This Document Contains Chapters 10 to 11 Chapter 10 The Investment Function in Banking and Financial-Services Management Fill in the Blank Questions 1. A(n) _________ is a security issued by the federal government which has less than one year to maturity when it is issued. Answer: Treasury bill 2. Debt instruments issued by cities, states and other political entities and which are exempt from federal taxes are collectively known as _________. Answer: municipal securities 3. The investment maturity strategy which calls for the bank to have one half of its investment portfolio in very short term assets and one half of its investment portfolio in long term assets is known as the _________. Answer: barbell strategy 4. A(n) _________ is a security where the interest portion of the security is sold separately from the principal portion of the security. Answer: stripped security 5. _________ are the way the federal, state and local governments guarantee the safety of their deposits with banks. Answer: Pledging requirements 6. The most aggressive investment maturity strategy calls for the bank to continually shift the maturities of its securities in responses to changes in interest rates and is called the _________. Answer: rate expectation strategy 7. _________ is the risk that the bank will have to sell part of its investment portfolio before their maturity for a capital loss. Answer: Liquidity risk 8. _________ is the risk that the economy of the market area they service may take a down turn in the future. Answer: Business risk 9. _________ is the risk that the company whose bonds the financial institution owns may retire the entire issue of corporate bonds in advance of their maturity leaving the bank with the risk of earnings losses resulting from reinvesting the cash at lower interest rates. Answer: Call risk 10. A security issued by the federal government with 1 to 10 years to maturity when it is issued is called a(n) _________. Answer: Treasury note 11. A short term debt security issued by major corporations is known as _________. Answer: commercial paper 12. The investment maturity strategy which calls for the bank to have all of their investment assets in very short term maturities is called the _________. Answer: front-end-loaded policy 13. A money market security which represents a bank's commitment to pay a stipulated amount of money on a specific future date under specific conditions and which is often used in international trade is known as a(n) _________. Answer: bankers' acceptance 14. A(n) _________ is an interest-bearing receipt for the deposit of funds in a bank for a stipulated time period. Ones that are oriented towards business customers or institutions are known as jumbos. Answer: certificate of deposit 15. _________ are any securities which reach maturity in under one year. Answer: Money market securities 16. _________ are any securities whose original maturity exceeds one year. Answer: Capital market securities 17. Securities sold by Fannie Mae, Freddie Mac and others are known as _________. Answer: federal agency securities 18. Claims against the expected income and principal generated by a pool of similar-type loans are known as _________. Answer: securitized assets 19. The long term debt obligations of major corporations are known as _________. Answer: corporate bonds 20. The investment maturity strategy which calls for the bank to have all of their investment assets in very long term maturities is known as the _________. Answer: back-end-loaded policy 21. Financial Institutions may invest in municipal bonds issued by smaller local governments. These bonds are known as ____________ bonds. Answer: bank qualified 22. Marketable notes and bonds sold by agencies owned by the government or sponsored by the government are known as _________. Answer: government agency securities 23. A security issued by the federal government with greater than 10 years to maturity when it is issued is called a(n) _________. Answer: Treasury Bond 24. _________ are time deposits of fixed maturity issued by the world’s larges banks headquartered in financial centers around the globe. The heart of this market is centered in London. Answer: Eurocurrency deposits 25. _________ are a type of municipal bond that are backed by the full faith and credit of the issuing government. Answer: General obligation bonds 26. _________ are a type of municipal bond that are paid only from certain stipulated source of funds. Answer: Revenue bonds 27. _________ are closely related to CMOs and partition the cash flow from a pool of mortgage loans or mortgage backed securities into multiple maturity classes in order to reduce the cash-flow uncertainty of investors. Answer: Real Estate Mortgage Investment Conduits (REMICs) 28. _________ is the risk that loans will be terminated or paid off ahead of schedule. This is a particular problem with residential home mortgages and other consumer loans that are pooled and used as collateral in securitized assets. Answer: Prepayment risk 29. A lending institution that sells lower-yielding securities at a loss in order to reduce current taxable income while simultaneously purchasing higher-yielding new securities in order to boost future returns is doing a(n) _________. Answer: tax swap 30. A(n) _________ is a picture of how market interest rates differ across loans securities of varying times to maturity. Answer: yield curve True/False Questions 31. Investments in securities provide diversification for a bank's assets because most loans come from the local areas served by a bank's offices. Answer: True 32. Bank income from loans is fully taxable. Answer: True 33. Investment securities are expected to "dress up" a bank's balance sheet, according to the textbook. Answer: True 34. Investment securities are expected to help stabilize a financial institutions's income. Answer: True 35. A short-term IOU offered by major corporations that is of short maturity (most of these lOUs mature in 90 days or less) is known as a CMO. Answer: False 36. Prepayment risk on securitized assets generally increases when interest rates rise. Answer: False 37. Stripping a security eliminates prepayment risk. Answer: False 38. According to the textbook the dominant security held in U.S. bank investment portfolios is state and local government bonds. Answer: False 39. Interest income and capital gains from a bank's portfolio of investment securities is taxed in the United States as ordinary income. Answer: True 40. Eurocurrency deposits that some banks purchase as investments generally carry higher market yields than domestic time deposits issued by comparable-size