CH-10-11 Banking and the Management of Financial Institutions – The Economics of Money, Banking and Financial Markets : Exam Guide

This Document Contains Chapters 10 to 11 Chapter 10 Banking and the Management of Financial Institutions 10.1 The Bank Balance Sheet 1) Which of the following statements are true? A) A bank's assets are its sources of funds. B) A bank's liabilities are its uses of funds. C) A bank's balance sheet shows that total assets equal total liabilities plus equity capital. D) A bank's balance sheet indicates whether or not the bank is profitable. Answer: C 2) Which of the following statements is false? A) A bank's assets are its uses of funds. B) A bank issues liabilities to acquire funds. C) The bank's assets provide the bank with income. D) Bank capital is recorded as an asset on the bank balance sheet. Answer: D 3) Which of the following are reported as liabilities on a bank's balance sheet? A) Reserves B) Checkable deposits C) Loans D) Deposits with other banks Answer: B 4) Which of the following are reported as liabilities on a bank's balance sheet? A) Discount loans B) Reserves C) U.S. Treasury securities D) Loans Answer: A 5) The share of checkable deposits in total bank liabilities has A) expanded moderately over time. B) expanded dramatically over time. C) shrunk over time. D) remained virtually unchanged since 1960. Answer: C 6) Which of the following statements is false? A) Checkable deposits are usually the lowest cost source of bank funds. B) Checkable deposits are the primary source of bank funds. C) Checkable deposits are payable on demand. D) Checkable deposits include NOW accounts. Answer: B 7) In recent years the interest paid on checkable and time deposits has accounted for around ________ of total bank operating expenses, while the costs involved in servicing accounts have been approximately ________ of operating expenses. A) 45 percent; 55 percent B) 55 percent; 4 percent C) 25 percent; 50 percent D) 50 percent; 30 percent Answer: C 8) Which of the following statements are true? A) Checkable deposits are payable on demand. B) Checkable deposits do not include NOW accounts. C) Checkable deposits are the primary source of bank funds. D) Demand deposits are checkable deposits that pay interest. Answer: A 9) Because checking accounts are ________ liquid for the depositor than passbook savings, they earn ________ interest rates. A) less; higher B) less; lower C) more; higher D) more; lower Answer: D 10) Which of the following are transaction deposits? A) Savings accounts B) Small-denomination time deposits C) Negotiable order of withdraw accounts D) Certificates of deposit Answer: C 11) Which of the following is not a non transaction deposit? A) Savings accounts B) Small-denomination time deposits C) Negotiable order of withdrawal accounts D) Certificate of deposit Answer: C 12) Large-denomination CDs are ________, so that like a bond they can be resold in a ________ market before they mature. A) non negotiable; secondary B) non negotiable; primary C) negotiable; secondary D) negotiable; primary Answer: C 13) Because ________ are less liquid for the depositor than ________, they earn higher interest rates. A) money market deposit accounts; time deposits B) checkable deposits; passbook savings C) passbook savings; checkable deposits D) passbook savings; time deposits Answer: C 14) Because ________ are less liquid for the depositor than ________, they earn higher interest rates. A) passbook savings; time deposits B) money market deposit accounts; time deposits C) money market deposit accounts; passbook savings D) time deposits; passbook savings Answer: D 15) Banks acquire the funds that they use to purchase income-earning assets from such sources as A) cash items in the process of collection B) savings accounts. C) reserves. D) deposits at other banks. Answer: B 16) Bank loans from the Federal Reserve are called ________ and represent a ________ of funds. A) discount loans; use B) discount loans; source C) fed funds; use D) fed funds; source Answer: B 17) Which of the following is not a source of borrowings for a bank? A) Federal funds B) Eurodollars C) Transaction deposits D) Discount loans Answer: C 18) Bank capital is equal to ________ minus ________. A) total assets; total liabilities B) total liabilities; total assets C) total assets; total reserves D) total liabilities; total borrowings Answer: A 19) Bank capital is listed on the ________ side of the bank's balance sheet because it represents a ________ of funds. A) liability; use B) liability; source C) asset; use D) asset; source Answer: B 20) Bank reserves include A) deposits at the Fed and short-term treasury securities. B) vault cash and short-term Treasury securities. C) vault cash and deposits at the Fed. D) deposits at other banks and deposits at the Fed. Answer: C 21) The fraction of checkable deposits that