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Answers to Review Questions (MCQ only) are Highlighted in Red

1. Which of the following statements is FALSE?
a. A financial intermediary specializes in the production of information.
b. A financial intermediary reduces its risk exposure by pooling its assets.
c. A financial intermediary benefits society by providing a mechanism for payments.
d. A financial intermediary may act as a broker to bring together funds deficit and funds surplus
e. A financial intermediary acts as a lender of last resort.
2. In its role as a delegated monitor, a bank:
a. keeps track of required interest and principal payments on loans it originates.
b. works with financially distressed borrowers in danger of defaulting on their loans.
c. holds portfolios of loans that they continue to service.
d. maintains contact with borrowers to ensure that loan proceeds are utilized for intended purposes.
e. all of the above.
3. The reason financial institutions can offer highly liquid, low price-risk contracts to savers while
investing in relatively illiquid and higher risk assets is:
a. because diversification allows a bank to predict more accurately the expected returns on its asset
b. significant amounts of portfolio risk are diversified away by investing in assets that have
correlations between returns that are less than perfectly positive.
c. because individual savers cannot benefit from risk diversification.
d. because FIs have a cost advantage in monitoring their portfolios.
e. all of the above.
4. Which of the following refers to the term "maturity intermediation"?
a. Creation of a secondary market mature enough to withstand volatility.
b. Overcoming constraints to buying assets imposed by large minimum denomination size.
c. Mismatching the maturities of assets and liabilities.
d. Reducing information costs or imperfections between households and corporations.
e. The transfer of wealth from one generation to the next.
5. Why do households prefer to use banks as intermediaries to invest their surplus funds?
a. Transaction costs are low to the household since banks are more efficient in monitoring and
gathering investment information.
b. To receive the benefits of diversification that households may not be able to achieve on their
c. The bank can benefit from combining funds, negotiating lower asset prices and transactions
d. all of the above.
e. None of the above.
6. Which of the following statements does not reflect a borrower-specific factor often used in qualitative
default risk models?
a. Reputation is an implicit contract regarding borrowing and repayment that extends beyond the
formal explicit legal contract.
b. A borrower’s leverage ratio is positively related to the probability of default over all levels of
c. Firms with high earnings variance are less attractive credit risks than those firms
that have a
history of stable earnings.
d. Loans can be collateralized or uncollateralized.
e. None of the above.

c. Liquidity planning primarily is designed to assist management in dealing with relatively predictable events. d. e. d. Liquidity planning should identify the size of potential deposit withdrawals over various time horizons in the future. c. b. 8. Long-term loans are more likely to be made under a loan commitment agreement than shortterm loans. a & b only e. Analyzing historic or past default risk experience. Consumers may increase their loans and pay off the loans over an indefinite period of time. All of the above f. A liquidity plan for a bank should provide a detailed list of fund providers who are most likely to withdraw in the case of a liquidity crisis. e. both foreign and domestic. Many consumer loans are open-end (no maturity) lines of credit. d. Which of the following statement is TRUE with regard to below-prime market pricing ? a. What is the essential idea behind RAROC? a. None of the above. Cost-plus loan pricing method considers that lenders today are multiproduct businesses that often have difficulty in allocating operating costs among many different services they offer. All of the above e. b. c. Dividing net interest and fees by the amount lent. Most consumer loans are for relatively small amounts b. d.7. c. Which of the following statement(s) is FALSE? a. d. It works well for large well-known corporations. Cost-plus loan pricing method takes into consideration that competition impacts a lender’s desired profit margin. b. Which of the following statement (s) is true? a. Consumer loans differ from commercial and real estate loans in several respects: a. Default by a large corporation is seldom a problem for banks since these corporations have many different sources of borrowed funds c. None of the above . d. a & c only e. Most consumer loans are not secured by collateral c. b. The amount of security or collateral on a loan and the interest rate or risk premium on a loan normally are negatively related. e. LIBOR offers a common pricing standard for all banks. It is a short term loan rate below the posted prime rate. 11. This pricing method fails to cover risk exposure and profit margin. None of the above 12. Balancing expected interest and fee income less the cost of funds against the loan’s expected risk. A borrower’s reputation is an example of a market-specific factor in the credit decision. Extracting expected default rates from the current term structure of interest rates. None of the above 9. Which of the following statement is TRUE? a. b. None of the above 10. Evaluating the actual or contractually promised annual ROA on a loan.