U.S. banks. Answer: True 41. Bankers' acceptances are considered to be among the safest of all money market instruments. Answer: True 42. An eligible acceptance is one that can be used as collateral for borrowing from a Federal Reserve bank. Answer: True 43. When a bank irrevocably guarantees a commercial paper issue, the bank's credit rating substitutes for the borrower's credit rating. Answer: True 44. The principal risk banks face from investing in structured notes is credit (default) risk. Answer: False 45. The principal risk to a financial institution buying CMOs is market risk. Answer: False 46. Stripped mortgage-backed securities fully protect investors from having to reinvest their income at lower and lower interest rates. Answer: False 47. Stripped mortgage-backed securities make maturity matching of bank assets and liabilities easier to accomplish than do most other investment securities that banks buy. Answer: False 48. Lower interest rates increase the present value of all projected cash flows from a loan-backed security so that its market value could rise. Answer: True 49. Treasury bills are the long term debt obligations issued by the federal government. Answer: False 50. Commercial paper is the short term debt instrument issued by major banks. Answer: False 51. Treasury notes and bonds are issued by the federal government and are coupon instruments. Answer: True 52. Interest rate risk is the risk financial institutions face due to changes in market interest rates. Answer: True 53. One investment maturity strategy popular among smaller institutions is the ladder or spaced maturity policy. It is popular because it does not take much expertise to implement. Answer: True 54. One investment maturity strategy, called the front end loaded policy, requires that the bank put all of its investment portfolio in long term securities. Answer: False 55. Business risk is the risk that the bank will experience a cash shortage and will have to sell some of its investments securities. Answer: False 56. Inflation risk is the possibility that the purchasing power of interest income and repaid principal from a security or loan will be eroded by rising prices for goods and services. Answer: True 57. Call risk refers to the right of debt collectors to call in the loans in advance of maturity and get an early repayment. Answer: False 58. If interest rates fall, a callable bond at par has the potential for large increases in price. Answer: False 59. The yield to maturity is the discount rate that equates a security’s purchase price with the stream of income expected until it is sold to another investor. Answer: False Multiple Choice Questions 60. An important investment security popular with banks that must by law mature within one year from the date of issue and which has a high degree of safety and marketability is the: A) Treasury bill B) Treasury note C) FNMA note D) Bankers' acceptance E) Eurodollar CD Answer: A 61. A bank's promise to pay the holder a designated amount of money on a designated future date and is often used in international trade is known as a (or an): A) Promissory guarantee B) Discount security C) Bankers' acceptance D) In the money option E) Accretion note Answer: C 62. Pools of mortgages put together either by a government agency or by a private investment banking corporation to raise more loanable funds for the issuer are known as a (or an): A) Accretion bond B) Participation certificate C) CMO D) Stripped security E) Commercial paper Answer: C 63. Fluctuations in the timing of cash payments flowing from an underlying pool of securitized assets is referred to as: A) Income risk B) Prepayment risk C) Liquidity risk D) Capital risk E) None of the above Answer: B 64. Principal roles that a financial institution's investment portfolio play include which of the following? A) Income stability B) Geographic diversification C) Hedging interest rate risk D) Backup liquidity E) All of the above Answer: E 65. _____________ is the method by which banks can provide a safeguard for the deposits of governmental units. A) Hedging B) Collateralization C) Pledging D) Securitization E) Window dressing Answer: C 66. The most aggressive investment maturity strategy that calls for the bank to continually shift the maturities of its securities in response to changes in interest rates and other economic conditions is the A) Barbell strategy B) Rate expectations approach C) Front-end-loaded policy D) Ladder approach E) None of the above Answer: B 67. Which of the following statements is (are) correct regarding duration? A) In comparing two bonds with the same yield to maturity and the same maturity, a bond with a higher coupon rate will have a longer duration. B) In comparing two loans with the same maturity and the same interest rate, a fully amortized loan will have a shorter duration than a loan with a balloon payment. C) The duration will always be shorter than the maturity for all debt instruments. D) All of the above E) B and C Answer: B 68. Which of the following is not one of the Capital Market instruments in which banks invest? A) U.S. Treasury notes B) Corporate notes and bonds C) U.S. Treasury bonds D) Municipal bonds E) Commercial paper Answer: E 69. Which of the following is true of Treasury bills? A) Interest on Treasury bills is exempt from state income taxes. B) Interest on Treasury bills is exempt from federal income taxes. C) Treasury bills pay a lower pretax yield than comparable corporate securities. D) All of the above are true. E) A and C only Answer: E 70. In recent years security dealers have assembled pools of federal agency securities whose principal interest yield may be periodically reset based on what happens to a stated interest rate or may carry multiple coupon rates that are periodically adjusted; the foregoing describes a: A) Financial futures contract B) Revenue-anticipation note C) Zero coupon instrument D) Structured note E) None of the above Answer: D 71. Banks are generally not allowed to invest in speculative grade bonds. What kind of risk is this designed to limit? A) Liquidity risk B) Business risk C) Credit risk D) Tax exposure E) Interest rate risk Answer: C 72. A security where the interest payments and the principal payments are sold separately is called: A) A Treasury note B) An accretion C) A structured note D) A stripped security E) None of the above Answer: D 73. Which of the following is true? Mortgage prepayment risk: A) Is higher on high interest rate mortgages B) Is felt most dramatically when interest rates rise C) Is eliminated by the use of mortgage backed securities D) Is eliminated by the purchase of a stripped