QUIZZES Q&A

Question 1

T/F financial institutions act as intermediaries between suppliers & users of money

Answer 1

true

Question 2

T/F commercial banks in the US often are subject to more than 1 of 4 regulatory agencies

Answer 2

true

Question 3

T/F if not done by FIs, the process of monitoring the actions of borrowers would reduce the attractiveness and increase the risk of investing in corporate debt & equity by individuals

Answer 3

true

Question 4

T/F if a household invests in corporate securities and does not supervise how the funds are invested or used by the corporation, the risk of not earning the desired return or not having the funds returned increase.

Answer 4

true

Question 5

T/F large money center banks finance most of their activities by using retail consumer deposits as the primary source of funds.

Answer 5

false

Question 6

Negative externalities exist in the depository sector when:

a. the fear of DI insolvency leads to bank deposit runs.
b. lending activity is impaired or constrained.
c. banks that are healthy suffer when another bank nears insolvency.
d. there are delays in disbursements from insolvent DIs.
e. all of the above

Answer 6

all of the above

Question 7

Which of the following FIs does not provide a business lending function?

a. Finance companies.
b. Insurance companies.
c. Depository institutions.
d. Mutual funds.
e. Pension funds.

Answer 7

d. Mutual funds

Question 8

The reason FIs can offer highly liquid, low price-risk contracts to savers while investing in relatively illiquid and higher risk assets is:

a. because individual savers cannot benefit from risk diversification.
b. because FIs have a cost advantage in monitoring their portfolios.
c. significant amounts of portfolio risk are diversified away by investing in assets that have correlations between returns that are less than perfectly positive.
d. because diversification allows an FI to predict more accurately the expected returns on its asset
portfolio.
e. all of the above

Answer 8

e. all of the above

Question 9

Which of the following identifies the primary function of the Office of the Comptroller of the Currency?

a. Stand as the “lender of last resort” for troubled banks.
b. Charter national banks and approve their merger activity.
c. Manage the deposit insurance fund and carry out bank examinations.
d. Regulate and examine bank holding companies as well as individual commercial banks.
e. Determine permissible activities for state chartered banks.
f. all of the above

Answer 9

b. Charter national banks and approve their merger activity.

Question 10

Customer deposits are classified on a DI’s balance sheet as:

a. liabilities, because the DI must meet reserve requirements on customer deposits.
b. assets, because customers view deposits as assets.
c. liabilities, because DIs are required to serve depositors.
d. assets, because the DI uses deposit funds to earn profits.
e. liabilities, because the DI uses deposits as a source of funds.
f. all of the above

Answer 10

e. liabilities, because the DI uses deposits as a source of funds.

Question 11

In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities?

How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?

Answer 11

Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations.

However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.

Question 12

What is a prudential regulator?

Answer 12

A prudential regulator is a government agency charged with setting regulations and ensuring an FIs’ compliance with the rules. Prudential regulators can be federal (e.g. OSFI) or provincial. Their focus is the safety and soundness of the financial system.

Question 13

T/F Hedge funds offer a high degree of privacy for their investors.

Answer 13

true

Question 14

T/F Credit default swaps are a product offered by insurance companies.

Answer 14

true

Question 15

T/F Most exchange traded funds (ETFs) are long-term mutual funds designed to replicate a particular market index.

Answer 15

true

Question 16

T/F Life insurance companies tend to concentrate their investments at the longer term of the investment spectrum.

Answer 16

true

Question 17

T/F Mutual funds are financial intermediaries that invest in diversified portfolios of assets.

Answer 17

true

Question 18

The primary function of insurance companies is to:

a. sell a variety of consumer investment products.
b. protect policyholders from adverse events.
c. assist in the transfer of wealth into the future.
d. generate fees for the banks that sell insurance products.
e. provide contracts that encourage policyholders to save current income.
f. all of the above

Answer 18

b. protect policyholders from adverse events.

Question 19

The returns obtained by investors of mutual funds include the following except:

a. dividend income earned on assets.
b. refunds of load charges and management fees.
c. interest income earned on assets.
d. capital appreciation in the underlying value of the assets held in the portfolio.
e. capital gains on assets sold by the fund.

Answer 19

b. refunds of load charges and management fees.

Question 20

Which of the following is common to both hedge funds and mutual funds?

a. Performance fees.
b. Disclosure rules.
c. Management fees.
d. Investor profiles.
e. SEC Registration.

Answer 20

c. Management fees.

