Chapter 9
If a bank has $1000 in deposits and the required reserve ratio is 10%, then the amount required as the bank's reserves is $_______
#11 Screenshot CH9 .1x1000 = $100
Using the T-accounts of the First National Bank and the Second National Bank, describe what happens when Jane Brown writes a check for $65 on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second National Bank.
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What happens to reserves at the First National Bank if one person withdraws $1,300 of cash and another person deposits $800 of cash? Use a T-account to explain your answer.
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NewBank started its first day of operations with $114 million in capital. A total of $94 million in checkable deposits is received. The bank makes a $21 million commercial loan and another $22 million in mortgage loans. The required reserve ratio is 6.7%. (Note: Information is based on NewBank's first month of operations.)
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Asset
A financial claim or piece of property that is a store of value.
Gap analysis
A measurement of the sensitivity of bank profits to changes in interest rates, calculated by subtracting the amount of rate-sensitive liabilities from the amount of rate-sensitive assets.
Principal-agent problem
A moral hazard problem that occurs when the managers in control (the agents) act in their own interest rather than in the interest of the owners (the principals) due to different sets of incentives.
Which of the following is not an asset on a bank's balance sheet? A. Checkable deposits. B. Reserves. C. Loans. D. Government securities.
A. Checkable deposits.
If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation? (Check all that apply.) A. Decrease dividend payments to increase retained earnings. B. Issue stock. C. Call in existing loans in an attempt to decrease its asset holdings. D. Borrow from other banks or corporations.
A. Decrease dividend payments to increase retained earnings. B. Issue stock. C. Call in existing loans in an attempt to decrease its asset holdings.
Which of the following may not be used as a backup line of credit? A. Mortgages B. Loan commitments C. Standby letters of credit D. Overdraft privileges
A. Mortgages
If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why or why not? A. No, the bank is holding too many excess reserves, and bank profits may be low. B. Yes, the bank must be offering low-interest rate loans, thereby reducing the moral hazard problem. C. No, the bank must be earning more from deposits than from loans, and this is not possible. D. Yes, the bank is holding enough excess reserves to always cover deposit outflows, so bank profits must be high.
A. No, the bank is holding too many excess reserves, and bank profits may be low.
A bank finds that its ROE is too low because it has too much bank capital. Which of the following will not raise its ROE? A. The bank can sell part of its holdings of securities and hold more excess reserves B. The bank can pay out more dividends C. The bank can buy back some of its shares D. The bank can increase the amount of its assets by acquiring new funds
A. The bank can sell part of its holdings of securities and hold more excess reserves
Measuring the sensitivity of bank profits to changes in interest rates by calculating the product of the gap and the change in the interest rate is called: A. basic gap analysis B. gap-exposure analysis C. basic duration analysis D. interest-exposure analysis
A. basic gap analysis
Which of the following is the greatest source of funds to commercial banks in the past in the past? A. checkable deposits B. nontransaction deposits C. borrowings D. bank capital
A. checkable deposits
Required reserves are a fixed percentage of a bank's A. checkable deposits. B. capital. C. liabilities. D. loans. E. assets.
A. checkable deposits.
"Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is this statement true or false? Explain your answer. A. True. Diversification is a desirable strategy for a bank, so it does not make sense for a bank to specialize in certain types of lending. B. False. A bank may have developed expertise in screening and monitoring a particular type of loan, thus improving its ability to handle problems of adverse selection and moral hazard. C. False. A bank does not gain anything by diversifying; the bank only raises its costs when it diversifies. D. True. A bank can reduce its risk by using diversification, just like individuals can.
B. False. A bank may have developed expertise in screening and monitoring a particular type of loan, thus improving its ability to handle problems of adverse selection and moral hazard.
Which of the following statements about interest-rate risk is true? A. Banks tend to have more rate-sensitive assets than liabilities. B. If a bank has more rate-sensitive liabilities than assets, an increase in interest rates reduces bank profits. C. An increase in interest rates always increases commercial bank profits. D. A commercial bank usually has a larger "gap" than an equivalent size savings and loan.
B. If a bank has more rate-sensitive liabilities than assets, an increase in interest rates reduces bank profits.
Which of the following is a cost for a bank when it decides to increase the amount of its bank capital? A. The liquidity of its loans and other assets falls. B. The return on equity decreases. C. The return on assets decreases. D. The safety of its loans decreases
B. The return on equity decreases.
The volume of checkable deposits relative to total bank liabilities has: A. expanded moderately over time. B. declined over time. C. expanded dramatically over time. D. remained virtually unchanged since 1960.