mortgage obligation E) All of the above are true Answer: A 74. A bank replaces 5-year corporate bonds with a yield to maturity of 9.75 percent with 5-year municipal bonds with a yield to maturity of 7 percent. This bank is in the 35 percent tax bracket and these bonds have the same default risk. What is the most likely reason this bank changed from the corporate to the municipal bonds? A) Liquidity risk B) Business risk C) Credit risk D) Tax exposure E) Interest rate risk Answer: D 75. Suppose a bank has found bank qualified municipal bonds which have a nominal gross rate of return of 8 percent and that it can borrow funds needed for this purchase at a rate of 6.25 percent. This bond is in the 35 percent tax bracket. What is the net after-tax return on this bond? A) 5.20 percent B) 3.5 percent C) 1.75 percent D) 0 percent E) None of the above Answer: B 76. An investor can invest in either a tax-exempt security that pays 5% or a taxable corporate security of comparable risk and maturity that pays 8%. At what marginal tax rate will the investor be indifferent between these two securities? A) 25.0% B) 32.5% C) 37.5% D) 57.5% E) 62.5% Answer: C 77. Which of the following would not be considered a bank qualified municipal security? A) A Columbia County general obligation bond to modernize the county fire department. B) A Bucks County general obligation bond to build a new sewer plant. C) A City of San Marcos general obligation bond to pay for street repairs. D) A City of Chicopee general obligation bond to pay for a new city jail. E) A Treasury bond to finance government debt. Answer: E 78. A bond has three years to maturity and has a coupon rate of 15 percent. This bond is selling in the market for $1072 and has a yield to maturity of 12%. What is the duration of this bond? A) 3 years B) 1 year C) 1.92 years D) 2.45 years E) 2.64 years Answer: E 79. A bond has six years to maturity and has a coupon rate of 7.5 percent. Coupon payments are made annually and this bond has a face value of $1000. This bond is selling in the market for $1127. What is the yield to maturity on this bond? A) 7.5 percent B) 5 percent C) 11.5 percent D) 2.5 percent E) None of the above Answer: B 80. A bond has eight years to maturity and a coupon rate of 6.5 percent. Coupon payments are made annually and this bond has a face value of $1000. This bond is selling in the market for $862. What is the yield to maturity on this bond? A) 6.5 percent B) 10 percent C) 8.5 percent D) 9 percent E) None of the above Answer: D 81. A bond has eight years to maturity and a coupon rate of 6.5 percent. Coupon payments are made annually and this bond has a face value of $1000. This bond is selling in the market for $862. If this bond is sold at the end of four years for $1046, what is the holding period return on this bond? A) 6.5 percent B) 12 percent C) 9 percent D) 6 percent E) None of the above Answer: B 82. A security which was created by the Treasury to protect against inflation risk is called a(n): A) CMO B) FNMA C) GNMA D) TIPS E) CD Answer: D 83. A financial institution that is concerned about the possibility that the purchasing power of both the interest income and principal income will decline on a loan is concerned about which of the following things? A) Business risk B) Liquidity risk C) Tax exposure D) Credit risk E) Inflation risk Answer: E 84. A bank that is concerned that the economic conditions of the market area they serve may take a downturn with falling demand for loans and higher bankruptcies in the areas is concerned about which of the following things? A) Business risk B) Liquidity risk C) Tax exposure D) Credit risk E) Inflation risk Answer: A 85. Which of the following is a characteristic of Treasury bills? A) They are coupon instruments B) They are the short term debt instruments issued by major corporations C) They are discount securities D) They have more risk than other money market securities E) All of the above are characteristics of Treasury bills Answer: C 86. The investment maturity strategy which calls for the bank to put all of their investment assets into very long term securities is called the: A) Front-end-loaded maturity policy B) Back-end-loaded maturity policy C) Ladder or spaced maturity policy D) Barbell investment portfolio strategy E) Rate expectation approach Answer: B 87. The Lancaster State Bank is thinking about purchasing a corporate bond that has a yield of 8.5%. This bank has a marginal tax rate of 25%. What is the after-tax yield on this bond? A) 11.33% B) 8.5% C) 6.375% D) 2.125% E) None of the above Answer: C 88. The Ferson National Bank is thinking about purchasing a municipal bond that has a yield of 5.5%. This bank has a marginal tax rate of 30%. What is the after-tax yield on this bond? A) 7.86% B) 5.5% C) 3.85% D) 1.65% E) None of the above Answer: B 89. The Stumbaugh State Bank is thinking about purchasing a corporate bond that has a yield of 9%. This bank has a marginal tax rate of 40%. What is the after-tax yield on this bond? A) 15% B) 9% C) 5.4% D) 3.6% E) None of the above Answer: C 90. The Price Perpetual Bank has purchased a bond that has a coupon rate of 5.5% and a face value of $1000. It has 11 years to maturity and is selling in the market for $887.52. The bond makes annual coupon payments. What is the yield to maturity on this bond? A) 7% B) 5.5% C) 11% D) 4.70% E) None of the above Answer: A 91. The Price Perpetual Bank has purchased a bond that has a coupon rate of 5.5% and a face value of $1000. It has 11 years to maturity and is selling in the market for $887.52. The bond makes annual coupon payments. The Price Perpetual Bank is planning on selling this bond at the end of 5 years for $1036.50. What is the holding period return on this bond? A) 5.5% B) 7% C) 11% D) 9% E) None of the above Answer: D 92. The Farmer National Bank has purchased a bond that has a coupon rate of 11.5% and a face value of $1000. It has 16 years to maturity and is selling in the market for $1309.80. The bond makes annual coupon payments. What is the yield to maturity on this bond? A) 11.5% B) 16% C) 8% D) 12.21% E) None of the above Answer: C 93. The Farmer National Bank has purchased a bond that has a coupon rate of 11.5% and a face value of $1000. It has 16 years to maturity and is selling in the market for $1309.80. The bond makes annual coupon payments. The Farmer National Bank plans on selling this bond at the end of 8 years for $1071. What is the holding period return on this bond? A) 7% B) 8% C) 11.5% D) 16% E) None of the above Answer: A 94. The Johnson National Bank has purchased a bond that has a coupon rate of 5.5% and a face value of $1000. It