Question 21

An open-ended fund has stocks of three companies: 200 shares of IBM currently valued at $50.00, 100 shares of GE currently values at $20 and 100 shares of Digital currently valued at $30. The fund has 500 shares outstanding. What is the net asset value (NAV) of the fund?

a. $120.00
b. $37.50
c. $60.00
d. $12.00
e. $30.00

Answer 21

e. $30.00

The assets in the mutual fund are worth $15,000. With 500 shares of the mutual fund outstanding, the NAV is $15,000 ÷ 500 = $30.00

Question 22

In comparison to a typical commercial bank, an investment bank is likely to have:

a. lower levels of capital.
b. lower levels of repurchase agreements.
c. higher reliance on long-term debt.
d. higher levels of net interest margin.
e. higher levels of loans to customers.
f. all of the above

Answer 22

a. lower levels of capital.

Question 23

Suppose Bank A earns 2 percent on assets (ROA), while Bank B earns 2.5 percent (ROA).

a) Estimate the return on equity (ROE) and equity multiplier (EM) if Bank A’s equity to asset ratio is 5%, and Bank B’s equity ratio is 12%. Interpret the estimates for the ratios.

b) How would results vary if both banks have a ROA of 1%. Interpret the new estimates and comment on what the findings suggest about financial leverage (equity vs debt financing) and profits.

Answer 23

a)

BANK A
ROA: 2%
E/A: 5%
EM: 1/5% = 20x
ROE: 2% x 20x = 40%

BANK B
ROA: 2.5%
E/A: 12%
EM: 1/12% = 8.33x
ROE: 2.5% x 8.33x = 20.83%

Bank A uses more leverage (higher A/E (equity multiplier)) thus provide higher returns to shareholders for each $ in net income, while Bank B uses less leverage thus a lower return to shareholders.

b) the EM is now = to ROE. The two firms still uses the same capital structure as the equity/asset ratio remain the same and Bank A still provide higher returns to shareholders than Bank B, even though it is less than in scenario a).

Question 24

Suppose today a mutual fund contains 2,000 shares of JPMorgan Chase, currently trading at $64.75; 1,000 shares of Walmart, currently trading at $63.10; and 2,500 shares of Pfizer, currently trading at $31.50. The mutual fund has no liabilities and 10,000 shares outstanding held by investors.

a) What is the NAV of the fund?

b) Calculate the change in the NAV of the fund if tomorrow JPMorgan Chase’s shares increase to $66, Walmart’s shares increase to $68, and Pfizer’s shares increase to $34.

c) Suppose that today 1,000 additional investors buy one share each of the mutual fund at the NAV of $27.135. This means that the fund manager has $27,135 additional funds to invest. The fund manager decides to use these additional funds to buy additional shares in Walmart. Calculate tomorrow’s NAV given the same rise in share values as assumed in part (b).

Answer 24

a. NAV = (2,000 x $64.75 + 1,000 x $63.10 + 2,500 x $31.50)/10,000 = $271,350/10,000 = $27.135

b. NAV = (2,000 x $66 + 1,000 x $68 + 2,500 x $34)/10,000 = $285,000/10,000 = $28.500, or an increase of $1.365.

c. At today’s market price, the manager could buy 430 additional shares ($27,135/$63.10) of Walmart. Thus, its new portfolio of shares has 2,000 in JPMorgan Chase, 1,430 in Wal-mart, and 2,500 in Pfizer.

NAV = (2,000 x $66 + 1,430 x $68 + 2,500 x $34)/11,000 = $314,240/11,000 = $28.567, or an increase of $1.432.

Note that the fund’s value changed over the month due to both capital appreciation and investment size.
A comparison of the NAV in part b. with the one in this part indicates that the additional shares and the profitable investments made with the new funds from these shares resulted in a slightly higher NAV than had the number of shares remained static ($28.500 versus $28.567).

Question 25

If financial markets operated perfectly and costlessly, would there be a need for financial intermediaries?

Answer 25

To a certain extent, financial intermediation exists because of financial market imperfections. If information were available at no cost to all participants, savers would not need intermediaries to act as either their brokers or their delegated monitors.

However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections.

Question 26

What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors?

Why do individuals rather than corporations hold most mutual funds?

Answer 26

One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, fund managers are able to hold well-diversified portfolios of assets. In addition, managers can obtain lower transaction costs because of the volume of transactions, both in dollars and numbers, and they benefit from research, information, and monitoring activities at reduced costs.

Many small investors are able to gain benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis. In many cases, the amount of the investment would be insufficient for direct access to the money and capital markets. On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual securities and assets, and money and capital markets are easily accessible by direct investment. Further, an argument can be made that the goal of corporations should be to maximize shareholder wealth, not to be diversified.

Question 27

What is the adverse selection problem?

