The share of checkable deposits in total bank liabilities has

1. A) expanded moderately over time.
2. B) expanded dramatically over time.
3. C) shrunk over time.
4. D) remained virtually unchanged since 1960.

Answer: C

Which of the following statements is FALSE?

1. A) Checkable deposits are usually the lowest cost source of bank funds.
2. B) Checkable deposits are the primary source of bank funds.
3. C) Checkable deposits are payable on demand.
4. D) Checkable deposits include NOW accounts.

Answer: B

In recent years the interest paid on checkable and nontransaction deposits has accounted for around ________ of total bank operating expenses, while the costs involved in servicing accounts have been approximately ________ of operating expenses.

1. A) 45 percent; 55 percent
2. B) 55 percent; 4 percent
3. C) 25 percent; 50 percent
4. D) 50 percent; 30 percent

Answer: C

Which of the following statements are TRUE?

1. A) Checkable deposits are payable on demand.
2. B) Checkable deposits do not include NOW accounts.
3. C) Checkable deposits are the primary source of bank funds.
4. D) Checkable deposits are assets for the bank.

Answer: A

Because checking accounts are ________ liquid for the depositor than savings accounts, they earn ________ interest rates.

1. A) less; higher
2. B) less; lower
3. C) more; higher
4. D) more; lower

Answer: D

Which of the following are transaction deposits?

1. A) savings accounts
2. B) small-denomination time deposits
3. C) checkable deposits
4. D) certificates of deposit

Answer: C

All of the following are nontransaction deposits EXCEPT

1. A) savings accounts.
2. B) small-denomination time deposits.
3. C) checkable deposits.
4. D) certificates of deposit.

Answer: C

Large-denomination CDs are ________, so that like a bond they can be resold in a ________ market before they mature.

1. A) nonnegotiable; secondary
2. B) nonnegotiable; primary
3. C) negotiable; secondary
4. D) negotiable; primary

Answer: C

Because ________ are less liquid for the depositor than ________, they earn higher interest rates.

1. A) money market deposit accounts; time deposits
2. B) checkable deposits; savings accounts
3. C) savings accounts; checkable deposits
4. D) savings accounts; time deposits

Answer: C

Because ________ are less liquid for the depositor than ________, they earn higher interest rates.

1. A) savings accounts; time deposits
2. B) money market deposit accounts; time deposits
3. C) money market deposit accounts; savings accounts
4. D) time deposits; savings accounts

Answer: D

Banks acquire the funds that they use to purchase income-earning assets from such sources as

1. A) cash items in the process of collection.
2. B) savings accounts.
3. C) reserves.
4. D) deposits at other banks.

Answer: B

Bank loans from the Federal Reserve are called ________ and represent a ________ of funds.

1. A) discount loans; use
2. B) discount loans; source
3. C) fed funds; use
4. D) fed funds; source

Answer: B

Which of the following is NOT a source of borrowings for a bank?

1. A) federal funds
2. B) Eurodollars
3. C) transaction deposits
4. D) discount loans

Answer: C

Bank capital is equal to ________ minus ________.

1. A) total assets; total liabilities
2. B) total liabilities; total assets
3. C) total assets; total reserves
4. D) total liabilities; total borrowings

Answer: A

Bank ________ is/are listed on the liability side of the bank's balance sheet.

1. A) reserves
2. B) capital
3. C) securities
4. D) cash items

Answer: B

Bank reserves include

1. A) deposits at the Fed and short-term treasury securities.
2. B) vault cash and short-term Treasury securities.
3. C) vault cash and deposits at the Fed.
4. D) deposits at other banks and deposits at the Fed.

Answer: C

The amount of checkable deposits that banks are required by regulation to hold are the

1. A) excess reserves.
2. B) required reserves.
3. C) vault cash.
4. D) total reserves.

Answer: B

Which of the following are reported as assets on a bank's balance sheet?

1. A) borrowings
2. B) reserves
3. C) savings deposits
4. D) bank capital

Answer: B

Which of the following are NOT reported as assets on a bank's balance sheet?

1. A) cash items in the process of collection
2. B) deposits with other banks
3. C) U.S. Treasury securities
4. D) checkable deposits

Answer: D

Through correspondent banking, large banks provide services to small banks, including

1. A) loan guarantees.
2. B) foreign exchange transactions.
3. C) issuing stock.
4. D) debt reduction.

Answer: B

The largest percentage of banks' holdings of securities consist of

1. A) Treasury and government agency securities.
2. B) tax-exempt municipal securities.
3. C) state and local government securities.
4. D) corporate securities.