banks are required by regulation to hold are A) excess reserves. B) required reserves. C) vault cash. D) total reserves. Answer: B 22) Which of the following are reported as assets on a bank's balance sheet? A) Borrowings B) Reserves C) Savings deposits D) Bank capital Answer: B 23) Which of the following are not reported as assets on a bank's balance sheet? A) Cash items in the process of collection B) Deposits with other banks C) U.S. Treasury securities D) Checkable deposits Answer: D 24) Through correspondent banking, large banks provide services to small banks, including A) loan guarantees. B) foreign exchange transactions. C) issuing stock. D) debt reduction. Answer: B 25) The largest percentage of banks' holdings of securities consist of A) Treasury and government agency securities. B) tax-exempt municipal securities. C) state and local government securities. D) corporate securities. Answer: A 26) Which of the following bank assets is the most liquid? A) Consumer loans B) Reserves C) Cash items in process of collection D) U.S. government securities Answer: B 27) Secondary reserves include A) deposits at Federal Reserve Banks. B) deposits at other large banks. C) short-term Treasury securities. D) state and local government securities. Answer: C 28) Because of their ________ liquidity, ________ U.S. government securities are called secondary reserves. A) low; short-term B) low; long-term C) high; short-term D) high; long-term Answer: C 29) Secondary reserves are so called because A) they can be converted into cash with low transactions costs. B) they are not easily converted into cash, and are, therefore, of secondary importance to banking firms. C) 50% of these assets count toward meeting required reserves. D) they rank second to bank vault cash in importance of bank holdings. Answer: A 30) Banks' asset portfolios include state and local government securities because A) their interest payments are tax deductible for federal income taxes. B) banks consider them helpful in attracting accounts of Federal employees. C) the Federal Reserve requires member banks to buy securities from state and local governments located within their respective Federal Reserve districts. D) there is no default-risk with state and local government securities. Answer: A 31) Bank's make their profits primarily by issuing ________. A) equity B) negotiable CDs C) loans D) NOW accounts Answer: C 32) The most important category of assets on a bank's balance sheet is A) discount loans. B) securities. C) loans. D) cash items in the process of collection. Answer: C 33) Which of the following are bank assets? A) the building owned by the bank B) a discount loan C) a negotiable CD D) a customer's checking account Answer: A 10.2 Basic Banking 1) Banks earn profits by selling ________ with attractive combinations of liquidity, risk, and return, and using the proceeds to buy ________ with a different set of characteristics. A) loans; deposits B) securities; deposits C) liabilities; assets D) assets; liabilities Answer: C 2) In general, banks make profits by selling ________ liabilities and buying ________ assets. A) long-term; shorter-term B) short-term; longer-term C) illiquid; liquid D) risky; risk-free Answer: B 3) Asset transformation can be described as A) borrowing long and lending short. B) borrowing short and lending long. C) borrowing and lending only for the short term. D) borrowing and lending for the long term. Answer: B 4) When a new depositor opens a checking account at the First National Bank, the bank's assets ________ and its liabilities ________. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer: A 5) When Jane Brown writes a $100 check to her nephew (who lives in another state), Ms. Brown's bank ________ assets of $100 and ________ liabilities of $100. A) gains; gains B) gains; loses C) loses; gains D) loses; loses Answer: D 6) When you deposit a $50 bill in the Security Pacific National Bank, A) its liabilities decrease by $50. B) its assets increase by $50. C) its reserves decrease by $50. D) its cash items in the process of collection increase by $50. Answer: B 7) When you deposit $50 in currency at Old National Bank, A) its assets increase by less than $50 because of reserve requirements. B) its reserves increase by less than $50 because of reserve requirements. C) its liabilities increase by $50. D) its liabilities decrease by $50. Answer: C 8) Holding all else constant, when a bank receives the funds for a deposited check, A) cash items in the process of collection fall by the amount of the check. B) bank assets increase by the amount of the check. C) bank liabilities decrease by the amount of the check. D) bank reserves increase by the amount of required reserves. Answer: A 9) When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then A) the liabilities of the First National Bank increase by $10. B) the