How does adverse selection affect the profitable management of an insurance company?

Answer 27

The adverse selection problem occurs because customers who are most in need of insurance are most likely to acquire insurance.

However, the premium structure for various types of insurance typically is based on an average population proportionately representing all categories of risk. Thus, the existence of a proportionately larger share of high-risk customers may cause the premium revenue received by the insurance provider to underestimate the revenue needed to cover the insured liabilities and to provide a reasonable profit for the insurance company.

Insurance companies deal with the adverse selection problem by establishing different pools of the population based on health and related characteristics (such as income). By altering the pool used to determine the probability of losses to a particular customer’s health characteristics, the insurance company can more accurately determine the probability of having to pay out on a policy and can adjust the insurance premium accordingly.

Question 28

T/F All FIs tend to mismatch the maturities of their assets and liabilities to some extent.

Answer 28

true

Question 29

T/F The repricing model is a simplistic approach to focusing on the exposure of net interest income to changes in market levels of interest rates for given maturity periods.

Answer 29

true

Question 30

T/F Duration measures the average life of a financial asset or financial liability.

Answer 30

true

Question 31

T/F Duration gap considers the degree of leverage on an FI’s balance sheet as well as the timing of the payment or arrival of cash flows on assets and liabilities.

Answer 31

true

Question 32

Which of the following observations about the repricing model is correct?

a. It helps to determine an FI’s profit exposure to interest rate changes.
b. It accounts for the problem of rate-insensitive asset and liability runoffs and prepayments.
c. Its information value is limited.
d. It considers market value effects of interest rate changes.
e. It accommodates cash flows from off-balance-sheet activities.
f. all of the above

Answer 32

a. It helps to determine an FI’s profit exposure to interest rate changes.

Question 33

Which of the following statements is true regarding duration?

a. decreases as the coupon or interest payment increases.
b. decreases as the yield on a security increases.
c. increases with the maturity of a fixed-income security but at a decreasing rate.
d. all of the above

Answer 33

d. all of the above

Question 34

A positive gap implies that an increase in interest rates will cause ________ in net interest income.

a. no change or a decrease
b. an unpredictable change
c. a decrease
d. an increase
e. no change

Answer 34

d. an increase

Question 35

There are three zero coupon bonds with a face value of EUR 10 million each. One matures one year from now and is selling at EUR 9,433,962.30. The second matures two years from now and is selling for EUR 8,573,388.20. The third matures three years from now and is selling at EUR 7,117,802.5.

What are the yields to maturity of each of those bonds?

Answer 35

Question 36

Consider the following balance sheet positions for a financial institution:

Rate-sensitive assets = $200 million.
Rate-sensitive liabilities = $100 million

Rate-sensitive assets = $100 million.
Rate-sensitive liabilities = $150 million

Rate-sensitive assets = $150 million.
Rate-sensitive liabilities = $140 million

a) Calculate the repricing gap and the impact on net interest income of a 1 percent increase in interest rates for each position.

b) Calculate the impact on net interest income of each of the above situations, assuming a 1 percent decrease in interest rates.

c) What conclusion can you draw about the repricing model from these results?

Answer 36

a)
Rate-sensitive assets = $200 million.
Rate-sensitive liabilities = $100 million.
Repricing gap = RSA - RSL = $200 - $100 million = +$100 million.
DNII = ($100 million)(0.01) = +$1.0 million, or $1,000,000.

Rate-sensitive assets = $100 million.
Rate-sensitive liabilities = $150 million.
Repricing gap = RSA - RSL = $100 - $150 million = -$50 million.
DNII = (-$50 million)(0.01) = -$0.5 million, or -$500,000.

Rate-sensitive assets = $150 million.
Rate-sensitive liabilities = $140 million.
Repricing gap = RSA - RSL = $150 - $140 million = +$10 million.
DNII = ($10 million)(0.01) = +$0.1 million, or $100,000.

b)
DNII = ($100 million)(-0.01) = -$1.0 million, or -$1,000,000.
DNII = (-$50 million)(-0.01) = +$0.5 million, or $500,000. DNII = ($10 million)(-0.01) = -$0.1 million, or -$100,000.

c)
The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap), while the FI in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest rate risk exposure since the absolute value of the repricing gap is the lowest, while the opposite is true for the FI in part (1).

Question 37

Explain why demand deposits warrant special attention in the repricing model? Comment on some of the arguments used against the inclusion of demand deposits as rate-sensitive liabilities.

Answer 37

Demand deposits warrant special attention as they are generally rate-insensitive. They are not included as RSLs.

