TUTORIAL 8

BANKS AND MANAGEMENT

I. Review questions
1. What are uses of funds and sources of funds for a bank?
2. How does a bank make a profit?
3. What are the major aspects of bank management?
4. How can a bank manage credit risks?
5. How can a bank manage interest rate risks?

II. Multiple-choice questions

1. The fundamental balance sheet identity is:
A. Total assets = total liabilities + capital
B. total assets + capital = total liabilities
C. Total assets = total liabilities
D. total assets = total liabilities – capital

2. The largest bank asset is

A. Securities
B. Loans
C. Physical Assets
D. Reserves

3. The largest bank liability is

A. non-transaction deposits
B. government bonds
C. borrowing
D. checkable deposits

4. Short-term security holdings by banks are often referred to as:

A. secondary reserves
B. required reserves
C. excess reserves
D. total reserves

5. For bank A, a deposit of $100 (in cash or currency) in a checking account will:
A. increase the money supply by $100.
B. reduce the money supply by $100.
C. increase both reserves and checkable deposits by $100.
D. reduce both reserves and checkable deposits by $100.

6. If a bank gains $100 of reserves and $100 of checkable deposits, and the reserve
requirement ratio is 15%, then the bank will:
A. gain $85 of excess reserves.
 B. gain $15 of excess reserves.
C. gain $85 of required reserves.
D. gain $100 of excess reserves.

7. If a bank is short of required reserves, it may:

A. borrow from the Fed at the Fed Funds rate.
B. increase loans.
C. increase security holdings.
D. borrow from the Fed at the current discount rate.

8. If a bank sells $100 of securities, it will:

A. gain $100 of bank capital.
B. gain $100 of savings accounts.
C. gain $100 of loans.
D. gain $100 of reserves.

9. When a bank purchases an earning asset (security or loan) it will:

A. lose reserves.
B. increase reserves.
C. increase savings accounts.
D. gain bank capital.

10. Return on Assets (ROA) is defined as:

A. net profit before taxes/assets.
B. net profit before taxes/liabilities.
C. net profit after taxes/assets.
D. net profit after taxes/liabilities.

11. What do banks count as reserves?

A. Capital and deposits at the Fed
B. Vault cash and deposits at the Fed
C. Deposits at other banks and cash items in process of collection
D. Vault cash and U.S. government securities

12. Acquiring funds at low cost is the main concern of ________ management
A. liquidity
B. capital
C. liability
D. asset

13. To manage credit risk, financial intermediaries can:

A. Require collateral and compensating balances.
B. Screen and monitor customers.
C. Develop long term relationships with customers
D. All of the above

14. In "gap analysis," the gap is the difference between a bank's:

A. long-term securities and short-term securities.
 B. assets and liabilities.
C. rate-sensitive assets and rate-sensitive liabilities.
D. deposits and loans.

15. Off-balance sheet activities include all of the following except:

A. Secondary loan participation
B. Short term loans
C. Speculation in the futures markets
D. Loan commitment fees

III. Practice exercises

Questions taken and adapted from chapter 9 (Mishkin, 2019)

1. Suppose your bank has the following balance sheet:

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

The $50 million deposit outflow means that reserves fall by $50 million to $0 million.
Since the required reserves are $15 million (10% of the $150 million of deposits), your
bank needs to acquire $15 million of reserves.
You could obtain these reserves by either calling in or selling off $15 million of loans,
borrowing $15 million in discount loans from the Fed, borrowing $15 million from other
banks or corporations, selling $15 million of securities, or some combination of all of
these.
2. Suppose your bank has the following balance sheet:

What would happen to bank profits if the interest rates in the economy go down by
1%? What actions could you take to reduce the bank’s interest-rate risk?

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.

3. If a bank finds that its ROE is too low because it has too much bank capital, what
can it do to raise its ROE?

To lower capital and raise ROE, holding its assets constant, it can pay out more
dividends or buy back some of its shares. Alternatively, it can keep its capital constant,
but increase the amount of its assets by acquiring new funds and then seeking out new
loan business or purchasing more securities with these new funds.

4. If a bank doubles the amount of its capital and ROA stays constant, what will
happen to ROE?

ROE will fall in half.

5. If you are a banker and expect interest rates to rise in the future, would you
prefer to make short-term loans or long-term loans?

You should want to make short-term loans. Then, when these loans mature, you will be
able to make new loans at higher interest rates, which will generate more income for the
bank.
6. Using the T-accounts of the First National Bank and the Second National Bank
given in this chapter, describe what happens when Jane Brown writes a check for
$90
on her account at the First National Bank to pay her friend Joe Green, who in turn
deposits the check in his account at the Second National Bank.

7. Suppose you are the manager of a bank that has $15 million of fixed-rate assets,
$30 million of rate sensitive assets, $25 million of fixed-rate liabilities, and $20
million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show
what will happen to bank profits if interest rates rise by 5 percentage points. What
actions could you take to reduce the bank’s interest-rate risk?

The gap is $10 million ($30 million of rate-sensitive assets minus $20 million of rate-
sensitive liabilities). The change in bank profits from the interest rate rise is $0.5 million
(5% $10 million);
The interest-rate risk can be reduced by increasing rate-sensitive liabilities to $30 million
or by reducing rate-sensitive assets to $20 million. Alternatively, you could engage in an
interest-rate swap in which you swap the interest on $10 million of rate-sensitive assets
for the interest on another bank’s $10 million of fixed-rate assets.

8. A commercial bank has mixed up the assets and liabilities items as follows: (in
$’m)
Checkable deposits 80
Deposit with central bank 20
Cash on hand 20
Savings 120
Long-term loan to customer 150
Security (fixed rate) 80
Capital 120
Other assets 35
Borrowing from other bank 80
Time deposits 150
Short-term loan to customer 120
Deposit with other bank 65
Security (floating rate) 60

a) Rearrange the above items into a balance sheet of the bank

b) If the required reserve ratio is 10% for checkable deposits and 5% for saving
deposits and time deposits, does the bank hold any excess reserves? If yes,
how much are they? What is the meaning of these excess reserves?

c) If customers withdraw 10m from checkable deposits and 20m from saving
accounts:
 What will the bank’s balance sheet be? Using T-account
 What is the problem with this new balance sheet?
 How can the bank do to solve this problem?
 d) Refer to the B/S of the bank in (1), the following information is provided:
 Short-term loan includes 40% fixed rate loan.
 Long-term loan is floating-rate loan
 Borrowing from other banks are fixed rate loan
 Time deposits include 60% floating rate.
You are required to analyze the interest rate risks of the bank and options to avoid
the risks.