reserves of the First National Bank increase by $ 10. C) the liabilities of Citibank increase by $10. D) the assets of Citibank fall by $10. Answer: C 10) When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then A) the liabilities of the First National Bank decrease by $10. B) the reserves of the First National Bank increase by $10. C) the liabilities of Citibank decrease by $10. D) the assets of Citibank decrease by $10. Answer: A 11) When you deposit $50 in your account at First National Bank and a $100 check you have written on this account is cashed at Chemical Bank, then A) the assets of First National rise by $50. B) the assets of Chemical Bank rise by $50. C) the reserves at First National fall by $50. D) the liabilities at Chemical Bank rise by $50. Answer: C 12) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to hold any excess reserves but makes loans instead, then, in the bank's final balance sheet, A) the assets at the bank increase by $800,000. B) the liabilities of the bank increase by $1,000,000. C) the liabilities of the bank increase by $800,000. D) reserves increase by $160,000. Answer: B 13) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to make any loans but to hold excess reserves instead, then, in the bank's final balance sheet, A) the assets at the bank increase by $1 million. B) the liabilities of the bank decrease by $1 million. C) reserves increase by $200,000. D) liabilities increase by $200,000. Answer: A 14) With a 10% reserve requirement ratio, a $100 deposit into New Bank means that the maximum amount New Bank could lend is A) $90. B) $100. C) $10. D) $110. Answer: A 15) Using T-accounts show what happens to reserves at Security National Bank if one individual deposits $1000 in cash into her checking account and another individual withdraws $750 in cash from her checking account. Answer: Security National Bank 10.3 General Principles of Bank Management 1) Which of the following are primary concerns of the bank manager? A) Maintaining sufficient reserves to minimize the cost to the bank of deposit outflows B) Extending loans to borrowers who will pay low interest rates, but who are poor credit risks C) Acquiring funds at a relatively high cost, so that profitable lending opportunities can be realized D) Maintaining high levels of capital and thus maximizing the returns to the owners. Answer: A 2) If a bank has $100,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $40,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is A) $30,000. B) $25,000. C) $20,000. D) $10,000. Answer: B 3) If a bank has $200,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $80,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is A) $50,000. B) $40,000. C) $30,000. D) $25,000. Answer: A 4) If a bank has $10 million of checkable deposits, a required reserve ratio of 10 percent, and it holds $2 million in reserves, then it will not have enough reserves to support a deposit outflow of A) $1.2 million. B) $1.1 million. C) $1 million. D) $900,000. Answer: A 5) If a bank has excess reserves greater than the amount of a deposit outflow, the outflow will result in equal reductions in A) deposits and reserves. B) deposits and loans. C) capital and reserves. D) capital and loans. Answer: A 6) A $5 million deposit outflow from a bank has the immediate effect of A) reducing deposits and reserves by $5 million. B) reducing deposits and loans by $5 million. C) reducing deposits and securities by $5 million. D) reducing deposits and capital by $5 million. Answer: A 7) Bankers' concerns regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of A) liability management. B) liquidity management. C) managing interest rate risk. D) managing credit risk. Answer: B 8) If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can A) reduce deposits by $3 million. B) increase loans by $3 million. C) sell $3 million of securities. D) repay its discount loans from the Fed. Answer: C 9) A bank with insufficient reserves can increase its reserves by A) lending federal funds. B) calling in loans. C) buying short-term Treasury securities. D) buying municipal bonds. Answer: B 10) Of the following, which would be the first choice for a bank facing a reserve deficiency? A) Call in loans B) Borrow from the Fed C) Sell securities D) Borrow from other banks Answer: D 11) In general, banks would prefer to acquire funds quickly by ________ rather than ________. A) reducing loans; selling securities B) reducing loans; borrowing from the Fed C) borrowing from the Fed; reducing loans D) "calling in" loans; selling securities Answer: C 12) ________ may antagonize customers and thus can be a very costly way of acquiring funds to meet an unexpected deposit outflow. A) Selling securities B) Selling loans C) Calling in loans D) Selling negotiable CDs Answer: C 13) Banks hold excess and secondary reserves to A) reduce the interest-rate