Deck 23: Risk Management in Financial Institutions

Question 1

A bank's commitment (for a specified future period of time)to provide a firm with loans up to a given amount at an interest rate that is tied to a market interest rate is called

A)credit rationing.
B)a line of credit.
C)continuous dealings.
D)none of the above.

Answer 1

a line of credit.

Question 2

Of the following methods that banks might use to reduce moral hazard problems, the one not legally permitted in the United States is the requirement that

A)firms keep compensating balances at the banks from which they obtain their loans.
B)firms place on their board of directors an officer from the bank.
C)loan contracts include restrictive covenants.
D)individuals provide detailed credit histories to bank loan officers.

Answer 2

firms place on their board of directors an officer from the bank.

Question 3

From the standpoint of ________, specialization in lending is surprising but makes perfect sense when one considers the ________ problem.

A)moral hazard; diversification
B)diversification; moral hazard
C)adverse selection; diversification
D)diversification; adverse selection

Answer 3

diversification; adverse selection

Question 4

Banks attempt to screen good credit risks from bad to reduce the incidence of loan defaults. To do this, banks

A)specialize in lending to certain industries or regions.
B)write restrictive covenants into loan contracts.
C)expend resources to acquire accurate credit histories of their potential loan customers.
D)do all of the above.

Question 5

When banks offer borrowers smaller loans than they have requested, banks are said to ________.

A)shave credit
B)discount the loan
C)raze credit
D)ration credit

Question 6

Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.

A)adverse selection
B)moral hazard
C)moral suasion
D)intentional fraud

Question 7

Liabilities that are partially, but not fully, rate-sensitive include ________.

A)checkable deposits
B)federal funds
C)non-negotiable CDs
D)fixed-rate mortgages
E)money market deposit accounts

Question 8

Which of the following are not generally rate-sensitive assets?

A)securities with a maturity of less than one year
B)variable-rate mortgages
C)fixed-rate mortgages
D)all of the above are rate-sensitive assets
E)none of the above are rate-sensitive assets

Question 9

Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the

A)adverse selection problem.
B)lemon problem.
C)adverse credit risk problem.
D)moral hazard problem.

Question 10

Credit rationing occurs when a bank

A)refuses to make a loan of any amount to a borrower, even when she is willing to pay a higher interest rate.
B)restricts the amount of a loan to less than the borrower would like.
C)does either A or B of the above.
D)does neither A nor B of the above.

Question 11

Provisions in loan contracts that proscribe borrowers from engaging in specified risky activities are called ________.

A)proscription bonds
B)collateral clauses
C)restrictive covenants
D)liens

Question 12

If borrowers with the most risky investment projects are more likely to seek bank loans than borrowers with the safest investment projects, banks face the problem of ________.

A)adverse credit risk
B)adverse selection
C)moral hazard
D)conflict of interest

Question 13

A bank that wants to monitor the check payment practices of its commercial borrowers, so that moral hazard can be prevented, will require borrowers to

A)place a bank officer on their board of directors.
B)place a corporate officer on the bank's board of directors.
C)keep compensating balances in a checking account at the bank.
D)do all of the above.
E)do only A and B of the above.

Question 14

In one sense, ________ appears surprising since it means that the bank is not ________ its portfolio of loans and thus is exposing itself to more risk.

A)specialization in lending; diversifying
B)specialization in lending; rationing
C)credit rationing; diversifying
D)screening; rationing

Question 15

Compensating balances

A)are a particular form of collateral commonly required on commercial loans.
B)are a required minimum amount of funds that a borrower (i.e., a firm receiving a loan)must keep in a checking account at the bank.
C)allow banks to monitor firms' check payment practices, which can yield information about their borrowers' financial conditions.
D)are all of the above.

Question 16

When a lender refuses to make a loan, even though borrowers are willing to pay the stated interest rate or even a higher rate, it is said to engage in ________.

A)specialized lending
B)strategic refusal
C)diversified lending
D)coercive behavior
E)none of the above

Question 17

When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, it is said to engage in ________.

A)constrained lending
B)strategic refusal
C)credit rationing
D)collusive behavior

Question 18

Banks' attempts to solve adverse selection and moral hazard problems help explain loan management principles such as

A)screening and monitoring of loan applicants.
B)collateral and compensating balances.
C)credit rationing.
D)all of the above.
E)only A and B of the above.

