TUTORIAL 8

BANKS AND MANAGEMENT

I. Review questions
1. What are uses of funds and sources of funds for a bank?
2. How does a bank make profit?
3. What are the major aspects of bank management?
4. How can a bank manage credit risks?
5. How can a bank manage interest rate risks?

II. Multiple-choice questions

1. The fundamental balance sheet identity is:
A. Total assets = total liabilities + capital
B. total assets + capital = total liabilities
C. Total assets = total liabilities
D. total assets = total liabilities – capital

2. The largest bank asset is

A. Securities
B. Loans
C. Physical Assets
D. Reserves

3. The largest bank liability is

A. non-transaction deposits (saving and time deposit)
B. government bonds
C. borrowing
D. checkable deposits

4. Short-term security holdings by banks are often referred to as:

A. secondary reserves
B. required reserves
C. excess reserves
D. total reserves

5. For bank A, a deposit of $100 (in cash or currency) in a checking account will:
A. increase the money supply by $100.
B. reduce the money supply by $100.
C. increase both reserves and checkable deposits by $100.
D. reduce both reserves and checkable deposits by $100.

6. If a bank gains $100 of reserves and $100 of checkable deposits, and the reserve
requirement ratio is 15%, then the bank will:
A. gain $85 of excess reserves.
 B. gain $15 of excess reserves.
C. gain $85 of required reserves.
D. gain $100 of excess reserves.

7. If a bank is short of required reserves, it may:

A. borrow from the Fed at the Fed Funds rate.
B. increase loans.
C. increase security holdings.
D. borrow from the Fed at the current discount rate.

8. If a bank sells $100 of securities, it will:

A. gain $100 of bank capital.
B. gain $100 of savings accounts.
C. gain $100 of loans.
D. gain $100 of reserves.

9. When a bank purchases an earning asset (security or loan) it will:

A. lose reserves.
B. increase reserves.
C. increase savings accounts.
D. gain bank capital.

10. Return on Assets (ROA) is defined as:

A. net profit before taxes/assets.
B. net profit before taxes/liabilities.
C. net profit after taxes/assets.
D. net profit after taxes/liabilities.

11. What do banks count as reserves?

A. Capital and deposits at the Fed
B. Vault cash and deposits at the Fed
C. Deposits at other banks and cash items in process of collection
D. Vault cash and U.S. government securities

12. Acquiring funds at low cost is the main concern of ________ management
A. liquidity
B. capital
C. liability
D. asset

13. To manage credit risk, financial intermediaries can:

A. Require collateral and compensating balances.
B. Screen and monitor customers.
C. Develop long term relationships with customers
D. All of the above

14. In "gap analysis," the gap is the difference between a bank's:

A. long-term securities and short-term securities.
 B. assets and liabilities.
C. rate-sensitive assets and rate-sensitive liabilities.
D. deposits and loans.

15. Off-balance sheet activities include all of the following except:

A. Secondary loan participation
B. Short term loans
C. Speculation in the futures markets
D. Loan commitment fees

III. Practice exercises

Questions taken and adapted from chapter 9 (Mishkin, 2019)

1. Suppose your bank has the following balance sheet:

If the required reserve ratio is 10%, what actions should the bank manager take if there is
an unexpected deposit outflow of $50 million?

New RR = 10%*150m = $15m > TR = 0

 Acquire additional 15m reserves
1. Borrowing from other banks

Assets Liabilities
Reserves $15m CD $150m
Securities $50m Borrowing from other banks $15m
Loans $150m Bank capital $50m
2. Selling securities

Assets Liabilities
Reserves $15m CD $150m
Securities $50m – 15m = 35m Bank capital $50m
Loans $150m
3. Borrow from the central bank
Assets Liabilities
Reserves $15m CD $150m
Securities $50m Borrowing from central bank $15m
Loans $150m Bank capital $50m
 4. Calling in/selling off loans
Assets Liabilities
Reserves $15m CD $150m
Securities $50m Bank capital $50m
Loans $150m – 15m = 135m

