4 FMI quiz sol - 4th FMI Quiz PDF

Preview

Summary

4th FMI Quiz...

Description

Online Test 4 – Answers 1.

Limits on deposit insurance encourage the owners of both large and small deposits to monitor the risktaking behavior of banks. FALSE

2.

Limits on deposit insurance encourage the owners of large deposits to monitor the risk-taking behavior of banks; the owners of small deposits below the limit are protected by deposit insurance and have less of an incentive to monitor banks. Insolvency occurs when an institution's duration gap becomes negative. FALSE Insolvency means that the net worth of a financial institution is negative, not its duration gap. The net worth of a financial institution can be positive even if its duration gap is negative (depending on the relative durations of its assets and liabilities).

3.

If a bank has a negative income gap, falling interest rates increase profits. TRUE Recall that the change in profits is the income gap multiplied by the change in interest rates. If the income gap is negative and the change in interest rates is negative (because they fall), this product will be positive, which means that profits go up.

4.

Credit rationing occurs because borrowers that are willing to pay high interest rates are precisely the ones who are most likely to default on their loans.

TRUE Credit rationing means either refusing loans to some customers (even if they are willing to pay a high interest rate) or restricting the size of the loan. It occurs because borrowers that are willing to pay high interest rates are precisely the ones who are most likely to default on their loans. 5.

Income gap analysis enables one to estimate the impact of interest rate changes on the net worth of a financial institution. FALSE Income gap analysis enables one to estimate the impact of interest rate changes on the net income of a financial institution, not on its net worth.

6.

Balance sheet information is the only information that regulators need in order to assess whether a

financial institution is healthy. FALSE Not only balance sheet information matters for the supervision of financial institutions: equally important is knowing the velocity by which the situation can deteriorate, which depends on the institution's risk management. Without proper risk management, a financial institution may exhibit a perfect-looking balance sheet today and yet go bankrupt tomorrow (because it was exposed to severe risks).

7.

A positive duration gap implies that the net worth of the financial institution will decrease when interest rates rise. Therefore, in order to eliminate exposure to interest rate risk the financial institution needs to achieve a negative duration gap. FALSE A negative duration gap does not imply that the institution is immune to interest-rate risk: It's net worth will go down if interest rates go down. The only way to eliminate interest-rate risk is to achieve a duration gap of zero.

8.

Risk weights from the Basel Accords are calculated by dividing the value of a particular asset by the total value of assets. FALSE Risk-weights are weights reflect the riskiness of a particular asset, not its share in the total value of assets.

9.

During a banking crisis, banks cut lending in order to avoid greater losses as the amount of their capital falls. This process is called deleveraging. TRUE When the amount of capital that the banks have falls, the ratio of capital to assets falls as well. In order to remain solvent, the banks can either raise capital or reduce assets. Generally, they opt to do the latter, which is called deleveraging.

10.

Long-term lending relationships are a way for financial institutions to manage credit risk because they enable these institutions to observe the behavior of borrowers more closely. TRUE True. Long-term relationships reveal more information, which enables banks to mitigate credit risk.

11.

An entrepreneur has a project that yields $1,000,000 if it succeeds and 0 otherwise. The probability of success is 10%. In order to implement the project, the entrepreneur needs a loan of $200,000 and is willing to pay an interest rate of 100%. The bank should lend to this entrepreneur.

FALSE Calculate the bank's expected payoff if it lends $200,000 at 100%. It receives $400,000 (the original $200,000 plus interest) with probability 10% and 0 otherwise. Thus, this bank's expected payoff is $40,000, which is far below $200,000 that it needs to lend. 12.

You have a $150,000 deposit at JPM. You learn that there is a 50% chance that JPM is insolvent. If deposit insurance covers the first $250,000 of deposits, per individual, you will try to withdraw your money (i.e you have a strong incentive to withdraw the deposit). FALSE Since the insurance covers $250,000, you will receive your deposit no matter what happens to the bank. Therefore, you have no incentives to withdraw your money.

13. A bank has on-balance-sheet assets with a book value of $450 million and a market value of $590 million and on- balance-sheet liabilities with a book value of $300 million and a market value of $350 million. The bank also has off-balance-sheet assets currently valued at $120 million and off-balance-sheet liabilities worth $140 million. What is this bank's accounting value of stockholders' net worth? What is the market value of stockholders' net worth? Is this bank solvent? What will be this bank's [accounting] leverage ratio if its assets lose $100 of their value? A. B. C. D.