has 4 years to maturity and is selling in the market for $917. The bond makes annual coupon payments. What is the yield to maturity on this bond? A) 5.5% B) 4.0% C) 1.5% D) 8% E) None of the above Answer: D 95. The Johnson National Bank has purchased a bond that has a coupon rate of 5.5% and a face value of $1000. It has 4 years to maturity and is selling in the market for $917. The bond makes annual coupon payments. What is the duration of this bond? A) 3.38 years B) 3.68 years C) 4.00 years D) 5.50 years E) None of the above Answer: B 96. The Sheets Savings and Loan Association has purchased a bond that has a coupon rate of 7.5% and a face value of $1000. It has 5 years to maturity and is selling in the market for $1063. The bond makes annual coupon payments. What is the duration of this bond? A) 7.50 years B) 5.00 years C) 4.65 years D) 4.37 years E) None of the above Answer: D 97. The Dillinger State Bank has purchased a bond from the Interstate Manufacturing Company that has 15 years to maturity and has a coupon rate of 12.5%. Market interest rates have recently declined to 8% and the Dillinger State Bank is worried that the Interstate Manufacturing Company will retire the bond and issue new ones with a lower coupon rate. What type of risk is the Dillinger State Bank worried about? A) Credit risk B) Interest-rate risk C) Business- risk D) Call risk E) Prepayment risk Answer: E 98. The Terrell State Bank is a small bank located in Guyman, Oklahoma. All of their loans are agriculture and small business loans in Guyman. They want to buy a municipal bond from the state of South Carolina. What type of risk are they likely trying to reduce with this purchase? A) Credit risk B) Interest-rate risk C) Business risk D) Call risk E) Prepayment risk Answer: C 99. The Caldwell National Bank has purchased a bond that pays a coupon rate of 10.5%. They are a little concerned because they believe rates will decrease in the future and they will not be able to reinvest the coupon payments at the same rate. What type of risk are they concerned about? A) Credit risk B) Interest rate risk C) Business risk D) Call risk E) Prepayment risk Answer: B 100. Moody’s Investor Service has added the numbers 1, 2 and 3 to some of their ratings. What type of risk are these ratings attempting to measure? A) Credit risk B) Interest rate risk C) Business risk D) Call risk E) Prepayment risk Answer: A 101. The Roy State Bank has just purchase a portfolio of asset backed securities. What type of risk do these securities have that other securities do not have? A) Credit risk B) Interest rate risk C) Business risk D) Call risk E) Prepayment risk Answer: E 102. The Carey State Bank has purchased a bank-qualified municipal bond with a yield of 6%. This bank has had to borrow funds to make this purchase at a cost of 5.25%. This bank is in the 40% tax bracket. What is the net after-tax return on this bank-qualified municipal bond? A) 6.00% B) .75% C) 2.85% D) 2.43% E) None of the above Answer: D 103. The Wesson Wisconsin State Bank has purchased a bank-qualified municipal bond with a yield of 7.5%. This bank had to borrow funds to make this purchase at a cost of 6%. This bank is in the 25% tax bracket. What is the net after-tax return on this bank-qualified municipal bond? A) 7.5% B) 2.7% C) 3.0% D) 1.5% E) None of the above Answer: B 104. The Goodknight Company has issued securities with 45 days to maturity. What type of security have they issued? A) Commercial Paper B) Banker’s Acceptance C) Corporate Bond D) Certificate of Deposit E) Municipal Bond Answer: A 105. The Dakota National Bank has purchased a security issued by the state of Tennessee that has 20 years to maturity. What type of security have they purchased? A) Commercial Paper B) Banker’s Acceptance C) Corporate Bond D) Certificate of Deposit E) Municipal Bond Answer: E Chapter 11 Liquidity and Reserves Management: Strategies and Policies Fill in the Blank Questions 1. A(n) _________ is an asset which can be converted into cash easily, which has a relatively stable price and is reversible so that the seller can recover their original investment with little risk of loss. Answer: liquid asset 2. When a financial institution sells assets to manage liquidity it faces _________. They lose the future earnings on those assets, they face transaction costs on those sales and the assets most easily sold often have the lowest return. Answer: opportunity costs 3. _________ is when the financial institution borrows money in the money market to meet their liquidity needs. Answer: Purchased (borrowed) liquidity 4. The _________ is the total difference between its sources and uses of funds. Answer: liquidity gap 5. _________ are the deposits and other borrowings of the bank which are very interest sensitive or where the bank is sure they will be withdrawn during the current period. Answer: "Hot money" liabilities 6. The _________ is the idea that management should make all good loans and count on its ability to borrow funds if it does not have the liquidity to meet its cash needs. Answer: customer relationship doctrine 7. _________ are the assets the bank must by law hold behind its deposits. In the U.S. only vault cash and deposits held with the Federal Reserves can be used to meet these requirements. Answer: Legal reserves 8. A(n) _________ is the account the bank must have at the Federal Reserve to cover any checks drawn against the bank. Answer: clearing balance 9. A(n) _________ is a service developed by banks where the bank shifts money out of accounts with reserve requirements and into savings accounts overnight. Answer: sweeps account 10. The _________ is a 14 day period stretching from a Thursday to a Wednesday. This is the period in which the bank has to keep their average daily level of required reserves for a particular computation period. Answer: reserve maintenance period 11. _________ is the availability of cash in the amount needed at a reasonable cost. Answer: Liquidity 12. The oldest approach to meeting liquidity needs which relies on the sale of liquid assets to meet liquidity demands is called _________. Answer: asset liquidity management 13. Under a _________ strategy some of the expected demands for liquidity are stored in assets, while others are backstopped by arrangements for lines of credit from banks or other suppliers of funds. Answer: balanced liquidity management 14. A(n) _________ is the person in the bank responsible for the bank's cash position and meeting legal reserve requirements. Answer: money position manager 15. The method used in the U.S. to determine a bank's legal reserve requirement in which the period