Answer: A

Which of the following bank assets is the most liquid?

1. A) consumer loans
2. B) reserves
3. C) state and local government securities
4. D) U.S. government securities

Answer: B

Secondary reserves include

1. A) deposits at Federal Reserve Banks.
2. B) deposits at other large banks.
3. C) short-term U.S. government securities.
4. D) state and local government securities.

Answer: C

Because of their ________ liquidity, ________ U.S. government securities are called secondary reserves.

1. A) low; short-term
2. B) low; long-term
3. C) high; short-term
4. D) high; long-term

Answer: C

Secondary reserves are so called because

1. A) they can be converted into cash with low transactions costs.
2. B) they are not easily converted into cash, and are, therefore, of secondary importance to banking firms.
3. C) 50% of these assets count toward meeting required reserves.
4. D) they rank second to bank vault cash in importance of bank holdings.

Answer: A

Banks' asset portfolios include state and local government securities because

1. A) they help to attract business from these government entities.
2. B) banks consider them helpful in attracting accounts of Federal employees.
3. C) the Federal Reserve requires member banks to buy securities from state and local governments located within their respective Federal Reserve districts.
4. D) there is no default-risk with state and local government securities.

Answer: A

Bank's make their profits primarily by issuing

1. A) equity.
2. B) negotiable CDs.
3. C) loans.
4. D) NOW accounts.

Answer: C

The most important category of assets on a bank's balance sheet is

1. A) other assets.
2. B) securities.
3. C) loans.
4. D) cash items in the process of collection.

Answer: C

Which of the following are bank assets?

1. A) the building owned by the bank
2. B) a discount loan
3. C) a negotiable CD
4. D) a customer's checking account

Answer: A

Banks may borrow from or lend to another bank in the Federal Funds market. A loan of excess reserves from one bank to another bank is recorded as a(n) ________ for the borrowing bank and a(n) ________ for the lending bank.

1. A) asset; asset
2. B) asset; liability
3. C) liability; liability
4. D) liability; asset

Answer: D

Banks earn profits by selling ________ with attractive combinations of liquidity, risk, and return, and using the proceeds to buy ________ with a different set of characteristics.

1. A) loans; deposits
2. B) securities; deposits
3. C) liabilities; assets
4. D) assets; liabilities

Answer: C

In general, banks make profits by selling ________ liabilities and buying ________ assets.

1. A) long-term; shorter-term
2. B) short-term; longer-term
3. C) illiquid; liquid
4. D) risky; risk-free

Answer: B

Asset transformation can be described as

1. A) borrowing long and lending short.
2. B) borrowing short and lending long.
3. C) borrowing and lending only for the short term.
4. D) borrowing and lending for the long term.

Answer: B

When a new depositor opens a checking account at the First National Bank, the bank's assets ________ and its liabilities ________.

1. A) increase; increase
2. B) increase; decrease
3. C) decrease; increase
4. D) decrease; decrease

Answer: A

When Jane Brown writes a $100 check to her nephew and he cashes the check, Ms. Brown's bank ________ assets of $100 and ________ liabilities of $100.

1. A) gains; gains
2. B) gains; loses
3. C) loses; gains
4. D) loses; loses

Answer: D

When you deposit a $50 bill in the Security Pacific National Bank

1. A) its liabilities decrease by $50.
2. B) its assets increase by $50.
3. C) its reserves decrease by $50.
4. D) its cash items in the process of collection increase by $50.

Answer: B

When you deposit $50 in currency at Old National Bank

1. A) its assets increase by less than $50 because of reserve requirements.
2. B) its reserves increase by less than $50 because of reserve requirements.
3. C) its liabilities increase by $50.
4. D) its liabilities decrease by $50.

Answer: C

Holding all else constant, when a bank receives the funds for a deposited check

1. A) cash items in the process of collection fall by the amount of the check.
2. B) bank assets increase by the amount of the check.
3. C) bank liabilities decrease by the amount of the check.
4. D) bank reserves increase by the amount of required reserves.

Answer: A

When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then

1. A) the liabilities of the First National Bank increase by $10.
2. B) the reserves of the First National Bank increase by $ 10.
3. C) the liabilities of Citibank increase by $10.
4. D) the assets of Citibank fall by $10.

