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Money And Banks > Chapter 9 > Flashcards

Chapter 9 Flashcards

1
Q

What is the Bank Balance Sheet?

A

It is a list of the assets and liabilities of the bank

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2
Q

What is the formula for calculating the Bank Balance Sheet?

A

total assets= total liabilities +capital

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3
Q

What are bank liabilities?

A

Sources of funds for the bank

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4
Q

What are bank assets?

A

Uses of funds acquired
by the bank.

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5
Q

How do banks make profits?

A

Bank makes profits by earning interest on its assets holdings higher than interest and other expenses on its liabilities.

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6
Q

What are checkable deposits?

A

They are bank accounts that allow the owner of the account to write checks on them.

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7
Q

What are the characteristics of checkable deposits?

A
  • They are payable on demand .
  • They are assets for depositors and liabilities for the bank.
  • They are usually the lowest –cost source of bank funds.
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8
Q

What are the costs associated with maintaining checkable deposits?

A

The bank costs of maintaining checkable deposits include interest payments and cost incurred in servicing these accounts

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9
Q

List the following:

Liabilities of the bank :
(sources of funds)

A
  • Checkable deposits
  • Nontransaction deposits
  • Borrowings
  • Bank capital
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10
Q

What are types of checkable deposits?

A
  • Non-Interest Bearing Checking Accounts
  • Interest-Bearing NOW
  • MMDAs
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11
Q

What are nontransaction deposits?

A

They are the primary source of bank funds owners can not write checks on them.

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12
Q

What are the types of nontransaction deposits?

A

There are two basic types of nontransaction deposits:
saving accounts and time deposits (CDs)

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13
Q

What are saving accounts?

A

Funds can be added to or withdrawn from them at any time

They were the most common type of nontransaction deposits.

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14
Q

How are transactions and interest payments recorded for saving accounts?

A

They are are recorded in a monthly statement or a passbook held by the owner of the account.

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15
Q

What are time deposits?

A

They have a fixed maturity length, ranging from several months to over five years and assess substantial penalties for early withdrawal of funds

They are less liquid than saving accounts so they earn higher interest rates and more costly source of fund for the bank.

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16
Q

What are the types of time deposits?

A
  • small denomination time deposits < 100,000 dollars .
  • Large denomination time deposits are available in denominations of 100,000 or more and are bought mainly by corporations and other banks. They are negotiable (resold in secondary markets before they mature).
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17
Q

What are borrowings?

A

A way for banks to obtain Funds.

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18
Q

What are the different ways banks can obtain funds through borrowings?

A

Bank can obtain funds by borrowing from:
* CB (The Federal Reserve System).(discount loans or advances )
* Reserves overnight of other banks in the federal fund market. Interbank loans(The Federal Funds).
* Parent companies (bank holdings companies)
* Loan arrangements with corporations (like repurchase agreements).
* Borrowing from Eurocurrencies .

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19
Q

Bank capital equals the difference between _______

A

It equals the difference between total assets and liabilities .

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20
Q

How can bank capital be raised?

A

by selling new equity(stock) or from retained earnings.

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21
Q

What is the function of bank capital?

A

Secures against Insolvency

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22
Q

What is bank capital and how does it protect the bank from insolvency?

A

It is the bank cushion against a drop in the value of its assets which occurs when a bank has liabilities in excess of assets
(the bank can be forced into liquidation).

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23
Q

What are reserves, and what is included in them?

A

All banks hold some of the funds they acquire as reserves . Reserves consists of deposits held at The CB (Fed) + currency physically held by banks called vault cash.

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24
Q

What are required reserves and excess reserves, and how do they differ?

A

Required reserves are held because of reserve requirements.(Required reserve ratio) while Excess reserves (additional reserves) are the most liquid of all bank assets and bank can use them to meet its obligations.

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25
Q

What are cash items in process of collection, and why are they considered assets?

A

When a check is written on an account at another bank is deposited in your bank ,and the funds for this check have not yet been received(collected) from the other bank. It is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days.

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26
Q

What are deposits at other banks, and why do small banks hold them in large banks?

A

Small banks hold them in large banks in exchange for services

Examples of Exchange service
* Check collection
* Foreign exchange transactions
* Securities purchases

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27
Q

What are securities, and how are they classified in the US?