B. declined over time.
Why is being nosy a desirable trait for a banker? A. A banker has to screen out good credit risks from bad credit risks B. A banker determines credit risk by learning as much as possible about potential borrowers C. To reduce moral hazard, a banker must continually monitor borrowers to ensure that they are complying with restrictive loan covenants D. All of the above are correct
D. All of the above are correct
If the bank suffers a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, what actions can you take to keep your bank from failing? A. You can call in or sell off loans. B. You can borrow reserves in the federal funds market. C. You can go to the discount window. D. Any of the above are appropriate actions to take.
D. Any of the above are appropriate actions to take.
Bank loans from the Federal Reserve are called ________ and represent a source of new funds for financial intermediaries. A. federal funds B. agency loans C. prime loans D. discount loans
D. discount loans
Liabilities
IOUs or debts.
Moral hazard
The risk that one party to a transaction will engage in behaviour that is undesirable from the other party's point of view.
Banks make profits by selling liabilities with one set of characterisitics and using the proceeds to buy assets with a different set of characteristics. This process is known as
asset transformation
Banks make profits by selling liabilities with one set of characterisitics and using the proceeds to buy assets with a different set of characteristics. This process is known as ▼ T-account asset transformation liaibility management liquidity management
asset transformation
NewBank started its first day of operations with $101 million in capital. A total of $280 million in checkable deposits is received. The bank makes a $2626 million commercial loan and another $23 million in mortgage loans. Required reserves are 5.3%. NewBank decides to invest $176 million in 30-day T-bills. The T-bills are currently trading at $4,983 (including commissions) for a $5,050 face value instrument. How many do they purchase? (Note: Information is based on NewBank's first month of operations.)
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Joe deposits his $2600 paycheck into his checking account at Local Bank. The bank's assets will then increase by $___________
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If a bank experiences a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, which balance sheet would the bank rather have initially: Balance Sheet A or Balance Sheet B? Why?
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X-Bank reported an ROE of 15% and an ROA of 1.28%. What is the equity multiplier? How well capitalized is this bank?
#33 Screenshot CH9 15/1.28 = 11.72 This is a well-capitalized bank because its equity/asset ratio exceeds the minimum required level.
A bank has $200,000 of checkable deposits and a required reserve ratio of 5 percent. The bank currently holds $190,000 in reserves. How much of these reserves are excess reserves?
#34 in notebook CH9 190,000 - (200,000x.05) = 180,000
Suppose that a bank has $120 in checkable deposits, reserves of $15, and a reserve requirement of 10%. Also assume that the the bank suffers a $12 deposit outflow. If the bank chooses to borrow from the Fed to meet its reserve requirement, then the bank would need to borrow $_____________
#36 Screenshot CH9 (0.1x (120-12)) - (15-12) = $7.80
Suppose that you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points.
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Suppose First National Bank holds $100million in assets with an average duration of 5 years, and it holds $90 million in liabilities with an average duration of 2 years. Further suppose there is a 4-percentage-point increase in interest rates. Calculate the percentage decrease in First National Bank's net worth relative to the total original asset value.
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The dramatic slowdown in the growth of credit in the wake of the financial crisis starting in 2007 triggered a 'credit crunch' in which credit was hard to get. As a result, the performance of the economy in 2008 and 2009 was very poor. What caused the credit crunch?
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Joe deposits his $2000 paycheck into his checking account at Local Bank. The bank's assets will then increase by $_____________
$2000
Suppose $25,000 is deposited at a bank. The required reserve ratio is 10 percent, and the bank chooses not to hold any excess reserves but makes loans instead. What are the bank's total loans?
25,000x.10 = 2500 25,000-2,500 = 22,500 Total Loans
Suppose $25,000 is deposited at a bank. The required reserve ratio is 25 percent, and the bank chooses not to hold any excess reserves but makes loans instead. What are the bank's total reserves?
25,000x.25 = $6250 Total Reserves
Assets of value promised to the lender as compensation if the borrower defaults are called: A. collateral B. restrictive covenants C. contingencies D. deductibles
A. collateral
In order to reduce the ________ problem in loan markets, banks often insist on collateral from potential borrowers. A. moral hazard B. asymmetric information C. adverse lending D. principal-agent
A. moral hazard
Banks often specialize in providing loans to firms in a particular industry because this activity A. reduces the cost of acquiring and analyzing information about the borrower. B. is required by law. C. allows the bank to increase the diversification of its loan portfolio. D. reduces the bank's exposure to interest-rate risk.
A. reduces the cost of acquiring and analyzing information about the borrower.
The sum of a bank's vault cash plus its deposits at the Fed is the bank's A. reserves. B. excess reserves. C. capital. D. cash items in the process of collection. E. federal funds.