risk problem. B) provide for deposit outflows. C) satisfy margin requirements. D) achieve higher earnings than they can with loans. Answer: B 14) Which of the following statements most accurately describes the task of bank asset management? A) Banks seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity. B) Banks seek to have the highest liquidity possible subject to earning a positive rate of return on their operations. C) Banks seek to prevent bank failure at all cost; since a failed bank earns no profit, liquidity needs supersede the desire for profits. D) Banks seek to acquire funds in the least costly way. Answer: A 15) The goals of bank asset management include A) maximizing risk. B) minimizing liquidity. C) lending at high interest rates regardless of risk. D) purchasing securities with high returns and low risk. Answer: D 16) Banks that suffered significant losses in the 1980s made the mistake of A) holding too many liquid assets. B) minimizing default risk. C) failing to diversify their loan portfolio. D) holding only safe securities. Answer: C 17) A bank will want to hold more excess reserves (everything else equal) when A) it expects to have deposit inflows in the near future. B) brokerage commissions on selling bonds increase. C) the cost of selling loans falls. D) the discount rate decreases. Answer: B 18) As the costs associated with deposit outflows ________, the banks willingness to hold excess reserves will ________. A) decrease; increase B) increase; decrease C) increase; increase D) decrease; not be affected Answer: C 19) Which of the following would a bank not hold as insurance against the highest cost of deposit outflow-bank failure? A) Excess reserves B) Secondary reserves C) Bank capital D) Mortgages Answer: D 20) Which of the following has not resulted from more active liability management on the part of banks? A) Increased bank holdings of cash items B) Aggressive targeting of goals for asset growth by banks C) Increased use of negotiable CDs to raise funds D) An increased proportion of bank assets held in loans Answer: A 21) Banks that actively manage liabilities will most likely meet a reserve shortfall by A) calling in loans. B) borrowing federal funds. C) selling municipal bonds. D) seeking new deposits. Answer: B 22) Modern liability management has resulted in A) increased sales of certificates of deposits to raise funds. B) increase importance of deposits as a source of funds. C) reduced borrowing by banks in the overnight loan market. D) failure by banks to coordinate management of assets and liabilities. Answer: A 23) A bank failure occurs whenever A) a bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its reserve requirements. B) a bank suffers a large deposit outflow. C) a bank has to call in a large volume of loans. D) a bank is not allowed to borrow from the Fed. Answer: A 24) A bank is insolvent when A) its liabilities exceed its assets. B) its assets exceed its liabilities. C) its capital exceeds its liabilities. D) its assets increase in value. Answer: A 25) Holding large amounts of bank capital helps prevent bank failures because A) it means that the bank has a higher income. B) it makes loans easier to sell. C) it can be used to absorb the losses resulting from bad loans. D) it makes it easier to call in loans. Answer: C 26) Net profit after taxes per dollar of assets is a basic measure of bank profitability called A) return on assets. B) return on capital. C) return on equity. D) return on investment. Answer: A 27) Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called A) return on assets. B) return on capital. C) return on equity. D) return on investment. Answer: C 28) The amount of assets per dollar of equity capital is called the A) asset ratio. B) equity ratio. C) equity multiplier. D) asset multiplier. Answer: C 29) For a given return on assets, the lower is bank capital, A) the lower is the return for the owners of the bank. B) the higher is the return for the owners of the bank. C) the lower is the credit risk for the owners of the bank. D) the lower the possibility of bank failure. Answer: B 30) Bank capital has both benefits and costs for the bank owners. Higher bank capital ________ the likelihood of bankruptcy, but higher bank capital ________ the return on equity for a given return on assets. A) reduces; reduces B) increases; increases C) reduces; increases D) increases; reduces Answer: A 31) In the absence of regulation, banks would probably hold A) too much capital, reducing the efficiency of the payments system. B) too much capital, reducing the profitability of banks. C) too little capital. D) too much capital, making it more difficult to obtain loans. Answer: C 32) Conditions that likely contributed to a credit crunch in 2008 include: A) capital shortfalls caused in part by falling real estate prices. B) regulated hikes in bank capital