for holding legal reserves follows the period used to calculate the required amount of legal reserves is called _________. Answer: lagged reserve accounting 16. The fed funds rate is generally most volatile on bank __________ day. Answer: settlement 17. Many depository institutions hold __________ balances (extra reserves) to help prevent overdraft penalties. Answer: precautionary 18. Not all _______ banks around the world have reserve requirements. Answer: central 19. For several decades, the largest banks around the world have chosen _________ which calls for borrowing immediately spendable funds to cover all anticipated demands for liquidity. Answer: liability management 20. The _________ approach to managing liquidity starts with two simple facts, liquidity rises as deposits increase and loans decrease and liquidity falls when deposits fall and loans increase. Answer: sources and uses of funds 21. In the _________ approach to managing liquidity deposits and other sources of funds are divided into categories and then liquidity managers must set aside liquid funds according to some desired operating rule. Answer: structure of funds 22. Many financial service institutions estimate their liquidity needs based upon experience and industry averages. This approach to managing liquidity is called the _________ approach. Answer: liquidity indicator 23. Many analysts believe there is only one sound method for assessing a financial institution’s liquidity needs. This method centers on _________. Answer: discipline of the financial marketplace (signals from the marketplace) 24. The _________ for deposits and other reservable liabilities and for vault cash holdings is a two week period extending from Tuesday to a Monday two weeks later. Answer: reserve computation period 25. If total legal reserves held are greater than required reserves the bank has. Answer: excess reserves 26. If total legal reserves held are less than required reserves the bank has. Answer: a reserve deficit 27. The _________ is where a money position manager can cover a large reserve deficit quickly. It is usually one of the cheapest places to borrow but is also frequently volatile. Answer: federal funds market 28. One of the ratios used in the liquidity indicator approach to managing a financial institution’s liquidity needs is _________. This ratio is cash and due from depository institutions divided by total assets where a greater ratio indicates a stronger liquidity position. Answer: cash position indicator True/False Questions 29. Liquid assets must have a reasonably stable price so that the market is deep enough to absorb the sale without a significant loss of value. Answer: True 30. Asset liquidity management (or asset conversion) involves storing liquidity in assets, such as deposits and jumbo CDs. Answer: False 31. Asset liquidity management (or asset conversion) involves storing liquidity in assets, such as cash and marketable securities. Answer: True 32. Liquid assets generally have a stable price but are not necessarily reversible. Answer: False 33. Asset conversion is considered to be a costless approach to liquidity management. Answer: False 34. One principle of sound bank liquidity management is to be sure to sell first those assets with the least profit potential. Answer: True 35. Borrowed liquidity (liability) management is less risky for a financial institution than is asset conversion. Answer: False 36. A financial institution's liquidity gap represents the difference between its sources and uses of liquid funds. Answer: True 37. A bank expects to lose its "hot money" liabilities, according to the textbook. Answer: True 38. According to the customer relationship doctrine a bank should turn down any loan requests for which it does not have enough deposits on hand but should help its borrowing customer obtain funds from some other source (such as by issuing a letter of credit to backstop the customer's loan from another lender). Answer: False 39. A U.S. bank can run up to a 5-percent deficit in its legal reserve requirement without incurring an interest penalty from the Federal Reserve System. Answer: False 40. Most liquidity problems in banking arise from inside a bank, not from its customers. Answer: False 41. Holdings of liquid assets at U.S. banks have experienced a gradual decline in recent years. Answer: True 42. The Federal Reserve has been lowering deposit reserve requirements in recent years. Answer: True 43. The liquidity indicator, core deposits divided by total assets, is a measure of stored liquidity. Answer: False 44. A bank's money position manager is responsible for insuring that the bank maintains an adequate level of legal reserves. Answer: True 45. If a bank in the United States runs a legal reserve deficit of more than 2 percent of its required daily average legal reserve position it will be assessed an interest penalty equal to the Federal Reserve's discount rate plus 5 percent. Answer: False 46. If a bank receives more checks deposited to the accounts it holds than checks drawn against its deposit accounts, the bank's legal reserves will tend to increase. Answer: True 47. According to the textbook if a bank's liquidity deficit is expected to last for only a few hours, the federal funds market or the central bank's discount window is normally the preferred source of funds. Answer: True 48. Banks making heavy use of borrowed sources of liquidity must wrestle with the problem of interest cost uncertainty, according to the textbook. Answer: True 49. All central banks impose reserve requirements on the banks they regulate. Answer: False 50. The sources and uses of funds method of estimating a bank's liquidity requirements divides the bank's liabilities into three types (hot money, vulnerable funds and stable funds) and estimates the probability of each being withdrawn from the bank. Answer: False 51. One of the problems with liquidity management for a bank is that rarely does the demand for funds equal the supply of funds at a given time. Answer: True 52. One of the problems with liquidity management for a bank is that there is a trade-off between bank liquidity and profitability. Answer: True 53. The liquidity problem for banks is made easier because most of their liabilities are not subject to immediate repayment. Answer: False 54. The liquidity problem for banks is made easier because depositors and borrowers are not sensitive to changing interest rates. Answer: False 55. The oldest approach to liquidity management is the asset liquidity management approach. Answer: True 56. Some central banks around the world impose reserve requirements on bank loans. Answer: True 57. Some central banks around the world impose reserve requirements on no deposit liabilities. Answer: True 58. Interest in bank and financial service liquidity management is a relatively new phenomenon which arose following the 9/11 crisis. Answer: False 59. Bank robberies have declined in recent years. Answer: False 60. Discount window loans jumped dramatically the day following 9/11. Answer: True 61. A bank or financial service institution can meet reserve requirements by selling Treasury securities in its portfolio. Answer: True 62. All central banks around the world have some specified reserve requirement. Answer: False 63. Core deposit ratio is used as one of the liquidity indicators for depository institutions and is defined as the ratio of core deposits to total assets. Answer: True 64. Loan commitments ratio measures the volume of promises a lender has made to its customers to provide credit up to pre-specified amount over a given time period. Answer: True Multiple Choice Questions 65. A financial institution that has ready access to immediately spendable funds at reasonable cost at precisely the time those funds are needed is: A) Risk free B) Liquid C) Efficient D) Profitable E) None of the above Answer: B 66. Which of the following is not a reason that banks to hold liquid assets? A) To meet customer's needs for currency. B) To meet capital requirements. C) To meet required reserves. D) To compensate for correspondent bank services. E) To assist in the check clearing process. Answer: B 67. The two most pressing demands for liquidity from a bank come from, first, customers withdrawing their deposits and, second, from: A) Credit requests from those customers the bank wishes to keep B) Checks being cashed at local stores and directly from the bank C) Demands for wired funds from correspondent banks. D) Legal reserve requirements set by the Federal Reserve Board. E) None of the above. Answer: A 68. A bank expects in the week about to begin $30 million in incoming deposits, $20 million in deposit withdrawals, $15 million in revenues from the sale of no deposit services, $25 million in customer loan repayments, $5 million in sales of bank assets, $45 million in money market borrowings, $60 million in acceptable loan requests, $10 million in repayments of bank borrowings, $5 million in cash outflows to cover other operating expenses, and $10 million in dividend payments to its stockholders. This bank's net liquidity position for the week is: A) $30 million B) $20 million C) $10 million D) $15 million E) None of the above Answer: D 69. There is a trade-off problem between liquidity and: A) Risk exposure B) Safety. C) Profitability D) Efficiency E) None of the above Answer: C 70. Financial institutions face significant liquidity problems because of: A) Imbalances between the maturities of their assets and their principal liabilities. B) Their high proportion of liabilities subject to immediate withdrawal. C) Their sensitivity to changes in interest rates. D) Both A and B E) All of the above. Answer: E 71. Sources of liquidity for banks include: A) Deposit inflows B) Money market borrowings C) Sales of marketable securities D) Loan repayments E) All of the above Answer: E 72. Which of the following is not a source of liquidity for financial institutions? A) Deposits B) Money market borrowings C) Sales of marketable securities D) Dividend payments to stockholders E) All of the above Answer: D 73. Which of the following liquidity strategies is the most effective for banks today? A) Asset Management B) Liability Management C) Balanced Liquidity Management D) All of the above E) A and B above Answer: C 74. When a bank's sources of liquidity exceed it uses of liquidity, the bank will have a _______________ liquidity gap. A) Positive B) Negative C) Cyclical D) Seasonal E) None of the above Answer: A 75. "Core deposits", "hot money", and "vulnerable money" are categories of funds under which of the following methods of estimating a bank's liquidity needs? A) Sources and Uses of Funds Approach B) Structure of Funds Approach C) Liquidity Indicator Approach D) None of the above E) A and C Answer: B 76. Factors that influence a bank's choice among the various sources of reserves include which of the following? A) Immediacy of the need B) Duration of the need C) Interest rate outlook D) Regulations E) All of the above Answer: E 77. The risk that liquid funds will not be available in the volume needed by a bank is often called: A) Market risk B) Price risk C) Availability risk D) Interest-rate risk E) None of the above Answer: C 78. A bank following an _________ liquidity management strategy must take care that those assets with the least profit potential are sold first. The strategy that correctly fills in the blank in the foregoing sentence is: A) Asset conversion B) Liability management C) Availability D) Funds source E) None of the above Answer: A 79. When some of a bank's expected demand for liquidity are stored in its assets, while other unexpected cash needs are met from near-term borrowings this approach to liquidity management is described by which of the terms listed below? A) Liability management B) Asset conversion C) Borrowed liquidity management D) Balanced liquidity management E) None of the above Answer: D 80. The notion that bank management should strive to meet all good loans that walk in the door in order to build lasting customer relationships is referred to as the: A) Asset conversion liquidity strategy B) Customer relationship doctrine C) Loan accommodation doctrine D) Balanced funds management doctrine E) None of the above Answer: B 81. A bank manager responsible for overseeing the institution’s legal reserve account is called: A) Reserve manager B) Money market manager C) Money position manager D) Legal counselor E) None of the above Answer: C 82. If a bank's management uses "the discipline of the financial marketplace" to gauge its liquidity position one indicator of this market test of the adequacy of a bank's liquidity position is: A) The bank's return on equity capital B) The volume of bank stock outstanding C) The bank's return on assets D) The size of risk premiums on CDs the bank issues E) None of the above Answer: D 83. Which of the following is an example of a use of funds for the bank? A) A customer withdraws $1000 from their account B) A borrower repays $1500 of a loan they have received C) The bank issues a $1,000,000 CD D) The bank sells $5,000,000 of T-Bills E) None of the above are uses of funds Answer: A 84. Which of the following is an example of a source of funds? A) A customer withdraws $1000 from their account