Answer: C

When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then

1. A) the liabilities of the First National Bank decrease by $10.
2. B) the reserves of the First National Bank increase by $10.
3. C) the liabilities of Citibank decrease by $10.
4. D) the assets of Citibank decrease by $10.

Answer: A

When you deposit $50 in your account at First National Bank and a $100 check you have written on this account is cashed at Chemical Bank, then

1. A) the assets of First National rise by $50.
2. B) the assets of Chemical Bank rise by $50.
3. C) the reserves at First National fall by $50.
4. D) the liabilities at Chemical Bank rise by $50.

Answer: C

When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to hold any excess reserves but makes loans instead, then, in the bank's final balance sheet

1. A) the assets at the bank increase by $800,000.
2. B) the liabilities of the bank increase by $1,000,000.
3. C) the liabilities of the bank increase by $800,000.
4. D) reserves increase by $160,000.

Answer: B

When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to make any loans but to hold excess reserves instead, then, in the bank's final balance sheet

1. A) the assets at the bank increase by $1 million.
2. B) the liabilities of the bank decrease by $1 million.
3. C) reserves increase by $200,000.
4. D) liabilities increase by $200,000.

Answer: A

With a 10% reserve requirement ratio, a $100 deposit into New Bank means that the maximum amount New Bank could lend is

1. A) $90.
2. B) $100.
3. C) $10.
4. D) $110.

Answer: A

A deposit outflow results in equal reductions in

1. A) loans and reserves.
2. B) assets and liabilities.
3. C) reserves and capital.
4. D) assets and capital.

Answer: B

A $100 deposit into my checking account at My Bank increases my checkable deposits by $100, and the bank's ________ by $100.

1. A) reserves
2. B) loans
3. C) capital
4. D) securities

Answer: A

Using T-accounts show what happens to reserves at Security National Bank if one individual deposits $1000 in cash into her checking account and another individual withdraws $750 in cash from her checking account.

Answer: Security National Bank

Assets Liabilities

Reserves +$250 Checkable deposits +$250

Which of the following are primary concerns of the bank manager?

1. A) maintaining sufficient reserves to minimize the cost to the bank of deposit outflows
2. B) extending loans to borrowers who will pay low interest rates, but who are poor credit risks
3. C) acquiring funds at a relatively high cost, so that profitable lending opportunities can be realized
4. D) maintaining high levels of capital and thus maximizing the returns to the owners

Answer: A

If a bank has $100,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $40,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is

1. A) $30,000.
2. B) $25,000.
3. C) $20,000.
4. D) $10,000.

Answer: B

If a bank has $200,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $80,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is

1. A) $50,000.
2. B) $40,000.
3. C) $30,000.
4. D) $25,000.

Answer: A

If a bank has $10 million of checkable deposits, a required reserve ratio of 10 percent, and it holds $2 million in reserves, then it will not have enough reserves to support a deposit outflow of

1. A) $1.2 million.
2. B) $1.1 million.
3. C) $1 million.
4. D) $900,000.

Answer: A

If a bank has excess reserves greater than the amount of a deposit outflow, the outflow will result in equal reductions in

1. A) deposits and reserves.
2. B) deposits and loans.
3. C) capital and reserves.
4. D) capital and loans.

Answer: A

A $5 million deposit outflow from a bank has the immediate effect of

1. A) reducing deposits and reserves by $5 million.
2. B) reducing deposits and loans by $5 million.
3. C) reducing deposits and securities by $5 million.
4. D) reducing deposits and capital by $5 million.

Answer: A

Bankers' concerns 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

1. A) liability management.
2. B) liquidity management.
3. C) managing interest rate risk.
4. D) managing credit risk.

Answer: B

If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can

1. A) reduce deposits by $3 million.
2. B) increase loans by $3 million.
3. C) sell $3 million of securities.
4. D) repay its discount loans from the Fed.

Answer: C

A bank with insufficient reserves can increase its reserves by

1. A) lending federal funds.
2. B) calling in loans.
3. C) buying short-term Treasury securities.
4. D) buying municipal bonds.

Answer: B

Of the following, which would be the last choice for a bank facing a reserve deficiency?

1. A) Call in loans.
2. B) Borrow from the Fed.
3. C) Sell securities.
4. D) Borrow from other banks.

Answer: A

In general, banks would prefer to acquire funds quickly by ________ rather than ________.