A

They are Income-Earning Assets (debt instruments)
They can be classified into three categories:
* The U.S government and agency securities.
* State and local government securities ( they are less liquid and riskier than U.S government securities ).
* Other securities.
* Treasury Bills (secondary reserves)

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28
Q

What are the advantages of Treasury Bills as a secondary reserve?

A

Treasury Bills (secondary reserves)
* Easily traded
* Converted into cash with low transaction costs

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29
Q

Why do banks earn their highest returns on loans, and what are the risks associated with loans?

A

Because Lack of liquidity and the higher default risk as:
* Loans are less liquid than other assets as they can not be turned into cash until the loan matures .
* Loans have higher probability of default than other assets .

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30
Q

What is included in the “other assets” category?

A

The physical capital (bank buildings , computers and other equipment ) is included in the other assets category

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31
Q

List the following:

Assets:(uses of funds)

A
  • Reserves
  • Cash items in process of collection
  • Deposits at other banks
  • Securities
  • Loans
  • Other assets
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32
Q

What is asset transformation?

A

Banks “borrow short & lend long”. Because it makes long term loans and funds them by issuing short term deposits.

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33
Q

How do banks make profits?

A

Banks make profits by selling liabilities and use the proceeds to buy assets with a different set of characteristics.

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34
Q

What are the characteristics of liabilities that banks sell?

A

Liquidity, risk, size, & return

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35
Q

What is a T-account?

A

simplified balance sheet listing only the changes that occur in the balance sheet items starting from some initial balance sheet position.

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36
Q

What happens to a bank’s reserves when a checking account is opened?

A

Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits.

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37
Q

What happens when a check written on an account at one bank is deposited in another?

A

The bank receiving the deposits gain reserves equal to the amount of the check while the bank on which the check is written sees its reserves fall by the same amount.

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38
Q

What do banks gain when they receive additional deposits through check deposits?

A

gains an equal amount of reserves

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39
Q

When a bank loses deposits, what does it lose an equal amount of?

A

It loses an equal amount of reserves

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40
Q

What is asset transformation in banking?

A

Selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

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41
Q

How do banks borrow and lend to make profits?

A

The bank borrows short and lends long

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42
Q

What are the “five C’s” used by bank officers to evaluate potential borrowers?

Used to reduce problems of asymmetric information.

A

character,capacity, collateral, conditions, & capital

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43
Q

What is liquidity management?

A

Liquidity management is the process of acquiring enough liquid assets to meet obligations in the face of deposit outflows.

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44
Q

What is asset management?

A

Asset management is the process of acquiring diversified assets

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45
Q

What is liability management?

A

Liability management is the process of acquiring funds at a low cost

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46
Q

What is capital adequacy management?

A

Capital adequacy management is the process of deciding the amount of capital the bank should maintain and then acquiring the needed capital.

47
Q

What is credit risk?

A

Credit risk is the risk arising because borrowers may default.

48
Q

What is interest-rate risk?

A

Interest-rate risk is the riskiness of earnings and returns on bank assets caused by interest rate changes.

49
Q

What are excess reserves and how do they affect a bank’s balance sheet in case of a deposit outflow?

A

Excess reserves are the additional reserves held by banks above the required reserves. If a bank has ample excess reserves, a deposit outflow (i.e., when customers withdraw funds from their accounts) does not necessitate changes in other parts of its balance sheet since the bank can use the excess reserves to meet its obligations. Therefore, excess reserves provide a cushion for banks against deposit outflows and other unexpected events.

50
Q

What happens if a bank has a shortfall in reserves?

A

If a bank has a shortfall in reserves, it must eliminate the shortfall because reserves are a legal requirement.

51
Q

What happens if a bank has a shortfall in reserves?

A

If a bank has a shortfall in reserves, it must eliminate the shortfall because reserves are a legal requirement.

52
Q

What are excess reserves and how do they help banks deal with deposit outflows?

A

Excess reserves are insurance against the costs associated with deposit outflows

53
Q

What is the cost incurred by banks or corporations when they borrow funds and what is the interest rate paid on borrowed funds called?

A

Cost incurred is the interest rate paid on the borrowed funds (federal funds rate)

54
Q

What is the cost of selling securities for a bank or corporation?

A

The cost of selling securities is the brokerage and other transaction costs.