B) A borrower repays $1500 of a loan they have received C) A bank increases its Fed funds sold by $1,000,000 D) The bank purchases $5,000,000 in T-Bills E) None of the above are uses of funds Answer: B 85. A bank currently has $150 million in "hot money" deposits against which they want to hold an 80 percent reserve. This bank has $90 million in vulnerable deposits against which they want to hold a 30 percent reserve and this bank has $45 million in stable deposits against which they want to hold a 5 percent reserve. The legal reserves for this bank are 5 percent of all deposits. What is this bank's liability liquidity reserve? A) $149.25 million B) $285 million C) $141.7875 million D) $216.60 million E) None of the above Answer: C 86. A bank maintains a clearing balance of $5,000,000 with the Federal Reserve. The Federal funds rate is currently 6.5 percent. What credit will this bank earn over the reserve maintenance period to offset any fees charged this bank by the Federal Reserve? A) $325,000 B) $8,357,143 C) $194,444 D) $12,639 E) None of the above Answer: D 87. A bank maintains a clearing balance of $1,000,000 with the Federal Reserve. The Federal funds rate is currently 4.5 percent. What credit will this bank earn over the reserve maintenance period to offset any fees charged this bank by the Federal Reserve? A) $17,500 B) $1,750 C) $45,000 D) $12,500 E) None of the above Answer: B 88. A bank currently holds $105 million in transaction deposits subject to legal reserves but has managed to enter into sweep account arrangements affecting $55 million of these accounts. Given that the bank must hold 3 percent legal reserves up to $47.8 million of transaction deposits and 10 percent legal reserves on any amount above that, how much has this bank reduced its total legal reserves as a result of these sweep arrangements? A) $5.500 million B) $1.449 million C) $7.119 million D) $1.619 million E) None of the above Answer: A 89. A bank money manager estimates that the bank will experience a liquidity deficit of $400 million with a probability of 10 percent, a liquidity deficit of $900 million with a probability of 20 percent, a liquidity surplus of $600 million with a probability of 30 percent and a liquidity surplus of $1200 with a probability of 40 percent over the next month. What is this bank's expected liquidity deficit or surplus over this next month? A) $880 liquidity surplus B) $440 liquidity deficit C) $440 liquidity surplus D) $880 liquidity deficit E) None of the above Answer: C 90. A bank expects in the week to come $55 million in incoming deposits, $75 million in acceptable loan requests, $35 million in money market borrowings, $10 million in deposit withdrawals and $30 million in loan repayments. This bank is expecting a: A) Liquidity deficit B) Liquidity surplus C) Balanced liquidity position D) None of the above Answer: B 91. A financial institution has estimated that its growth rate in deposits over the last ten years has averaged 6 percent per year. This is the _________ of estimating future deposits. A) Trend component B) Seasonal component C) Cyclical component D) Stationary component E) None of the above Answer: A 92. A financial institution has estimated that over the last ten years the deposit withdrawals during Christmas time is about 25% higher than during any other time of the year. This is the _________ of estimating future deposits. A) Trend component B) Seasonal component C) Cyclical component D) Stationary component E) None of the above Answer: B 93. Which of the following is a guideline for liquidity managers of banks? A) The liquidity manager must keep track of the activities of all departments of the bank B) The liquidity manager must know in advance (if possible) the plans of major creditors and depositors C) The liquidity manager should make sure the bank has clear priorities and objectives for liquidity management D) The liquidity manager must analyze the liquidity needs of the bank on a continuous basis E) All of the above are guidelines for liquidity managers Answer: E 94. A manager that uses ratios such as cash and due from banks to total assets and U.S. government securities to total assets to measure their liquidity position is using: A) The sources and uses of funds approach B) The structured funds approach C) The liquidity indicator approach D) Signals from the market place E) None of the above Answer: C 95. A manager that examines the stock price behavior of the bank and the risk premium on the bank CD's to measure their liquidity position is using: A) The sources and uses of funds approach B) The structured funds approach C) The liquidity indicator approach D) Signals from the marketplace E) None of the above Answer: D 96. A manager that looks at deposit increases and decreases and loan increases and decreases among other things to measure their liquidity position is using: A) The sources and uses of funds approach B) The structured funds approach C) The liquidity indicator approach D) Signals from the marketplace E) None of the above Answer: A 97. Which of the following statements is correct? A) The demands for liquidity and sources of liquidity for a bank are generally equal to each other B) Most liquidity problems in banking arise from outside the bank C) The liquidity problems for a bank are made easier because most of their liabilities are not subject to immediate repayment D) Liquidity management is easy for a bank because a bank that is very liquid is also very profitable. E) All of the above statements are correct Answer: B 98. The Fed funds market is most volatile on bank: A) Computation day B) Settlement day C) Reserve day D) Maintenance day E) Holiday Answer: B 99. The Fed funds rate usually hovers around the Feds: A) Target rate B) Set rate C) Quoted rate D) Limit rate E) Average rate Answer: A 100. A bank or financial service institution can generally meet reserve requirements using all of the following except: A) Selling liquid investments B) Borrowing in the fed funds market C) Drawing on any excess correspondent balances D) Borrowing in the repo market E) Selling new shares Answer: E 101. The Shirley State Bank has $90 in transaction deposits subject to legal reserves. This bank must hold 3 percent legal reserves up to $43.9 of transaction deposits and 10 percent legal reserves on any amount above this. What is this bank’s total legal reserves? A) $2.700 million B) $1.449 million C) $5.924 million D) $4.170 million E) None of the above Answer: C 102. John Camey, the money manager of the First State Bank, has estimated that the bank has a 20 percent chance of a liquidity deficit of $700, a 30 percent