requirements. C) falling interest rates that raised interest rate risk, causing banks to choose to hold more capital. D) increases in reserve requirements. Answer: A 33) Which of the following would not be a way to increase the return on equity? A) Buy back bank stock B) Pay higher dividends C) Acquire new funds by selling negotiable CDs and increase assets with them D) Sell more bank stock Answer: D 34) If a bank needs to raise the amount of capital relative to assets, a bank manager might choose to A) buy back bank stock. B) pay higher dividends. C) shrink the size of the bank. D) sell securities the bank owns and put the funds into the reserve account. Answer: C 35) Your bank has the following balance sheet: If the required reserve ratio is 10%, what actions should the bank manager take if there is an unexpected deposit outflow of $50 million? Answer: After the deposit outflow, the bank will have a reserve shortfall of $15 million. The bank manager could try to borrow in the Federal Funds market, take out a discount loan from the Federal Reserve, sell $15 million of the securities the bank owns, sell off $15 million of the loans the bank owns , or lastly call-in $15 million of loans. All of the actions will be costly to the bank. The bank manager should try to acquire the funds with the least costly method. 10.4 Managing Credit Risk 1) Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans. A) adverse selection B) moral hazard C) moral suasion D) intentional fraud Answer: A 2) If borrowers with the most risky investment projects seek bank loans in higher proportion to those borrowers with the safest investment projects, banks are said to face the problem of A) adverse credit risk. B) adverse selection. C) moral hazard. D) lemon lenders. Answer: B 3) Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the A) adverse selection problem. B) lemon problem. C) adverse credit risk problem. D) moral hazard problem. Answer: D 4) In order to reduce the ________ problem in loan markets, bankers collect information from prospective borrowers to screen out the bad credit risks from the good ones. A) moral hazard B) adverse selection C) moral suasion D) adverse lending Answer: B 5) In one sense ________ appears surprising since it means that the bank is not ________ its portfolio of loans and thus is exposing itself to more risk. A) specialization in lending; diversifying B) specialization in lending; rationing C) credit rationing; diversifying D) screening; rationing Answer: A 6) From the standpoint of ________, specialization in lending is surprising but makes perfect sense when one considers the ________ problem. A) moral hazard; diversification B) diversification; moral hazard C) adverse selection; diversification D) diversification; adverse selection Answer: D 7) Provisions in loan contracts that prohibit borrowers from engaging in specified risky activities are called A) proscription bonds. B) restrictive covenants. C) due-on-sale clauses. D) liens. Answer: B 8) To reduce moral hazard problems, banks include restrictive covenants in loan contracts. In order for these restrictive covenants to be effective, banks must also A) monitor and enforce them. B) be willing to rewrite the contract if the borrower cannot comply with the restrictions. C) trust the borrower to do the right thing. D) be prepared to extend the deadline when the borrower needs more time to comply. Answer: A 9) Long-term customer relationships ________ the cost of information collection and make it easier to ________ credit risks. A) reduce; screen B) increase; screen C) reduce; increase D) increase; increase Answer: A 10) Unanticipated moral hazard contingencies can be reduced by A) screening. B) long-term customer relationships. C) specialization in lending. D) credit rationing. Answer: B 11) A bank's commitment to provide a firm with loans up to pre-specified limit at an interest rate that is tied to a market interest rate is called A) an adjustable gap loan. B) an adjustable portfolio loan. C) loan commitment. D) pre-credit loan line. Answer: C 12) Property promised to the lender as compensation if the borrower defaults is called ________. A) collateral B) deductibles C) restrictive covenants D) contingencies Answer: A 13) A bank that wants to monitor the check payment practices of its commercial borrowers, so that moral hazard can be prevented, will require borrowers to A) place a bank officer on their board of directors. B) place a corporate officer on the bank's board of directors. C) keep compensating balances in a checking account at the bank. D) purchase the bank's CDs. Answer: C 14) Of the following methods that banks might use to reduce moral hazard problems, the one not legally permitted in the United States is the A) requirement that firms keep compensating balances at the banks from which they obtain their loans. B) requirement