Some arguments against the inclusion of RSLs are:
1. the explicit IR on demand deposits is 0 by regulation
2. many act as demand deposits for FIs (long-term source of funds)
3. explicit interest is paid on transaction accounts so the rates do not directly fluctuate with general level of interest rates.

Question 38

Compare the duration of a zero-coupon bond vs coupon bond. What can explain the observed difference in duration depending on the type of a fixed-income security?

Answer 38

The duration of zero-coupon bonds = bond’s maturity.

On the other hand, the duration of coupon bond is inversely related to the coupon size. The duration depends on CFs and since there are no intervening CFs between issue & maturity for zero-coupon bon, that is why we observe a difference.

Question 39

For small change in interest rates, market prices of bonds are inversely proportional to their

A. liability value.
B. asset value.
C. equity.
D. duration value.
E. none of the options.

Answer 39

D. duration value.

Question 40

An FI has financial assets of $800 and equity of $50. If the duration of assets is 1.21 years and the duration of all liabilities is 0.25 years, what is the leverage-adjusted duration gap?

A. 0.8844 years.
B. 0.9000 years.
C. 0.9756 years.
D. 0.9600 years.
E. Cannot be determined.

Answer 40

Question 41

Calculate the duration of a two-year corporate bond paying 6 percent interest annually, selling at par. Principal of $20,000,000 is due at the end of two years.

A. 1.91 years.
B. 1.94 years.
C. 1.49 years.
D. 2 years.
E. 1.75 years.

Answer 41

• take note that the 1,200,000 is the coupon!!!
  with coupon bonds, you have to discount the COUPON!

Question 42

First Duration Bank has the following assets and liabilities on its balance sheet

What is the FI’s interest rate risk exposure?

A. Exposed to decreasing rates.
B. Perfectly balanced.
C. Exposed to long-term rate changes.
D. Exposed to increasing rates.
E. Insufficient information.

Answer 42

D. Exposed to increasing rates.

Question 43

T/F Default by a large corporation is seldom a problem for FIs since these corporations have many different sources of borrowed funds.

Answer 43

false

Question 44

T/F The primary benefit from credit scoring is that credit lenders can more accurately predict a borrower’s performance without having to use more resources.

Answer 44

true

Question 45

Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves at the Fed are 6 percent. What is the expected or promised gross return on the loan?

A. 12.02 percent.
B. 12.29 percent.
C. 11.19 percent.
D. 11.90 percent.
E. 12.22 percent.

Answer 45

E. 12.22 percent.

Question 46

A financial institution has the following market value balance sheet structure:

a) The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a one-year maturity and a 6 percent rate of interest. The FI expects no additional asset growth. What will be the net interest income at the end of the first year?

b) If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is this result caused by reinvestment risk or refinancing risk?

c) Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or dividends.

Answer 46

a)
BOND
FV = $10,000; T = 10 years; c = 10%

CD
T = 1 year; r = 6%
interest income = 10,000 x 0.1 = 1,000
interest expense = 10,000 x 0.06 = 600
NII = interest income - interest expense = 1,000 - 600 = $400

b)
the increase in interest rates doesn’t affect interest income because of the fixes-rate coupon for 10 years

NII = interest income - interest expense = 1,000 - (10,000 x 0.07) = 10,000 - 700 = $300

The decrease in NII is caused by an increase in financing cost (interest expense) without a corresponding increase in earnings rate (interest income). Therefore, the change in NII is a result of refinancing risk.

c)
ASSETS
cash = $1,000
bond = $9,446
total assets = $10,446

LIABILITIES
certificate of deposit = $10,000

EQUITY = $10,446 - $10,000 = $446

Question 47

A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12 percent. The loan requires payment of accrued interest and one-half of the principal at the end of six months. The remaining principal and accrued interest are due at the end of the year.

a) What will be the cash flows at the end of six months and at the end of the year?

b) What is the present value of each cash flow discounted at the market rate? What is the total present value?

c) What proportion of the total present value of cash flows occurs at the end of six months?

d) What proportion occurs at the end of the year?

e) What is the duration of this loan?

Answer 47

V = 100,000; c = 12%; r = 12%

a)
CF 1/2 = value + interest = (100,000 x 1/2) + (100,000 x (0.12 x 1/2)) = $56,000
CF 1 = value + interest = (100,000 x 1/2) + ((100,000-50,000) x (0.12 x 1/2)) = $53,000

b)
PV 1/2 = 56,000/1.06 = $52,830.19
PV 1 = 53,000/1.06^2 = $47,169.81
total PV = 52,830.19 + 47,169.81 = $100,000

c)
x 1/2 = PV(CF 1/2) / V = 52,830.19 / 100,000 = 52.83%

d)
x 1 = PV(CF 1) / V = 47,169.81 / 100,000 = 47.17%

e) D = (0.5283 x 1/2) + (0.4717 x 1) = 0.7358 years

total PV should be equal to V
duration should always be < than maturity unless it is a zero-coupon bond, in which D = M

Question 48

Suppose the interest rates in the market for one-year, zero-coupon Treasury strips and for one-year, zero-coupon grade B corporate bonds are, respectively:

i = 2.05%
k = 7.80%

Compute the probabilities of repayment and default as well as the risk premium.