1. A) reducing loans; selling securities
2. B) reducing loans; borrowing from the Fed
3. C) borrowing from the Fed; reducing loans
4. D) "calling in" loans; selling securities

Answer: C

________ may antagonize customers and thus can be a very costly way of acquiring funds to meet an unexpected deposit outflow.

1. A) Selling securities
2. B) Selling loans
3. C) Calling in loans
4. D) Selling negotiable CDs

Answer: C

Banks hold excess and secondary reserves to

1. A) reduce the interest-rate risk problem.
2. B) provide for unexpected deposit outflows.
3. C) satisfy margin requirements.
4. D) achieve higher earnings than they can with loans.

Answer: B

If a bank needs to acquire funds quickly to meet an unexpected deposit outflow, the bank could

1. A) borrow from another bank in the federal funds market.
2. B) buy U.S. Treasury bills.
3. C) increase loans.
4. D) buy corporate bonds.

Answer: A

Which of the following statements most accurately describes the task of bank asset management?

1. A) Banks seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity.
2. B) Banks seek to have the highest liquidity possible subject to earning a positive rate of return on their operations.
3. C) Banks seek to prevent bank failure at all cost; since a failed bank earns no profit, liquidity needs supersede the desire for profits.
4. D) Banks seek to acquire funds in the least costly way.

Answer: A

The goals of bank asset management include

1. A) maximizing risk.
2. B) minimizing liquidity.
3. C) lending at high interest rates regardless of risk.
4. D) purchasing securities with high returns and low risk.

Answer: D

Banks that suffered significant losses in the 1980s made the mistake of

1. A) holding too many liquid assets.
2. B) minimizing default risk.
3. C) failing to diversify their loan portfolio.
4. D) holding only safe securities.

Answer: C

A bank will want to hold more excess reserves (everything else equal) when

1. A) it expects to have deposit inflows in the near future.
2. B) brokerage commissions on selling bonds increase.
3. C) the cost of selling loans falls.
4. D) the discount rate decreases.

Answer: B

As the costs associated with deposit outflows ________, the banks willingness to hold excess reserves will ________.

1. A) decrease; increase
2. B) increase; decrease
3. C) increase; increase
4. D) decrease; not be affected

Answer: C

Which of the following would a bank NOT hold as insurance against the highest cost of deposit outflow-bank failure?

1. A) excess reserves
2. B) secondary reserves
3. C) bank capital
4. D) mortgages

Answer: D

Which of the following has NOT resulted from more active liability management on the part of banks?

1. A) increased bank holdings of cash items
2. B) aggressive targeting of goals for asset growth by banks
3. C) increased use of negotiable CDs to raise funds
4. D) an increased proportion of bank assets held in loans

Answer: A

Banks that actively manage liabilities will most likely meet a reserve shortfall by

1. A) calling in loans.
2. B) borrowing federal funds.
3. C) selling municipal bonds.
4. D) seeking new deposits.

Answer: B

Modern liability management has resulted in

1. A) increased sales of negotiable CDs to raise funds.
2. B) increase importance of deposits as a source of funds.
3. C) reduced borrowing by banks in the overnight loan market.
4. D) failure by banks to coordinate management of assets and liabilities.

Answer: A

A bank failure occurs whenever

1. A) a bank cannot satisfy its obligations to pay its depositors and other creditors.
2. B) a bank suffers a large deposit outflow.
3. C) a bank has to call in a large volume of loans.
4. D) a bank refuses to make new loans.

Answer: A

A bank is insolvent when

1. A) its liabilities exceed its assets.
2. B) its assets exceed its liabilities.
3. C) its capital exceeds its liabilities.
4. D) its assets increase in value.

Answer: A

Holding large amounts of bank capital helps prevent bank failures because

1. A) it means that the bank has a higher income.
2. B) it makes loans easier to sell.
3. C) it can be used to absorb the losses resulting from bad loans.
4. D) it makes it easier to call in loans.

Answer: C

Net profit after taxes per dollar of assets is a basic measure of bank profitability called

1. A) return on assets.
2. B) return on capital.
3. C) return on equity.
4. D) return on investment.

Answer: A

Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called

1. A) return on assets.
2. B) return on capital.
3. C) return on equity.
4. D) return on investment.

Answer: C

The amount of assets per dollar of equity capital is called the

1. A) asset ratio.
2. B) equity ratio.
3. C) equity multiplier.
4. D) asset multiplier.

Answer: C

For a given return on assets, the lower is bank capital

1. A) the lower is the return for the owners of the bank.
2. B) the higher is the return for the owners of the bank.
3. C) the lower is the credit risk for the owners of the bank.
4. D) the lower the possibility of bank failure.

