Chapter 17: Banking and the Management of Financial Institutions

2) Which of the following statements is true? A) A bank's assets are its uses of funds. B) A bank's assets are its sources of funds. C) A bank's liabilities are its uses of funds. D) Only B and C of the above are true.

A) A bank's assets are its uses of funds. Assets represent the uses of funds for a bank. Banks utilize their assets to generate income and fulfill their core functions, such as providing loans and investments. Assets can include cash, loans, securities, physical properties, and other financial instruments. Option B is incorrect because a bank's assets are not its sources of funds. Sources of funds for a bank typically come from deposits, borrowings, and capital injections from investors. Option C is incorrect because a bank's liabilities do not represent its uses of funds. Liabilities reflect the obligations of the bank to repay funds to depositors, creditors, and other stakeholders. Option D is incorrect because option B is not true. Therefore, only option A is correct, stating that a bank's assets are its uses of funds.

3) Which of the following are reported as liabilities on a bank's balance sheet? A) Discount loans B) Cash items in the process of collection C) State government securities D) All of the above E) Only B and C of the above

A) Discount loans Discount loans are reported as liabilities on a bank's balance sheet. These loans are loans extended to borrowers where the interest is deducted upfront from the loan amount, and the borrower receives the net amount. Since the bank has an obligation to repay the full loan amount to the lender, it is considered a liability.

17) Examples of off-balance-sheet activities include A) loan sales. B) extending loans to depositors. C) borrowing from other banks. D) all of the above.

A) loan sales. Off-balance-sheet activities refer to transactions or financial arrangements that are not recorded on a company's balance sheet but still have an impact on its financial position and risk profile. These activities are typically contingent or potential obligations that may arise in the future. Loan sales are an example of off-balance-sheet activities. When a bank sells a loan to another party, it transfers the ownership and associated risk of the loan to the buyer. The bank receives proceeds from the sale, which can be used to generate liquidity or reduce its exposure to certain loans. Since the loan is sold, it is no longer recorded as an asset on the bank's balance sheet. On the other hand, extending loans to depositors (option B) and borrowing from other banks (option C) are not considered off-balance-sheet activities. Extending loans to depositors refers to providing credit to customers who have deposited funds with the bank. These loans are typically recorded as assets on the balance sheet. Borrowing from other banks involves obtaining funds from other financial institutions, and such borrowings are typically recorded as liabilities on the balance sheet. Therefore, the correct answer is A) loan sales, as it is an example of an off-balance-sheet activity. Options B and C are not examples of off-balance-sheet activities.

4) Which of the following are reported as assets on a bank's balance sheet? A) Discount loans from the Fed B) Loans C) Borrowings D) Only A and B of the above

B) Loans Loans are reported as assets on a bank's balance sheet because they represent the bank's claims on borrowers and the expected future cash flows from those loans. Banks extend loans to individuals, businesses, and other entities, and these loans generate interest income for the bank. Therefore, loans are considered assets because they have economic value and are expected to generate future cash flows for the bank. Discount loans from the Fed (option A) are loans provided by the Federal Reserve to banks to meet short-term liquidity needs. While these loans do have value, they are typically classified separately as "loans from the Federal Reserve" or "borrowings" and are not included in the regular loan portfolio. Therefore, they are not reported as assets along with other loans on a bank's balance sheet. Borrowings (option C) generally represent the liabilities of a bank rather than assets. Borrowings refer to funds borrowed by the bank from external sources, such as issuing bonds or obtaining loans from other financial institutions. These liabilities are reported separately on the bank's balance sheet and are not considered assets.

7) Which of the following bank assets are the least liquid? A) Reserves B) Mortgage loans C) Cash items in process of collection D) Deposits with other banks