A. reserves.
When investors are involved in trading activities in an attempt to outguess markets, investors are: A. speculating B. hedging C. diversifying D. engaging in riskless arbitrage
A. speculating
Which of the following is not a method by which banks reduce their credit risk? A. use gap analysis to help balance a bank's rate-sensitive assets and liabilities B. develop long-term relationships with borrowers C. enforce restrictive covenants in the loan contract D. engage in credit rationing E. collect information on prospective borrowers to screen out high-risk borrowers
A. use gap analysis to help balance a bank's rate-sensitive assets and liabilities
Risk that is related to the uncertainty about future interest-rate movements is called: A. interest-rate risk B. security risk C. liquidity risk D. default risk
A. interest-rate risk
Transformation of assets can be accomplished by: A. borrowing and lending only for the long term B. borrowing short and lending long C. borrowing long and lending short D. borrowing and lending only for the short term
B. borrowing short and lending long
The process of asset transformation is frequently described by saying that banks are in the business of A. borrowing long and lending short. B. borrowing short and lending long. C. lending as much as possible. D. borrowing as little as possible.
B. borrowing short and lending long. Banks are in the business of "borrowing short and lending long."
Gap analysis measures the difference between a bank's: A. assets and liabilities B. rate-sensitive liabilities and rate-sensitive assets C. deposits and loans D. long-term securities and short-term securities
B. rate-sensitive liabilities and rate-sensitive assets
The portion of checkable deposits that banks are required to hold is called: A. currency outstanding. B. required reserves. C. excess reserves. D. vault cash.
B. required reserves.
Provisions in loan contracts designed to mitigate the moral hazard problem are called: A. liens B. restrictive covenants C. proscription bonds D. due-on-sale clauses
B. restrictive covenants
The principal-agent problem that exists for bank trading activities can be reduced by: A. eliminating the regulation of the financial industry B. the physical separation of trading activities from bookkeeping activities C. combining trading activities with bookkeeping activities D. eliminating internal controls
B. the physical separation of trading activities from bookkeeping activities
Off-balance-sheet activities
Bank activities that involve trading financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets.
Why might a bank be willing to borrow funds from other banks at a higher rate rather than borrow from the Fed? A. Other banks are willing to lend reserves for free within the banking community. B. Non-member banks can only borrow from the Fed by paying additional loan origination fees. C. Borrowing from the Fed might invite greater supervisory scrutiny from the central bank. D. The Fed charges a lending rate much higher than market rates.
C. Borrowing from the Fed might invite greater supervisory scrutiny from the central bank.
"Bank managers should always seek the highest return possible on their assets." Is this statement true, false, or uncertain? A. True. Seeking the highest return possible will always prevent a bank failure. B. True. The highest return possible on assets will guarantee the highest income for the bank. C. False. A bank must also consider an asset's risk and liquidity when deciding which assets to hold. D. Uncertain. This statement is true only if the bank has more rate-sensitive liabilities than assets.
C. False. A bank must also consider an asset's risk and liquidity when deciding which assets to hold.
Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves? A. The overnight loan market has supplanted the Fed as the lender of last resort. B. This new market has led to an increase in interest rates, thus raising the opportunity cost of holding excess reserves. C. The presence of overnight loan markets reduces the costs associated with deposit outflows. D. Banks find it more profitable to loan out their excess reserves in the overnight market.
C. The presence of overnight loan markets reduces the costs associated with deposit outflows.
If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans? A. You would want to make short-term loans since there is no guarantee that the interest rate will rise as expected. B. You would want to make long-term loans to secure the higher interest rate for an extended period of time. C. You would want to make short-term loans so you can reinvest the funds at higher interest rates after their maturity. D. Both short-term and long-term loans will be profitable with an expected interest rate increase.
C. You would want to make short-term loans so you can reinvest the funds at higher interest rates after their maturity.
If borrowers with the most risky investment projects are more likely to seek bank loans as compared to those borrowers with the safest investment projects, banks are said to face the problem of: A. moral hazard B. adverse credit risk C. adverse selection D. risk satiation
C. adverse selection
Other things being the same, a bank with a greater amount of capital A. has a higher rate of return on equity to the owners. B. is more liquid. C. has a lower risk of failure. D. is less liquid.
C. has a lower risk of failure.
Banks generate profits by earning higher returns on their ____________ than they pay in interest on _____________. A. liabilities; deposits B. deposits; loans C. loans; deposits D. deposits; securities
C. loans; deposits
Large-denomination CDs are ________, so that like a bond, they have a ________ degree of liquidity and can be sold in secondary markets. A. non-negotiable; greater B. non-negotiable; smaller C. negotiable; greater D. negotiable; smaller
C. negotiable; greater
When a bank suffers deposit outflows and has no excess reserves, the bank will generally first try to raise the funds by A. borrowing from the Fed. B. selling some loans. C. selling some of its securities. D. calling in some loans.