Answer: B

Bank capital has both benefits and costs for the bank owners. Higher bank capital ________ the likelihood of bankruptcy, but higher bank capital ________ the return on equity for a given return on assets.

1. A) reduces; reduces
2. B) increases; increases
3. C) reduces; increases
4. D) increases; reduces

Answer: A

In the absence of regulation, banks would probably hold

1. A) too much capital, reducing the efficiency of the payments system.
2. B) too much capital, reducing the profitability of banks.
3. C) too little capital.
4. D) too much capital, making it more difficult to obtain loans.

Answer: C

Banks hold capital because

1. A) they are required to by regulatory authorities.
2. B) higher capital increases the returns to the owners.
3. C) it increases the likelihood of bankruptcy.
4. D) higher capital increases the return on equity.

Answer: A

Conditions that likely contributed to a credit crunch during the global financial crisis include

1. A) capital shortfalls caused in part by falling real estate prices.
2. B) regulated hikes in bank capital requirements.
3. C) falling interest rates that raised interest rate risk, causing banks to choose to hold more capital.
4. D) increases in reserve requirements.

Answer: A

Which of the following would NOT be a way to increase the return on equity?

1. A) Buy back bank stock.
2. B) Pay higher dividends.
3. C) Acquire new funds by selling negotiable CDs and increase assets with them.
4. D) Sell more bank stock.

Answer: D

If a bank needs to raise the amount of capital relative to assets, a bank manager might choose to

1. A) buy back bank stock.
2. B) pay higher dividends.
3. C) shrink the size of the bank.
4. D) sell securities the bank owns and put the funds into the reserve account.

Answer: C

Your bank has the following balance sheet:

Assets Liabilities

Reserves $ 50 million Checkable deposits $200 million

Securities 50 million

Loans 150 million Bank capital 50 million

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

Answer: After the deposit outflow, the bank will have a reserve shortfall of $15 million. The bank manager could try to borrow in the Federal Funds market, take out a discount loan from the Federal Reserve, sell $15 million of the securities the bank owns, sell off $15 million of the loans the bank owns, or lastly call-in $15 million of loans. All of the actions will be costly to the bank. The bank manager should try to acquire the funds with the least costly method.

Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.

1. A) adverse selection
2. B) moral hazard
3. C) moral suasion
4. D) intentional fraud

Answer: A

If borrowers with the most risky investment projects seek bank loans in higher proportion to those borrowers with the safest investment projects, banks are said to face the problem of

1. A) adverse credit risk.
2. B) adverse selection.
3. C) moral hazard.
4. D) lemon lenders.

Answer: B

Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the

1. A) adverse selection problem.
2. B) lemon problem.
3. C) adverse credit risk problem.
4. D) moral hazard problem.

Answer: D

In order to reduce the ________ problem in loan markets, bankers collect information from prospective borrowers to screen out the bad credit risks from the good ones.

1. A) moral hazard
2. B) adverse selection
3. C) moral suasion
4. D) adverse lending

Answer: B

In one sense ________ appears surprising since it means that the bank is not ________ its portfolio of loans and thus is exposing itself to more risk.

1. A) specialization in lending; diversifying
2. B) specialization in lending; rationing
3. C) credit rationing; diversifying
4. D) screening; rationing

Answer: A

From the standpoint of ________, specialization in lending is surprising but makes perfect sense when one considers the ________ problem.

1. A) moral hazard; diversification
2. B) diversification; moral hazard
3. C) adverse selection; diversification
4. D) diversification; adverse selection

Answer: D

Provisions in loan contracts that prohibit borrowers from engaging in specified risky activities are called

1. A) proscription bonds.
2. B) restrictive covenants.
3. C) due-on-sale clauses.
4. D) liens.

Answer: B

To reduce moral hazard problems, banks include restrictive covenants in loan contracts. In order for these restrictive covenants to be effective, banks must also

1. A) monitor and enforce them.
2. B) be willing to rewrite the contract if the borrower cannot comply with the restrictions.
3. C) trust the borrower to do the right thing.
4. D) be prepared to extend the deadline when the borrower needs more time to comply.

Answer: A

Long-term customer relationships ________ the cost of information collection and make it easier to ________ credit risks.