10% 22% 14.29% 33.33%

The bank’s accounting net worth is $150 (=450-300). This bank’s market net worth is $220 (=590350+120-140). This bank is solvent. The bank's current [accounting] leverage (=capital to assets) ratio is 33.33%: 33.33% = 150/450 If the assets lose $100 of their value, then the value of assets and the value of net worth will both decrease by $100. Hence, the leverage ratio will become 14.29%: 14.29% = 50/350

14. Financial intermediation involves banks taking deposits and making private loans. These loans have to be private for which of the following reasons? I. To increase competition across banks. II. To avoid free-riding. III. To ensure that depositors can more easily distinguish between competing banks. IV. To avoid excessive regulation.

A. B. C. D.

II only. III only. II and III only. I and IV only. If loans are not private, all investors will be able to see which borrowers are bad and which borrowers are good, in effect free-riding on the banks' information. This will diminish the banks' incentives to collect information and differentiate between good and bad borrowers. As a result, financial intermediation will break down. The fact that loans are private and cannot be observed by depositors also creates an additional motive to regulate banks, in order to make sure that they do not take excessive risks.

15. A bank has on-balance-sheet assets with a book value of $940 million and a market value of $985 million and on-balance-sheet liabilities with a book value of $900 million and a market value of $930 million. The bank also has off-balance-sheet assets currently valued at $150 million and off-balance-sheet liabilities worth $160 million. What should be the market value of stockholders' net worth (in millions)? A. B. C. D. E.

$50 $45 $40 $30 $55 (985M + 150M) - (930M + 160M) = 45M

16. A bank has three assets. It has $75 million invested in consumer loans with a 3-year duration, $39 million invested in T-Bonds with a 16-year duration, and $18 million in 6-month maturity T-Bills. What is the duration of the bank's asset portfolio (in years)?

A. B. C. D. E.

6.50 years 3.95 years 7.38 years 11.51 years 4.83 years

17. The duration of a bank's assets is 2.25 years and the duration of its liabilities is 1.25 years. The bank has total assets of $2 billion and $1.8 billion in liabilities (other than net worth). Assume that the interest rate applied to net worth is 9%. If all interest rates decrease by 50 basis points, what will be the predicted change in the bank's net worth?

A. B. C. D. E.

$10.37 million $11.25 million -$10.32 million -$11.25 million $10.32 million First, calculate this bank's duration gap: DurGap = DurA - (L/A)xDurL = 2.25 - (1.8/2) x 1.25 = 1.125. Recall that ΔNW/A= - DurGap x Δi/(1+i). Therefore, ΔNW= - DurGap x [Δi/(1+i)] x A. We have: ΔNW = - 1.125 x (-0.005/1.09) x $2 bill = $10.32 million

18. Capital requirements ensure that banks hold enough capital, as measured by regulators. These requirements exists to achieve which of the following? I. To enable bank owners to take excessive risks. II. To prevent bank owners from taking excessive risks. III. To align the incentives of bank owners with those of depositors by ensuring that the former bear greater losses in the case of failure. IV. To increase the amount of information that financial institutions disclose. V. To make it easier for regulators to monitor financial institutions. A. B. C. D.

I, III, and IV only. III, IV, and V only. II and IV only. II and III only. A larger amount of capital ensures that the incentives of bank owners are aligned with those of depositors and also prevents bank owners from taking excessive risks. This is because more capital implies greater losses for bank owners in the case of bank failure.

19. Consider an entrepreneur who wants to build a new factory. If all goes well, this factory will be worth $2,000,000. Otherwise, the investment will be worthless (the factory will be worth 0). There is a 20% chance that the entrepreneur will succeed (and an 80% change that he will fail). In order to build the factory, the entrepreneur needs $500,000 from a bank. He is willing to pay interest of 20% on this loan. The minimum return that the bank requires is 10%. In this case, A. B. C. D.

the best course of action for the bank cannot be determined from the information provided. the bank should deny the loan. the bank should diversify by providing $250,000 and asking another bank to provide the rest. the bank should provide the entrepreneur with the loan. Calculate the bank's expected payoff if it provides the loan. With probability 20%, the loan will be repaid with interest, or $600,000. With probability 80%, the bank gets nothing. Therefore, the bank expects to receive $120,000, on average. This is far less than the $500,000 that it needs to lend. Note that lending $250,000 (or any other amount) does not solve the problem. Assume that the bank lends X. In this case, it receives 1.2X with probability 20% and 0 with probability 80%, or 0.24X in expectation. This is always less than X, the amount that it lends.

