Deck 8: How Banks Work

Question 1

A legally enforced part of a loan contract that requires the borrower to act in a certain way or to use the borrowed funds for a particular purpose is known as

A)collateral.
B)a net worth requirement.
C)a covenant.
D)a clause.

Answer 1

C

Question 2

A credit crunch occurs when

A)banks do not lend as they ordinarily would, but rather have much higher requirements for borrowers to qualify for loans than normal.
B)inflation rises, driving up interest rate near their legal ceiling, causing people to pull their funds out of banks.
C)regulators pressure banks to increase loans to under-served groups in society.
D)government officials force banks to lend in areas where they wish to establish branches.

Answer 2

A

Question 3

The S&L crisis in the late 1970s and early 1980s was made much worse by

A)moral hazard, when regulators failed to close bankrupt S&Ls, which in turn caused a credit crunch.
B)adverse selection, when commercial banks were allowed to buy financially sound S&Ls but did not buy bankrupt S&Ls.
C)asymmetric information, because the government did not realize the bad financial condition of the S&Ls.
D)the regulatory dialectic.

Answer 3

A

Question 4

A financial intermediary that accepts deposits from savers, and makes loans to borrowers is a

A)stock exchange.
B)bond market.
C)bank.
D)finance company.

Question 5

When people or firms that are worse than average risks are most likely to enter a contract that is offered to everyone, the problem is called

A)irrational expectations.
B)adverse selection.
C)opportunity cost.
D)moral hazard.

Question 6

When the existence of a contract changes the behavior of a party to the contract, the problem is called

A)irrational expectations.
B)adverse selection.
C)opportunity cost.
D)moral hazard.

Question 7

When one party to a transaction knows more than another, the situation is one of

A)rational expectations.
B)imperfect credibility.
C)opportunity cost.
D)asymmetric information.

Question 8

Collateral is a(n)____ that a borrower promises to give to the bank if that borrower is unable to repay the bank's loan.

A)document
B)liability
C)asset
D)interest payment that a borrower promises to give to the bank if that borrower is unable to repay the

Question 9

Borrowers know more about their abilities to repay loans than the banks do.This is a situation of

A)adverse selection.
B)rational behavior.
C)credit crunch.
D)bank run.

Question 10

Banks earn profit by

A)borrowing from depositors at a lower interest rate, and lending those funds at a higher interest rate.
B)reducing the service charges for safety vaults and ATM facilities.
C)lending more loans to non-risky business firms.
D)reducing the amount of transaction deposits.

Question 11

Savings-and-loan associations suffered losses in the late 1970s when

A)the farm sector of the economy became unprofitable, forcing many farmers into bankruptcy, leading to many bad farm loans.
B)inflation rose, causing short-term interest rates to rise.
C)oil prices rose sharply, causing S&Ls to lose money invested in the oil sector.
D)short-term interest rates fell, causing S&Ls to suffer capital losses on their portfolios of short-term securities.

Question 12

Borrowers who default are more likely to seek loans than the borrowers who don't default.This is an example of

A)irrational expectations.
B)rent-seeking behavior.
C)moral hazard.
D)adverse selection.

Question 13

Accounting rules require that a bank's _____equals its_____ .

A)equity capital; assets plus liabilities.
B)assets; liabilities minus equity capital.
C)liabilities; assets plus equity capital.
D)liabilities; assets minus equity capital.

Question 14

Which of the following is true of the credit crunch that occured in the U.S.economy in the early 1990s?

A)The credit crunch affected only big business firms.
B)Small business firms that were unable to obtain bank loans were most affected during the credit crunch.
C)The main reason behind the credit crunch was the dramatic decline in housing prices.
D)The government bailed out many of the financial firms that were affected by the credit crunch.

Question 15

If a business firm takes out a loan from a bank, but does not use the funds as the bank intended, the problem is

A)moral hazard.
B)adverse selection.
C)intermediation.
D)securitization.

Question 16

Which of the following is the main reason behind the financial crisis of 2008?

A)There was a sharp decline in the growth rate of money supply.
B)There was a sharp increase in the quantity of exports from the U.S.to Asian countries.
C)Banks in the U.S.made subprime mortgage loans.
D)Banks had much higher requirements for borrowers to qualify for loans than normal.