there will be no effect on the balance sheet. the accessibility of international money markets. there will be no effect on the balance sheet. Which of the following is NOT a primary source of liquidity? a. b. 14. The liability side of its balance sheet is decreasing. b. None of the above 18. c. the resulting shrinkage of the bank’s balance sheet. Net positive drain on deposits. Which of the following is a condition for a bank to be growing? a. 15. a and b only e. Borrowings in the purchased funds market. e. If purchased liquidity is used by a bank to fund an exercised loan commitment: a. A disadvantage of using asset management to manage a bank's liquidity risk is: a. 17. Bank relies heavily on the short-term money market to fund loans. e. If purchased liquidity is used by a DI to fund an exercised loan commitment a. c. only the liability side of the balance sheet will increase. Excess cash reserves over and above regulatory reserve requirements. b. e. only the liability side of the balance sheet will increase. loss of flexibility as a result of dependence upon purchased liabilities. the balance sheet will decrease by the amount of the new loan. b. When banks use stored liquidity management. 16.13. Capital notes and other long-term financing alternatives. threaten the capital position of the institution. Bank has large amounts of asset-side liquidity. Average deposit drain such that new deposit funds more than offset deposit withdrawals. Liquidity concerns are at a bare minimum for the bank. 19. the balance sheet will decrease by the amount of the new loan. d. d. None of the above. d. they a. the high cost of purchased liabilities. e. only the asset side of the balance sheet will increase. may shrink the balance sheet if cash is used as the liquidity adjustment mechanism. must pay interest on the funds that are stored. None of the above. Cash-type assets that can be sold with little price risk and low transaction costs. b. Unused loan commitments is increasing. None of the above . e. d. Borrowings in the money market. necessarily increase the asset side of the balance sheet. d. What does a high ratio of loans to deposits indicate? a. d. c. c. b. d. only the asset side of the balance sheet will increase. the balance sheet will increase by the amount of the new loan. c. b. e. c. c. the balance sheet will increase by the amount of the new loan.

22. c and d only. d. as opposed to the least cost amount.20. d. c. floors. c. Interest rate swaps. c. risk-free assets and liabilities. 23. d. Regulators are interested in making sure that banks carry an adequate quantity of liquidity. items omitted from the short form balance sheet. are insurance against the frequency or severity of some particular future occurrence. Crisis liquidity is the ability of the bank to sustain itself when under financial distress due to abnormal losses on loans . All of the above. e. Interest rate caps. c. Ranges in maturity from a few days to a few weeks. are standardized contract guaranteed by organized exchanges to deliver and pay for an asset in the future. e. contingent assets and liabilities. Financial futures contracts. b. 24. b. d. d. Interest rate hedging devices used by banks today include which of the following: a. e. APRA supervises bank liquidity. b and c only. b. b. exceptionally risky assets and liabilities. b and c only. A quality swap e. are non-standard contracts between two parties to deliver and pay for an asset in the future. A way to transform actual cash flows through the bank to more closely match desired cash flow patterns. An interest rate swap b. A way to convert from fixed rates to floating rates. e. A currency swap c. If the ratio of liquid assets and liabilities in period t divided by estimated liquidity needs in period t is between zero and 1. A way to achieve lower borrowing costs. 21. An interest rate collar: a. Off-balance-sheet items are: a. A swaption d. All of the above. and collars. 25. are contractual commitments to make a loan up to a stated amount at a given interest rate in the future. A way to change a bank's exposure to interest rate fluctuations. b. Which of the following statement(s) is true? a. c. d. . the LCs and SLCs sold by financial institutions: a. c. Combines a rate floor and a rate cap into one agreement. e. there will not be a problem with bank liquidity. Protects a lender from rising interest rates. All of the above. a. b. foreign (off-shore) assets and liabilities. In economic terms. None of the above 26. An agreement where two parties agree to exchange different currencies is known as: a. An interest rate swap is: a.

