1.

The equity multiplier for a bank measures the amount of _____________________

of the bank and is one part of the evaluation of the bank's ROE. leverage (debt)

2. __________________________ is the risk that has to do with the quality of the

bank's assets and, in particular, the bank's loans. Credit risk

3. Solvency (or capital) risk for a bank can be measured

by__________________________. List one way solvency risk can be measured.
Purchased Funds/Total Liabilities (There are several other ratios that can answer this
question as well)

4. __________________________ are the assets of a financial institution that will

mature or be repriced within a set period of time. Interest Sensitive Assets

5. __________________________ is the risk that the value of the financial institution's

asset portfolio (particularly government or other marketable securities) will decline in
value. Market risk

6. Eurodollars, Fed Funds, Repurchase Agreements, and large CDs together are know as
_____________________.: Purchased Funds

7. __________________________ is the risk that the financial institution may not be

able to meet the needs of depositors for cash. Liquidity risk

8. __________________________ are loans which are past due by 90 days or more.

Nonperforming loans

9. __________________________ reflects the bank's portfolio management policies and

the mix and yield on the bank's securities and is one part of the evaluation of ROE.
Asset utilization

10. __________________________ reflects the effectiveness of the expense management

of the bank and is one part of the evaluation of ROE. Net profit margin

11. ROE measures the return to stockholders on their investment in the bank. It is the
product of net profit margin, asset utilization and the equity multiplier.

12. Answer: Equity multiplier measures the amount of debt or leverage a bank has and is
one part of the evaluation of the bank's ROE) It is generally a number larger than
one.
Answer: Equity multiplier

14. Solvency risk (or capital risk) measures the bank's risk of long run survival. It
measures the bank's capital position and shows if there has been any erosion of capital
over time.

15. Answer: Interest rate risk is the risk that shifting interest rates in the market will
adversely affect a financial institution's net income or the value of its assets or equity.
 17. Operational (transactional) risk refers to the uncertainty regarding the financial firm’s
earnings due to failures in computer systems, errors, misconduct by employees,
lightening strikes and similar events.

18. refers to variability in earnings resulting from

actions taken by the legal system including unenforceable contracts, lawsuits and
adverse judgements. Legal risk

19. includes violations of rules and regulations. It

can include failure to hold adequate capital which can lead to costly corrective
actions. Compliance risk
20. Answer: Reputation risk the uncertainty associated with public opinion. Negative
publicity (whether true or not) can affect a financial firm’s earnings by dissuading
customers from using the services of the institution.

21. As data processing of financial information becomes more important, managers of

financial firms can realize cost savings from ,
transferring tasks from inside to firm itself to other firms specializing in information
technology.: outsourcing

22. A traditional measure of earnings efficiency is the or total

interest income over total earnings assets less total interest expenses over total interest
bearing bank liabilities. It measures the effectiveness of a firm’s intermediation
function in the borrowing and lending of money. earnings spread

23. One part of ROE is or net income over pre-tax net

operating income which measures the financial firm’s use of security gains and losses
and other tax management tools to minimize tax exposure. tax management efficiency

24. Net profit margin can be split into two parts, and tax management
efficiency. The first part is pre-tax net operating income over total operating revenue
which looks at how many dollars of revenue survive after operating expenses are
removed. expense control efficiency

True/False Questions

26.Financial institutions that pursue the "quiet life" as a goal are really pursuing
risk minimization. True
Financial institutions that aim for the "quiet life" typically prioritize stability and avoiding
unnecessary risks

27.Attempting to maximize a bank's stock value is the key objective for banks which
should have priority over all other bank goals. True
A high stock value signals to the market that the bank is performing well, which can lead
to increased investor confidence and improved access to capital

28.If the expected stream of future bank shareholder dividends rises, a bank's stock
price should also rise, other factors held constant. True
This is because shareholders value dividends as a return on their investment. An increase
in expected dividends signals higher potential returns for shareholders, leading to
increased demand for the stock, which can drive up its price

29.If the discount factor associated with the value of a bank's stock rises, the bank's
stock price should rise, other factors held constant. False
The discount factor represents the rate at which future cash flows (such as dividends) are
discounted to their present value. A higher discount factor means that future cash flows
are being discounted at a higher rate, leading to a lower present value for those cash
flows.