1. A) reduce; screen
2. B) increase; screen
3. C) reduce; increase
4. D) increase; increase

Answer: A

Unanticipated moral hazard contingencies can be reduced by

1. A) screening.
2. B) long-term customer relationships.
3. C) specialization in lending.
4. D) credit rationing.

Answer: B

A bank's commitment to provide a firm with loans up to pre-specified limit at an interest rate that is tied to a market interest rate is called

1. A) an adjustable gap loan.
2. B) an adjustable portfolio loan.
3. C) loan commitment.
4. D) pre-credit loan line.

Answer: C

Property promised to the lender as compensation if the borrower defaults is called

1. A) collateral.
2. B) deductibles.
3. C) restrictive covenants.
4. D) contingencies.

Answer: A

Collateral requirements lessen the consequences of ________ because the collateral reduces the lender's losses in the case of a loan default and it reduces ________ because the borrower has more to lose from a default.

1. A) adverse selection; moral hazard
2. B) moral hazard; adverse selection
3. C) adverse selection; diversification
4. D) diversification; moral hazard

Answer: A

A bank that wants to monitor the check payment practices of its commercial borrowers, so that moral hazard can be reduced, will require borrowers to

1. A) place a bank officer on their board of directors.
2. B) place a corporate officer on the bank's board of directors.
3. C) keep compensating balances in a checking account at the bank.
4. D) purchase the bank's CDs.

Answer: C

Of the following methods that banks might use to reduce moral hazard problems, the one not legally permitted in the United States is the

1. A) requirement that firms keep compensating balances at the banks from which they obtain their loans.
2. B) requirement that firms place on their board of directors an officer from the bank.
3. C) inclusion of restrictive covenants in loan contracts.
4. D) requirement that individuals provide detailed credit histories to bank loan officers.

Answer: B

When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, the bank is said to engage in

1. A) coercive bargaining.
2. B) strategic holding out.
3. C) credit rationing.
4. D) collusive behavior.

Answer: C

When banks offer borrowers smaller loans than they have requested, banks are said to

1. A) shave credit.
2. B) rediscount the loan.
3. C) raze credit.
4. D) ration credit.

Answer: D

Credit risk management tools include

1. A) deductibles.
2. B) collateral.
3. C) interest rate swaps.
4. D) duration analysis.

Answer: B

How can specializing in lending help to reduce the adverse selection problem in lending?

Answer: Reducing the adverse selection problem requires the banks to acquire information to screen bad credit risks from good credit risks. It is easier for banks to obtain information about local businesses. Also if the bank lends to firms in a few specific industries they will become more knowledgeable about those industries and a better judge of creditworthiness in those industries.

Risk that is related to the uncertainty about interest rate movements is called

1. A) default risk.
2. B) interest-rate risk.
3. C) the problem of moral hazard.
4. D) security risk.

Answer: B

All else the same, if a bank's liabilities are more sensitive to interest rate fluctuations than are its assets, then ________ in interest rates will ________ bank profits.

1. A) an increase; increase
2. B) an increase; reduce
3. C) a decline; reduce
4. D) a decline; not affect

Answer: B

If a bank has ________ rate-sensitive assets than liabilities, then ________ in interest rates will increase bank profits.

1. A) more; a decline
2. B) more; an increase
3. C) fewer; an increase
4. D) fewer; a surge

Answer: B

If a bank has ________ rate-sensitive assets than liabilities, a ________ in interest rates will reduce bank profits, while a ________ in interest rates will raise bank profits.

1. A) more; rise; decline
2. B) more; decline; rise
3. C) fewer; decline; decline
4. D) fewer; rise; rise

Answer: B

If a bank's liabilities are more sensitive to interest rate movements than are its assets, then

1. A) an increase in interest rates will reduce bank profits.
2. B) a decrease in interest rates will reduce bank profits.
3. C) interest rates changes will not impact bank profits.
4. D) an increase in interest rates will increase bank profits.

Answer: A

If a bank has $50 million in rate-sensitive assets and $20 million in rate-sensitive liabilities then

1. A) an increase in interest rates will reduce bank profits.
2. B) a decrease in interest rates will reduce bank profits.
3. C) interest rate changes will not impact bank profits.
4. D) a decrease in interest rates will increase bank profits.

Answer: B

The difference of rate-sensitive liabilities and rate-sensitive assets is known as the

1. A) duration.
2. B) interest-sensitivity index.
3. C) rate-risk index.
4. D) gap.

Answer: D

If the First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause profits to

1. A) increase by $15 million.
2. B) increase by $1.5 million.
3. C) decline by $15 million.
4. D) decline by $1.5 million.

