Practice Quiz 5-1

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University of Massachusetts, Amherst *

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Finance

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Jan 9, 2024

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1. From the list below, which are sources of funds, and which are uses for funds for commercial bank? Transaction Accounts (checking accounts) Time Deposits Borrowed Funds Equity Commercial Loans Real Estate Loans Treasury Securities Mortgage-Backed Securities Vault Cash Reserves at the Federal Reserve Bank The first 2 rows are sources of funding (liabilities) while the remaining ones are uses of funds (assets) 2. Why do banks hold securities? For trading purposes (for large banks) For liquidity purposes as securities are more liquid than loans (for all banks) Investment securities consist of items such as interest-bearing deposits purchased from other FIs, federal funds sold to other banks, repurchase agreements, U.S. Treasury and agency securities, municipal securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities. Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes. Many investment securities held by banks are highly liquid, have low default risk, and can usually be traded in secondary markets. 3. Why is the mismatch in the maturities of bank’s liabilities and assets important? The mismatch could lead to interest rate risk and liquidity risk. Overall, the liability structure of banks’ balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers. Short-term interest rates affect the cost of funding, and these rates could change more quickly than long-term rates which affect the return loans. 4. What is meant by off-balance sheet activity? What gives rise to them? An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly accounted for on the bank’s balance sheet. An item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet, or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet, or an expense item is realized on the income statement. They are often reported in the notes to the financial statement or on a separate schedule. Examples of these are letters of credit, lines of credit, options, forwards, and swaps.

5. What are the major differences in the sources of funding between a community bank and a money center bank? Community banks: major source of funding are deposits and use very little borrowed funds. Money center banks: The rely relatively more on borrowed funds. 6. What are the major differences between the business activities of smaller banks and large money center banks? Small or community banks —with less than $1 billion in asset size—tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans and accessing the local deposit base. Large regional and money center banks engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending, both regionally and nationally. 7. How do the ROA and ROE of smaller banks compare to those of larger banks? Smaller banks tend to have lower ROA and ROE than larger banks. See the handout. 8. How does the cost of funding smaller banks compare to the cost of funding of larger banks? Smaller banks have lower cost of funding. See handout. 9. Why does the cost of funding for smaller banks differ from the cost of funding of larger banks? Large banks operate in competitive markets and therefore have to offer competitive rates to attract and maintain deposits. Most of the smaller banks’ customers stay with their banks because of the inconvenience of changing banking and therefore smaller banks do not need to offer competitive rates on deposits. 10. Who are the major regulators of commercial banks? The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. FDIC regulates all banks that have their customers’ deposits insured by the Deposit Insurance Fund. OCC regulates national banks – those who receive their charters from the Federal Government. FRS regulates all member banks (state or national) as well as all banking holding companies and banks these BHC own. State regulators examine banks that receive their charter from the state.

11. Classify the following accounts into one of the following categories: Assets, Liabilities, Revenue, Expenses, Off-Balance-Sheet Activities A. Service fees charged on deposit accounts. B. Retail CDs C. Loan commitments D. Consumer loans E. Federal funds sold F. Swaps G. Interest on NOW accounts H. NOW accounts I. Commercial letters of credit J. Provision for loan losses K. Allowance for loan losses L. Cash Vault A. Income. B. Liabilities C. OBA D. Assets E. Assets F. OBA G. Expenses H. Assets I. OBA J. Expenses K. Assets L. Assets 12. How come Repurchase Agreements appear on both sides of the balance sheet? A repurchase agreement is an asset if Bank-A "purchased" securities from Bank-B with the understanding that Bank-B would repurchase these securities from Bank-A in the near future. Bank-A is lending money to Bank-B. If Bank-A had instead "sold" the securities to Bank-B and promised to repurchase them from Bank-B in the near future, then this would represent a liability for Bank-A. Bank-A is borrowing money from Bank-B 13. What do core deposits refer to? Stable deposits of the bank are referred to as core deposits. These deposits are not expected to be withdrawn over short periods of time and are therefore a more permanent source of funding for the bank. Core deposits are also the cheapest funds banks can use to finance their assets. Because they are both a stable and low-cost source of funding, core deposits are the most frequently used source of funding by commercial banks. 14. What are the top 2 categories of loans on commercial banks’ balance sheets? Commercial and industrial loans Residential mortgages 15. What are the three types of risks that banks face because of their asset-liability structures? Credit risk: the risk that borrowers could default and may not fully repay their loans on time. Liquidity risk: the risk of an unexpected and sudden increase in depositors withdrawing their funds, and the bank not being able to meet their demands because of the illiquidity of their assets. Interest rate risk: Arises from changes interest rates and the fact that there is a maturity mismatch between a bank’s assets and its liabilities.