B) Mortgage loans Among the given options, mortgage loans are typically the least liquid bank asset. A) Reserves: Reserves refer to the funds that banks hold either as required reserves or excess reserves at the central bank. Reserves are highly liquid assets as they are held in the form of cash or deposits with the central bank, which can be easily accessed and used by the bank. B) Mortgage loans: Mortgage loans are loans extended to individuals or businesses to finance the purchase of real estate. These loans are generally long-term in nature and involve a significant amount of money. Mortgage loans are considered less liquid compared to other bank assets because they typically have a longer duration, making it more challenging to convert them into cash quickly. Selling or liquidating mortgage loans often requires time and effort, as they involve legal processes and finding suitable buyers in the secondary market. C) Cash items in the process of collection: Cash items in the process of collection refer to checks or negotiable instruments that have been deposited but have not yet been cleared by the issuing bank. While these assets are not as liquid as reserves, they still represent funds that are expected to be received in the near future and can be converted into cash relatively quickly. D) Deposits with other banks: Deposits with other banks are assets held by a bank with other financial institutions. Although these deposits are not as liquid as reserves, they can still be accessed and used by the bank if necessary, typically through interbank transactions or withdrawals. In comparison to the other options, mortgage loans have the longest duration and typically require a complex process to convert them into cash. Therefore, they are considered the least liquid bank asset among the given options (Reserves, Mortgage loans, Cash items in process of collection, Deposits with other banks).

11) Bankers' concern regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of A) liability management. B) liquidity management. C) managing interest-rate risk. D) none of the above.

B) liquidity management. Bankers' concern regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of liquidity management. Liquidity management involves the strategies and actions taken by banks to ensure that they have enough liquid assets or funding sources to meet their short-term obligations and handle unexpected changes in deposit flows or other liquidity needs. In this case, the concern about the optimal mix of various liquidity sources (excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks) reflects the bank's effort to effectively manage its liquidity position. The bank needs to strike a balance between holding excess reserves, maintaining secondary reserves such as highly liquid assets, and potentially utilizing borrowing options from the Federal Reserve or other banks to address deposit outflows. Managing liquidity is crucial for banks to maintain stability, fulfill withdrawal requests, meet regulatory requirements, and avoid liquidity crises. By considering the different liquidity sources and their implications, bank managers aim to ensure that the bank has sufficient liquidity to handle deposit outflows effectively.

8) In general, banks make profits by selling ________ liabilities and buying ________ assets. A) long-term; shorter-term B) short-term; longer-term C) illiquid; liquid D) risky; risk-free

B) short-term; longer-term In general, banks make profits by selling short-term liabilities and buying longer-term assets. A) Long-term; shorter-term: This option is incorrect because banks typically sell shorter-term liabilities and invest in longer-term assets. Selling long-term liabilities would mean that the bank is obtaining long-term funding, which may not align with their strategy of using shorter-term funding sources such as deposits or short-term borrowings. Buying shorter-term assets may limit the bank's ability to generate long-term returns. B) Short-term; longer-term: This option is correct because banks often rely on short-term funding sources such as deposits and borrowings with shorter maturities. These short-term liabilities provide the bank with the necessary funds to invest in longer-term assets such as loans, mortgages, or other investments. By leveraging the maturity mismatch, banks can earn profits through the interest rate spread between the longer-term assets and the shorter-term liabilities. C) Illiquid; liquid: This option is incorrect as the focus is not on the liquidity of the assets and liabilities but rather on the term structure. While liquidity is an important consideration for banks, it is not the primary factor determining their profitability. D) Risky; risk-free: This option is incorrect as banks typically engage in a variety of risk-taking activities to generate profits. They may invest in assets with different levels of risk and return potential. The profitability of banks is not solely reliant on investing in risk-free assets. Therefore, the correct answer is B) short-term; longer-term, as banks typically make profits by selling short-term liabilities and buying longer-term assets.

1) Which of the following statements is true? A) A bank's assets are its sources of funds. B) A bank's liabilities are its uses of funds. C) A bank's balance sheet shows that total assets equal total liabilities plus equity capital. D) All of the above are true.

C) A bank's balance sheet shows that total assets equal total liabilities plus equity capital. In a bank's balance sheet, assets represent what the bank owns or has a claim on, while liabilities represent what the bank owes to others. Equity capital represents the ownership interest in the bank. The balance sheet equation is expressed as Assets = Liabilities + Equity Capital. This equation must hold true for the balance sheet to be in balance. Option A is incorrect because a bank's assets are not its sources of funds. Sources of funds for a bank include deposits, borrowings, and capital injections. Option B is incorrect because a bank's liabilities are not its uses of funds. Liabilities reflect the obligations of the bank to repay funds to depositors, creditors, and other stakeholders. Option C is correct because it accurately describes the relationship between assets, liabilities, and equity capital on a bank's balance sheet. The balance sheet provides a snapshot of the bank's financial position, showing that the total value of assets must be equal to the sum of liabilities and equity capital.

