Essay questions

What is the restrictive banking system? What are the strengths and weaknesses

weaknesses 1. Does not prevent bank failure. 2. Cannot eliminate economic risk. 3. Does not guarantee good management decisions. Three drawbacks: 1. Assumes market for bank products could be protected and not encroached on by other firms. 2. Discriminated against U.S. versus foreign firms. 3. Penalizes customers without convenient access to range of products demanded

Discuss two ways that a bank can increase its noninterest income

1. Charging fees on agency services 2. Charging processing fees on loans; charges for insufficient funds

Regulators use the CAMELS system to analyze bank risk. What does CAMELS stand for and what financial ratios might best capture each factor?

C: use capital adequacy ratio (measures capital against risk) A: use ROA (profitability) M: sales/revenue per employee (operating) E: use profitability ratios L: liquidity ratios like quick & current S: use market ratios like EPS or use activity ratios

List and discuss the five goals and functions of depository institution regulation

1. To ensure the safety and soundness of depository institutions and financial instruments a. Purpose: to maintain domestic and international confidence, protect depositors and, ultimately, taxpayers, and maintain financial stability b. accomplished by: limiting risk-taking at individual institutions, by limiting entry and exit, and by the federal government's willingness to act as a lender of last resort. 2. To provide an efficient and competitive financial system a. prevent undue concentration of depository institution resources that would be anticompetitive, yet allow firms to alter their product mix and delivery systems to meet economic and market needs b. restricting mergers and acquisitions that reduce the number and market power of competing institutions. 3. To provide monetary stability a. control the growth in the banking system's liquidity and hence the nation's money supply and influence the general level of interest rates b. by buying and selling government securities and targeting the federal funds rate 4. To maintain the integrity of the nation's payments system a. As long as regulators ensure that banks clear checks and settle noncash payments in a fair and predictable way, participants will have confidence that the payments media can be used to effect transactions. 5. To protect consumers from abuses by credit-granting institutions b. regulations now stipulate that borrowers should have equal credit opportunities such that depository institutions cannot discriminate based on race, gender, age, geographic location, and so on. Lenders must also report key borrowing and savings rates in a manner that allows meaningful comparisons and disclose why a borrower is denied a loan.

What are the major categories of depository institution assets and liabilities? How do these differ from a typical business balance sheet statement?

Assets: Loans Fixed assets Investment securities Reserves Physical assets Compared to businesses, banks have lower fixed assets, no inventory, and many loans. Banks have assets that facilitate their payment system. Liabilities: Transaction deposits Borrowings Shareholder's equity Banks have lots of NOW & ATS, federal funds, lower capital, mostly short-term borrowings. Bank liabilities are mostly short-term and consist mainly of deposit and transaction accounts.

How would a bank's ability to control its burden ratio impact its return on equity?

Banks target ROE and make active use of leverage to effect the speed of adjustments towards ROE targets. Banks will take on more leverage to achieve high returns when risk when risk premium are low, and decrease their leverage to contain losses when risk and risk premiums are high.

List the risks included in CAMELS. Explain the risks and provide an example to each. How do we measure these risks?

C: A: indicates the relative volume of the problem loans & loan losses.

What are the principal sources of risk facing a bank manager?

Capital adequacy Asset quality Management quality Earnings quality Liquidity Sensitivity to market risk

What are the primary sources of noninterest income for both a small community bank and a large bank with many subsidiaries and global operations?

