Depository Institutions

4/8/24, 4:13 PM Test 12 2018
Chapter 12
Depository Institutions: Banks and Bank Management
Multiple-Choice Questions
1. Which of the following correctly portrays a bank's balance sheet?

a. Total Bank Liabilities = Total Bank Capital + Total Bank Assets
b. Total Bank Assets = Total Bank Capital – Total Bank Liabilities
c. Total Bank Assets = Total Bank Liabilities – Total Bank Capital
d. Total Bank Assets = Total Bank Liabilities + Total Bank Capital
Ans: D
Difficulty: 01 Easy
Learning Objective: 12-01
AACSB: Reflective Thinking
Blooms: Remember
Topic: The Balance Sheet of Commercial Banks
2. Considering a bank's balance sheet, which of the following statements is true?

a. Total Bank Assets = Total Bank Capital – Total Bank Liabilities
b. Total Bank Assets = Total Bank Liabilities + Total Bank Capital
c. Total Bank Assets + Total Bank Capital = Total Bank Liabilities
d. Total Bank Assets + Total Bank Liabilities =Total Bank Capital
Ans: B
Difficulty: 01 Easy
Blooms: Remember
3. Considering a bank's balance sheet, which of the following statements is false?

a. Total Bank Assets + Total Bank Liabilities = Total Bank Capital
b. Total Bank Assets = Total Bank Liabilities + Total Bank Capital
c. Total Bank Liabilities = Total Bank Assets – Total Bank Capital
d. Total Bank Capital = Total Bank Assets – Total Bank Liabilities
Ans: A
Difficulty: 01 Easy
Blooms: Remember
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4. A bank's net worth is synonymous with its:

a. assets.
b. assets + bank's liabilities.
c. capital.
d. required reserves.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
5. Considering the balance sheet for all commercial banks in the U.S., the largest category of
assets is:
a. cash items.
b. U.S. Government Securities.
c. required reserves.
d. loans.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
6. Considering the balance sheet for all commercial banks in the U.S., the largest category of
liabilities is:
a. borrowing from other banks in the U.S.
b. saving's deposits and time deposits.
c. checkable deposits.
d. borrowings from non-banks in the U.S.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
capital
7. Considering the balance sheet for all commercial banks in the U.S., the net worth of banks is:
a. about 5 times the total assets.
b. about 1/11 of total assets.
c. just about the same as total assets.
d. about the same as total liabilities.
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Ans: B
Difficulty: 01 Easy
Blooms: Remember
8. Considering the balance sheet for all commercial banks in the U.S., the net worth of banks is:
a. about 11% of total liabilities.
b. about 5 times total assets.
c. about the same as total assets.
d. about 4 times total liabilities.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
9. The total assets of commercial banks in 2015 amounted to:

a. three times nominal GDP in the U.S.
b. about one-half of nominal GDP in the U.S.
c. about four-fifths of nominal GDP in the U.S.
d. about one-tenth of nominal GDP in the U.S.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
10. A bank's reserves include:

a. U.S. Treasury bills.
b. currency in the bank but not currency in the ATM machines.
c. the bank's deposits at the Federal Reserve.
d. U.S. Treasury bills and currency in the bank.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
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11. A bank's reserves include:

a. vault cash.
b. U.S. Treasury Securities.
c. the bank's loan portfolio.
d. U.S. Treasury bills and vault cash.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
12. A category of assets for banks is cash items in the process of collection. This is:
a. uncollected funds the bank is due to receive from the clearing of checks.
b. currency the bank is due from the Treasury.
c. late fees the bank is owed from loan payments that were not made on time.
d. payments from the FDIC insurance fund due the bank.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
13. Banks do not hold a lot of their assets in the form of cash mainly because of:
a. regulation.
b. the fear of being robbed.
c. the opportunity cost of holding cash; cash does not earn interest.
d. it can encourage employee theft.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
14. Bank's hold marketable securities as part of their assets. For U.S. banks these marketable
securities include:
a. stocks and bonds.
b. only the stocks of U.S. corporations.
c. only the bonds of the U.S. treasury.
d. only bonds.
Ans: D
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Difficulty: 01 Easy
Blooms: Remember
15. Secondary reserves for banks are:

a. the same as the bank's net worth.
b. mainly the bank's liquid securities.
c. vault cash.
d. deposits the bank has at the Federal Reserve.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
16. Considering U.S. commercial banks, loans account for:

a. about one-third of total assets.
b. more than one-half of total assets.
c. two-thirds of liabilities.
d. three-quarters of total assets.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
17. One thing that is common for all bank loans is that they are:
a. securitized.
b. liquid.
c. part of the banks' assets.
d. unsecured.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
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18. Savings and loans primarily provide:

a. large commercial loans.
b. unsecured credit card loans.
c. student loans.
d. home mortgages.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
19. Commercial banks differ from credit unions in the following way:
a. credit unions focus on consumer loans while commercial banks primarily make loans to
businesses.
b. credit unions make loans and accept deposits while commercial banks just make loans.
c. commercial banks cannot make auto loans to individuals, just to businesses while credit unions
can do both.
d. credit unions do not have to hold reserves while commercial banks do.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
20. Commercial banks increased their involvement in mortgages over the years due to:
a. the ability to securitize mortgages which made them more liquid.
b. the demands of regulators.
c. the increase in commercial loans demanded due to the development of the commercial paper
market.
d. the reduced risk of borrowers' defaulting on mortgage loans.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
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21. Which of the following statements is not true?