30.A bank's ROA equals its ROE times the ratio of total assets divided by total
equity capital. False. A bank's Return on Assets (ROA) does not equal its Return on
Equity (ROE) times the ratio of total assets divided by total equity capital. ROA is
calculated as net income divided by average total assets. It measures how effectively a
bank is generating profits from its assets.

31.According to the textbook a bank's asset-utilization ratio reflects the mix and
yield on the bank's portfolio of assets. True

32.The bank's profit margin or ratio of net after-tax income to total operating
revenue is a measure of financial leverage for a bank. False
Financial leverage typically refers to the use of debt (or leverage) to increase the potential
return on investment. It is usually measured by the ratio of total debt to equity or other
financial metrics that indicate the extent to which a company is using debt to finance its
operations.

33.The ratio of a bank's net after-tax income to pre-tax net operating income is
described in the text as a measure of tax management efficiency. True

34.In the textbook the ratio of pre tax net operating income to total operating
revenues is described as a measure of the effectiveness of a financial institution’s
expense-control efficiency.
True This ratio, often referred to as the efficiency ratio or operating efficiency ratio,
evaluates how efficiently a financial institution is managing its operating expenses
relative to its revenue

35.The ratio of non-performing assets to total loans and leases is a measure of credit
risk in banking. True
Non-performing assets refer to loans or leases that are in default or are significantly past
due, indicating a higher likelihood of defaul

36.The measure of a bank's efficiency and return known as the "earnings spread"
subtracts total interest expenses from all the bank's interest income and these two
items are then divided by total assets. False
The earnings spread, also known as the net interest margin (NIM), is calculated by
subtracting total interest expenses from total interest income and dividing the result by
average interest-earning assets
38.If a bank adds more full-time employees and posts the same net operating
income, its employee productivity ratio, as defined in the text, must fall. True
if the bank adds more full-time employees without increasing net operating income, the
total non-interest expenses would likely increase, resulting in a higher employee
productivity ratio, indicating lower productivity

40.ROA measures how capably the management of a financial institution has been
converting the institution's assets into net earnings. True
ROA is calculated by dividing the net income of the institution by its average total assets.
It provides insight into the profitability and efficiency of the institution in generating
earnings from its asset base.

41.The noninterest margin is generally positive for most banks. False

the noninterest margin can vary depending on the bank's business model, operating
efficiency, and revenue sources.

42.The ratio of nonperforming assets to total loans and leases is considered to be a

measure of a bank's market risk. False
The ratio of nonperforming assets to total loans and leases is not considered to be a
measure of a bank's market risk. Instead, it is typically regarded as a measure of credit
risk.

43.Charge-offs represent securities a bank decides to sell because they have declined
in value.
False. Charge-offs refer to loans or other receivables that a bank considers unlikely to be
collected and therefore removes from its books as a loss.

44.Loans past due for 90 days or more are classified as nonperforming assets. True
These assets are typically categorized as nonperforming when payments are past due by a
certain number of days, often 90 days or more, depending on regulatory standards and
internal bank policies.

45.The ratio of cash and government securities to total assets is considered to be a

measure of liquidity risk in banking. True
The ratio of cash and government securities to total assets reflects the bank's ability to
meet short-term liquidity needs and withstand potential liquidity shocks. A higher ratio
indicates a higher level of liquidity and may suggest that the bank is better positioned to
handle liquidity demands

46.The ratio of uninsured deposits to total deposits is considered to be a measure of

credit risk in banking. False
The ratio of uninsured deposits to total deposits, on the other hand, is related to deposit
insurance and depositor protection rather than credit risk

47.The interest rate spread between market yields on bank debt issues (such as
capital notes and CDs) and the market yields on government securities of the same
maturity is considered to be a measure of market risk in banking. False
Therefore, the interest rate spread between bank debt and government securities is a measure of
credit risk, not market risk.
 48.The ratio of a bank's net operating income to the number of a bank's full-time-
equivalent employees is called the employee productivity ratio. True
This ratio, also known as the revenue per employee ratio or the efficiency ratio, measures
the efficiency with which a bank generates net operating income relative to its staffing
levels.