Question 17

____occurs in banking if the firm receiving a bank loan behaves differently after it receives the loan, in a way that harms the bank.

A)Irrational expectations
B)Adverse selection
C)Moral hazard
D)Rent-seeking behavior

Question 18

A bank offers credit cards with a 25 percent interest rate, when its competitors' cards have just a 15 percent interest rate.Despite the high rate, the bank finds itself losing money because many of its customers fail to repay the balances on their cards.The bank's losses are most likely to have occurred because of

A)bad management.
B)the lock-in effect.
C)redlining.
D)adverse selection.

Question 19

The main problems caused by asymmetric information are

A)irrational expectations and moral hazard.
B)imperfect credibility and adverse selection.
C)adverse selection and irrational expectations.
D)adverse selection and moral hazard.

Question 20

Which of the following reduces the risk of moral hazard and the bank's risk in making loans?

A)Collateral
B)Adverse selection
C)Fixed interest rate
D)Securitization

Question 21

A bank has currency and coins equal to $20 million in its vaults.It has securities worth $10 million, has borrowings equal to $5 million, and has given out loans equal to $2 million.It also has deposits with the Federal Reserve equal to $4 million.The total reserves of the bank equals

A)$12 million.
B)$22 million.
C)$24 million.
D)$36 million.

Question 22

Suppose a bank has $200 million as transaction deposits, and holds $25 million as reserves.If the reserve requirement is uniformly 10% on any positive amount, the bank's excess reserves equals

A)$25 million.
B)$10 million.
C)$5 million.
D)$1 million.

Question 23

A bank's reserves equal its

A)government securities.
B)transactions deposits.
C)vault cash plus deposits at the Federal Reserve.
D)cash assets plus government securities.

Question 24

Sarah, a customer of a bank, transfers $10,000 from her checking account to her money-market deposit account. Which of the following changes will be reflected in Sarah's bank's balance sheet?

A)Reserves decrease by $10,000.
B)Transactions deposits increase by $10,000.
C)Nontransactions deposits decrease by $10,000.
D)Borrowings increase by $10,000.

Question 25

The interest rate in the market for loans of reserves between banks is the

A)three-month Treasury bill rate.
B)reserve ratio.
C)discount rate.
D)federal funds rate.

Question 26

In which of the following ways can a bank increase its reserves?

A)Give out more loans
B)Sell securities
C)Reduce interest rate on time deposits
D)Increase service charges for safety vault facility

Question 27

The discount rate is the interest rate on

A)loans of reserves between banks.
B)discount loans from the Federal Reserve.
C)discount bonds.
D)federal agency securities.

Question 28

The federal funds rate is the interest rate in the market for

A)mortgage loans.
B)loans of reserves between banks.
C)loans of government securities.
D)federal agency securities.

Question 29

Paul, a customer of a bank, writes a check for $50,000 to a customer of another bank.Which of the following changes will be reflected in Paul's bank's balance sheet?

A)Reserves decrease by $50,000.
B)Transactions deposits increase by $50,000.
C)Nontransactions deposits increase by $50,000.
D)Borrowings increase by $50,000.

Question 30

A bank with transaction deposits totaling $45 million had reserves equal to $0.98 million.The reserve requirement for this bank is_____ percent.(Hint: use the cutoff amounts as per the reserve requirements for the year 2013)

A)10
B)8
C)3
D)2

Question 31

The market in which banks with excess reserves lend them to banks that desire additional reserves is known as the ________ market.

A)capital reserves
B)excess reserves
C)federal funds
D)excess funds

Question 32

Under which of the following options does the Fed offer reserves to banks through a competitive auction process?

A)Term deposit facility
B)Discount lending
C)Quantitative easing
D)Safety vault facility

Question 33

The reserve requirement is 0 percent on the first $8 million in transaction deposits, 3 percent on amounts between $8 million and $50 million, and 10 percent on amounts above $50 million.A bank with transaction deposits totaling $7 million has required reserves equal to

A)$0.00 million.
B)$0.21 million.
C)$0.70 million.
D)$1.17 million.

Question 34

A bank's excess reserves equal its

A)vault cash plus deposits at the Federal Reserve.
B)total reserves minus required reserves.
C)reserve requirement times transactions deposits.
D)vault cash plus required reserves.