C. selling some of its securities.
Rank the following bank assets from most liquid (1) to least liquid (4). (Enter a numerical value between 1 and 4.) Commercial loans Securities Reserves Physical capital
Commercial loans - 3 Securities - 2 Reserves - 1 Physical capital - 4
Which of the following is not an income-producing asset on a bank's balance sheet? A. Consumer loans. B. Treasury notes. C. Treasury bills. D. Bank reserves.
D. Bank reserves.
If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? Why or why not? What options are available for you to provide the funds your customer needs? A. Yes. In response to the subprime mortgage meltdown, the Federal Lending Act of 2008 stipulates that excess reserves are the only source of new lending. B. Yes. Although excess reserve are not the only source of new lending, the cost of acquiring the excess reserves for lending are higher than the expected return on the loan. C. No. There are only two sources of funds that can used to acquire reserves. The bank can borrow at the discount window or in the federal funds market. D. No. There are several ways that reserves can be acquired. For example, the bank can borrow at the discount window or in the federal funds market, or it can acquire funds by issuing negotiable CDs.
D. No. There are several ways that reserves can be acquired. For example, the bank can borrow at the discount window or in the federal funds market, or it can acquire funds by issuing negotiable CDs.
Why do equity holders care more about ROE than about ROA? A. A change in ROE indicates a change in the safety of the investment, while a change in ROA does not. B. A higher ROE indicates a higher level of liquidity for the investment, while a higher ROA does not. C. ROE measures how efficiently the bank is being run, while ROA measures how much equity holders are earning. D. ROE measures how much equity holders are earning, while ROA measures how efficiently the bank is being run.
D. ROE measures how much equity holders are earning, while ROA measures how efficiently the bank is being run.
Which of the following is a benefit for a bank when it decides to increase the amount of its bank capital? A. The liquidity of its loans and other assets rises. B. The return on equity increases. C. The return on assets rises. D. The safety of its loans increases.
D. The safety of its loans increases.
Reserves, cash items in process of collection, and deposits at other banks are collectively called A. bank capital B. secondary reserves C. discount loans D. cash items
D. cash items
When you deposit your $4000 paycheck in your bank, which was written on an account at a different bank, the immediate impact on your bank's balance sheet is that your bank's cash items in the process of collection rise by $4000 and your bank's A. reserves rise by $4000. B. capital rises by $4000. C. loans rise by $4000. D. deposits rise by $4000.
D. deposits rise by $4000.
A bank's balance sheet includes several components such as the following except A. cash items in process of collection. B. nontransaction deposits. C. bank capital. D. employed workers.
D. employed workers.
If a depositor withdraws $300 from his deposit at a bank, then the bank's reserves A. increase by less than $300. B. increase by $300. C. fall by less than $300. D. fall by $300.
D. fall by $300.
A bank with excess reserves can economize on these reserves by: A. buying short-term Treasury securities. B. buying municipal bonds. C. calling in loans. D. lending reserves in the federal funds market.
D. lending reserves in the federal funds market.
Examples of off-balance-sheet activities include: A. borrowing from other banks B. extending loans to depositors C. selling negotiable CDs D. selling loan portfolios
D. selling loan portfolios
Asset transformation
Low transaction costs allow financial intermediaries to share risk at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is often referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors.
Return on equity (ROE)
Net profit after taxes per dollar of equity capital.
If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE? A. Even if the bank doubles its amount of capital, if ROA is constant, then ROE will remain unchanged. B. Given the ROA, if bank capital doubles, then ROE will also double. C. Given the ROA, if bank capital doubles, then ROE will fall by half. D. The effect on ROE cannot be determined based on the information provided.
ROE=ROA×EM. If a bank doubles the amount of itscapital, its equity multiplier falls in half. If ROA staysconstant, ROE will also fall in half. C. Given the ROA, if bank capital doubles, then ROE will fall by half.
A bank's balance sheet is a list of its ____________ its uses to which the funds are put.
assets
Banks also obtain funds by borrowing from the Federal Reserve System. These borrowings are known as ▼ nontransaction deposits vault cash discount loans checkable deposits
discount loans
The sensitivity of bank profits to changes in interest rates can be measured more directly using ▼ duration analysis gap analysis credit rationing , in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets.
gap analysis
A bank's balance sheet is a list of its ▼ assets federal funds discount loans liabilities , its sources of bank funds sources of bank funds.
liabilities
Short-term U.S. government securities are called ▼ secondary reserves excess reserves T-account discount loans because of their high liquidity.
secondary reserves
Reserves
Banks' holding of deposits in accounts with the Fed plus currency that is physically held by banks (vault cash).