Deck 16: Off-Balance-Sheet Risk

Question 1

The Federal Reserve requires banks to complete schedule L with their quarterly call reports to list the notional size and variety of off-balance-sheet activities.

Answer 1

True

Question 2

All off-balance-sheet items will eventually move on to the balance sheet at some point in time.

Answer 2

False

Question 3

Off-balance sheet positions are risky because they may yield negative future cash flows.

Answer 3

True

Question 4

The current market value of an off-balance-sheet item is determined by finding the current market value of the underlying item.

Question 5

Off-balance-sheet items can generate cash flows that immediately impact the bank's financial performance.

Question 6

The delta of an option is the sensitivity of an option's value to a unit change in the value of the underlying asset.

Question 7

If an FI enters into a loan commitment,it is essentially entering into a forward contract.

Question 8

An FI can protect itself against insolvency resulting from off-balance sheet activities by purchasing insurance.

Question 9

The present value of an off-balance-sheet item is referred to as its notional value.

Question 10

Off-balance-sheet items often are called contingent assets and liabilities because they may,or may not,affect the balance sheet in the future.

Question 11

A default option is exercised when the holder requests a draw on the loan commitment.

Question 12

The current market value or contingent claim value of OBS items overestimates their notional value.

Question 13

Off-balance-sheet activities generally have risk-reducing attributes,but seldom have risk-increasing attributes.

Question 14

Off-balance-sheet activities are an important source of fee income for many FIs.

Question 15

The extremely high growth of OBS activities since the early 1990s has caused regulators to recognize the potential risk exposure to FIs from their use.

Question 16

Even though an FI may have off-balance-sheet activities,the true net worth is equal to on-balance sheet assets minus on-balance sheet liabilities.

Question 17

All call options are eventually exercised and the underlying asset must be delivered.

Question 18

Interest rate risk is part of the loan commitment contingent risk because of the uncertainty of changes in interest rates before the borrower exercises his option to borrow.

Question 19

Off-balance sheet activities can have both positive and negative effects on the risk of the FI.

Question 20

The use of an up-front fee by a bank eliminates the contingent risk on a loan commitment.

Question 21

Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

Question 22

Standby letters of credit perform an insurance function similar to that of commercial and trade letters of credit.

Question 23

If an FI is a counterparty to a swap arrangement,it must record the notational value of the swap as the market value.

Question 24

One way to completely protect the lender against interest rate risk on a loan commitment is for the lender to price the loan at a variable rate against some index.

Question 25

In many ways,standby letters of credit (SLCs)perform similar functions for a borrower as do loan commitments.

Question 26

Contingent credit risk occurs with the use of derivative products and involves the potential default by a counterparty.

Question 27

One way to minimize contingent credit risk is to use derivative products sold on organized exchanges.

Question 28

Contingent credit risk on derivative contracts is more serious for futures contracts than for forward contracts.

Question 29

In the U.S. ,commercial banks are the only issuers of standby letters of credit.

Question 30

Commercial letters of credit are used only in international trade.

Question 31

The use of letters of credit (LCs)and standby letters of credit (SLCs)may result in an FI having a higher concentration ratio than desired for a particular industry.

Question 32

As compared to letters of credit (LCs),standby letters of credit (SLCs)typically are used to cover contingencies that potentially are more severe and which may not be trade related.

Question 33

Contingent credit risk is more serious for futures contracts than forward contracts because the over-the-counter arrangements necessary to replicate the guarantees at a later date.

Question 34

Derivative products used in managing contingent credit risk can only be acquired as over-the-counter arrangements.

Question 35

The ability to provide loan commitments is a signal to borrowers that the FI has a lower risk portfolio.

Question 36

Loan commitment activities increase the insolvency exposure of FIs that engage in such activities.

Question 37

An up-front fee on a loan commitment rewards the FI for its willingness to stand ready to lend the commitment amount during some agreed upon time period.

Question 38

The aggregate commitment funding risk can increase the cost of funds above normal levels.

Question 39

If a commercial bank engages in OBS activities,there are no additional capital requirements imposed by regulators.

Question 40

Commercial letters of credit are guarantees that are issued to cover contingencies that are potentially more severe and less predictable than those covered by standby letters of credit.

Question 41

The source of strength doctrine involving failed FIs in multibank holding company corporate structures has been widely accepted by the courts.

Question 42

Standby letters of credit are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.

Question 43

The Clearing House Interbank Payments System (CHIPS)is an international wire transfer system owned by the participating banks in the countries in which it is used.

Question 44

Funds transferred on the Clearing House Interbank Payments System (CHIPS)are settled immediately.

Question 45

Loans sold without recourse have contingent liability off-balance-sheet implications for the FI that sells the loan.

Question 46

The amount of regulations that have been proposed because of the increased use of risk-reducing OBS derivatives is increasing.