Question 35

The reserve requirement is 0 percent on the first $8 million in transaction deposits, 3 percent on amounts between $8 million and $50 million, and 10 percent on amounts above $50 million.A bank with transaction deposits totaling $83 million has required reserves equal to

A)$2.49 million.
B)$4.56 million.
C)$6.54 million.
D)$8.30 million.

Question 36

The_____ is a place where banks can request loans from the Federal Reserve.

A)money market
B)domestic trading desk
C)Treasury
D)discount window

Question 37

Which of the following is recorded under the asset side of a bank's balance sheet?

A)Transaction deposits
B)Equity capital
C)Borrowings
D)Reserves

Question 38

Suppose a bank's excess reserves are equal to $100 million.The bank is required to hold $50 million as reserves.The bank currently holds _____as reserves.

A)$50 million
B)$100 million
C)$150 million
D)$200 million

Question 39

A bank is said to have_____ when its average costs decline as its volume of sales increases.

A)economies of scope.
B)economies of scale.
C)cost diminution.
D)decreasing returns to scale.

Question 40

Which of the following is recorded under the liabilities side of a bank's balance sheet?

A)Transaction deposits
B)Securities
C)Reserves
D)Loans

Question 41

Before October 2008, banks earned interest on reserve balances that they held at the Federal Reserve at a rate of

A)0.00%.
B)0.05%.
C)0.60%.
D)1.00%.

Question 42

A bank can reduce the impact of a default risk by

A)having assets with the same time to maturity.
B)making risky loans at low interest rates.
C)making safe loans at high interest rates.
D)diversifying its portfolio.

Question 43

A bank's spread equals

A)the bank's average profit per dollar of assets.
B)the bank's return on equity.
C)the average interest rate on all the bank's investments minus the inflation rate.
D)the average interest rate on the bank's assets minus the average interest rate on its liabilities.

Question 44

If a bank has assets with the same time to maturity as its liabilities, then

A)the interest rate on assets changes faster than the interest rate on liabilities.
B)the interest rate on liabilities changes faster than the interest rate on assets.
C)changes in interest rates will not affect the bank's overall portfolio.
D)changes in interest rates puts the bank at a high risk of default.

Question 45

The possibility that a bank's loan customers might not repay their loans is known as

A)withdrawal risk.
B)default risk.
C)interest-rate risk.
D)foreign-exchange risk.

Question 46

Which of the following statements is true of banks?

A)Small banks do not face the same competitive pressure as large banks do.
B)Location of banks does not determine the level of competition among them.
C)Bank spreads are large for large banks.
D)Returns on equity are large for small banks.

Question 47

The risk that market interest rates may change, affecting the value of a bank's assets and liabilities, is known as

A)withdrawal risk.
B)default risk.
C)interest-rate risk.
D)foreign-exchange risk.

Question 48

In addition to paying interest on reserves starting in October 2008, the Fed also provided

A)lending against a variety of collateral, such as commercial paper and mortgage-backed securities.
B)advice on how to conduct contemporaneous reserve accounting.
C)the power for banks to print and distribute their own currency.
D)staff people to help banks make real-estate decisions regarding the locations of their branch offices.

Question 49

Which size category of banks generally has the largest spread?

A)Small banks
B)Medium-sized banks
C)The 100 largest banks
D)The 10 largest banks

Question 50

A bank borrows funds from its depositors by paying them 2% interest on the funds.It lends those funds to borrowers by charging an interest of 5% on the loans.The bank's spread is

A)2 percent.
B)3 percent.
C)4 percent.
D)5 percent.

Question 51

Suppose a bank earned $173 million in interest on its assets of $2,153 million, it paid out $81 million in interest on its liabilities (excluding capital) of $2,007 million, and it paid its workers $71 million in total compensation.The bank's return on equity is approximately

A)12 percent.
B)14 percent.
C)16 percent.
D)18 percent.

Question 52

When the Fed began paying interest on reserves, reserve balances

A)increased dramatically.
B)decreased dramatically.
C)decreased only slightly.
D)increased only slightly.

Question 53

Suppose a bank earned $12 million in interest on its assets of $157 million, it paid out $8 million in interest on its liabilities (excluding capital) of $172 million, and it paid its workers $3 million in total compensation.The bank's profit equals

A)$12 million.
B)$8 million.
C)$3 million.
D)$1 million.