20. Collateral decreases credit risk because of which of the following? I. Collateral reduces the lender's losses if the borrower defaults. II. Collateral mitigates moral hazard on behalf of the borrower. III. If the value of the collateral rises above the amount that the borrower owes, the lender can keep the collateral instead of the loan. IV. Collateral increases competition between banks. A. B. C. D.

II and IV only I and II only I and III only I only Collateral reduces credit risk via two channels. First, collateral reduces losses conditional on default, since the lender will be able to recover the value of collateral if the borrower defaults. Second, collateral ensures that the borrower has incentives to repay the loan, since otherwise he/she will lose the collateral to the lender. This second channel, therefore, reduces moral hazard on behalf of the borrower.

21. Bank A has the following assets: reserves of $100, high-quality government bonds of $500, and residential mortgages of $500. Bank A's net worth is $100. Bank B has the following assets: reserves of $50, municipal bonds of $400, and corporate loans of $50. Bank B's net worth is $75. Which bank will be considered riskier according to the Basel methodology? Assume that the following risk weights apply: Reserves — 0% High-quality government bonds — 0% Residential mortgages — 50% Municipal bonds — 50% Corporate loans — 100%. A. B. C. D.

Bank A is riskier. Bank B is riskier. Both banks have the same level of risk. The relative riskiness of the two banks cannot be determined from the information provided. First, calculate each bank's risk-weighted assets. Risk-weighted assets are $250 for both banks. Since the amount of capital that Bank B holds is lower than that of Bank A, it will be considered relatively more risky.

22. A bank has substantially less rate-sensitive assets than rate-sensitive liabilities. The bank's manager is worried that the bank's potential losses in the case of an increase in interest rates could be larger than the limits set by the bank's risk management framework. Which of the following measures could help reduce potential losses (if interest rates go up)?

A. the bank sells some of its rate-sensitive assets and uses the proceeds to reduce its rate-insensitive liabilities by the same amount B. the bank re-allocates some of its rate-sensitive assets into rate-insensitive assets C. the bank sells some of its rate-sensitive assets and uses the proceeds to reduce its rate-sensitive liabilities by the same amount D. the bank re-allocates some of its rate-sensitive liabilities into rate-insensitive liabilities The bank has a negative income gap. By re-allocating rate-sensitive liabilities into rate-insensitive ones, the bank can bring its income gap closer to zero and reduce potential losses in case of interest rate increases.

23. Imagine a bank that has the following balance sheet: Assets Reserves Loans

Liabilities 20 Deposits 80 Capital

95 5

Due to asymmetric information problems, the loans are illiquid and will only sell for 80 cents on the dollar (i.e., for 80% of their book value) if they have to be sold before maturity. Assume the bank cannot borrow from markets, other lenders or the central bank. Assume the bank is allowed to remain operative until capital falls to 0, and there are no reserve requirements. What amount of deposits can be withdrawn from this bank before the bank has depleted all its capital and goes bankrupt?

A. At most 40 deposits can be withdrawn before reaching bankruptcy. B. At most 20 deposits can be withdrawn before reaching bankruptcy. C. At most 45 deposits can be withdrawn before reaching bankruptcy. D. At most 80 deposits can be withdrawn before reaching bankruptcy. The bank can immediately handle the withdrawal of 20 units of deposits by using its reserves. On top of this, it can sell an amount X of its (illiquid) loans to other banks. This will yield 0.8*X in fresh reserves which can then be used to meet 0.8*X further withdrawals; however, because the bank only recovers 0.8 of reserves on each dollar it sells in loans, capital (defined as assets minus liabilities) will shrink by 0.2*X, too! So the bank will go bankrupt when 0.2*X = 5 (the available amount of capital), which implies X = 25. Thus, the bank can in total pay out 20 (from reserves) + 20 (=0.8*X from loan sales) units of deposits before it goes bankrupt. 24. Does government deposit insurance always make a banking system safer? A. Yes, this is unconditionally true. Deposit insurance guarantees the funds of depositors, which makes them less reluctant to deposit at a bank. Interest expenses will be lower, and the net interest margin of banks increases. Thus, the banking system will always become more stable. B. It depends. If strong regulatory institutions are absent, banks will become more risky as they will take advantage of the safety net offered by deposit insurance (moral hazard). Thus, the banking system can become more risky. If, on the other hand, moral hazard is contained by strong and effective banking regulation, the banking system will become safer with deposit insurance because depositors have no more incentive to run the bank. C. Yes, this is unconditionally true. Deposit insurance eliminates people's incentives to run the bank, thus there will always be fewer banking panics and bank failures under deposit insurance. D. No, deposit insurance will have the opposite effect. It increases moral hazard on the side of banks, which cannot be controlled, and the banking system will always be less stable.