a. The largest source of funds for banks to lend comes from the owner's capital.
b. Transaction deposits make up less than 10 percent of banks sources of funds.
c. The largest sources of funds for banks are non-transactions accounts.
d. Borrowing is a larger source of funds for banks than transaction deposits.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
22. Checkable deposits have decreased since the 1970's mainly because:
a. regulators allowed higher rates to be paid on these accounts and banks found them to be highly
unprofitable.
b. people prefer to use credit cards rather than writing checks.
c. these deposit accounts offer little or no interest so depositors find them to be expensive.
d. as banks added fees to these accounts people increased their holdings of currency.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
23. The primary difference in certificates of deposit (CDs) that are equal to or less than
$100,000 and those over $100,000 (other than the amount) is:
a. a bank does not have to include CDs equal to or less than $100,000 in its liabilities.
b. CDs greater than $100,000 are negotiable and therefore can be bought and sold.
c. CDs equal to or less than $100,000 are issued for only six months or less.
d. CDs greater than $100,000 are issued for only six months or less.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
24. The federal funds market:

a. is the term used for bank borrowing from the Federal Reserve System.
b. is the lending to banks by the U.S. treasury when banks face liquidity emergencies.
c. is the inter-bank market where excess reserves from one bank can be loaned to another bank.
d. is the borrowing by American banks from foreign lenders.
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Ans: C
Difficulty: 01 Easy
Blooms: Remember
25. Loans made in the federal funds market:

a. are highly collateralized.
b. are made by the Federal Reserve System to the bank within 24 hours.
c. are unsecured loans.
d. are insured by the FDIC.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
26. Which of the following statements best completes this sentence: "On a bank's balance
sheet..."?
a. liabilities show the uses of funds and assets show the sources of funds.
b. assets show the sources of funds and the net worth shows the uses of funds.
c. net worth shows the sources of funds and liabilities show the uses of funds.
d. liabilities show the sources of funds and assets show the uses of funds.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
27. Which of the following statements best completes this sentence: "On a bank's balance
sheet…"?
a. assets show the sources of funds and the net worth shows the uses of funds.
b. net worth shows the sources of funds and liabilities show the uses of funds.
c. assets show the uses of funds and liabilities show the sources of funds.
d. net worth represents both a source and a use of funds.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
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28. Which of the following is a bank liability?

a. Mortgage loans
b. Demand deposits
c. Reserves
d. U.S. Treasury securities
Ans: B
Difficulty: 01 Easy
Blooms: Remember
29. Which of the following is a bank asset?

a. Demand deposits
b. Borrowings from other banks
c. Mortgage loans
d. CDs
Ans: C
Difficulty: 01 Easy
Blooms: Remember
30. Which of the following is not a bank liability?

a. Reserves
b. Demand deposits
c. Non-transaction deposits
d. Federal fund borrowings
Ans: A
Difficulty: 01 Easy
Blooms: Remember
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31. Which of the following is not a bank asset?

a. Securities
b. Mortgage loans
c. Reserves
d. Non-transaction deposits
Ans: D
Difficulty: 01 Easy
Blooms: Remember
32. Which of the following statements regarding checkable deposits is most accurate?
a. Checkable deposits are a larger source of bank funds today than in 1970.
b. Checkable deposits are no longer a source of bank funds.
c. Checkable deposits are a less important source of bank funds today than in 1970.
d. Checkable deposits continue to be the largest source of bank funds.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
33. A non-transaction deposit would include each of the following, except:

a. a savings account.
b. a checking account.
c. a passbook savings account.
d. a certificate of deposit.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
34. A repurchase agreement is:

a. an asset that represents the value of all collateral repossessed by the bank and held for sale.
b. a long-term collateralized loan.
c. an agreement where the parties agree to reverse the transaction on a specific day.
d. only made between two or more banks.
Ans: C
Difficulty: 01 Easy
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Blooms: Remember
35. Repurchase agreements are usually used by banks that:

a. have a need for long-term financing.
b. need cash for a very short period of time.
c. have negative net worth.
d. cannot obtain financing from any other source.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
36. Capital is the cushion banks have against:

a. sudden drops in the value of their assets.
b. an unexpected decrease in liabilities.
c. liquidity risk.
d. moral hazard.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
37. Money center banks differ from community banks in all of the following ways except:
a. they are usually much smaller.
b. they obtain their funds primarily through borrowing and not by deposits.
c. they are a much smaller percentage of the total number of banks.
d. they are actively engaged in the money market.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
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38. Savings and loan institutions:

a. are owned by the depositors.
b. originally were formed primarily to make home mortgages.
c. today offer a much smaller array of services than when originally formed.
d. are owned by depositors who also have a common bond.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
39. Of the roughly 6,200 banks in the United States at the end of 2015, by far the greatest
numbers of them were:
a. regional banks.
b. money center banks.
c. community banks.
d. savings banks.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
40. Suppose a particular bank is very large in terms of assets, and makes consumer and
residential loans as well as commercial and industrial loan. The bank is probably a:
a. regional or super-regional bank.
b. money center bank.
c. community bank.
d. savings bank.
Ans: A
Difficulty: 02 Medium
Blooms: Understand
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41. Suppose a particular depository institution that specializes in residential mortgages is owned
by its depositors. The institution is probably a:
a. regional or super-regional bank.
b. money center bank.
c. community bank.
d. savings bank.
Ans: D
Blooms: Understand
42. If a bank sells off all of its assets and pays all of its liabilities, the amount remaining would
be its:
a. net profit.
b. reserves.
c. net worth.
d. excess reserves.
Ans: C
Difficulty: 01 Easy
Blooms: Understand
43. A bank's loan loss reserves are:

a. the amount of loans that have defaulted in the past twelve months.
b. the same as equity capital.
c. an amount the bank sets aside to cover potential losses from defaulted loans.
d. a liability of the bank since it is a source of funds.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
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44. The largest liability for commercial banks in the U.S. is:
a. demand deposits.
b. non-transaction deposits.
c. borrowing from other U.S. banks.
d. borrowing from the Federal Reserve.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
45. Suppose that a bank initially has a leverage ratio of 8 to 1. If this bank increases its capital
by $1 million and its assets by $10 million, then the bank's:
a. risk increases and its leverage decreases.
b. liabilities decrease and its leverage increases.
c. leverage decreases and its liabilities increase.
d. leverage and risk increases.
Ans: D
Difficulty: 03 Hard
AACSB: Knowledge Application
Blooms: Apply
46. Which of the following bank assets would be categorized as secondary reserves?
a. U.S. Treasury bills
b. Cash
c. Mortgage loans
d. Deposits at the Federal Reserve
Ans: A
Blooms: Understand
47. If a bank has $100 million in assets and a net worth of $10 million, its debt-to-equity ratio is:
a. 10 to 1.
b. 5 to 1.
c. 9 to 1.
d. 0.1 to 1.
Ans: C
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Difficulty: 03 Hard
Blooms: Apply
48. If a bank has $150 million in assets and a net worth of $20 million, its asset-to-equity ratio
is:
a. 6.5 to 1.
b. 7.5 to 1.
c. 0.13 to 1.
d. 0.15 to 1.
Ans: B
Difficulty: 03 Hard
Blooms: Apply
49. If bank with leverage of 8 to 1 increases its assets by adding $1 to capital for every $1 added
to assets:
a. leverage increases.
b. leverage decreases.
c. leverage stays constant.
d. the answer cannot be determined from the information in the question.
Ans: B
Difficulty: 03 Hard
Blooms: Apply
50. If bank with $100 million in assets and $10 million in equity increases its assets by adding
$1 to capital for every $1 added to assets:
a. the debt-to-equity ratio will increase.
b. the debt-to-equity ratio will remain constant.
c. the debt-to-equity ratio will decrease.
d. the answer cannot be determined from the information in the question.
Ans: C
Difficulty: 03 Hard
Blooms: Apply
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51. A bank's return on assets (ROA) is calculated by dividing:

a. the bank's assets by its net worth.
b. the bank's net profits after taxes by its assets.
c. the bank's net worth by its assets.
d. the bank's assets less its net profit after taxes by its net worth.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
52. A bank's return on equity (ROE) is calculated by:

a. dividing the bank's net profit after taxes by the bank's capital.
b. dividing the banks liabilities by the bank's capital.
c. taking the bank's assets plus the net profit after taxes and dividing this sum by the bank's
capital.
d. dividing the bank's net profit after taxes by the sum of the bank's assets and its liabilities.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
53. Everything else equal, if the ratio of bank assets to bank capital increases, the bank's return
on equity should:
a. remain constant.
b. decrease.
c. increase.
d. cannot be determined from the information provided.
Ans: C
Blooms: Understand
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54. Everything else equal, if the ratio of bank assets to bank capital decreases, the bank's return
on equity should:
a. decrease.
b. remain constant.
c. increase.
d. cannot be determined from the information provided.
Ans: A
Blooms: Understand
55. If a bank's return on equity remains constant, but the ratio of bank assets to bank capital
increases:
a. the bank's return on assets must have increased.
b. the bank's return on assets must have decreased.
c. the bank's assets and capital must have increased by the same percentage.
d. the bank must be unprofitable.
Ans: B
Blooms: Understand
56. If a bank's return on equity remains constant, but the ratio of bank assets to bank capital
decreases:
a. the bank's return on assets must have increased.
b. the bank's return on assets must have decreased.
c. the bank's assets and capital must have increased by the same percent.
d. the bank must be unprofitable.
Ans: A
Blooms: Understand
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57. The tendency for large banks to have a higher return on equity than small banks suggests:
a. small banks have better management than large banks.
b. large banks can charge higher interest rates than small banks.
c. there could be significant economies of scale in banking.
d. larger banks are better able to escape the cost of regulation.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
58. Net interest income for a bank is:

a. the difference between gross income and net income after taxes.
b. the interest banks earn from uses of funds.
c. the difference between interest income and interest expense.
d. the difference between interest income and total expenses.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
59. A bank's net interest margin is calculated by taking net interest income and:
a. dividing it by the bank's capital.
b. dividing it by the bank's assets.
c. dividing it by the sum of the bank's assets and capital.
d. subtracting taxes.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
60. The weighted average difference between the interest received on assets and the interest rate
paid for liabilities for a bank is the bank’s:
a. interest rate spread.
b. net interest margin.
c. net interest income.
d. return on equity.
Ans: A
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Difficulty: 01 Easy
Blooms: Remember
61. Which of the following statements is most correct for U.S. commercial banks?
a. Net interest margin is much larger than return on equity.
b. Net interest margin is about equal to return on equity.
c. Net interest margin averages about two times the return on equity.
d. Net interest margin is closely related to the return on assets.
Ans: D
Blooms: Understand
62. A bank's off-balance-sheet activities usually:

a. increase both its assets and liabilities while reducing net income.
b. increase its net income but do not change its assets or liabilities.
c. increases a bank's liabilities but not its assets.
d. increases a bank's assets but not its liabilities.
Ans: B
Difficulty: 01 Easy
Blooms: Remember
63. A rumor starts that says a bank has suffered significant losses and may not be able to honor
its promises to depositors. This causes most of the depositors to line up in front of the bank the
next morning wanting to withdraw their deposits. This is an example of:
a. liquidity risk.
b. operational risk.
c. interest rate risk.
d. credit risk.
Ans: A
Blooms: Understand
Topic: Bank Risk: Where it Comes From and What to do About It
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64. A bank that cannot meet its loan commitments is experiencing the results of:
a. interest rate risk.
b. credit risk.
c. trading risk.
d. liquidity risk.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
65. Many people believed that when the calendar changed from December 31, 1999 to January
1, 2000, many bank records were going to be wiped out, so many people planned on
withdrawing their funds. If this were to happen, this would be an example of:
a. credit risk.
b. operational risk.
c. interest rate risk.
d. liquidity risk.
Ans: D
Blooms: Understand
66. The difference between a bank's reserves and its required reserves is:
a. profits.
b. net interest income.
c. excess reserves.
d. vault cash.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
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67. If a bank has $200 million in deposits, the required reserve rate is 10 percent and the bank
has $23 million in reserves:
a. the bank is short of required reserves.
b. the bank has excess reserves of $21 million.
c. the bank has excess reserves of $13 million.
d. the bank has excess reserves of $3 million.
Ans: D
Difficulty: 03 Hard
Blooms: Apply
68. If a bank has deposits of $250 million, reserves that total $30 million and has a required
reserve rate of 10 percent:
a. the bank is short of required reserves.
b. the bank has excess reserves of $27.5 million.
c. the bank has excess reserves of $5 million.
d. the bank has excess reserves of $3 million.
Ans: C
Difficulty: 03 Hard
Blooms: Apply
69. If a bank has customer deposits of $150 million, $15 million in reserves and the amount of
excess reserves equals 0 (zero):
a. the required reserve rate is 15 percent.
b. the required reserve rate is 10 percent.
c. the required reserve rate is 1 percent.
d. the bank's net interest margin is zero (0).
Ans: B
Difficulty: 03 Hard
Blooms: Apply
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70. Regulators require a bank to hold some of its assets as reserves mainly to address:
a. liquidity risk.
b. trading risk.
c. credit risk.
d. operational risk.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
71. A bank that does not want to hold a lot of excess reserves but wants to manage liquidity risk
is likely to:
a. hold a lot in highly liquid securities.
b. make sure that most of its assets are in small business loans.
c. have a high ratio of loans to securities.
d. limit withdrawals by customers.
Ans: A
Blooms: Understand
72. If Bank A sells some its loans to Bank B for cash, everything else equal:
a. Bank A's assets decrease and Bank B's assets increase.
b. Bank A becomes less liquid while Bank B becomes more liquid.
c. Banks A's total assets do not change, but Bank A is more liquid.
d. Bank A's liabilities decrease by the amount of the loans that are sold.
Ans: C
Blooms: Understand
73. A bank that meets deposit withdrawal by borrowing additional funds will alter:
a. the asset side of their balance sheet.
b. the liabilities side of the balance sheet.
c. the amount of bank capital.
d. the asset and liabilities side of the balance sheet.
Ans: B
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Blooms: Understand
74. The credit risk a bank faces is the risk resulting specifically from:
a. the economy entering a recession.
b. interest rates falling.
c. some of the bank's loans not being repaid.
d. the bank experiencing a decrease in deposits.
Ans: C
Difficulty: 01 Easy
Blooms: Remember
75. A bank that specializes in granting loans to firms in a specific line of business:
a. may decrease its operating cost and decrease its credit risk.
b. may increase both its operating cost and its credit risk.
c. may increase its operating cost and decrease its credit risk.
d. may decrease its operating costs and increase its credit risk.
Ans: D
Blooms: Understand
76. One way for a bank to deal with credit risk is to:
a. charge all borrowers from the same industry an average rate for that industry.
b. add a mark-up for a specific borrower based on the borrower's credit history to the cost of
funds.
c. avoid making loans to borrowers from a broad spectrum and to specialize geographically and
in specific industries.
d. increase the number of loans made in any year.
Ans: B
Blooms: Understand
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77. The fact that a bank's assets tend to be long-term while its liabilities are short-term creates:
a. interest-rate risk.
b. credit risk.
c. lower risk for the bank, this is why they follow this strategy.
d. trading risk.
Ans: A
Blooms: Understand
78. A bank's assets tend to be long-term while its liabilities are short-term. Therefore, when
interest rates rise, the value of the bank's assets:
a. increases by more than the value of its liabilities.
b. will decrease by more than the value of its liabilities.
c. increases and the value of its liabilities decreases.
d. decreases and the value of its liabilities increases.
Ans: B
Blooms: Understand
79. When interest rates fall a bank's capital will usually:

a. not change.
b. decrease.
c. turn negative.
d. increase.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
80. If a bank has more interest-rate sensitive liabilities than interest-rate sensitive assets, an
increase in the interest rate will cause profits to:
a. increase.
b. decrease.
c. remain constant.
d. be negative, meaning there will not be profits, only losses.
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Ans: B
Blooms: Understand
81. For every $100 in assets, a bank has $30 in interest-rate sensitive assets, and the other $70 in
non-interest-rate sensitive assets. The same bank has $60 for every $100 in liabilities in interest-
rate sensitive liabilities, the other $40 are in liabilities that are not interest-rate sensitive. If the
interest rate on assets decreases from 6 to 5 percent, and the interest rate on liabilities decreases
from 4 to 3 percent, the impact on the bank's profits per $100 of assets will be:
a. a reduction of $0.30.
b. an increase of $0.30.
c. a reduction of $3.00.
d. zero since the interest rates on assets and liabilities fell by the same amount.
Ans: A
Difficulty: 03 Hard
Blooms: Apply
82. For every $100 in assets, a bank has $40 in interest-rate sensitive assets, and the other $60 in
non-interest-rate sensitive assets. The same bank has $50 for every $100 in liabilities in interest-
rate sensitive liabilities, the other $50 are in liabilities that are not interest-rate sensitive. If the
interest rate on assets increases from 5 to 6 percent, and the interest rate on liabilities increases
from 3 to 4 percent, the impact on the bank's profits per $100 of assets will be:
a. an increase of $0.10.
b. a decrease of $0.10.
c. a reduction of $1.00.
d. zero since the interest rates on assets and liabilities increased by the same amount.
Ans: B
Difficulty: 03 Hard
Blooms: Apply
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83. The procedure that estimates the interest-rate sensitivity of a bank's assets and liabilities is
called:
a. managing credit risk.
b. estimating operating risk differential.
c. trading risk minimization.
d. gap analysis.
Ans: D
Difficulty: 01 Easy
Blooms: Remember
84. A bank that makes most of its long-term loans at adjustable interest rates is:
a. reducing both interest rate and credit risk.
b. increasing credit risk and reducing interest rate risk.
c. reducing credit risk and increasing interest-rate risk.
d. increasing both interest-rate and credit risk.
Ans: B
Blooms: Understand
85. Trading risk faced by U.S. banks results from:

a. the free-rider problem.
b. changes in regulations.
c. adverse selection.
d. moral hazard.
Ans: D
Blooms: Understand
86. A bank faces foreign exchange risk when:

a. it has assets denominated in one currency and liabilities in another.
b. it lends to foreign borrowers because they are less likely to repay a U.S. bank.
c. foreign governments restrict dollar-denominated payments.
d. it has branches in other countries.
Ans: A
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Blooms: Understand
87. Mergers resulting from the financial crisis of 2007-2009 have left what percentage of
deposits in the hands of 4 banks?
a. 10%
b. 30%
c. 40%
d. 60%
Ans: C
Difficulty: 01 Easy
Blooms: Remember
88. One of the lessons from the 2007-2009 financial crisis regarding the management of risk by
financial institution is that:
a. many banks lacked real-time information that would allow them to assess their various risk
exposures at the bank-wide level.
b. some banks, especially large ones, overestimated the trading risk associated with mortgage
backed securities.
c. banks were holding too much capital as a protection against market risk.
d. many of the usual mechanisms for managing liquidity risk actually worked pretty well.
Ans: A
Difficulty: 01 Easy
Blooms: Remember
Short Answer Questions
89. What is the equation that reflects a bank's balance sheet?