All of the above 31. EPS will fall. compensation are all tools to maintain and increase employee motivation and job satisfaction. b. Latest technology to the public is to improve the competitiveness of the bank. c. c. b. Public confidence is necessary to maintain bank solvency. training. None of the above 32. b. EVA is a measure of the value added in any given period by a bank’s operations in excess of the cost of capital used in those operations. Has a small amount of financial leverage c. d. Which of the following statement (s) is true? a. e. Failure to comply will prompt some form of supervisory action. c. What type of risk is Forrest attempting to measure with these ratios? a. a. Job enrichment programs. None of the above 28. Bank planning: a. A high P/E ratio indicates that investors are confident about the future growth and profitability of the bank. All of the above e. He is examining certain ratios of the bank including the ratio of non-performing loans to total loans and leases and the provision for loan losses to total loans and leases.27. Banks generally must seek to maximize profits subject to meeting regulatory requirements. b. c. or by lowering the equity allocated to the investment. Which following statement(s) is true? a. A bank that has a high asset utilization (AU) ratio most likely: a. None of the above . If growth in assets is not matched in earnings. Market risk d. A critical step in applying RAROC is determining the capital at risk. they can be translated into specific. Interest rate risk e. e. In evaluating external bank performance. Once the objectives of the bank are developed. d. Increased growth can also lead to increased risk and a subsequent loss of shareholder value. Is allocating assets to the most productive investments e. d. quantifiable goals. Liquidity risk c. Other bank objectives facilitate this result. A higher EVA can be achieved by boosting adjusted earnings. Operational risk 29. Budgets and strategic planning are key tools in overall bank planning d. which following statement(s) is FALSE? a. Is doing a poor job of controlling expenses b. Credit risk b. b & c e. None of the above 30. ultimate objective of the bank is the maximization of owners’ equity. Forrest Fennell is thinking about investing in Capital City Bank. Has a small amount of liquidity risk d. lowering the cost of equity.

c. Competitive pressures facing banks to reduce loan pricing b. All of the above . Change in the mix of liabilities. e. c. All of the above e. c. None of the above 35. None of the above 34. the bank has a mix of interest bearing sources that is heavily weighted toward cheaper sources. d.33. b. e. c. Factors that can affect profit margin adversely: a. b. d. for each interest bearing source the bank pays a lower rate. Funds are more expensive in international whole sale market where large banks are inactive. Bank manager will usually attempt to expand fee income. d. Change in the mix of assets. The earnings spread measures the effectiveness of the bank's intermediation function of borrowing and lending money. b. all of the above 37. A decrease in whole sale rates. There are no differences in volumes. d. where there is strong growth in lower margin products. the bank has more of its assets funded with noninterest bearing sources of funds such as demand deposits and equity. b. short-term opportunities can be accepted with RAROC even though this rate of return is below the long-term cost of capital c. non-interest margin and earnings spread? a. Like RAROC. NIM and bank size varies inversely because: a. d. All of the above. perhaps because it is less risky. Give three explanations for a bank having a lower ratio of interest expenses to total assets than its peers? a. Larger banks use greater amounts deposits compared to smaller banks. Larger banks tend to have more fixed-rate loans compared to smaller banks. 36. mixes and pricing between small and large banks. A declining NIM is undesirable because the bank's interest spread is being squeezed. such as core deposits. Why do the managers of financial firms often pay close attention today to the net interest margin. while controlling closely the growth of non-interest expenses in order to make a negative non-interest margin less negative. Investment opportunities must earn returns that exceed the cost of capital in the long-term as suggested by EVA. Which statement (s) is FALSE? a. EVA is beneficial is assessing managerial performance and developing incentive compensation schemes compatible with shareholder wealth goals. or it may simply have less need for funds.