55
Q

What are the costs of borrowing from the central bank, and why should banks avoid excessive borrowing from the central bank?

A

Borrowing from the Fed (CB) also incurs costs which are interest payments based on the discount rate. Where Too much borrowing restricts borrowing in the future.

56
Q

What is the most costly way for a bank to acquire reserves?

A

Reduction of loans

57
Q

What is one potential drawback of selling loans off to other banks?

A

Other banks may only agree to purchase loans at a substantial discount.

58
Q

What is the potential consequence of calling in loans?

A

Calling in loans (not renewing them when they come due antagonizes customers.

59
Q

What is the opportunity cost of holding excess reserves?

A

that is the earnings foregone by not holding income – earning assets such as loans or securities

60
Q

Why do banks hold excess reserves?

A

to insure against losses due to deposit outflows.

61
Q

What are some steps that banks take to protect themselves against deposit outflows?

A

They may shift their holdings of assets to more liquid securities ( secondary reserves)

62
Q

To maximize profits, a bank must
simultaneously seek three goals:

A
  • Seek the highest possible returns on loans and securities.
  • Reduce risk.
  • Have adequate liquidity.
63
Q

What is the first tool banks use to accomplish their goals?

A

Find borrowers who will pay high interest rates and have low possibility of defaulting.

64
Q

What is the second tool banks use to accomplish their goals?

A

Purchase securities with high returns and low risk.

65
Q

How do banks lower risk according to the third tool?

A

Diversifying both assets and loans.

66
Q

What is the fourth tool banks use to balance the need for liquidity against the benefits of increased returns?

A

Balancing the need for liquidity against the benefits of increased returns from less liquid assets.

67
Q

Why did banks take their liabilities as fixed in the past?

A
  • Banks can not compete with one another for Checkable deposits by paying interest on them
  • The markets for making overnight loans between banks were not well developed
68
Q

What is the percentage of bank funds obtained through checkable deposits that cannot pay any interest?

A

More than 60% of bank funds were obtained through checkable deposits that by law could not pay any interest

69
Q

When did liability management start becoming a phenomenon in banking?

A

Liability management is a recent phenomenon (starting in 1960s)

70
Q

What factors contributed to the rise of liability management?

A
  • due to rise of money center banks ( large banks)
  • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)
  • Checkable deposits have decreased in importance as source of bank funds
71
Q

What are the three reasons banks have to make decisions about the amount of capital they need to hold?

A

Banks have to make decisions about the amount of capital they need to hold for three Reasons:
1. Bank capital helps prevent bank failure
2. The amount of capital affects return for owners of the bank
3. Regulatory requirements mandate a minimum amount of capital that is required by regulatory authorties

72
Q

What is bank failure and how does the bank capital prevent it?

A

Bank failure is a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and goes out of business. An important rationale for a bank to maintain suffcient level of capital is to lessen the chance that it will become insolvent. Banks with high capital still have a positive net worth after a loss, whereas low capital banks are in big trouble as the value of assets has fallen bellow that of its liabilities and its net worth is negative.

73
Q

How does the amount of bank capital affect the return of equity holders, and what are the measures used to assess bank perforance?

A

The lower the bank capital, the higher the return for the owners of the bank. ROA (return on assets) provides information on how effeciently a bank is run as it indicates how much profit is generated on average by each dollar of assets. ROE (return on equity) measures how well the owners are doing on their investments. The equity multiplier, which is the ratio of assets to capital, is used to determine the effect of capital levels on equity holder’s returns.

74
Q

What is the Equity Multiplier in Capital Adequacy Management?

A

The Equity Multiplier is the amount of assets per dollar of equity capital. It is expressed as
EM= Assets/(Equity Capital)

75
Q

What is return on Assets (ROA) in capital Adequacy Management?

A

Return on Assets (ROA) is a measue of net profit after taxes per dollar of assets. It is expressed as
ROA = (net profit after taxes)/ assets)

76
Q

What is return on Equity (ROE) in capital Adequacy Management?

A

Return on Equity (ROE) is a measue of net profit after taxes per dollar of equity. It is expressed as
ROE = (net profit after taxes)/ equity capital)

77
Q

What is the relationship between ROA amd ROE in capital Adequacy management?