Community bank...........................Large banks 1. deposit fees..................................deposit fees 2. mortgage fees.............................mortgage servicing fees 3. investment product fees.........investment banking fees 4. trust fees.........................................trading profits 5. commissions and fees..............asset management fees 6. credit card fees 7. fees from insurance produces

What are the primary sources of risk that depository institution managers face? Described how each risk type potentially affects performance

Credit risk is the risk of defaulting on debt repayments. It may have an adverse effect on future cash flows and could result in disrupting the future growth of the firm. It can be measured by the net losses to total loans ratio. Liquidity risk is the risk that arises when a bank does not have enough cash to meet its requirement or clear obligations on a timely basis and in a cost-effective manner. It arises when banks lock sources of internal cash or when the bank cannot predict the money withdrawal or loan demand. It can be measured with loans to total deposits ratio. Market risk is the risk That can arise due to changes in markets. Institutions do not have control over these risk. These risks may arise due to changes in interest rates, changes in security prices, changes in foreign exchange rates, natural disasters, recessions, and more. It can be measured using the net position to total assets ratio. Operational risk is the risk that arises due to any internal activity or operation of a firm. Failure of a system or equipment along with any human error can result in operational risk. They can be measured by loans per employee ratio. Legal & reputation risk Lego Rescue negatively affect the condition, profitability, operations, and solvency of the institution. This occurs due to lawsuits, contrary judgments and unenforceable contracts. Reputation risk is due to negative publicity whether it is true or false that adversely affects the goodwill of the bank. This negatively affects the probability of a bank. Reputation risk is intangible in nature so it is difficult to measure. Capital or solvency risk is affected by all other types of risk. A bank is stated to be insolvent when it has negative net worth. It can be measured through total bank capital and minority interest to total assets ratio.

Bank L operates with an equity-to-asset ratio of 6 percent, while Bank S operates with a similar ration of 10 percent. Calculate the equity multiplier for each bank and the corresponding return on equity if each bank earns 1.5 percent on assets. Suppose, instead, that both banks report a ROA of 1.2 percent. What does this suggest about financial leverage?

EM L: 16.67 (1/0.06) S: 10 (1/0.1) ROE L: (16.67*1.5) S: (10*1.5) An ROA of 1.2% is very low and suggests that both banks are not using the amount raised through debts very effectively. Bank bank's ROE is high. This is due to the fact that the equity capital is very low.

If regulators raise average capital from 10% to 20%, what are the implications for risk, profits, balance sheet, operations, economy, etc.? (picture question)

Higher capital requirements increase banks' funding costs. This incentivizes banks to take less risk. The cost of loans to the public and depositors will rise. Depositors' rate of interest for savings will decrease, and stockholders return on the investment will also decrease. Since there will be less currency in the market, inflation rates will fall. Less risk less fin. leverage more liquidity mkt could lower the value of capital stock price will go down if ROA is less than 2% which would lower the capital/asset ratio WACC will rise if ROE>return of debt

Describe why the efficiency ratio is a meaningful measure of cost control.

The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities internally. It tracks and analyzes the performance of commercial and investment banks. The efficiency ratio is the noninterest expenditure divided by the sum total of noninterest & net interest income. It measures the costs in overhead for generating $1 of revenue. A smaller ratio shows that a bank is more proficient since it takes less overhead to produce $1 of revenue.

Depository institutions typically differentiate between interest and non-interest income and expense. What are the primary components of each? Define net interest income (NIM) and burden. What does a bank's efficiency ratio measure?

The efficiency ratio measures a bank's ability to control non-interest expense. NIM is the difference between gross interest income and gross interest expense. Interest income: Sum of interest and fees earned on all of a bank's assets, including loans, deposits held at other institutions,municipal and taxable securities, and trading account securities. CD Money market funds Bank deposits Loans to customers Burden is non-interest expense minus non-interest income. Non-interest income: Income from products and services offered by a financial institution that is not earnings from lending activities. Annual credit cards fees Account maintenance fees Insufficient funds fees Loan processing fees

What impact will online brokerages have on traditional commercial banks?

There has been an increasing growth in popularity of the online banking accounts as it represents a substitute delivery means for banking services. Due to demand from clients, markets are moving from traditional form towards online form. Most banks will have to offer access to banking services over the internet in order to hold on to their clients. The banks can offer online brokerage accounts depending on the benefits and costs to the clients of the banks.