. In order to be able
many liquid assets.
5. Explain why banks’ holdings of cash have increased significantly as a portion of their
balance sheets in recent times. (LO1)
Answer: Banks hold cash for liquidity purposes – to meet immediate withdrawal
requests from customers. Holding cash is costly for banks, however, due to the
began paying interest on bank reserves (one type of cash asset), further reducing the
opportunity cost of holding cash in this form.
6. Why are checking accounts not an important source of funds for commercial banks in
the United States? (LO2)
Answer: Financial innovation has reduced the importance of checkable deposits in the
day-to-day business of banking. The reason for their decline is that checking accounts
balances in their checking accounts and began to look for ways to earn higher interest
rates. Banks obliged by offering innovative accounts whose balances could be shifted
automatically when the customers’ checking accounts ran low.
7. The volume of commercial and industrial loans made by banks has declined over the
of 2007-2009. (LO2)
Answer: The rise of the commercial paper market enabled businesses to raise funds
directly, diminishing their need to borrow from banks. The creation of
mortgage-backed securities meant that banks did not have to hold the relatively
8. *Why do you think that U.S. banks are prohibited from holding equity as part of their
own portfolios? (LO3)
Answer: If a bank owns equity in a company to which it extends a loan, the fact that it
its stock and so adversely impact the value of the bank’s equity investment.
9. Explain how a bank uses liability management to respond to a deposit outflow. Why
do banks prefer liability management to asset management? (LO1)
Answer: Banks can respond to a deposit outflow by borrowing from another bank or
management because asset management shrinks the size of a bank’s balance sheet,
while liability management does not.
10. A bank with a two-year horizon has issued a one-year certificate of deposit for $50
entering into these transactions? What would happen if all interest rates were to rise
by 1 percent? (LO3)
Answer: The bank faces the risk that the short-term interest rate will rise before the
second year, increasing the amount of interest the bank has to pay on the CD, but
bank’s profit falls to ((.04) × $50 million) – ((.03) × $50 million) = $500,000.
11. *In response to changes in banking legislation, the past two decades have seen a
business? (LO3)
Answer: The increase in interstate branching increases the ability of banks to
This would reduce the credit risk banks face.
12. Consider the balance sheets of Bank A and Bank B. If reserve requirements were 10
greatest liquidity risk? Explain your answer. (LO3)
Answer: On the basis of the information given, Bank B is at greater risk. The liability
sides of the balance sheets are the same, so the analysis should focus on the asset side.
securities in the market place if funds were needed immediately.
13. Looking again at Bank A and Bank B in Problem 12, based on the information
available, which bank do you think is at the greatest risk of insolvency? What other
information might you use to assess the risk of insolvency of these banks? (LO3)
Answer: Bank A has net worth (bank capital) of $320 million while Bank B has net
as would information on each bank’s off-balance sheet commitments.
14. Bank Y and Bank Z both have assets of $1 billion. The return on assets for both banks
million. In which bank would you prefer to hold an equity stake? Explain your
choice. (LO2)
Answer: Your choice will depend on your preference for return versus risk.
$100 million, so the return on equity is higher for Bank Z.
Bank Z has a higher leverage ratio than Bank Y, however, as a higher portion of its
15. *You are a bank manager and have been approached by a swap dealer about
which side would you want to receive? (LO3)
Answer: A typical bank has liabilities that are shorter-term than its assets – or has
floating rate liabilities and fixed rate assets. Because the bank receives fixed interest
increase to offset the higher rates the bank must pay its depositors.
16. If lines of credit and other off-balance sheet activities do not, by definition, appear on
the bank is exposed? (LO3)
Answer: With lines of credit, customers pay a fee to the bank for the right to borrow
loan regardless of its liquidity situation at that point in time. This increases the
liquidity risk faced by the bank.