A

It is expressed by the Equity Multiplier, which is the amount of assets per dollar of equity capital.
ROE = ROA * EM

78
Q

Why do the owners of a bank not want to hold too much capital in Capital Adequacy Managememt?

A

The Owners of a bank may not want to hold too much capital in capital Adequacy management because the lower the bank capital, the higher the return for the owners of the bank, given the returns on assets

79
Q

What is the trade-off between safety and returns to equity holders in bank capital management?

A

The higher the bank capital, the lower the probability of bankruptcy, which benefits the owners of the bank by making their investment safe. However, a high bank capital is also costly to the owners of the bank because the return on equity (ROE) decreases with higher bank capital for a given return on assets (ROA).

80
Q

Why do banks hold capital?

A

Banks are required to hold capital by regulatory authorities to maintain a minimum level of capital adequacy.

81
Q

If a bank finds that its ROE is too low due to high bank capital, what can it do to raise its ROE?

A

To increase ROE, holding assets constant, the bank can either pay out more dividends, buy back some of its shares, or increase the amount of its assets by acquiring new funds and seeking out new loan business or purchasing more securities.

82
Q

What are the strategies for managing bank capital?

A

To increase the amount of capital relative to assets and prevent bank failure, a bank can raise the amount of bank capital holding its assets constant by issuing equity or reducing the bank dividends to stockholders. Alternatively, the bank can keep the bank capital constant and reduce the bank assets by making fewer loans or selling off securities. However, a shortfall of bank capital is likely to lead a bank to reduce its assets and lead to credit crunch.

83
Q

What is credit risk?

A

Credit risk is the risk that arises from the possibility that borrowers may default, which means they are unable to repay their loan.

84
Q

What is screening in credit risk management?

A

Screening is the process of collecting reliable information about the potential borrower to evaluate how good a credit risk they are. This information is used to calculate the borrower’s credit score, which is a statistical measure derived from their financial information.

85
Q

How does specialization in lending help manage credit risk?

A

Specialization in lending means that banks focus on lending to specific locations or industries. This allows banks to develop expertise in collecting information about these specialized activities and improve their ability to handle asymmetric information problems. By improving their screening and monitoring capabilities, banks can better manage credit risk.

86
Q

What are restrictive covenants in credit risk management?

A

Restrictive covenants are clauses included in loan contracts that restrict borrowers from engaging in risky activities. This is done to reduce moral hazard, which is the risk that borrowers may engage in activities that increase the likelihood of default. By monitoring borrowers’ activities and enforcing these covenants, banks can reduce their credit risk.

87
Q

What are the benefits for a bank and its customers in maintaining long-term relationships?

A

For the bank, maintaining long-term customer relationships reduces the cost of collecting information and monitoring, and customers are less likely to engage in risky activities. For customers, it is easier to obtain loans from a bank they already have a relationship with and they may receive more favorable terms.

88
Q

What is a loan commitment?

A

A loan commitment is a bank commitment to provide a firm with loans for a specified future period of time.

89
Q

What are the agreed characteristics of a loan commitment?

A

The agreed characteristics of a loan commitment include the provision of loans up to a given amount at an interest rate that is tied to some market interest rate.

90
Q

What is the advantage of a loan commitment for the bank?

A

The advantage of a loan commitment for the bank is that it promotes long-term relationships with customers and reduces the cost of screening and information collection

91
Q

What is the advantage of a loan commitment for the customer?

A

The advantage of a loan commitment for the customer is that they have a source of funds in the future.

92
Q

How does a loan commitment reduce the cost of screening and information collection?

A

A loan commitment reduces the cost of screening and information collection because the bank has already performed the necessary due diligence on the borrower, and can therefore offer the loan commitment with a reduced level of screening and information collection.

93
Q

What is collateral in lending?

A

Collateral is a property or asset pledged by a borrower to a lender to secure a loan in case of default.

94
Q

How does collateral reduce adverse selection?

A

Collateral reduces adverse selection by reducing the lender’s losses in case of default. If the borrower defaults on the loan, the lender can seize the collateral and sell it to recover some of the funds owed.

95
Q

What is the purpose of compensating balances in lending?

A

Compensating balances are a form of collateral required by some lenders where the borrower is required to keep a minimum balance in a checking account at the bank. It serves as a guarantee of the borrower’s commitment to repay the loan and reduces the risk of default.

