FIN 480 UPDATED EXAM END OF COURSE QUESTIONS
AND SOLUTIONS GUARANTEE A+
✔✔Net Interest Margin - ✔✔interest income generated by assets minus interest
expense from liabilities relative to amount of assets
ex: $100 of loans (assets) payed $5 & paid $2 on deposits
- net interest income = $5-2 = $3
- net interest margin = (5-2)/100 = 3%
✔✔???
One measure of a bank's profitability is "net interest income." This is based on the idea
that... - ✔✔a bank receives higher interest rates on its assets relative to what it pays for
its liabilities
✔✔Off-Balance-Sheet Activities - ✔✔to generate fees, banks engage in a number of
these, types of activities expose a bank to risk that is not readily apparent on their
balance sheet (way of hiding risk):
- lines of credit
- letters of credit
✔✔Lines of Credit - ✔✔similar to limits on credit cards, firm pays bank a fee in return for
ability to borrow whenever necessary, pmt. is made when agreement is signed & firm
receives a *loan commitment*, when firm has drawn down line of credit... transaction
appear on bank's balance sheet
✔✔Letters of Credit - ✔✔guarantee that a customer of the bank will be able to make a
promised payment, customer might request that bank send a commercial letter to an
exporter in diff. country guaranteeing payment for goods, bank receives fee for taking
on this risk
✔✔Market Risk - ✔✔decline in market value of assets, risk that instrument may go
down in value rather than up, aka trading risk
✔✔Mark-to-market - ✔✔these accounting rules require banks to adjust record value of
assets on their balance sheet when the market value changes... when price falls, the
value is "written down" and *write downs* reduce a bank's capital
✔✔More Capital - ✔✔the larger a bank's capital cushion, the less likely it is to go
bankrupt... but banks don't like to hold capital because it is costly relative to other
deposits
*Borrowings are larger source of funds than deposits*
✔✔???
Which of the following statements is not true?
,a. The largest source of funds for banks to lend comes from the owner's capital.
b. Transaction deposits make up less than 10% of bank's sources of funds.
c. The largest sources of funds for banks are non-transaction accounts.
d. Borrowings are a larger sources of funds for banks than transaction deposits. - ✔✔a.
The largest source of funds for banks to lend comes from the owner's capital.
✔✔Bank's Type of Risks - ✔✔liquidity, credit, interest-rate, trading
✔✔Liquidity Risk - ✔✔risk of a sudden demand for liquid funds, banks far on both sides
of their balance sheets (deposit-withdrawal on liabilities side, lines of credit on asset
side), in past solution was to hold more cash reserves (too expensive)
✔✔Managing Liquidity Risk (Asset-Side) - ✔✔1. Sell a portion of its securities portfolio -
easiest option, can be sold quickly at low cost
2. Sell some of its loans to other banks - banks generally make sure that a portion of the
loans they hold are marketable for this purpose
3. Renew a customer loan that has come due - bad for business, loss of good
customers, reducing assets lowers profitability
✔✔Managing Liquidity Risk (Liability-Side) - ✔✔1. Borrow to meet any shortfall - either
from Fed or another bank
2. Attract additional deposits - allow banks to manage without changing asset side,
where large certificates of deposits are valuable... can solve short-term liquidity
problems, locks in money for particularly long time & can sell to other banks
✔✔Credit Risk - ✔✔risk that a bank's loans will not be repaid
✔✔Tools to Manage Credit Risk - ✔✔diversification & credit risk analysis
✔✔Diversification - ✔✔can be difficult for banks, especially if focus on a certain type of
lending... if bank lends in only one geographic area or industry, exposed to more
economic downturns
✔✔Credit Risk Analysis - ✔✔produces info that is very similar to bond rating systems...