Question 47

The ability to form financial holding companies for the purpose of creating full-service financial institutions has caused an increase in affiliate risk.

Question 48

FIs generally include when-issued OBS items as part of their holdings of option contracts.

Question 49

Funds transferred on Fedwire are settled at the end of the day.

Question 50

Where are the contingent items disclosed in the financial statements?

A)On the assets side of the balance sheet.
B)On the liabilities side of the balance sheet.
C)As footnotes to financial statements.
D)In the income statement.

Question 51

Loan commitments are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.

Question 52

Credit derivatives allow FIs to hedge credit risk on individual assets,but not on portfolios of assets.

Question 53

Rediscounted bankers' acceptances are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.

Question 54

Settlement risk on wire transfers involves intraday credit risk.

Question 55

When-issued trading involves the commitment to buy and sell securities before they are issued.

Question 56

Loans sold with recourse by an FI may have future contingent liability off-balance-sheet implications for the FI.

Question 57

To be an affiliate of a holding company,the parent must own at least 50 percent of the shares of the affiliate company.

Question 58

Fees from derivative products are an increasing component of noninterest income for many FIs.

Question 59

The estoppel argument used in bank failures is based on the concept of financial unsophistication.

Question 60

More FIs fail as a result of credit risk exposures than either interest rate or foreign exchange (FX)risk exposure.

Question 61

Off-balance-sheet items are

A)items omitted from the short form balance sheet.
B)contingent assets and liabilities.
C)risk-free assets and liabilities.
D)exceptionally risky assets and liabilities.

Question 62

FIs are competing directly with loan commitments,one of their own OBS products,when they also offer

A)Futures contracts.
B)Swaps.
C)Standby letters of credit.
D)Forward contracts.

Question 63

As of the first quarter of 2015,the vast majority of OBS activities of commercial banks was

A)future and forward contracts.
B)credit derivatives.
C)commitments to buy foreign exchange (FX).
D)swap contracts.

Question 64

The quantity risk exposure of a loan commitment is

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.

Question 65

When an FI pre-commits to lending at a fixed rate,it is exposed to

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.

Question 66

An "adverse material changes in conditions" clause is included in loan commitments to protect the FI against

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.

Question 67

An exporter demands a letter of credit in order to

A)guarantee safe delivery of goods to the importer.
B)guarantee receipt of payment from the importer upon receipt of the goods.
C)protect against adverse changes in foreign exchange rates.
D)protect against adverse changes in international interest rates.

Question 68

Which of the following is the newest addition to the derivative securities markets?

A)Options contracts.
B)Futures contracts.
C)Swap agreements.
D)Forward contracts.
E)Credit derivatives.

Question 69

Which of the following is true of an 'adverse material change in conditions clause' used in a loan commitment?

A)It allows the FI to cancel or reprice a loan commitment.
B)It protects the lender against takedown risk.
C)It protects the lender against basis risk.
D)Exercise of the clause helps defaulted borrowers.

Question 70

Up-front fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.

Question 71

If a future credit crunch is possible,a loan commitment may expose the FI to

A)credit risk.
B)interest rate risk.
C)sovereign country risk.
D)funding risk.

Question 72

The effect to an FI of default by the counterparty to a derivative contract is LEAST serious with

A)options contracts.
B)futures contracts.
C)swap agreements.
D)forward contracts.

Question 73

Back-end fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.

Question 74

Takedown risk in a loan commitment exposes the FI to

A)immediate liquidity risk.
B)basis risk.
C)spread risk.
D)externality effects.
E)future liquidity risk.

Question 75

What is a possible reason behind restricted supply of spot loans to borrowers during a credit crunch?

A)Expansionary monetary policy actions of the Federal Reserve.
B)FI's increased aversion toward lending.
C)Shift to the right in the loan supply function at all interest rates.
D)Low aggregate demand from borrowers to take down loan commitments.

Question 76

Which of the following situations is similar to the externality effect?

A)Exercising an adverse material change in conditions clause as a last resort,thereby canceling or repricing a loan commitment.
B)Increase in the cost of funds above normal levels while many FIs scramble for funds to meet their commitments to customers during a credit crunch.
C)In a loan commitment,the borrower takes down only part of the funds over the specified time-period.
D)The buyer of a commercial letter of credit fails to perform as promised under a contractual obligation.

Question 77

As of 2015,the top 25 U.S.commercial banks accounted for ________ percent of OBS derivative contracts among FDIC-insured institutions.

A)100
B)99.8
C)92.6
D)81.9

Question 78

Which of the following statements best describe a derivative contract?

A)Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C)Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future.
D)Trading in securities prior to their actual issue.

Question 79

Which of the following refers to the fee charged on the unused balance of a loan commitment.

A)Up-front fee.
B)Facility fee.
C)Compensating balance.
D)Commitment fee.

Question 80

Loan loss reserves are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.