Answer 48

risk premium = p x (1 + k) = 1+ i
p = probability of repayment
1 - p = probability of default

p = (1 + i) / (1 + k) = 1.0205 / 1.0780 = 0.9467
1 - p = 1 - 0.9467 = 0.0533
risk premium = k - i = 5.75%

Question 49

Suppose an FI wants to evaluate the credit risk of a $1 million loan with a duration of 2.7 years to a AAA borrower. Assume there are currently 400 publicly traded bonds in that class (i.e., bonds issued by firms of a rating type similar to that of the borrower).

Estimate loan (or capital) risk, assuming that the current average level of rates (R) on AAA bonds is 5 percent.

Answer 49

the denominator of the risk-adjusted return on capital (RAROC) is loan risk so:

change in LN/LN = (-D LN) x (LN) x (change in R) / (1 + R) = -2.7 x 1 x (1.011 / 1.05) =
-$28,286

the $1M loan has a possible loss of $28,286

1.1% was chosen as the change in interest rate based on Figure 10-8 of the book. The 99% worst case was chosen - only 4 bonds/400 bonds had risk premiums increases > 99% worst case

Check slide 30, Topic 7A for more details

Question 50

a) What are the two different general interpretations of the concept of duration, and what is the technical definition of this term?

b) How does duration differ from maturity?

Answer 50

a) The two different general interpretations of the concept of duration are the time value of money (TVM) and the cash-flow (CF) perspectives.

• TVM: measure of the weighted average life of an asset/liability
• CF: measure of the interest-rate sensitivity (or elasticity) of an asset/liability

The technical definition of duration is the weighted-average time to maturity using relative present values of the cash flows as the weights.

b) The duration is a measure of interest rate sensitivity. It takes into account the time of arrival & rate of reinvestment of cash flows during the asset life.

Question 51

T/F When liquidity risk problems occur at a DI, they often threaten the solvency of the institution.

Answer 51

false

Question 52

T/F Core deposits represent a relatively short-term source of funds.

Answer 52

false

Question 53

When banks use stored liquidity management, they:

A. may shrink the balance sheet if cash is used as the liquidity adjustment mechanism.
B. threaten the capital position of the institution.
C. necessarily increase the asset side of the balance sheet.
D. must pay interest on the funds that are stored.
E. store the funds at the U.S. Treasury.

Answer 53

A. may shrink the balance sheet if cash is used as the liquidity adjustment mechanism.

Question 54

An open-end bond mutual fund is holding a three-year, $1 million face value 5 percent annual coupon bond selling at par. What is the impact on the total asset value of the fund of a 1 percent decrease in interest rates?

A. A decrease of $10,000.
B. A decrease of $26,730.
C. An increase of $27,751.
D. An increase of $10,000.
E. The answer depends upon the number of mutual funds shares outstanding.

Answer 54

C. An increase of $27,751.

Question 55

T/F Daily earnings at risk (DEAR) is defined as the dollar value of a position times price sensitivity of that position.

Answer 55

false

Question 56

Which term defines the risk related to the uncertainty of an FI’s earnings on its trading portfolio caused by changes, and particularly extreme changes in market conditions?

A. Default risk.
B. Credit risk.
C. Market risk.
D. Interest rate risk.
E. Sovereign risk.

Answer 56

C. Market risk.

Question 57

The capital requirements of internally generated market risk exposure estimates can be met:

A. only with short- or long-term subordinated debt.
B. only with two types of capital.
C. only with retained earnings, common stock, and long-term subordinated debt.
D. only with Tier 1, Tier 2, or Tier 3 capital.
E. with retained earnings and common stock only.

Answer 57

E. with retained earnings and common stock only.

Question 58

Fintech adoption rates, which measures fintech users as a percentage of the digitally active population, is universal across developed countries.

Answer 58

false

Question 59

PayPal is the most well-known P2P payment services with 267 million accounts.

Answer 59

true

Question 60

Blockchain organizes data into blocks, chained together in an append-only data structure.