16) The amount of assets per dollar of equity capital is called the A) asset ratio. B) equity ratio. C) equity multiplier. D) asset multiplier. E) return on equity.

C) equity multiplier. The amount of assets per dollar of equity capital is indeed called the equity multiplier. It is a financial ratio that measures the leverage or financial leverage of a company, including banks. The equity multiplier is calculated by dividing the total assets of the bank by its equity capital. It represents the proportion of assets financed by equity capital relative to other sources of funding, such as debt or liabilities. The formula for the equity multiplier is: Equity Multiplier = Total Assets / Equity Capital By examining the equity multiplier, we can assess the extent to which a bank relies on debt financing or leverage to support its asset base. A higher equity multiplier indicates a higher degree of leverage, implying that the bank has a larger asset base relative to its equity capital. Conversely, a lower equity multiplier suggests a lower reliance on debt and a relatively smaller asset base compared to equity capital. Therefore, the correct answer is C) equity multiplier, as it specifically refers to the amount of assets per dollar of equity capital.

6) Because of their ________ liquidity, ________ U.S. government securities are called secondary reserves. A) low; short-term B) low; long-term C) high; short-term D) high; long-term

C) high; short-term U.S. government securities are often referred to as secondary reserves because of their high liquidity and short-term nature. High liquidity refers to the ease and speed at which an asset can be converted into cash without significant loss in value. U.S. government securities, such as Treasury bills, notes, and bonds, are highly liquid instruments. They can be easily bought or sold in the secondary market, where investors trade previously issued securities. Short-term refers to the relatively short maturity periods of these securities. Treasury bills, for example, have maturities ranging from a few days to one year. Treasury notes and bonds have longer maturities but are still considered relatively short-term compared to other financial instruments like corporate bonds. Due to their high liquidity, U.S. government securities can be readily sold or pledged as collateral in financial transactions, providing banks and financial institutions with a reliable source of funds in the short term. Banks can quickly convert these securities into cash to meet their liquidity needs or regulatory requirements.

9) When you deposit $50 in currency at the Old National Bank, A) its assets increase by less than $50 because of reserve requirements. B) its reserves increase by less than $50 because of reserve requirements. C) its liabilities increase by $50. D) only A and B of the above occur.

C) its liabilities increase by $50. When you deposit $50 in currency at the Old National Bank, the bank's liabilities increase by $50. This is because the bank now owes you, as the depositor, $50 in the form of a deposit liability. Options A and B are incorrect: A) "Its assets increase by less than $50 because of reserve requirements" is incorrect because reserve requirements do not directly impact the bank's assets. Reserve requirements refer to the regulations that determine the minimum amount of reserves a bank must hold against its deposits. These reserves are typically held as cash or deposits with the central bank. The deposit of $50 in currency does not involve reserve requirements affecting the bank's assets. B) "Its reserves increase by less than $50 because of reserve requirements" is also incorrect. While reserve requirements may impact the bank's reserve levels, the act of depositing $50 in currency itself does not involve a reduction in reserves. Instead, the bank will hold a portion of the deposited funds as required reserves based on the reserve requirements set by the central bank. However, the initial deposit of $50 does not result in a reduction in reserves. Therefore, the correct answer is C) its liabilities increase by $50 because the bank now has an obligation to you, the depositor, in the form of a $50 deposit liability.

10) A bank manager has which of the following concerns? A) To acquire funds at low cost B) To minimize risk by diversifying asset holdings C) To have enough ready cash to meet deposit outflows D) All of the above

D) All of the above A bank manager typically has multiple concerns, and all of the options listed are valid concerns for a bank manager. A) To acquire funds at low cost: One of the primary concerns of a bank manager is to acquire funds (such as deposits or borrowings) at the lowest possible cost. This helps the bank in reducing its funding costs and maximizing profitability. B) To minimize risk by diversifying asset holdings: Another concern of a bank manager is to minimize risk by diversifying the bank's asset holdings. By spreading the bank's investments across various asset classes, sectors, and regions, the manager aims to reduce the impact of any individual asset's performance on the overall portfolio. Diversification helps in managing risk and protecting the bank from potential losses. C) To have enough ready cash to meet deposit outflows: A bank manager needs to ensure that the bank has sufficient liquidity, including enough ready cash or highly liquid assets, to meet deposit outflows. This involves managing the bank's cash reserves, maintaining access to funding sources, and monitoring the cash flow dynamics to fulfill customer withdrawal demands promptly. Since all three options represent genuine concerns for a bank manager and are valid considerations in managing a bank's operations and financial health, the correct answer is D) All of the above.

