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
units.
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
portfolio.
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
own.
c. The bank can benefit from combining funds, negotiating lower asset prices and transactions
costs.
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 borrowers leverage ratio is positively related to the probability of default over all levels of
debt.
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.

7. What is the essential idea behind RAROC?

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

13. Which of the following is a condition for a bank to be growing?

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

20. Which of the following statement(s) is true?

a. Regulators are interested in making sure that banks carry an adequate quantity of liquidity, as
opposed to the least cost amount.
b. APRA supervises bank liquidity.
c. Crisis liquidity is the ability of the bank to sustain itself when under financial distress due to
abnormal losses on loans .
d. If the ratio of liquid assets and liabilities in period t divided by estimated liquidity needs in period
t is between zero and 1, there will not be a problem with bank liquidity.
e. a, b and c only.
21. Off-balance-sheet items are:

a.
b.
c.
d.
e.

items omitted from the short form balance sheet.

contingent assets and liabilities.
risk-free assets and liabilities.
exceptionally risky assets and liabilities.
foreign (off-shore) assets and liabilities.

22. In economic terms, the LCs and SLCs sold by financial institutions:

a. are contractual commitments to make a loan up to a stated amount at a given interest

rate in the future.
b. are insurance against the frequency or severity of some particular future occurrence.
c. are non-standard contracts between two parties to deliver and pay for an asset in the
future.
d. are standardized contract guaranteed by organized exchanges to deliver and pay for an
asset in the future.
e. c and d only.

23. Interest rate hedging devices used by banks today include which of the following:
a. Financial futures contracts.
b. Interest rate swaps.
c. Interest rate caps, floors, and collars.
d. All of the above.
24. An interest rate swap is:
a. A way to change a bank's exposure to interest rate fluctuations.
b. A way to achieve lower borrowing costs.
c. A way to convert from fixed rates to floating rates.
d. A way to transform actual cash flows through the bank to more closely match desired cash flow
patterns.
e. All of the above.
25. An agreement where two parties agree to exchange different currencies is known as:
a. An interest rate swap
b. A currency swap
c. A swaption
d. A quality swap
e. None of the above
26. An interest rate collar:
a. Combines a rate floor and a rate cap into one agreement.
b. Ranges in maturity from a few days to a few weeks.
c. Protects a lender from rising interest rates.
d. All of the above.
e. b and c only.

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

33. Which statement (s) is FALSE?

a. Like RAROC, EVA is beneficial is assessing managerial performance and developing incentive
compensation schemes compatible with shareholder wealth goals.
b. short-term opportunities can be accepted with RAROC even though this rate of return is below
the long-term cost of capital
c. Investment opportunities must earn returns that exceed the cost of capital in the long-term as
suggested by EVA.
d. All of the above
e. None of the above
34. NIM and bank size varies inversely because:
a. Larger banks use greater amounts deposits compared to smaller banks.
b. Larger banks tend to have more fixed-rate loans compared to smaller banks.
c. Funds are more expensive in international whole sale market where large banks are inactive.
d. There are no differences in volumes, mixes and pricing between small and large banks.
e. None of the above
35. Why do the managers of financial firms often pay close attention today to the net interest margin,
non-interest margin and earnings spread?

a. A declining NIM is undesirable because the bank's interest spread is being squeezed.
b. Bank manager will usually attempt to expand fee income, while controlling closely the
growth of non-interest expenses in order to make a negative non-interest margin less
negative.
c. The earnings spread measures the effectiveness of the bank's intermediation function of
borrowing and lending money.
d. All of the above.

36. Give three explanations for a bank having a lower ratio of interest expenses to total assets than its
peers?
a.

the bank has more of its assets funded with noninterest bearing sources of funds such as demand
deposits and equity;
b. the bank has a mix of interest bearing sources that is heavily weighted toward cheaper sources,
such as core deposits;
c. for each interest bearing source the bank pays a lower rate, perhaps because it is less risky, or it
may simply have less need for funds.
d. all of the above

37. Factors that can affect profit margin adversely:

a. Competitive pressures facing banks to reduce loan pricing
b. A decrease in whole sale rates.
c. Change in the mix of liabilities.
d. Change in the mix of assets, where there is strong growth in lower margin products.
e. All of the above