Ans: The equation reflecting a bank's balance sheet is:
Total Bank Assets = Total Bank Liabilities + Bank Capital
Difficulty: 01 Easy
Blooms: Remember
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90. If a bank has a net worth that is negative, what do you know about the relationship between
the amounts the bank has in assets and liabilities?
Ans: If a bank had a negative net worth, it means the bank's capital is less than zero. This can
only be the case if the bank's liabilities exceed its assets.
Blooms: Understand
91. Identify the four broad categories that make up the asset side of the balance sheet for banks
and which category is usually the largest.
Ans: The four categories that make up the asset side of the balance sheet for banks include: cash
items, securities, loans and all other assets. The largest category is usually loans.
Difficulty: 01 Easy
Blooms: Remember
92. One of the cash items included on the asset side of banks' balance sheets is reserves. What
makes up reserves and what is their purpose?
Ans: Reserves are made up specifically of two items: one is cash in the bank, also referred to as
vault cash. The other is deposits the bank has at the Federal Reserve. The main purpose of
reserves is to make sure banks have enough liquidity to meet the demands of customers for
withdrawal requests.
Difficulty: 01 Easy
Blooms: Remember
93. What are the securities that U.S. banks own and why are they often referred to as secondary
reserves?
Ans: By regulation U.S. banks are not allowed to own stocks, so their securities are limited to
bonds. And, for regulatory reasons, banks choose to hold U.S. government and agency bonds.
Most of these bonds are highly liquid and in the case of need, can be sold quickly to back up the
cash positions of the bank. As a result they are often referred to as secondary reserves.
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Blooms: Understand
94. Explain why non-transactions accounts have become a more important source of funds for
the bank than transaction accounts over the past thirty years?
Ans: Non-transactions accounts include savings and time deposits, and certificates of deposit.
Over the past quarter of a century financial innovation and technology have caused people to
economize on their deposits in transaction accounts (checkable deposits) since most of these
accounts paid little to no interest. The development of money market accounts and the
technology that has allowed people to transfer funds out of savings accounts when their checking
account balances run low has caused the balances in the savings accounts to increase
significantly.
Blooms: Understand
95. Why would a bank usually want to minimize the amount of excess reserves it has on hand?
Ans: Reserves are assets held in the form of vault cash and deposits at the Federal Reserve in a
non-interest bearing account. As a result, the opportunity cost of holding reserves is usually high.
Regulations require banks to hold a certain amount of reserves, called required reserves, but any
amounts held above this level are excess reserves and the bank is forgoing the return that could
have been earned on these funds.
AACSB: Analytical Thinking
Blooms: Analyze
96. A bank has a need for cash for a short period of time to meet its liquidity needs. The bank
has significant holding of U.S. treasury securities. The bank really does not want to sell the
securities, realizing the liquidity need is a temporary problem. A pension fund has significant
cash holdings and would like to earn some return on part of these holdings. The problem is the
fund will need this cash in a few days to honor a purchase agreement it made for municipal
bonds being issued. Is there any way these two organizations can work together to solve each
other's problem?
Ans: This is a situation that is ideal for a repurchase agreement. Here the bank would agree to
sell the Treasury securities (or some portion of them) to the pension fund in return for cash, and
at the same time the bank would agree to buy the securities back at a future date (usually a day or
two later) at a price equal to what the bank sold them for plus an additional amount reflecting the
interest payment on the loan. In this way the bank gets the cash it needs and the securities back in
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a few days, and the pension fund earns income from the short-term loan and retains its cash
position to make the securities purchase it planned.
Difficulty: 03 Hard
Blooms: Analyze
97. Explain why a bank manager and a bank regulator would likely view the timing at which a
loan should be charged to the loan loss reserve differently.
Ans: The loan loss reserve is part of a bank's capital. A loan is part of a bank's assets. To charge
a loan against this reserve will reduce both the bank's assets and its capital. A manager will try to
avoid this scenario. Regulators, on the other hand, are more concerned with the bank's ability to
meet its obligations, including the liquidity needs of its depositors. Non-performing loans, while
they may appear as an asset are really not. The regulators would rather charge these off to the
loan loss reserve and obtain a clearer view of the bank's actual capital position and its ability to
meet its obligations and also to withstand a shock.
Blooms: Understand
98. You are provided with the following information: a bank has a net income after taxes of
$3.5 million; it has assets of $150 million; and bank capital of $12.5 million. What is the bank's
return on assets; its return on equity, and its debt-to-equity ratio?
Ans: The bank's return on assets is 2.33%; this is obtained by dividing the $3.5 million in net
income after taxes by the asset amount of $150 million and multiplying by 100 to convert the
decimal into a percentage. The return on equity is 28.0%. We divide the $3.5 million in this case
by the equity of $12.5 million and multiply by 100 to obtain our answer. The debt-to-equity ratio
requires we first obtain the amount in liabilities. This is done by realizing that bank capital
(equity) and total liabilities must equal total assets. So taking the amount in assets, $150 million,
and subtracting the amount in capital, $12.5 million, leaves us with liabilities of $137.5 million.
Dividing the $137.5 million by $12.5 million produces a debt-to-equity of 11 to 1.
Difficulty: 03 Hard
Blooms: Apply
99. Explain why a bank with a high debt-to-equity ratio may be more profitable than a bank with
a lower ratio but would also have a higher level of risk.
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Ans: A bank with a high debt-to-equity ratio is financing the acquisition of assets with borrowed
funds. The return (profit) earned on these assets belong to the owners (the providers of the bank's
capital or equity). With a high debt-to-equity ratio, the owners of the bank stand to earn a higher
return on equity than the owners of a bank with a lower debt-to-equity ratio, assuming the same
return on assets. The problem or the risk comes from the fact that with the high leverage
anything that reduces the value of assets can potentially wipe out the capital of the bank, leaving
the bank insolvent since the capital cushion is inadequate to meet the drop in asset value.
Blooms: Analyze
100. Considering that, on average, the return on assets is the same for small and large banks, and
the return on equity is higher for large banks than small banks, what can be one of the
explanations for the trend toward bank mergers?
Ans: The return on assets being the same suggests that large banks may not have any advantage
in managing assets than small banks. The fact that large banks have a higher return on equity
means that they must have higher leverage. This suggests that there are economies of scale in
banking.
Blooms: Evaluate
101. We saw in Chapter 12 that initially savings and loans were created to make home
mortgages, and their main source of funds was deposits from savers. In the late 1970's and into
the 1980's, the U.S. experienced rising interest rates that had depositors looking for higher
returns. Congress quickly removed the interest rate ceilings that savings and loans could offer.
Explain the initial impact this had on the interest rate spread and the net interest margin for the
savings and loans.
Ans: Before the dramatic increase in interest rates, savings and loans were paying a regulated
rate on their liabilities (deposits) and earning a higher rate on their assets (mortgages). They had
a positive interest rate spread which also gave them a positive net interest margin. Since they
were quite confident concerning the cost of funds, they could set mortgage rates that would
ensure an adequate spread and margin. Once interest rates began to increase and the rate ceiling
on deposits was removed, the interest rate offered to depositors (cost of funds) increased, but
because most of the assets of savings and loans were in long-term mortgages, the interest earned
on assets was fairly interest rate insensitive. This quickly put many savings and loans into
negative spread and margin positions and contributed to the crisis that was to hit this industry.
Difficulty: 03 Hard
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Blooms: Analyze
102. As the end of the year 1999 approached, many people worried that banks and more
specifically the banks' computers would not be able to read the year 2000 correctly. This was
commonly known as the Y2K problem. Many people were concerned that their bank would lose
the record of their deposits etc., and made plans to take most of their funds out of the bank.
Address the potential Y2K problem from the standpoint of bank risk. What two types of risk
potentially could have been involved?
Ans: First, if the problem did arise and bank records would have been wiped out, this would have
been an example of operational risk. A technological breakdown would have led to significant
problems for many people and potentially a financial market panic. The risk would not have
stopped there; as savers demanded their funds from banks, the banks would have faced liquidity
risk. Most banks would not have been able to meet the demand for liquidity. This was a concern
of the Federal Reserve who had significant amounts of currency on hand in the event that people
did start to withdraw their savings from banks.
Difficulty: 03 Hard
Blooms: Analyze
103. If the Federal Reserve were to do away with the required reserve regulation, do you think
banks would stop holding reserves? Explain.
Ans: If the Federal Reserve did away with the required reserve regulation, the likely outcome is
there wouldn't be much of a change in the reserve holdings of most depository institutions. The
reason for this is that these institutions are very sensitive to managing liquidity risk and as a
result would want to have liquid assets on hand to meet the liquidity needs of depositors.
Difficulty: 03 Hard
Blooms: Analyze
104. A bank has the following assets: Reserves of $15 million; Loans of $150 million; and
Securities of $50 million. Their liabilities include Deposits of $150 million; Borrowed funds of
$35 million and Bank Capital of $30 million. If the required reserve rate is 10 percent, answer
the following: What is the amount of excess reserves the bank is currently holding? What are the
options available to the bank if customers decide to withdraw $10 million in deposits?
Ans: The bank is not holding any excess reserves. With deposits of $150 million and a required
reserve rate of 10%, the reserves of $15 million are what the bank needs. If customers decide to
withdraw $10 million from the bank the bank can meet this need either through asset adjustment
or liability adjustment. First, from the asset side, the bank could sell securities for cash or decide
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not to renew some loans. Since the bank is interested in maintaining good customer relations,
they would probably opt for the selling of securities. From the liability adjustment side, the bank
could borrow the additional funds required or try to increase deposits, perhaps by offering an
attractive interest rate on long-term CDs.
Difficulty: 03 Hard
Blooms: Apply
105. Information asymmetry that exists in lending creates what type of risk for banks? Discuss
the ways for a bank to handle or minimize this risk.
Ans: Information asymmetry leads to the problems of moral hazard and adverse selection. In
banking this creates credit risk. The credit risk can be minimized by acquiring additional
information. This additional information may be in the form of a loan application, a credit report,
and credit scoring tools, charging different interest rates based on risk, and by monitoring the
borrower after the loan is made.
Blooms: Understand
106. If you focus on interest-rate risk, can you explain why banks offer higher interest rates on
longer-term CDs than they do on short-term CDs?
Ans: In looking at bank balance sheets one important difference is that bank assets tend to be
long term and its liabilities tend to be short term. This mismatch between maturities creates
interest-rate risk. One way to reduce the risk for banks is to try to move more liabilities from
short to long term. By offering higher rates on longer-term CDs banks may be able to lure savers
from shorter-term to longer-term CDs thus increasing the average maturity of the banks'
liabilities.
Blooms: Understand
107. A bank has $100 million in assets and 50 percent of its assets are interest sensitive. The
bank has $75 million in liabilities, 50 percent of which are interest sensitive. What is the bank's
gap between interest-sensitive assets and liabilities?
Ans: The amount of assets that are interest sensitive is 50 percent of $100 million or $50 million.
The amount of liabilities that are interest sensitive is 50 percent of $75 million which is $37.5
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million. Subtracting the interest-sensitive liabilities from the interest-sensitive assets leaves a gap
of +$12.5 million.
Difficulty: 03 Hard
Blooms: Apply
108. A home buyer is presented with two options for financing the purchase of a home: a 20 year
fixed rate mortgage or a 20 year adjustable-rate mortgage, where the rate adjusts once a year.
Which mortgage would you expect to start at the lowest interest rate and why?
Ans: The adjustable-rate mortgage should start at a lower interest rate. In the case of an
adjustable-rate mortgage, the lender is able to transfer a significant amount of the interest-rate
risk to the borrower. But as we saw in a previous chapter, most people are risk averse and in
order to take on increased risk the individual requires compensation. Here the borrower is
enticed to take on the interest-rate risk with the compensation in the form of a lower starting
interest rate on the mortgage.
Blooms: Understand
109. The trading losses that some banks incurred could be thought to be from trading risk, but in
many cases the real cause of the losses could be attributed to moral hazard. Why was this the
case?
Ans: As the chapter points out, in the case of trading, often times the trader (the bank employee)
is in a situation where, if the trades turn out profitable, the trader reaps a large portion of the
gains; but if the trade generates losses, the bank loses. This is a classic moral hazard problem
where the trader has a strong incentive to take significant amounts of risk. This was certainly the
case with Nick Leeson and Barings Bank.
Difficulty: 03 Hard
Blooms: Analyze
110. Why are U.S. banks prohibited from owning stocks?