Answer 60

true

Question 61

Which industry is most likely affected by fintechs:

A. Banking
B. Brokerage
C. Accounting
D. Insurance
E. None of the options.

Answer 61

A. Banking

Question 62

AllStarBank has the following balance sheet (in millions):

AllStarBank’s largest customer decides to exercise a $15 million loan commitment. How will the new balance sheet appear if AllStar uses the following liquidity risk strategies?

a. Stored liquidity management.

b. Purchased liquidity management.

Answer 62

Question 63

Plainbank has $10 million in cash and equivalents, $30 million in loans, and $15 in core deposits.

a. Calculate the financing gap.

b. What is the financing requirement?

c. How can the financing gap be used in the day-to-day liquidity management of the bank?

Answer 63

a. Financing gap = Average loans – Average deposits = $30 million - $15 million = $15 million

b. Financing requirement = Financing gap + Liquid assets = $15 million + $10 million = $25 m

c. A rising financing gap on a daily basis over a period of time may indicate future liquidity problems due to increased deposit withdrawals and/or increased exercise of loan commitments. Sophisticated lenders in the money markets may be concerned about these trends and they may react by imposing higher risk premiums for borrowed funds or stricter credit limits on the amount of funds lent.

Question 64

Central Bank has the following balance sheet (in millions of dollars).

Cash inflows over the next 30 days from the bank’s performing assets are $7.5 million. Calculate the Liquidity Coverage Ratio (LCR) for Central Bank.

Answer 64

Question 65

Follow Bank has a $1 million position in a five-year, zero-coupon bond with a face value of $1,402,552

The bond is trading at a yield to maturity of 7.00 percent. The historical mean change in daily yields is 0.0 percent and the standard deviation is 12 basis points.

a. What is the modified duration of the bond?

b. What is the maximum adverse daily yield move given that we desire no more than a 1 percent chance that
yield changes will be greater than this maximum?

c. What is the price volatility of this bond?

d. What is the daily earnings at risk for this bond?

Answer 65

Follow Bank has a $1 million position in a five-year, zero-coupon bond with a face value of $1,402,552. The bond is trading at a yield to maturity of 7.00 percent. The historical mean change in daily yields is 0.0 percent and the standard deviation is 12 basis points.

a. MD = D/(1 + R) = 5/(1.07) = 4.6729 years

b. Potential adverse move in yield at 1 percent = 2.33 x standard deviation
= 2.33 x 0.0012 = 0.002796

c. Price volatility = MD x potential adverse move in yield
= 4.6729 x 0.002796
= 0.013065 or 1.3065%

d. DEAR = ($ market value of position) x (price volatility)
= $1,000,000 x 0.013065
= $13,065

Question 66

The DEAR for a bank is $8,500.

a. What is the VAR for a 10-day period?

b. A 20-day period?

c. Why is the VAR for a 20-day period not twice as much as that for a 10-day period?

Answer 66

a. For the 10-day period: VAR = 8,500 x [10]1⁄2 = 8,500 x 3.1623 = $26,879

b. For the 20-day period: VAR = 8,500 x [20]1⁄2 = 8,500 x 4.4721 = $38,013

c. The reason that 20-day VAR 1 (2 x 10-day VAR) is because [20]1⁄2 1 (2 x [10]1⁄2).

The interpretation is that the daily effects of an adverse event become less as time moves farther away from the event.

Question 67

What is a bank run?

What are some possible withdrawal shocks that could initiate a bank run?

What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run?

Answer 67

A bank run is a sudden and unexpected increase in deposit withdrawals from a DI. Bank runs can be triggered by several economic events including:
1. concerns about solvency relative to other DIs
2. failure of related DIs
3. sudden changes in investor preferences regarding the holding of nonbank financial assets.

The first-come, first-serve (full pay or no pay) nature of a demand deposit contract encourages priority positions in any line for payment of deposit accounts.

Thus, even though money may not be needed, customers have an incentive to withdraw their funds.

Question 68

Why is the measurement of market risk important to the manager of a financial institution?

Answer 68

Measurement of market risk can help an FI manager in the following ways:
1. Provide information on the risk positions taken by individual traders.
2. Establish limit positions on each trader based on the market risk of their portfolios.
3. Help allocate resources to departments with lower market risks and appropriate returns.
4. Evaluate performance based on risks undertaken by traders in determining optimal bonuses.
5. Help develop more efficient internal models so as to avoid using standardized regulatory models.

Question 69

What were the supply factors that contributed to the recent emergence of fintechs?

Answer 69

2008 global financial crisis and macroeconomic conditions.