Question 19

Lines of credit and long-term relationships between banks and their customers

A)reduce the costs of information collection.
B)make it easier for banks to screen good risks from bad.
C)enable banks to deal with moral hazard contingencies that are neither anticipated nor specified in restrictive covenants.
D)do all of the above.
E)do only A and B of the above.

Question 20

Because larger loans create greater incentives for borrowers to engage in undesirable activities that make it less likely they will repay the loans, banks

A)ration credit, granting borrowers smaller loans than they have requested.
B)ration credit, charging higher interest rates to borrowers who want large loans than to those who want small loans.
C)ration credit, charging higher fees as a percentage of the loan to borrowers who want large loans than to those who want small loans.
D)do none of the above.

Question 21

If a bank has a duration gap of 2 years, then a fall in interest rates from 6 percent to 3 percent will lead to

A)a rise in the market value of its net worth of 5.66 percent.
B)a fall in the market value of its net worth of 5.66 percent.
C)a rise in net interest income of 5.66 percent.
D)a fall in net interest income of 5.66 percent.
E)an unknown change.

Question 22

To use the concept of duration to analyze the effect of changes in interest rates on the market value of an asset, a bank manager would multiply

A)the negative of the duration of the asset by the change in the interest rate, Δi.
B)the negative of the duration of the asset by Δi /(1 + i).
C)the duration of the asset by the change in the interest rate, Δi.
D)the duration of the asset by Δi /(1 + i).

Question 23

The difference between rate-sensitive liabilities and rate-sensitive assets is known as the ________.

A)duration
B)interest-sensitivity index
C)interest-rate risk index
D)gap

Question 24

Use the following table to answer the questions : table23.1
Table 23.1
Refer to Table 23.1. Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, a rise in interest rates from 5% to 10% will cause the net worth of First National to ________ by ________ of the total original asset value.

A)increase; 11%
B)decline; 11%
C)increase; 10%
D)decline; 5%

Question 25

Duration analysis involves comparing the average duration of the bank's ________ to the average duration of its ________.

A)securities portfolio; nondeposit liabilities
B)loan portfolio; nondeposit liabilities
C)loan portfolio; rate-sensitive liabilities
D)rate-sensitive assets; rate-sensitive liabilities
E)assets; liabilities

Question 26

Duration gap analysis

A)is a refinement of basic gap analysis that accounts for interest-rate changes over a multiyear period.
B)is a refinement of basic gap analysis that accounts for how long a gap will last.
C)is a complement to basic gap analysis that accounts for the effect of interest rate changes on market value.
D)is a complement to basic gap analysis that accounts for the influence of partially rate-sensitive assets.

Question 27

If a bank has a duration gap of 2 years, then a rise in interest rates from 6 percent to 9 percent will lead to

A)a rise in the market value of its net worth of 5.66 percent.
B)a rise in net interest income of 5.66 percent.
C)a fall in the market value of its net worth of 5.66 percent.
D)a fall in net interest income of 5.66 percent.
E)an unknown change.

Question 28

If a bank has ________ rate-sensitive assets than rate-sensitive liabilities, then a(n)________ in interest rates will increase bank profits.

A)more; decline
B)more; increase
C)less; increase
D)both A and C

Question 29

If a decline in interest rates causes the market value of a bank's net worth to rise, then the bank must have a ________.

A)negative duration gap
B)positive duration gap
C)negative gap
D)positive gap

Question 30

If a bank has more rate-sensitive liabilities than rate-sensitive assets, then a(n)________ in interest rates will ________ bank profits.

A)increase; increase
B)increase; reduce
C)decline; reduce
D)decline; not affect

Question 31

If First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause profits to

A)increase by $15 million.
B)increase by $1.5 million.
C)decline by $15 million.
D)decline by $1.5 million.

Question 32

If a bank has more rate-sensitive assets than rate-sensitive liabilities, then a(n)________ in interest rates will ________ bank profits.

A)increase; increase
B)increase; reduce
C)decline; increase
D)decline; not affect

Question 33

Use the following table to answer the questions : table23.2
Table 23.2
Referring to Table 23.2, if interest rates rise by 5 percentage points, then bank profits (measured using gap analysis)will

A)decline by $0.5 million.
B)decline by $1.5 million.
C)decline by $2.5 million.
D)increase by $2.0 million.

Question 34

Use the following table to answer the questions : table23.1
Table 23.1
Referring to Table 23.1, First National Bank has a gap of ________.