14) A bank fails when the value of its ________ falls below the value of ________, causing the bank to become insolvent. A) reserves; required reserves B) loans; secondary reserves C) securities; deposit liabilities D) assets; liabilities

D) assets; liabilities A bank fails when the value of its assets falls below the value of its liabilities, causing the bank to become insolvent. Assets represent the resources owned by the bank, including loans, securities, reserves, and other investments. These assets generate income and have an assigned value on the bank's balance sheet. Liabilities, on the other hand, represent the obligations and debts owed by the bank, including deposit liabilities, borrowings, and other liabilities. Liabilities reflect the funds that the bank owes to its depositors, creditors, and other stakeholders. For a bank to remain solvent, the value of its assets must exceed or at least equal the value of its liabilities. This ensures that the bank has sufficient resources to meet its obligations and repay its debts. However, if the value of the bank's assets declines significantly or falls below the value of its liabilities, the bank becomes insolvent, meaning it is unable to meet its financial obligations. In this context, the correct answer is D) assets; liabilities, as a bank fails when the value of its assets falls below the value of its liabilities, leading to insolvency.

13) Banks can protect themselves from the disruption caused by deposit outflows by A) holding excess reserves. B) selling securities. C) "calling in" loans. D) doing all of the above. E) doing only A and B of the above.

D) doing all of the above. Banks can protect themselves from the disruption caused by deposit outflows by implementing various strategies, and all of the options listed can be effective measures to manage the situation. A) Holding excess reserves: By maintaining excess reserves above the required reserve amount, banks can have a buffer to withstand deposit outflows. Excess reserves provide liquidity that can be used to fulfill withdrawal requests and maintain stability during periods of increased outflows. B) Selling securities: Banks can sell securities from their investment portfolios to generate additional funds when faced with deposit outflows. Selling securities can provide an immediate source of cash that can be used to meet deposit withdrawal demands. C) "Calling in" loans: Banks have the option to "call in" or accelerate the repayment of loans when faced with deposit outflows. By requesting borrowers to repay their outstanding loans earlier than scheduled, the bank can increase its available funds and liquidity position. However, it's important to note that calling in loans may not always be a feasible or desirable option, as it can impact customer relationships and potentially lead to additional risks. D) Doing all of the above: The correct answer is D) doing all of the above because employing multiple strategies simultaneously can provide a more comprehensive approach to manage deposit outflows. Holding excess reserves, selling securities, and calling in loans can work in conjunction to enhance the bank's liquidity position, maintain stability, and mitigate the impact of deposit outflows on its operations.

12) If a bank has $1 million of deposits, a required reserve ratio of 20 percent, and $300,000 in reserves, it need not rearrange its balance sheet if there is a deposit outflow of A) $50,000. B) $75,000. C) $150,000. D) either A or B of the above.

D) either A or B of the above. To determine whether a bank needs to rearrange its balance sheet due to a deposit outflow, we need to calculate whether the bank's reserves would fall below the required reserve amount. Given: Total deposits = $1,000,000 Required reserve ratio = 20% (0.20) Reserves = $300,000 The required reserves can be calculated by multiplying the total deposits by the required reserve ratio: Required reserves = Total deposits * Required reserve ratio Required reserves = $1,000,000 * 0.20 Required reserves = $200,000 The bank currently has $300,000 in reserves, which is greater than the required reserve amount of $200,000. This means that the bank has excess reserves of $100,000 ($300,000 - $200,000). If there is a deposit outflow, the bank would need to use its reserves to meet the required reserves. As long as the deposit outflow is less than or equal to the excess reserves ($100,000), the bank does not need to rearrange its balance sheet. Let's consider the options: A) $50,000 deposit outflow: In this case, the bank's reserves would decrease to $300,000 - $50,000 = $250,000, which is still greater than the required reserves of $200,000. Therefore, the bank does not need to rearrange its balance sheet. B) $75,000 deposit outflow: With a deposit outflow of $75,000, the bank's reserves would decrease to $300,000 - $75,000 = $225,000, which is still greater than the required reserves of $200,000. Thus, the bank does not need to rearrange its balance sheet. C) $150,000 deposit outflow: If the deposit outflow is $150,000, the bank's reserves would decrease to $300,000 - $150,000 = $150,000. This falls below the required reserves of $200,000, meaning the bank would need to rearrange its balance sheet by either acquiring more reserves or reducing its assets to meet the required reserves. Therefore, the correct answer is D) either A or B of the above, as a deposit outflow of either $50,000 or $75,000 would not require the bank to rearrange its balance sheet, but a deposit outflow of $150,000 would necessitate adjustments.