banks do this for small firms wishing to borrow, credit agencies perform for individual
borrowers... result is an assessment of the likelihood that a particular borrower will
default
✔✔Interest-Rate Risk - ✔✔assets are less interest rate sensitive than liabilities,
liabilities (short-term) while assets (long-term)... when interest rates rise, banks face risk
that value of assets will fall more than value of liabilities (reducing bank's capital)
, *interest rate on liabilities must be lower than on its assets*... difference in these two =
net interest margin
✔✔Interest Rate Sensitive - ✔✔a change in interest rates will change the revenue
produced by an asset
✔✔Gap Analysis - ✔✔difference between the yield on interest-rate sensitive assets &
yield on interest-rate sensitive liabilities
-determine how sensitive the bank's balance sheet is to a change in interest rates...
managers compute an estimate of the change in the bank's profit for each one-
percentage-point change in the interest rate
✔✔Interest Rate Sensitivity (Assets) - ✔✔- long-term bonds pay same regardless of
interest rate changes
- short-term bonds... changes in interest rates change the yield
- if stable interest rates for a while... both types of assets will yield roughly same
✔✔Interest Rate Sensitivity (Liabilities) - ✔✔- short-term deposits (savings accounts) =
variable rate
- long-term deposits (CDs) = fixed rate
✔✔Net Interest Margin Example - ✔✔Suppose the bank has been receiving 5% on its
assets & paying 3% on its liabilities
- net interest margin = 5-3=2%
* check out interest rate sensitivity ex on pg. 18
✔✔Gap Analysis Example - ✔✔Ex: 20% of assets and 50% of liabilities are "sensitive",
interest rates rise 1% for interest-rate sensitive assets & liabilities
Gap = 20%-50%=-30%
multiply gap by projected change in interest rates to give us change in profits
Gap = -30 ... 1% increase in rate -> profits falls by $.30 per $100 in assets
✔✔Interest-Rate Risk Management Tools - ✔✔1. match interest-rate sensitivity of
assets with that of liabilities (decr. interest-rate risk, inc. credit risk)
2. use of derivatives, specifically interest rate swaps
✔✔Proprietary Trading - ✔✔large banks hire traders to actively buy and sell securities,
loans, and derivatives using a portion of the bank's capital
✔✔Moral Hazard - Trading Risk - ✔✔traders normally share in profits from good
investments, but the bank pays for the losses... creates moral hazard as traders take
more risk than banks would like
AND SOLUTIONS GUARANTEE A+
✔✔Net Interest Margin - ✔✔interest income generated by assets minus interest
expense from liabilities relative to amount of assets
ex: $100 of loans (assets) payed $5 & paid $2 on deposits
- net interest income = $5-2 = $3
- net interest margin = (5-2)/100 = 3%
✔✔???
One measure of a bank's profitability is "net interest income." This is based on the idea
that... - ✔✔a bank receives higher interest rates on its assets relative to what it pays for
its liabilities
✔✔Off-Balance-Sheet Activities - ✔✔to generate fees, banks engage in a number of
these, types of activities expose a bank to risk that is not readily apparent on their
balance sheet (way of hiding risk):
- lines of credit
- letters of credit
✔✔Lines of Credit - ✔✔similar to limits on credit cards, firm pays bank a fee in return for
ability to borrow whenever necessary, pmt. is made when agreement is signed & firm
receives a *loan commitment*, when firm has drawn down line of credit... transaction
appear on bank's balance sheet
✔✔Letters of Credit - ✔✔guarantee that a customer of the bank will be able to make a
promised payment, customer might request that bank send a commercial letter to an
exporter in diff. country guaranteeing payment for goods, bank receives fee for taking
on this risk
✔✔Market Risk - ✔✔decline in market value of assets, risk that instrument may go
down in value rather than up, aka trading risk
✔✔Mark-to-market - ✔✔these accounting rules require banks to adjust record value of
assets on their balance sheet when the market value changes... when price falls, the
value is "written down" and *write downs* reduce a bank's capital
✔✔More Capital - ✔✔the larger a bank's capital cushion, the less likely it is to go
bankrupt... but banks don't like to hold capital because it is costly relative to other
deposits
*Borrowings are larger source of funds than deposits*
✔✔???
Which of the following statements is not true?
,a. The largest source of funds for banks to lend comes from the owner's capital.
b. Transaction deposits make up less than 10% of bank's sources of funds.
c. The largest sources of funds for banks are non-transaction accounts.
d. Borrowings are a larger sources of funds for banks than transaction deposits. - ✔✔a.