1. 2008 global financial crisis left the brand image of banks severely shaken. In the wake of the financial crisis, banks shifted to comply with post-crisis regulatory developments and cost-cutting measures. As regulatory burdens increased and risk aversion rose, banks pulled back from some lending activities. With banks pulling back, some new players entered the marketplace with innovative products that used technology to overcome some of the advantages that incumbent banks had, including their network of branches. For example, some of the earliest peer-to-peer (P2P) lenders catered
2. macroeconomic conditions, the low interest rate environment in particular. The low interest rate environment put downward pressure on profits and increased the incentives of FIs to cut costs. For example, online marketplace lenders have streamlined traditional loan under-writing processes in order to reduce costs.

Question 70

T/F To reduce liquidity risk an FI can efficiently manage the liability structure of its portfolio.

Answer 70

true

Question 71

Which of the following liabilities have a high degree of withdrawal risk?

A. Wholesale CDs.
B. NOW Accounts.
C. Passbook savings.
D. Demand deposits.
E. Time deposits.

Answer 71

D. Demand deposits.

Question 72

Which of the following is an outcome of an increase in the reserve requirement ratio?

A. Increased credit availability in the economy.
B. A multiplier effect on the supply of DI deposits and thus the money supply.
C. DIs are only able to lend a smaller percentage of their deposits than before.
D. DIs are able to lend out a greater percentage of their deposits.
E. DIs may hold fewer reserves against their transaction accounts.

Answer 72

C. DIs are only able to lend a smaller percentage of their deposits than before.

Question 73

The weekend game is

A. the triple witching effect on the third Friday of the month.
B. a strategy to reduce bank interest rate risk exposure.
C. the buying and selling of Fed funds late Friday afternoon.
D. a strategy to reduce the cost of meeting reserve requirements.
E. a strategy to reduce bank liquidity risk exposure.

Answer 73

D. a strategy to reduce the cost of meeting reserve requirements.

Question 74

T/F Contagious runs on bank deposits are directed at FIs, whether they are failing or healthy.

Answer 74

true

Question 75

T/F The cost of insolvency of an FI to the FDIC is offset in part by the deposit insurance premiums paid by the bank.

Answer 75

true

Question 76

T/F Banks that are viewed by regulators as being too big to be closed and liquidated without imposing a systemic risk to the banking and financial system are referred to is large and in charge banks.

Answer 76

false

Question 77

Which of the following refers to mandatory actions that have to be taken by regulators as a DI’s capital ratio falls.

A. Capital forbearance.
B. Regulatory oversight.
C. Risk-based deposit insurance.
D. Prompt corrective action.
E. Too-big-to-fail.

Answer 77

D. Prompt corrective action.

Question 78

Deposit insurance contracts can be structured to reduce moral hazard behavior by

A. increasing regulator discipline.
B. increasing depositor discipline.
C. increasing stockholder discipline.
D. reducing owner incentives to take risks.
E. All of the options.

Answer 78

E. All of the options.

Question 79

T/F Capital is the primary protection for an FI against the risk of insolvency and failure.

Answer 79

true

Question 80

Note: The residential mortgages all have a loan-to-value of between 60 and 80 percent.
What is the amount of risk-weighted assets?

Answer 80

Question 81

The Basel capital requirements are based upon the premise that

A. banks with riskier assets should have higher capital ratios.
B. banks with riskier assets should have lower absolute amounts of capital.
C. banks with riskier assets should have lower capital ratios.
D. banks with riskier assets should have higher absolute amounts of capital.
E. there is no relationship between asset risk and capital.

Answer 81

D. banks with riskier assets should have higher absolute amounts of capital.

Question 82

Consider the assets (in millions) of two banks, A and B. Both banks are funded by $120 million in deposits and $20 million in equity.

a) Which bank has a stronger liquidity position?

b) Which bank probably has a higher profit?

Answer 82

a) Bank A is more liquid because it has more liquid assets than Bank B. Although it has less cash, Bank A has $40 million in Treasury securities, which are highly liquid assets.

b) Bank B probably earns a higher profit because the return on consumer loans should be greater than the return on Treasury securities. However, comparing the loan portfolios is difficult because it is impossible to evaluate the credit risk contained in each portfolio using just the information provided.

Question 83

The average daily net transaction accounts deposit balance of a local bank during the most recent reserve computation period is $325 million. The amount of average daily reserves at the Fed during the reserve maintenance period is $21.2 million and the average daily vault cash corresponding to the maintenance period is $4.3 million.

a. What is the average daily reserve balance required to be held by the bank during the maintenance period?

b. What is the average daily balance of reserves held by the bank over the maintenance period? By what amount were the average reserves held higher or lower than the required reserves?