Answer: D

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is called

1. A) basic duration analysis.
2. B) basic gap analysis.
3. C) interest-exposure analysis.
4. D) gap-exposure analysis.

Answer: B

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals times the change in the interest rate is called

1. A) basic gap analysis.
2. B) the maturity bucket approach to gap analysis.
3. C) the segmented maturity approach to gap analysis.
4. D) the segmented maturity approach to interest-exposure analysis.

Answer: B

First National Bank

Assets Liabilities

Rate-Sensitive $20M $50M

Fixed-Rate $80M $50M

If interest rates rise by 5 percentage points, say, from 10 to 15%, bank profits (measured using gap analysis) will

1. A) decline by $0.5 million.
2. B) decline by $1.5 million.
3. C) decline by $2.5 million.
4. D) increase by $1.5 million.

Answer: B

Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to decline by ________ of the total original asset value.

1. A) 5 percent
2. B) 10 percent
3. C) 15 percent
4. D) 25 percent

Answer: B

First National Bank

Assets Liabilities

Rate-Sensitive $40M $50M

Fixed-Rate $60M $50M

If interest rates rise by 5 percentage points, say from 10 to 15%, bank profits (measured using gap analysis) will

1. A) decline by $0.5 million.
2. B) decline by $1.5 million.
3. C) decline by $2.5 million.
4. D) increase by $2.0 million.

Answer: A

Assuming that the average duration of its assets is four years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to ________ by ________ of the total original asset value.

1. A) decline; 5 percent
2. B) decline; 10 percent
3. C) decline; 15 percent
4. D) increase; 20 percent

Answer: A

Duration analysis involves comparing the average duration of the bank's ________ to the average duration of its ________.

1. A) securities portfolio; non-deposit liabilities
2. B) assets; liabilities
3. C) loan portfolio; deposit liabilities
4. D) assets; deposit liabilities

Answer: B

Because of an expected rise in interest rates in the future, a banker will likely

1. A) make long-term rather than short-term loans.
2. B) buy short-term rather than long-term bonds.
3. C) buy long-term rather than short-term bonds.
4. D) make either short or long-term loans; expectations of future interest rates are irrelevant.

Answer: B

If a banker expects interest rates to fall in the future, her best strategy for the present is

1. A) to increase the duration of the bank's liabilities.
2. B) to buy short-term bonds.
3. C) to sell long-term certificates of deposit.
4. D) to increase the duration of the bank's assets.

Answer: D

Bruce the Bank Manager can reduce interest rate risk by ________ the duration of the bank's assets to increase their rate sensitivity or, alternatively, ________ the duration of the bank's liabilities.

1. A) shortening; lengthening
2. B) shortening; shortening
3. C) lengthening; lengthening
4. D) lengthening; shortening

Answer: A

Your bank has the following balance sheet

Assets Liabilities

Rate-sensitive $100 million Rate-sensitive $75 million

Fixed-rate 100 million Fixed-rate 125 million

What would happen to bank profits if the interest rates in the economy go down? Is there anything that you could do to keep your bank from being so vulnerable to interest rate movements?

Answer: The bank's profits would go down because it has more interest-rate sensitive assets than liabilities. In order to reduce interest-rate sensitivity, the bank manager could use financial derivatives such as interest-rate swaps, options, or futures. The bank manager could also try to adjust the balance sheet so that the bank's profits are not vulnerable to the movement of the interest rate.

Examples of off-balance-sheet activities include

1. A) trading activities.
2. B) extending loans to depositors.
3. C) borrowing from other banks.
4. D) selling negotiable CDs.

Answer: A

Banks earn profits from off-balance sheet loan sales

1. A) by foreclosing on delinquent accounts.
2. B) by selling the loans at discounted prices.
3. C) by selling existing loans for more than the original loan amount.
4. D) by calling-in loans before the maturity date.

Answer: C

All of the following are examples of off-balance sheet activities that generate fee income for banks EXCEPT

1. A) foreign exchange trades.
2. B) guaranteeing debt securities.
3. C) back-up lines of credit.
4. D) selling negotiable CDs.

Answer: D

Which of the following is NOT an example of a backup line of credit?

1. A) loan commitments
2. B) overdraft privileges
3. C) standby letters of credit
4. D) mortgages

Answer: D

Off-balance sheet activities involving guarantees of securities and back-up credit lines

1. A) have no impact on the risk a bank faces.
2. B) greatly reduce the risk a bank faces.
3. C) increase the risk a bank faces.
4. D) slightly reduce the risk a bank faces.