Ans: It probably has a lot to do with two main issues. One is the liquidity of these securities. The
markets for these securities at times can be less liquid than say for U.S. treasury securities, and
that can have an adverse impact on a bank that needs to get liquidity. Another issue can stem
from fluctuating market values for these securities. As their market values fluctuates so will the
value of the banks' assets. Especially in those instances when market values may drop
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significantly (stock market crashes, etc.), banks may find that the value of their assets falls so
much their net worth disappears and they may become insolvent. Compounding this will be the
potential runs on banks if it is rumored that a particular bank owned a lot of stock of a company
that is failing.
Blooms: Understand
111. What should be the impact on a bank's return on assets and return on equity from increased
use of off-balance-sheet activities?
Ans: Since off-balance-sheet activities generate income but do not add to assets or liabilities, the
impact should be to increase the return on assets. Since ROA is calculated by dividing net
income after taxes by total assets, only the numerator is increasing, not the denominator, so ROA
should increase. The same thing could be said about return on equity (ROE); the net return after
taxes increases, but the bank's capital does not, so ROE increases. This is the main reason banks
are increasing their use of off-balance-sheet activities.
Difficulty: 03 Hard
Blooms: Analyze
112. A bank develops specialized skills in analyzing companies from one specific industry. This
contributes significantly to the bank achieving economies of scale because a large portion of its
total loan portfolio is made up of companies in this industry. What are the long-run profit
prospects for this bank? Explain.
Ans: The bank may have lowered its transaction costs due to its specialization of mainly lending
to firms in one industry but it has considerably increased its idiosyncratic or credit risk. It would
likely suit the bank better in the long run to diversify its portfolio so it is only exposed to
systematic risk. Ideally if the bank could generate the loans and then securitize them and sell
them off (like home mortgages) it may have the best possible outcome.
Blooms: Analyze
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Essay Questions
113. An argument that comes up from time to time is that credit unions have an advantage over
other financial depository institutions in the sense that they are non-profit institutions and,
therefore, are exempt from taxes on income that other private depository institutions pay. As a
result, credit unions may be able to charge lower rates of interest to borrowers and pay a higher
rate to depositors than these other institutions. What do you think of this argument?
Ans: The argument may have some validity as stated, however, whether credit unions are able to
charge a lower rate of interest to borrowers or offer a higher rate to depositors is questionable.
Most credit unions are smaller than most banks, partially due to their employer ties and/or other
restrictions on membership, and as a result are not as able to exploit economies of scale and
scope as larger banks. Also, credit unions may have better information to assess members'
creditworthiness; on the other hand, they may make more questionable loans thinking that the
borrower represents a better risk because of this membership. This is a form of adverse selection.
Difficulty: 03 Hard
Blooms: Evaluate
114. We have discussed the principal-agent problem as a form of moral hazard. Discuss the
unique problems a bank manager faces in terms of trying to please the owners of the bankand at
the same time trying to appease regulators.
Ans: The principal-agent problem arises from the fact that often the manager of a company is not
acting in the best interest of the owners. In the case of a bank, the owners would certainly want a
high profit with a reasonable amount of risk. On the other hand the regulators of a bank prefer
the bank minimize risk. For example, we saw that increasing the leverage (higher debt-to-equity
ratio) can increase the return on equity, something the owners of the bank would prefer. The
higher leverage on the other hand also increases the risk, something the regulators will frown
upon. So the bank manager is in the unenviable position of having to balance the desires of the
owners, the regulators, and to a large degree the depositors. This is not an easy task.
Difficulty: 03 Hard
Blooms: Analyze
115. Bank managers seem to have to walk a tightrope between managing risk and earning a
profit. Explain.
Ans: If we consider the various forms of bank risk and the possible ways to manage it, we can
see the challenges posed for a bank seeking to make the highest possible profit (to satisfy its
owners). Managing liquidity risk means having to structure securities holdings so that sales can
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be carried out if needed. This means holding shorter-term securities such as Treasury securities,
but they tend to pay less of a return. Managing credit risk means having to diversify, which may
mean higher costs to the bank as it gives up a competitive advantage in a narrow line of
business? Managing interest-rate risk means restructuring assets to better match liabilities and, as
with liquidity risk management, this also reduces potential profitability. Add to this the
limitations imposed by regulators (such as not being able to own stock and monitoring of bank
leverage) and one might wonder how banks ever manage to earn a profit.
Blooms: Understand
116. The primary difference among various kinds of depository institutions is in the composition
of their loan portfolios. Agree or disagree? Explain.
Ans: All depository institutions have deposits as their sources of funds and use those funds to
make loans. There are three basic types of depository institutions: commercial banks, savings
institutions, and credit unions. Commercial banks make loans primarily to businesses; saving and
loans primarily provide mortgages to individuals; and credit unions specialize in consumer loans.
However, the balance sheets of these depository institutions have changed over time and they
now compete with each other to a greater degree than in the past. For example, on the deposits
side, savings institutions offer types of checking accounts. In terms of the loan portfolios,
commercial banks now serve individuals with consumer and residential loans, and savings and
loan institutions today engage in a much broader range of financial activities than in the past.
Therefore it is safe to say that while the depository institutions do differ from each other in terms
of the loan portfolios, the differences will mostly be matters of the proportions of different types
of loans each holds.
Difficulty: 03 Hard
Blooms: Evaluate
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4/8/24, 4:13 PM Test 12 2018