49.Smaller banks usually have fewer liquid assets than larger banks. False
Larger banks often have more diverse and complex operations, including extensive
lending activities, investment banking operations, and international activities. As a result,
they may have a lower proportion of their assets in liquid form to support these various
business lines.

50.The bank's asset utilization ratio reflects the effectiveness of the bank's expense
management.
False while the asset utilization ratio measures the efficiency of asset utilization in
generating revenue, it does not directly reflect the effectiveness of expense management.

53.Liquidity risk for a bank examines the quality of the bank's assets and, in
particular, the quality of the bank's loans. False
Liquidity risk for a bank primarily examines the bank's ability to meet its short-term
obligations with readily available cash or assets that can be quickly converted into cash
without significant loss.
Concept Checks

6-1. Why should banks and other corporate financial firms be concerned about their level
of profitability and exposure to risk?

Banks in the U.S. and most other countries are private businesses that must attract capital
from the public to fund their operations. If profits are inadequate or if risk is excessive, they
will have greater difficulty in obtaining capital and their funding costs will grow, eroding
profitability. Bank stockholders, depositors, and bank examiners representing the regulatory
community are all interested in the quality of bank performance. The stockholders are
primarily concerned with profitability as a key factor in determining their total return from
holding bank stock, while depositors (especially large corporate depositors) and examiners
typically focus on bank risk exposure.

6-2. What individuals or groups are likely to be interested in these dimensions of

performance for a financial institution?

The individuals or groups likely to be interested in the dimensions i.e., Bank profitability and
Risk are – Other banks lending to a particular bank, borrowers, large depositors, holders of
long-term debt capital issued by banks, bank stockholders, and the regulatory community.

6-3. What factors influence the stock price of a financial-services corporation?

A bank's stock price is affected by all those factors affecting its profitability and risk
exposure, particularly its rate of return on equity capital and risk to shareholder earnings.
Research evidence over the years has found that the stock prices of financial institutions is
sensitive to changes in market interest rates, currency exchange rates, and the strength or
weakness of the economy. A bank can raise its stock price by creating an expectation in the
minds of investors of greater earnings in the future, by lowering the bank's perceived risk
exposure, or by a combination of increases in expected earnings and reduced risk.

6-5. What is return on equity capital, and what aspect of performance is it supposed to
measure? Can you see how this performance measure might be useful to the managers of
financial firms?

Return on equity capital is the ratio of Net Income/Total Equity Capital. It represents the rate
of return earned on the funds invested in the bank by its stockholders. Financial firms have
stockholders, who too are interested in the return on the funds that they invested.

6-7 What is the return on assets (ROA), and why is it important? Might the ROA measure
be important to banking’s key competitors?

Return on assets is the ratio of Net Income/Total Assets. The rate of return secured on a
bank's total assets indicates the efficiency of its management in generating net income from
all of the resources (assets) committed to the institution. This would be important to banks
and their major competitors..

6-9. Why do the managers of financial firms often pay close attention today to the net
interest margin and noninterest margin? To the earnings spread?

The net interest margin (NIM) indicates how successful the bank has been in borrowing funds
from the cheapest sources and in maintaining an adequate spread between its returns on loans
and security investments and the cost of its borrowed funds. If the NIM rises, loan and
security income must be rising or the average cost of funds must be falling or both. A
declining NIM is undesirable because the bank's interest spread is being squeezed, usually
because of rising interest costs on deposits and other borrowings and increased competition
today.

In contrast, the noninterest margin reflects the banks spread between its noninterest income
(such as service fees on deposits) and its noninterest expenses (especially salaries and wages
and overhead expenses). For most banks the noninterest margin is negative. Management will
usually attempt to expand fee income, while controlling closely the growth of noninterest
expenses in order to make a negative noninterest margin less negative.