The largest source of funds for banks to lend comes from the owner's capital.
✔✔Bank's Type of Risks - ✔✔liquidity, credit, interest-rate, trading
✔✔Liquidity Risk - ✔✔risk of a sudden demand for liquid funds, banks far on both sides
of their balance sheets (deposit-withdrawal on liabilities side, lines of credit on asset
side), in past solution was to hold more cash reserves (too expensive)
✔✔Managing Liquidity Risk (Asset-Side) - ✔✔1. Sell a portion of its securities portfolio -
easiest option, can be sold quickly at low cost
2. Sell some of its loans to other banks - banks generally make sure that a portion of the
loans they hold are marketable for this purpose
3. Renew a customer loan that has come due - bad for business, loss of good
customers, reducing assets lowers profitability
✔✔Managing Liquidity Risk (Liability-Side) - ✔✔1. Borrow to meet any shortfall - either
from Fed or another bank
2. Attract additional deposits - allow banks to manage without changing asset side,
where large certificates of deposits are valuable... can solve short-term liquidity
problems, locks in money for particularly long time & can sell to other banks
✔✔Credit Risk - ✔✔risk that a bank's loans will not be repaid
✔✔Tools to Manage Credit Risk - ✔✔diversification & credit risk analysis
✔✔Diversification - ✔✔can be difficult for banks, especially if focus on a certain type of
lending... if bank lends in only one geographic area or industry, exposed to more
economic downturns
✔✔Credit Risk Analysis - ✔✔produces info that is very similar to bond rating systems...
banks do this for small firms wishing to borrow, credit agencies perform for individual
borrowers... result is an assessment of the likelihood that a particular borrower will
default
✔✔Interest-Rate Risk - ✔✔assets are less interest rate sensitive than liabilities,
liabilities (short-term) while assets (long-term)... when interest rates rise, banks face risk
that value of assets will fall more than value of liabilities (reducing bank's capital)
, *interest rate on liabilities must be lower than on its assets*... difference in these two =
net interest margin
✔✔Interest Rate Sensitive - ✔✔a change in interest rates will change the revenue
produced by an asset
✔✔Gap Analysis - ✔✔difference between the yield on interest-rate sensitive assets &
yield on interest-rate sensitive liabilities
-determine how sensitive the bank's balance sheet is to a change in interest rates...
managers compute an estimate of the change in the bank's profit for each one-
percentage-point change in the interest rate
✔✔Interest Rate Sensitivity (Assets) - ✔✔- long-term bonds pay same regardless of
interest rate changes
- short-term bonds... changes in interest rates change the yield
- if stable interest rates for a while... both types of assets will yield roughly same
✔✔Interest Rate Sensitivity (Liabilities) - ✔✔- short-term deposits (savings accounts) =
variable rate
- long-term deposits (CDs) = fixed rate
✔✔Net Interest Margin Example - ✔✔Suppose the bank has been receiving 5% on its
assets & paying 3% on its liabilities
- net interest margin = 5-3=2%
* check out interest rate sensitivity ex on pg. 18
✔✔Gap Analysis Example - ✔✔Ex: 20% of assets and 50% of liabilities are "sensitive",
interest rates rise 1% for interest-rate sensitive assets & liabilities
Gap = 20%-50%=-30%
multiply gap by projected change in interest rates to give us change in profits
Gap = -30 ... 1% increase in rate -> profits falls by $.30 per $100 in assets
✔✔Interest-Rate Risk Management Tools - ✔✔1. match interest-rate sensitivity of
assets with that of liabilities (decr. interest-rate risk, inc. credit risk)
2. use of derivatives, specifically interest rate swaps
✔✔Proprietary Trading - ✔✔large banks hire traders to actively buy and sell securities,
loans, and derivatives using a portion of the bank's capital
✔✔Moral Hazard - Trading Risk - ✔✔traders normally share in profits from good
investments, but the bank pays for the losses... creates moral hazard as traders take
more risk than banks would like