1. Which of the following correctly portrays a bank's balance sheet?

2. Considering a bank's balance sheet, which of the following statements is true?

3. Considering a bank's balance sheet, which of the following statements is false?

4. A bank's net worth is synonymous with its:

9. The total assets of commercial banks in 2015 amounted to:

10. A bank's reserves include:

11. A bank's reserves include:

15. Secondary reserves for banks are:

16. Considering U.S. commercial banks, loans account for:

18. Savings and loans primarily provide:

21. Which of the following statements is not true?

24. The federal funds market:

25. Loans made in the federal funds market:

Topic: The Balance Sheet of Commercial Banks

28. Which of the following is a bank liability?

29. Which of the following is a bank asset?

30. Which of the following is not a bank liability?

31. Which of the following is not a bank asset?

33. A non-transaction deposit would include each of the following, except:

34. A repurchase agreement is:

Learning Objective: 12-01

35. Repurchase agreements are usually used by banks that:

36. Capital is the cushion banks have against:

38. Savings and loan institutions:

43. A bank's loan loss reserves are:

Topic: The Balance Sheet of Commercial Banks

51. A bank's return on assets (ROA) is calculated by dividing:

52. A bank's return on equity (ROE) is calculated by:

58. Net interest income for a bank is:

62. A bank's off-balance-sheet activities usually:

79. When interest rates fall a bank's capital will usually:

85. Trading risk faced by U.S. banks results from:

86. A bank faces foreign exchange risk when:

Short Answer Questions

89. What is the equation that reflects a bank's balance sheet?

Topic: The Balance Sheet of Commercial Banks

AACSB: Reflective Thinking

110. Why are U.S. banks prohibited from owning stocks?

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