that firms place on their board of directors an officer from the bank. C) inclusion of restrictive covenants in loan contracts. D) requirement that individuals provide detailed credit histories to bank loan officers. Answer: B 15) When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, the bank is said to engage in A) coercive bargaining. B) strategic holding out. C) credit rationing. D) collusive behavior. Answer: C 16) When banks offer borrowers smaller loans than they have requested, banks are said to A) shave credit. B) rediscount the loan. C) raze credit. D) ration credit. Answer: D 17) Credit risk management tools include A) deductibles. B) collateral. C) interest rate swaps. D) duration analysis. Answer: B 18) How can specializing in lending help to reduce the adverse selection problem in lending? Answer: Reducing the adverse selection problem requires the banks to acquire information to screen bad credit risks from good credit risks. It is easier for banks to obtain information about local businesses. Also if the bank lends to firms in a few specific industries they will become more knowledgeable about those industries and a better judge of creditworthiness in those industries. 10.5 Managing Interest-Rate Risk 1) Risk that is related to the uncertainty about interest rate movements is called A) default risk. B) interest-rate risk. C) the problem of moral hazard. D) security risk. Answer: B 2) All else the same, if a bank's liabilities are more sensitive to interest rate fluctuations than are its assets, then ________ in interest rates will ________ bank profits. A) an increase; increase B) an increase; reduce C) a decline; reduce D) a decline; not affect Answer: B 3) If a bank has ________ rate-sensitive assets than liabilities, then ________ in interest rates will increase bank profits. A) more; a decline B) more; an increase C) fewer; an increase D) fewer; a surge Answer: B 4) If a bank has ________ rate-sensitive assets than liabilities, a ________ in interest rates will reduce bank profits, while a ________ in interest rates will raise bank profits. A) more; rise; decline B) more; decline; rise C) fewer; decline; decline D) fewer; rise; rise Answer: B 5) If a bank's liabilities are more sensitive to interest rate movements than are its assets, then A) an increase in interest rates will reduce bank profits. B) a decrease in interest rates will reduce bank profits. C) interest rates changes will not impact bank profits. D) an increase in interest rates will increase bank profits. Answer: A 6) The difference of rate-sensitive liabilities and rate-sensitive assets is known as the A) duration. B) interest-sensitivity index. C) rate-risk index. D) gap. Answer: D 7) If the First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause profits to A) increase by $15 million. B) increase by $1.5 million. C) decline by $15 million. D) decline by $1.5 million. Answer: D 8) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is called A) basic duration analysis. B) basic gap analysis. C) interest-exposure analysis. D) gap-exposure analysis. Answer: B 9) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals times the change in the interest rate is called A) basic gap analysis. B) the maturity bucket approach to gap analysis. C) the segmented maturity approach to gap analysis. D) the segmented maturity approach to interest-exposure analysis. Answer: B 10) If interest rates rise by 5 percentage points, say, from 10 to 15%, bank profits (measured using gap analysis) will A) decline by $0.5 million. B) decline by $1.5 million. C) decline by $2.5 million. D) increase by $1.5 million. Answer: B 11) Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to decline by ________ of the total original asset value. A) 5 percent B) 10 percent C) 15 percent D) 25 percent Answer: B 12) If interest rates rise by 5 percentage points, say from 10 to 15%, bank profits (measured using gap analysis) will A) decline by $0.5 million. B) decline by $1.5 million. C) decline by $2.5 million. D) increase by $2.0 million. Answer: A 13) Assuming that the average duration of its assets is four years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to ________ by ________ of the total original asset value. A) decline; 5 percent B) decline; 10 percent C) decline; 15 percent D) increase; 20 percent Answer: A 14) Duration analysis involves comparing the average duration of the bank's ________ to the average duration of its ________. A) securities portfolio; non-deposit liabilities B) assets; liabilities C) loan portfolio; deposit liabilities D) assets; deposit liabilities Answer: B 15) Because of an expected rise in interest rates in the future, a banker will likely A) make long-term rather than short-term loans. B) buy short-term rather than long-term bonds. C) buy long-term rather than short-term bonds. D) make either short or long-term