The earnings spread measures the effectiveness of the bank's intermediation function of
borrowing and lending money, which, of course, is the bank's primary way of generating
earnings. As competition increases, the spread between the average yields on assets and the
average cost of liabilities will be squeezed, forcing the bank's management to search for
alternative sources of income, such as fees from various services the bank offers.

6-11. What are the principal components of ROE, and what does each of these components
measure?

The principal components of ROE are:

a. The net profit margin or net after-tax income to Total operating revenues which reflects the
effectiveness of a bank's expense control program and service pricing policies;
b. The degree of asset utilization or ratio of Total operating revenues to Total assets which
measures the effectiveness of managing the bank's portfolio management policies, especially
the mix and yield on assets; and,

c. The equity multiplier or ratio of Total assets to Total equity capital which measures a
bank's use of leverage in funding its operations: sources chosen to fund the financial
institution (debt or equity).

6-14. What are the most important components of ROA, and what aspects of a financial
institution’s performance do they reflect?

The principal components of ROA are:

a. Total Interest Income Less Total Interest Expense divided by Total Assets, measuring a
bank's success at intermediating funds between borrowers and lenders;

b. Provision for Loan Losses divided by Total Assets which measures management's ability
to control loan losses and manage a bank's tax exposure;

c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the
ability of management to control salaries and wages, other noninterest costs and generate the
income;

d. Net Income Before Taxes divided by Total Assets, which measures operating efficiency
and expense control; and

e. Applicable Taxes divided by Total Assets, which is an index of tax management

effectiveness.

6-16. To what different kinds of risk are banks and their financial-service competitors
subjected today?

a. Credit Risk - the probability that the loans and securities the bank holds will not pay out as
promised.

b. Liquidity Risk - the probability that the bank will not have sufficient cash on hand in the
volume needed precisely when cash demands arise.

c. Market Risk - the probability that the market value of assets held by the bank will decline
due to falling market prices.

d. Price Risk – the probability or possibility that the value of bond portfolios and
stockholders’ equity may decline due to market prices movement against the financial firm.

e. Interest-Rate Risk - the possibility or probability that the interest rates will change,
subjecting the bank to lower profits or a lower value for the firm’s capital.

f. Foreign Exchange and Sovereign Risk – the uncertainty that due to fluctuation in currency
prices, assets denominated in foreign currencies may fall, forcing the written down of these
assets on its Balance Sheet.
g. Off-Balance-Sheet Risk – the probability that the volume of off-balance-sheet
commitments far exceeds the volume of conventional assets.

h. Operational Risk – the uncertainly regarding a financial firm’s earnings due to failures in
computer systems, employee misconduct, floods, lightening strikes and other similar events.

i. Legal and Compliance Risk – the uncertainty regarding a financial firm’s earnings due to
actions taken by our legal system or due to a violation of rules and regulations.

j. Reputation Risk – the uncertainty due to public opinion or the variability in earnings due to
positive or negative publicity about the financial firm.

k. Strategic Risk – the uncertainty in earnings due to adverse business decisions, lack of
responsiveness to industry changes and other poor decisions by management.

k. Capital Risk – the risk that the value of the assets will decline below the value of the
liabilities. All of the other risks listed above can affect earnings and the value of the assets
and liabilities and therefore can have an effect on the capital position of the firm.

6-17. What items on a bank's balance sheet and income statement can be used to measure its
risk exposure? To what other financial institutions do these risk measures seem to apply?

There are several alternative measures of risk in banking and financial service firms. Capital
risk is often measured by bank capital ratios, such as the ratio of total capital to total assets or
total capital to risk assets. Credit risk can be tracked by such ratios as net loan losses to total
loans or relative to total capital. Liquidity risk can be followed by using such ratios as cash
assets to total assets or by total loans to total assets. Interest-rate risk may be indicated by
such ratios as interest-sensitive liabilities to interest-sensitive assets or the ratio of money-
market borrowings to money-market assets.

These risk measures also applies to those nonbank financial institutions that are private, profit
making corporations, including stockholder-owned thrift institutions, insurance companies,
finance and credit-card companies, security broker and dealer firms, and mutual funds.