25. Consider the following example: Assets Rate-sensitive assets (Duration of 0.5 years) Rate-insensitive assets (Duration of 5 years) Total

Liabilities Rate-sensitive liabilities 50 (Duration of 0.3 years) Rate-insensitive liabilities 50 (Duration of 5 years) Bank capital 100Total

80 10 10 100

What is the bank’s duration gap? A. 2.75 B. 0.82 C. 2.012 D. 3.45 First, calculate the durations of assets and liabilities DUR(assets)=0.5*(50/100) + 5*(50/100)=2.75 DUR(liabilities)=0.3*(80/90) + 5*(10/90)=0.82 Now we can calculate the duration gap: 2.75−(90/100)*0.82=2.012 26. Consider the following bank, Bank BB: Assets Reserves German government debt Residential mortgages Municipal bonds Corporate loans Total

Liabilities 5Checkable deposits 10 Nontransaction deposits 20 Borrowings 30 35 Bank capital 100Total

20 60 11 9 100

Compute this bank's risk-weighted assets if reserves and German government bonds have a risk weight of 0%, residential mortgages and municipal bonds have a risk-weight of 50%, and corporate loans have a risk weight of 100%. A. B. C. D.

50 45 60 20

This bank's risk-weighted assets are €60: 60 = 5*0 + 10*0 + 20*0.5 + 30*0.5 + 35*1 27. Consider the following bank: Assets Reserves Loans Total

Liabilities 10 Deposits 90 Capital 100Total

80 20 100

When held until maturity, all loans are worth their book value. However, they can be sold only for 75% of their book value before maturity. How much can depositors withdraw before this bank becomes insolvent? Assume that the bank cannot increase borrowings and there are no reserve requirements. A. 60 B. 70 C. 10

D. 35 The bank can handle €10 worth of withdrawals with its reserves. Any further deposit withdrawals will trigger fire sales of loans. For every euro of loans sold, the depositors receive 0.75 euros, with 0.25 euros being written down (because of fire sales). The amount written down diminished the bank's net worth. Assume that depositors withdraw y, on top of the €10 that the bank can handle with its reserves. The bank needs to sell €y=0.75 worth of loans to meet these withdrawals, and 0.25 of this amount will be written down off net worth, for a total of 0,25y / 0.75 = y/3. The bank becomes insolvent when its net worth is depleted, which happens when y/3 = 20, or y = 60. Hence, depositors can withdraw at most €70 (=10+60) before the bank becomes insolvent. 28. Bank G has assets of $140 million and liabilities of $125 million. The duration of its assets is 4.3 years, and the duration of its liabilities is 1.2 years. What is the bank’s duration gap? By how much does its net worth change approximately if interest rates increase from 5% to 5.5%? A. B. C. D.

-$2.153 million $1.40 million $2.153 million $2.10 million

Duration gap: 4.3 years – 125/140 * 1.2 years = 3.23 years Change in net worth: ΔNW = A*(-DUR(gap))*Δi/(1+i) =$140 million * (-3.23)*(0.055-0.050)/(1+0.05) = -$2.153 million 29. Consider JPM’s balance sheet: Assets Reserves Other assets Total

Liabilities $27.83BDeposits $2.56TOther liabilities Bank capital Total

$1.36T $997.93B $2.59T

Imagine that JPM owners/managers have two possible business strategies: I. They can buy safe and liquid government securities, so that by the end of the year the value of assets will grow from $2.59T to $2.65T (with probability 100%). II. Or, they can engage in very risky operations. In this case, with probability 50% the assets will grow to $3T, and with probability 50% they will go down to 0. Which option...