A)-30
B)+30
C)60
D)0

Question 35

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is called ________.

A)basic duration analysis
B)basic gap analysis
C)interest-exposure analysis
D)gap-exposure analysis

Question 36

If First State Bank has a gap equal to a positive $20 million, then a 5 percentage point drop in interest rates will cause profits to

A)increase by $10 million.
B)increase by $1.0 million.
C)decline by $10 million.
D)decline by $1.0 million.

Question 37

Use the following table to answer the questions : table23.1
Table 23.1
Referring to Table 23.1, if interest rates rise by 5 percentage points, then bank profits (measured using gap analysis)will

A)decline by $0.5 million.
B)decline by $1.5 million.
C)decline by $2.5 million.
D)increase by $1.5 million.

Question 38

Use the following table to answer the questions : table23.2
Table 23.2
Referring to Table 23.2, First National Bank has a gap of ________.

A)-10
B)10
C)20
D)0

Question 39

Use the following table to answer the questions : table23.2
Table 23.2
Refer to Table 23.2. Assuming that the average duration of the bank's assets is four years, while the average duration of its liabilities is three years, a rise in interest rates from 5 percent to 10 percent will cause the net worth of First National to ________ by ________ of the total original asset value.

A)decline; 5%
B)decline; 1.3%
C)decline; 6.2%
D)increase; 5%

Question 40

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals by the change in the interest rate is called

A)basic gap analysis.
B)the segmented maturity approach to gap analysis.
C)the maturity bucket approach to gap analysis.
D)the segmented maturity approach to interest-exposure analysis.
E)none of the above.

Question 41

One problem with duration gap analysis is that it

A)is calculated assuming that the yield curve is flat.
B)is calculated assuming that the yield curve does not change.
C)does not measure the sensitivity of net worth to interest rate changes.
D)does not measure the sensitivity of income to interest rate changes.
E)applies only to financial institutions.

Question 42

What is duration gap analysis and why is it important to a bank?

Question 43

How do the concepts of adverse selection and moral hazard explain the credit risk management principles that banks adopt?

Question 44

Credit rationing occurs when lenders charge higher interest rates on the loans they make to riskier borrowers.

Question 45

What is the difference between credit risk and interest-rate risk?

Question 46

Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek bank loans.

Question 47

If interest rates rise by 5 percentage points, then bank profits (measured using gap analysis)will increase regardless of the income gap.

Question 48

What is gap analysis and why is it important to a bank?

Question 49

If a bank has more rate-sensitive liabilities than assets, then an increase in interest rates will reduce bank profits.

Question 50

A bank manager concerned about interest income who expects interest rates to fall and who knows the bank currently has a positive gap should ________ rate-sensitive assets and ________ rate-sensitive liabilities.

A)increase; increase
B)decrease; increase
C)decrease; decrease
D)increase; decrease

Question 51

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals by the change in the interest rate is called duration analysis.

Question 52

Credit rationing reduces adverse selection problems.

Question 53

How is credit risk related to the concepts of adverse selection and moral hazard?

Question 54

What steps do banks take to reduce their exposure to credit risk?

Question 55

The difference between rate-sensitive liabilities and rate-sensitive assets is known as the duration gap.

Question 56

If a rise in interest rates causes the market value of a bank's net worth to rise, then the bank must have a ________.

A)negative duration gap
B)positive duration gap
C)negative gap
D)positive gap

Question 57

If a bank has a negative gap, then a decrease in interest rates will increase income.

Question 58

Developing and maintaining long-term customer relationships help to reduce banks' costs of screening and monitoring borrowers.

Question 59

One problem with basic gap analysis is that it

A)is calculated assuming interest rates on all maturities are equal.
B)is calculated assuming interest rates on all maturities change by equal amounts.
C)measures the sensitivity of net worth to interest rate changes.
D)does not measure the sensitivity of income to interest rate changes.
E)applies only to financial institutions.

Question 60

A bank manager concerned about interest income who expects interest rates to rise and who knows the bank currently has a positive gap should ________ rate-sensitive assets and ________ rate-sensitive liabilities.

A)increase; increase
B)decrease; increase
C)decrease; decrease
D)increase; decrease

Question 61

What special assumptions do income and duration gap analyses make about interest rate changes and the yield curve?

Question 62

Explain how banks benefit from specialization in lending.

Question 63

Explain how banks benefit from long-term customer relationships.