Question 54

Credit risk means the same thing as

A)withdrawal risk.
B)default risk.
C)interest-rate risk.
D)foreign-exchange risk.

Question 55

Which size category of banks generally has the smallest spread?

A)The 10 smallest banks
B)The 100 smallest banks
C)Medium-sized banks
D)Large banks

Question 56

Suppose a bank earned $173 million in interest on its assets of $2,153 million, it paid out $81 million in interest on its liabilities (excluding capital) of $2,007 million, and it paid its workers $71 million in total compensation.The bank's spread is approximately

A)2 percent.
B)3 percent.
C)4 percent.
D)5 percent.

Question 57

Which of the following is a way in which banks can equalize the time to maturity of their assets and liabilities?​

A)​Securitization
B)​Quantitative easing
C)​Privatization
D)​Credit easing

Question 58

Which of the following is true of bank spread?

A)The more vigorous the competition among banks, the smaller will be spread between the interest rates on loans and deposits.
B)The larger the banks that are competing with each other, the larger will be spread between the interest rates on loans and deposits.
C)The spread between the interest rates on loans and deposits will be much narrower in banks in rural areas than the banks in big cities.
D)The lower the number of banks in a city, the smaller will be the spread between the banks' interest rates on loans and deposits.

Question 59

Securitization is the process by which a bank sells a loan (which it made previously) to

A)investors.
B)the government.
C)other banks.
D)depositors.

Question 60

A bank is said to have_____ when its average costs decline when it offers a wider variety of products.

A)economies of scope.
B)economies of scale.
C)cost diminution.
D)decreasing returns to scale.

Question 61

In order to manipulate the money supply, the Fed can change the interest rate that it pays on reserves in comparison to the ____ rate.

A)federal funds
B)prime
C)30-year fixed mortgage
D)credit card interest

Question 62

The reserve requirement is 0 percent on the first $6.0 million in transaction deposits, 3 percent on amounts between
$6.0 million and $42.1 million, and 10 percent on amounts above $42.1 million.
The First Bank of Boston has the following assets and liabilities (all amounts in millions of dollars):
$\begin{array} { l l } \text { Assets }\\\text { Reserves } & \$ 5.0 \\ \text { Loans } & \$ 345.0 \\ \text { Securities } & \$ 70.0 \end{array}$


$\begin{array}{ll}\text { Liabilities + Capital }\\\text { Transaction deposits } & \$ 75.0 \\\text { Nontransaction deposits } & \$ 315.0 \\\text { Equity capital } & \$ 30.0\end{array}$

a. Calculate the bank's excess reserves. Show your work.

b.Suppose First Bank makes a loan to a customer equal to the amount of the excess reserves b. you found in part a. Calculate the bank's excess reserves before the customer spends the
proceeds of the loan. Show your work.

c. Now suppose the customer spends the proceeds of the loan. Calculate the bank's excess reserves. Show your work.

Question 63

Reserve requirements for banks are currently:
$$\begin{array} { l l } \text { Amount of Bank's } & \text { Reserve } \\\text { Transaction Deposits } & \text { Requirement } \\\text { The first \$6.6 million } & 0 \text { percent } \\\text { Amounts from \$6.6 to \$45.4 million } & 3 \text { percent } \\\text { Amounts over \$45.4 million } & 10 \text { percent }\end{array}$$
Calculate the reserve requirements for three banks with the following amounts of transaction deposits.
a.$38.8 million
b.$95.6 million
c.$3,400 million

Question 64

In a recent year, a bank earned $36 million in interest on its assets of $523 million, it paid out $9 million in interest on its liabilities (excluding capital) of $470 million, and it paid its workers $21.5 million in total compensation.Calculate the bank's spread and its return on equity.

Question 65

A bank offers credit cards with a 24 percent interest rate, when its competitors' cards have just a 18 percent interest rate.What do you predict will happen? Will the bank profit from its offer?

Question 66

Which of the following measures by the Federal Reserve led to an increase in bank reserves between 2009 and 2013?

A)Moral Suasion
B)Open market operations
C)Haircut
D)Quantitative easing

Question 67

The fact that the Fed is willing to pay interest on reserves gives the Fed another mechanism for affecting the money supply and the amount of reserves that banks hold.How might a very low interest rate paid on reserves increase the money supply? (Hint: Consider the possible uses of excess reserves.)