Answer 83

a. Reserve requirements = (0 x $16.0m) + ($122.3m - $16.0m)(0.03) + ($325m - $122.3m) (0.10) = 0 + $3.198m + $20.270m = $23.459 million

After subtracting the average daily balance of vault cash of $4.3 million, the bank needs to maintain a target daily average of $19.159 million ($23.459 million - $4.3 million) during the maintenance period.

b. Yes. The bank has average reserves of $21.2 million. This amount exceeds the required amount by $2.041 million.

Question 84

State Bank has the following year-end balance sheet (in millions):

The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-term or variable-rate deposits. Rising interest rates have caused the failure of a key industrial company, and as a result, 3 percent of the loans are considered uncollectable and thus have no economic value. One-third of these uncollectable loans will be charged off. Further, the increase in interest rates has caused a 5 percent decrease in the market value of the remaining loans.

a) What is the impact on the balance sheet after the necessary adjustments are made according to book value accounting?

b) According to market value accounting?

Answer 84

a) Under book value accounting, the only adjustment is to charge off 1% (0.03 x 1/3) percent of the loans. Thus, the loan portfolio will decrease by $0.90million ($90m x 0.03 x 1/3) and a corresponding adjustment will occur in the equity account. The new book value of equity will be $9.10 million. We assume no tax affects.

b) Under market value accounting, the 3 percent decrease in loan value will be recognized, as will the 5 percent decrease in market value of the remaining loans. Thus, equity will decrease by 0.03 x $90m + 0.05 x $90m(1 – 0.03) = $7.065 million. The new market value of equity will be $2.935 million.

Question 85

National Bank has the following balance sheet (in millions) and has no off-balance-sheet activities.

a.What is the CET1 risk-based ratio?

b.What is the Tier I risk-based capital ratio?

c. What is the total risk-based capital ratio?

d. What is the leverage ratio?

e. In what capital risk category would the bank be placed?

Answer 85

a. Risk-weighted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730
The CET1 risk-based ratio is ($45 + $40)/$730 = 0.11644 or 11.644 percent.

b. Risk-weighted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730
Tier I capital ratio = ($45 + $40)/$730 = 0.11644 or 11.644 percent.

c. The total risk-based capital ratio = ($45 + $40 + $25)/$730 = 0.15068 or 15.068 percent.

d. The leverage ratio is ($45 + $40)/$1,090 = 0.07798 or 7.798 percent.

e. The bank would be place in the well-capitalized category.

Question 86

How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities?

Answer 86

For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event that liabilities begin to leave the FI or are not reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire-sale prices. These prices would tend to deviate further from their market value as the maturity of the assets increase. Thus, the FI may sustain larger losses.

Question 87

What are three suggested ways a deposit insurance contract could be structured to reduce moral hazard behavior?

Answer 87

Deposit insurance contracts could be structured to reduce moral hazard behavior by:

(1) increasing stockholder discipline
Link FDIC insurance premiums to risk profile of DI

(2) increasing depositor discipline
Depositors require higher interest rates or ratio amount of deposits held in riskier DIs

(3) increasing regulator discipline
Frequency and thoroughness of examinations
Forbearance shown to weak DIs

Question 88

Why are regulators concerned with the levels of capital held by an FI compared with those held by a nonfinancial institution?

Answer 88

Regulators are concerned with the levels of capital held by an FI because of its special role in society. A failure of an FI can have severe repercussions to the local and/or national economy unlike non-financial institutions. Such externalities impose a burden on regulators to ensure that these failures do not impose major negative externalities on the economy. Higher capital levels will reduce the probability of such failures.

Question 89

Under Basel III, what four capital ratios must DIs calculate and monitor?

Answer 89

Under Basel III, depository institutions must calculate and monitor four capital ratios: common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based capital ratio, and Tier I leverage ratio.

i) CET1 risk-based capital ratio = Common equity Tier I capital/risk-weighted assets

ii) Tier I risk-based capital ratio = Tier I capital (Common equity Tier I capital + additional Tier I capital)/
risk-weighted assets

iii) Total risk-based capital ratio = Total capital (Tier I + Tier II)/risk-weighted assets

iv) Tier I leverage ratio = Tier I capital / total exposure.

Question 90

Explain the process of calculating risk-weighted on-balance-sheet assets.

Answer 90

Balance sheet assets are assigned to one of several categories of credit risk exposure. The dollar amount of assets in each category is multiplied by an appropriate weight, e.g., 0 percent, 20 percent, 50 percent, 100 percent, or 150 percent. The weighted dollar amounts of each category are added together to get the total risk-weighted on-balance-sheet assets.