15) On a bank's income statement, the provision for loan losses is an ________ item and represents the amount of ________ in the bank's loan loss reserves. A) income; decrease B) income; increase C) expense; decrease D) expense; increase

D) expense; increase On a bank's income statement, the provision for loan losses is an expense item and represents the amount of increase in the bank's loan loss reserves. The provision for loan losses is an accounting entry made by banks to account for potential losses on loans due to factors such as defaults, delinquencies, or a deterioration in the creditworthiness of borrowers. It is an expense that is recognized to reflect the estimated losses that the bank may incur on its loan portfolio. By increasing the provision for loan losses, the bank is recognizing and setting aside funds to cover potential loan losses. This provision is typically based on various factors, including historical loan loss experience, economic conditions, industry trends, and specific credit risk assessments. As an expense, the provision for loan losses reduces the bank's net income, reflecting the cost associated with managing credit risk and ensuring the adequacy of loan loss reserves. The provision for loan losses contributes to the bank's overall expenses and affects its profitability. Therefore, the correct answer is D) expense; increase, as the provision for loan losses is an expense item that represents the amount of increase in the bank's loan loss reserves.

18) Bank capital A) is raised by selling new equity. B) is a cushion against a drop in the value of its assets. C) comes from retained earnings. D) is all of the above.

D) is all of the above. Bank capital refers to the financial resources or equity that a bank holds to support its operations and absorb potential losses. It serves as a cushion or buffer against a drop in the value of the bank's assets and helps ensure the bank's solvency and stability. Let's examine each option: A) Bank capital is raised by selling new equity: This statement is correct. Banks can raise additional capital by issuing and selling new shares of equity. By offering new equity to investors, the bank can increase its capital base and strengthen its financial position. B) Bank capital is a cushion against a drop in the value of its assets: This statement is correct. Bank capital acts as a buffer to absorb losses that may arise from a decline in the value of the bank's assets. If the value of assets decreases, the bank's capital provides a financial cushion to absorb those losses and maintain its solvency. C) Bank capital comes from retained earnings: This statement is correct. Retained earnings represent the portion of a bank's net income that is not distributed to shareholders as dividends but is instead retained within the bank. Retained earnings contribute to the bank's capital base, and they can be reinvested to support the bank's growth, absorb losses, or strengthen its financial position. Given that all three statements are correct, the correct answer is D) is all of the above. Bank capital can be raised by selling new equity, it acts as a cushion against asset value declines, and it includes retained earnings as a source of capital.

5) Which of the following are reported as assets on a bank's balance sheet? A) Cash items in the process of collection B) Deposits with other banks C) Checkable deposits D) Bank capital E) Only A and B of the above

E) Only A and B of the above A) Cash items in the process of collection: These are checks or other negotiable instruments that have been deposited by the bank's customers but have not yet been cleared by the issuing bank. They represent funds that are expected to be received by the bank in the near future. Cash items in the process of collection are considered assets because they represent the bank's claim on the funds and have economic value. B) Deposits with other banks: These are funds that a bank holds with other banks, usually as a part of its liquidity management strategy. These deposits are considered assets because the bank can access and use these funds to meet its own obligations or to earn interest. C) Checkable deposits: Checkable deposits, also known as demand deposits or transaction accounts, are the funds held by the bank on behalf of its customers in checking or current accounts. While these deposits are an important liability for the bank, representing the customers' claims on the bank, they are not reported as assets on the bank's balance sheet. D) Bank capital: Bank capital represents the bank's net worth or equity and is a measure of the bank's financial strength. While bank capital is an essential component of the bank's overall financial structure, it is not considered an asset. Bank capital is reported separately on the balance sheet as a part of the bank's capital and liabilities section.