chance of a liquidity deficit of $200, a 30 percent chance of a liquidity surplus of $400 and a 20 percent chance of a liquidity surplus of $900 over the next week. What is this bank’s expected liquidity deficit or surplus over the next week? A) $100 liquidity surplus B) $100 liquidity deficit C) $400 liquidity surplus D) $500 liquidity surplus E) $0 liquidity surplus Answer: A 103. A bank currently has $50 million in stable deposits against which they want to keep 10% reserves, $100 in vulnerable deposits against which they want to keep 40% reserves and they have $50 million in “hot money’ deposits against which they want to keep 90% reserves. The legal reserves for this bank are 10% of all deposits. What is this bank’s liability liquidity reserve? A) $90 million B) $81 million C) $70 million D) $20 million E) None of the above Answer: B 104. The Hollingsworth National Bank maintains a clearing balance of $7,000,000 with the Federal Reserve. The Federal Funds rate is currently 5.25 percent. What is the credit this bank will earn over the maintenance period to offset any fees charged this bank by the Federal Reserve? A) $367,500 B) $1021 C) $14,292 D) $30,625 E) None of the above Answer: C 105. A bank must maintain an average daily balance at the Fed of $600. In the first 2 days of the maintenance period, they maintain a balance of $450, the next three days they maintain a balance of $700, the next two days they maintain a balance of $650, the next three days they maintain a balance of $450 and the next three days they maintain a balance of $650. What does their balance at the Fed have to be on the last day of the maintenance period in order to have a zero cumulative reserve deficit? A) $600 B) $400 C) $500 D) $800 E) None of the above Answer: D 106. A bank must maintain an average daily balance at the Fed of $700. On the first day of the maintenance period they maintain a balance of $750, the next two days they maintain a balance of $725, the next three days they maintain a balance of $625, the next two days they maintain a balance of $775, the next two days they maintain a balance of $700 and the next two days they maintain a balance of $675. What does their balance have to be on the last day of the maintenance period in order to have a cumulative reserve deficit? A) $700 B) $650 C) $750 D) $325 E) None of the above Answer: B 107. David Ashby has just paid off the balance on his home mortgage with First American Bank. What source of liquidity does this represent to the bank? A) Incoming customer deposit B) Revenues from the same of no deposit services C) Customer loan repayment D) Sale of an asset E) Borrowings from the money market Answer: C 108. The Harmony Bank of the South has just increased its Federal Funds Purchased. What source of liquidity does this represent to the bank? A) Incoming customer deposit B) Revenues from the same of no deposit services C) Customer loan repayment D) Sale of an asset E) Borrowings from the money market Answer: D 109. The Peace Bank of Ohio has just received a $50 million credit at the local clearing house. Which type of factor affecting legal reserves is this for the bank? A) A controllable factor increasing legal reserves B) A noncontrollable factor increasing legal reserves C) A controllable factor decreasing legal reserves D) A noncontrollable factor decreasing legal reserves E) None of the above Answer: B 110. The Sasser State Bank has just sold $25 million in Treasury Bills. Which type of factor affecting legal reserves is this for the bank? A) A controllable factor increasing legal reserves B) A noncontrollable factor increasing legal reserves C) A controllable factor decreasing legal reserves D) A noncontrollable factor decreasing legal reserves E) None of the above Answer: A 111. The Hora National Bank has just received notice that a large depositor with the bank wants to close their account immediately. Which type of factor affecting legal reserves is this for the bank? A) A controllable factor increasing legal reserves B) A noncontrollable factor increasing legal reserves C) A controllable factor decreasing legal reserves D) A noncontrollable factor decreasing legal reserves E) None of the above Answer: D 112. The Simpson State Bank of Stillwater has just sold Federal Funds to another bank in their Federal Reserve district. Which type of factor affecting legal reserves is this for the bank? A) A controllable factor increasing legal reserves B) A noncontrollable factor increasing legal reserves C) A controllable factor decreasing legal reserves D) A noncontrollable factor decreasing legal reserves E) None of the above Answer: C 113. The Burr Bank has just calculated the ratio of U.S. Government Securities to Total Assets. Which liquidity indicator is this? A) Cash position indicator B) Liquid securities indicator C) Net federal funds and repurchase agreement position D) Capacity ratio E) Hot money ratio Answer: B 114. The HTR Bank of Summerville has just calculated the ratios of money market (short term) assets to volatile liabilities. Which liquidity indicator is this? A) Cash position indicator B) Liquid securities indicator C) Net federal funds and repurchase agreement position D) Capacity ratio E) Hot money ratio Answer: E 115. Which of the following is an option when a liquidity deficit arises and the bank wants to borrow liquidity to cover the deficit? A) Selling Treasury Bills B) Reducing their correspondent deposits with another bank C) Selling a municipal bond D) Issuing a jumbo CD E) All of the above Answer: D 116. Which of the following is an option when a liquidity deficit arises and the bank wants to use their stored liquidity in their assets to cover the deficit? A) Borrowing in the Federal Funds market B) Issuing a jumbo CD C) Selling Treasury Bills D) Increasing their correspondent deposits with another bank E) All of the above Answer: C 117. The Taylor Treadwell Bank has just calculated the ratio of net loans and leases to total assets. Which liquidity indicator is this? A) Cash position indicator B) Liquid securities indicator C) Net federal funds and repurchase agreement position D) Capacity ratio E) None of the above Answer: D 118. The Taylor Treadwell Bank has just calculated the ratio of demand deposits to total time deposits. Which liquidity indicator is this? A) Deposit composition ratio B) Liquid securities indicator C) Net federal funds and repurchase agreement position D) Capacity ratio E) None of the above Answer: A Test Bank for Bank Management and Financial Services Peter S. Rose, Sylvia C. Hudgins 9780073382432, 9780078034671
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