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16. What is the largest category of liabilities of commercial banks? Deposits account for about 80% of total liabilities. 17. What is the definition of Tier 1 Leverage Ratio? It is equal to Tier 1 Capital (Common stocks + retained Earnings + Certain Reserves) divided by Total Assets 18. What are shadow banks? These are financial institutions that engage in the activities of commercial banks but are unregulated as they are not classified as banks. For example, they may accept “deposits” from clients, but those deposits will not be insured by FDIC. 19. What has contributed to the recent sharp decline in the relative size of securities held by community and regional banks? This decline is a result of rising interest rates in the last two years. While banks actively purchased long duration securities until early 2022, the sharp decline was not the result of active sales by these institutions. Rather the rise in interest rates reduced the values of these securities. 20. What are the definitions of the following types “banks”? a. Money center banks b. Merchant banks c. Investment banks d. State banks e. Insured banks f. Member banks a. Large commercial banks located at leading financial centers. b. They are not depository institutions. They provide debt and equity to businesses. c. They are not depository institutions. They underwrite IPOs and provide capital to businesses. d. These are banks that have received their charters from states’ banking commissions. e. These are banks with their customers’ deposits insured by the FDIC. f. These are banks that are a member of the Federal Reserve System.

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Related Questions

Which of the items below are typically LIABILITIES for a commercial bank?(Select all that apply; two of the answers below are correct.) Reference: Chapters 11 & 12 Investment Securities (such as treasury bonds & money market securities) Vault Cash & Deposits at the Federal Reserve Customer Deposits (such as checking or savings accounts) Borrowed Funds (such as short-term borrowing from other banks, or from the Federal Reserve) Customer Loans (such as mortgages or small business loans)

What are some of the ways that banks can borrow short-term funds when they need "liquidity"?(Select all that apply; three of the answers below are correct.) Reference: Chapters 11 & 12 They can borrow directly from the Securities & Exchange Commission through the "regulatory" market. They can borrow from the Department of Treasury through the "Treasury" window. They can borrow another bank's reserves through the "fed funds" market. The can engage in a "sale & repurchase agreement" (or "repo") by selling some of their securities to another financial insitution and promising to buy them back the next day. They can borrow directly from the Federal Reserve through the "discount window".

The main liabilities on a bank’s balance sheet are typically?: 1. Bonds 2. Deposits 3. Mortgages 4. Preferred shares

The major assets on a commercial bank's balance sheet include 0 0 0 0 checkable deposits, securities, loans, and vault cash. reserves, securities, loans, and vault cash. reserves, checkable deposits, loans, and vault cash. reserves, securities, loans, and checkable deposits. The major liabilities on a commercial bank's balance sheet are Oloans. Ocheckable deposits. Ovault cash. O reserves.

The term ‘loanable funds' refers to: a. only those funds loaned by one bank to another bank. b. only those funds loaned to banks by the public. c. only those funds loaned to banks by the central bank. d. all those funds changing hands between the lenders and borrowers in the financial markets.

in terms of bank balance sheets which of the following is correct? Bank assets represent the sources of bank funds bank liabilities represent the uses of bank funds bank capital is the difference between a bank's assets and its liabilities all of the above none of the above

A bank has the following balance sheet: Assets Liabilities Cash 100 Deposits 600 Government bonds 100 Long term debt 185 Secured mortgages 200 Common Equity 15 Commercial loans 400 All questions are for Basel U. a) Calculate risk weighted assets. b) Does the bank satisfy capital requirements under Basel I? If the bank does not satisfy the requirement, what should it do? Give two examples and show your calculations.

What are the four major categories of assets on a commercial bank’s balance sheet and income statement? What is between core deposits and purchased funds and how does this transactions work?

Describe how a bank makes a profit with its securities trading account. What are the risks?

28. A financial institution that obtains most of its funds from deposits is a/an: A. investment bank B. commercial bank C. unit trust D. general insurer

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