Answer: C

When banks involved in trading activities attempt to outguess markets, they are

1. A) forecasting.
2. B) diversifying.
3. C) speculating.
4. D) engaging in riskless arbitrage.

Answer: C

Traders working for banks are subject to the

1. A) principal-agent problem.
2. B) free-rider problem.
3. C) double-jeopardy problem.
4. D) exchange-risk problem.

Answer: A

A reason why rogue traders have bankrupt their banks is due to

1. A) the separation of trading activities from the bookkeepers.
2. B) stringent supervision of trading activities by bank management.
3. C) accounting errors.
4. D) a failure to maintain proper internal controls.

Answer: D

One way for banks to reduce the principal-agent problems associated with trading activities is to

1. A) set limits on the total amount of a traders' transactions.
2. B) make sure that the person conducting the trades is also the person responsible for recording the transactions.
3. C) encourage traders to take on more risk if the potential rewards are higher.
4. D) reduce the regulations on the traders so that they have more flexibility in conducting trades.

Answer: A

The principal-agent problem that exists for bank trading activities can be reduced through

1. A) creation of internal controls that combine trading activities with bookkeeping.
2. B) creation of internal controls that separate trading activities from bookkeeping.
3. C) elimination of regulation of banking.
4. D) elimination of internal controls.

Answer: B

Banks develop statistical models to calculate their maximum loss over a given time period. This approach is known as the

1. A) stress-testing approach.
2. B) value-at-risk approach.
3. C) trading-loss approach.
4. D) doomsday approach.

Answer: B

When banks calculate the losses the institution would incur if an unusual combination of bad events happened, the bank is using the ________ approach.

1. A) stress-test
2. B) value-at-risk
3. C) trading-loss
4. D) maximum value

Answer: A

Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. If interest rates increase from 5 percent to 6 percent, the net worth of the bank falls by

1. A) $1 million.
2. B) $2.4 million.
3. C) $3.6 million.
4. D) $4.8 million.

Answer: D

Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. The duration gap for this bank is

1. A) 0.5 year.
2. B) 1 year.
3. C) 1.5 years.
4. D) 2 years.

Answer: C

If interest rates increase from 9 percent to 10 percent, a bank with a duration gap of 2 years would experience a decrease in its net worth of

1. A) 0.9 percent of its assets.
2. B) 0.9 percent of its liabilities.
3. C) 1.8 percent of its liabilities.
4. D) 1.8 percent of its assets.

Answer: D

One of the problems in conducting a duration gap analysis is that the duration gap is calculated assuming that interest rates for all maturities are the same. That means that the yield curve is

1. A) flat.
2. B) slightly upward sloping.
3. C) steeply upward sloping.
4. D) downward sloping.

Answer: A

Most of a bank's operating income results from

1. A) interest on assets.
2. B) service charges on deposit accounts.
3. C) off-balance-sheet activities.
4. D) fees from standby lines of credit.

Answer: A

All of the following are operating expenses for a bank EXCEPT

1. A) service charges on deposit accounts.
2. B) salaries and employee benefits.
3. C) rent on buildings.
4. D) servicing costs of equipment such as computers.

Answer: A

When a bank suspects that a $1 million loan might prove to be bad debt that will have to be written off in the future the bank

1. A) can set aside $1 million of its earnings in its loan loss reserves account.
2. B) reduces its reported earnings by $1, even though it has not yet actually lost the $1 million.
3. C) reduces its assets immediately by $1 million, even though it has not yet lost the $1 million.
4. D) reduces its reserves by $1 million, so that they can use those funds later.

Answer: A

For banks

1. A) return on assets exceeds return on equity.
2. B) return on assets equals return on equity.
3. C) return on equity exceeds return on assets.
4. D) return on equity is another name for net interest margin.

Answer: C

Interest income minus interest expenses divided by assets is a measure of bank performance known as the

1. A) operating income.
2. B) net interest margin.
3. C) return on assets.
4. D) return on equity.

Answer: B

Based on the Net Interest Margin the poor bank performance in the late 1980s

1. A) was not the result of interest-rate movements.
2. B) was not the result of risky loans made in the early 1980s.
3. C) resulted from a narrowing of the gap between interest earned on assets and inters paid on liabilities.
4. D) resulted from a huge decrease in provisions for loan losses.

Answer: A