2. Suppose your bank has the following balance sheet:

What would happen to bank profits if the interest rates in the economy go down by 1%?
What actions could you take to reduce the bank’s interest-rate risk?
ANSWER:
If interest rate in the economy go down by 1% -> GAP = 100-75=25 ->
change in Net interest income -> Decrease
Change in NII= 25.-1%=-0.25
bank may need to :
- Make Gap = 0 by reducing RSA or increase RSL
- Use option or swap derivative

3. If a bank finds that its ROE is too low because it has too much bank capital, what can it
do to raise its ROE?
=> The bank can sell part of its holdings of securities and hold more excess reserves

4. If a bank doubles the amount of its capital and ROA stays constant, what will happen
to ROE?
=> if the bank doubles its capital with a constant roa then roe will become half of what it
was before because the return on the asset stay constant, however the actual amount of
asset is double therefore leaving roe to be cut in half

5. If you are a banker and expect interest rates to rise in the future, would you
prefer to make short-term loans or long-term loans?

6. Using the T-accounts of the First National Bank and the Second National Bank given
in this chapter, describe what happens when Jane Brown writes a check for $90
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.
First national bank
RR -90 CD -90
SECOND NATIONAL BANK
RR +90 CD +90

7. Suppose you are the manager of a bank that has $15 million of fixed-rate assets, $30
million of ratesensitive assets, $25 million of fixed-rate liabilities, and $20 million of
rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen
to bank profits if interest rates rise by 5 percentage points. What actions could you take to
reduce the bank’s interest-rate risk?
The gap can be calculate:
GAP = RSA – RSL = 30 – 20 = 10
The change in bank profit if interest rates rise by 5% point = 5% x 10 = 0.5
To reducing the bank’s interest-rate risk by increasing RSL or decreasing RSA

8. A commercial bank has mixed up the assets and liabilities items as follows: (in $’m)
Checkable deposits 80
Deposit with central bank 20
Cash on hand 20
Savings 120
Long-term loan to customer 150
Security (fixed rate) 80
Capital 120
Other assets 35
Borrowing from other bank 80
Time deposits 150
Short-term loan to customer 120
Deposit with other bank 65
Security (floating rate) 60

a) Rearrange the above items into a balance sheet of the bank

Asset Liabilities
Cash on hand 20 CD 80
Deposit with 20 Savings 120
central bank
Long-term loan to 150 Borrowing from 80
customer other bank
Security 80 capital 120
Short-term loan to 120 Time deposit 150
customer
Deposit with other 65
bank
Security (floating 60
rate)
Other asset 35
 total 550 total 550

b) If the required reserve ratio is 10% for checkable deposit and 5% for saving
deposits and time deposits, does the bank hold any excess reserves? If yes, how
much are they? What is the meaning of these excess reserves?
ER=TR-RR
TR = cash on hand + deposit with central bank = 20+20=40
RR = 10%*80 +5%*(120+150) = $21.5m
 ER = 40 -21.5 =18.5m
c) If customers withdraw 10m from checkable deposits and 20m from saving
accounts:
 What will the bank’s balance sheet be? Using T-account
Asset Liabilities
Cash on hand 20 -20=0 CD 80 -10 = 70
Deposit with 20 -10 =10 Savings 120 – 20 =100
central bank
Long-term loan to 150 Borrowing from 80
customer other bank
Security 80 capital 120
Short-term loan to 120 Time deposit 150
customer
Deposit with other 65
bank
Security (floating 60
rate)
Other asset 35
total 550 total 550

 What is the problem of this new balance sheet?

 How can the bank do to solve this problem?
New rr = 10% CD + 5% (SV+TD) = 19.5
TR = 10
 SHORT FALL
 RAISE additional reserves of 9.5m
Borrow from other bank
Reduce loan
Sell securities
Borrow from fed
d) Refer to the B/S of the bank in (1), the following information is provided:
 Short-term loan includes 40% fixed rate loan.
 Long-term loan is floating rate loan
 Borrowing from other banks are fixed rate loan
 Time deposits include 60% floating rate.
You are required to analyze the interest rate risks of the bank and options to avoid the
risks.