96
Q

What is credit rationing?

A

Credit rationing refers to the situation when a bank refuses to make a loan to a borrower even though they are willing to pay the stated interest rates or even higher rates.

97
Q

What are the two forms of credit rationing?

A

The two forms of credit rationing are when a bank refuses to make a loan of any amount to a borrower, and when a bank is willing to make the loan but restricts the size of it to less than the borrowers would like.

98
Q

Why might a bank engage in credit rationing?

A

A bank might engage in credit rationing to hedge against the risk of adverse selection or moral hazard. In adverse selection, the bank is concerned that the loan is too risky, while in moral hazard, the bank is concerned that the borrower may engage in risky activities if given too much credit.

99
Q

What is interest-rate risk for a bank?

A

Interest-rate risk for a bank is the riskiness of earnings and returns on its assets caused by changes in interest rates.

100
Q

What are rate-sensitive assets?

A

Rate-sensitive assets are assets with interest rates that change frequently, at least once a year.

101
Q

What are rate-fixed assets?

A

Rate-fixed assets are assets with interest rates that remain unchanged for a long period, typically over a year.

102
Q

How is the change in profits of a bank affected by interest rate changes?

A

The change in profits of a bank is affected by the relation between rate-sensitive assets and rate-sensitive liabilities and the direction of the interest rate change. If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits, and a decline in interest rates will raise bank profits.

103
Q

What is interest-rate risk in banking?

A

Interest-rate risk in banking refers to the riskiness of earnings and returns on bank assets caused by changes in interest rates.

104
Q

What is the relationship between rate-sensitive assets and rate-sensitive liabilities in managing interest-rate risk?

A

The change in profits of a bank due to interest rate changes depends on the relation between rate-sensitive assets and rate-sensitive liabilities. If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits, and a decline in interest rates will raise bank profits.

105
Q

What are rate-sensitive assets and rate-fixed assets?

A

Rate-sensitive assets are assets with interest rates that change frequently (at least once a year), while rate-fixed assets are assets with interest rates that remain unchanged for a long period (over a year).

106
Q

What is gap analysis?

A

Gap analysis is a measure of sensitivity of bank profits to changes in interest rates.

107
Q

What is the basic gap analysis formula?

A

The basic gap analysis formula is (rate sensitive assets - rate sensitive liabilities) x change in interest rates = in bank profits.

108
Q

What is the maturity bucket approach in gap analysis?

A

The maturity bucket approach measures the gap for several maturity subintervals called maturity buckets so that the effects of interest rate changes over a multiyear period can be calculated.

109
Q

What is the standardized gap analysis?

A

The standardized gap analysis accounts for different degrees of rate sensitivity among rate sensitive assets and liabilities.

110
Q

What is the market value approach in gap analysis?

A

The market value approach examines the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates.

111
Q

How is the market value of security calculated in gap analysis?

A

% in market value of security ≈ - percentage point in interest rate x duration in years

112
Q

What is the weighted average duration in gap analysis?

A

The weighted average duration is used in gap analysis to see how net worth responds to a change in interest rates.

113
Q

What is the effect of a 5% increase in interest rates on a bank with assets duration of 3 years and liabilities duration of 2 years, assuming capital is 10% of assets?

A

The market value of the bank’s assets will fall by 15%, which is equal to a decline in the assets of the bank by 15 million (15% * 100 million = 15 million). The market value of the bank’s liabilities will fall by 10%, which is equal to a decline in the liabilities of the bank by 9 million (10% * 90 million = 9 million)

114
Q

If the duration of assets is 3 years and the duration of liabilities is 2 years, and the bank has 100 million of assets and 90 million of liabilities (assuming that capital is 10% of assets) and the interest rate increases by 5%, what is the decline in net worth for the bank?

A

The decline in net worth for the bank is 6 million. This is calculated by taking the market value of assets (100 million) and subtracting the market value of liabilities (90 million) after accounting for the effects of the 5% increase in interest rates on each. The market value of the assets falls by 15% (5% x 3 years), or 15 million, while the market value of the liabilities falls by 10% (5% x 2 years), or 9 million. Therefore, the net worth of the bank declines by 6 million (15 million - 9 million).

Money And Banks (6 decks)

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