loans; expectations of future interest rates are irrelevant. Answer: B 16) If a banker expects interest rates to fall in the future, her best strategy for the present is A) to increase the duration of the bank's liabilities. B) to buy short-term bonds. C) to sell long-term certificates of deposit. D) to increase the duration of the bank's assets. Answer: D 17) Bruce the Bank Manager can reduce interest rate risk by ________ the duration of the bank's assets to increase their rate sensitivity or, alternatively, ________ the duration of the bank's liabilities. A) shortening; lengthening B) shortening; shortening C) lengthening; lengthening D) lengthening; shortening Answer: A 18) Your bank has the following balance sheet What would happen to bank profits if the interest rates in the economy go down? Is there anything that you could do to keep your bank from being so vulnerable to interest rate movements? Answer: The bank's profits would go down because it has more interest-rate sensitive assets than liabilities. In order to reduce interest-rate sensitivity, the bank manager could use financial derivatives such as interest-rate swaps, options, or futures. The bank manager could also try to adjust the balance sheet so that the bank's profits are not vulnerable to the movement of the interest rate. 10.6 Off-Balance-Sheet Activities 1) Examples of off-balance-sheet activities include A) loan sales. B) extending loans to depositors. C) borrowing from other banks. D) selling negotiable CDs. Answer: A 2) All of the following are examples of off-balance sheet activities that generate fee income for banks except A) foreign exchange trades. B) guaranteeing debt securities. C) back-up lines of credit. D) selling negotiable CDs. Answer: D 3) Which of the following is not an example of a backup line of credit? A) loan commitments B) overdraft privileges C) standby letters of credit D) mortgages Answer: D 4) Off-balance sheet activities involving guarantees of securities and back-up credit lines A) have no impact on the risk a bank faces. B) greatly reduce the risk a bank faces. C) increase the risk a bank faces. D) slightly reduce the risk a bank faces. Answer: C 5) When banks involved in trading activities attempt to outguess markets, they are A) forecasting. B) diversifying. C) speculating. D) engaging in riskless arbitrage. Answer: C 6) Traders working for banks are subject to the A) principal-agent problem. B) free-rider problem. C) double-jeopardy problem. D) exchange-risk problem. Answer: A 7) A reason why rogue traders have bankrupt their banks is due to A) the separation of trading activities from the bookkeepers. B) stringent supervision of trading activities by bank management. C) accounting errors. D) a failure to maintain proper internal controls. Answer: D 8) One way for banks to reduce the principal-agent problems associated with trading activities is to A) set limits on the total amount of a traders' transactions. B) make sure that the person conducting the trades is also the person responsible for recording the transactions. C) encourage traders to take on more risk if the potential rewards are higher. D) reduce the regulations on the traders so that they have more flexibility in conducting trades. Answer: A 9) The principal-agent problem that exists for bank trading activities can be reduced through A) creation of internal controls that combine trading activities with bookkeeping. B) creation of internal controls that separate trading activities from bookkeeping. C) elimination of regulation of banking. D) elimination of internal controls. Answer: B 10) Banks develop statistical models to calculate their maximum loss over a given time period. This approach is known as the A) stress-testing approach. B) value-at-risk approach. C) trading-loss approach. D) doomsday approach. Answer: B 11) When banks calculate the losses the institution would incur if an unusual combination of bad events happened, the bank is using the ________ approach. A) stress-test B) value-at-risk C) trading-loss D) maximum value Answer: A 10.7 Web Appendix 1: Duration Gap Analysis 1) Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. If interest rates increase from 5 percent to 6 percent, the net worth of the bank falls by A) $1 million. B) $2.4 million. C) $3.6 million. D) $4.8 million. Answer: D 2) Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. The duration gap for this bank is A) 0.5 year. B) 1 year. C) 1.5 years. D) 2 years. Answer: C 3) If interest rates increase from 9 percent to 10 percent, a bank with a duration gap of 2 years would experience a decrease in its net worth of A) 0.9 percent of its assets. B) 0.9 percent of its liabilities. C) 1.8 percent of its liabilities. D) 1.8 percent of its assets. Answer: D 4) One of the problems in conducting a duration gap analysis is that the duration gap is calculated assuming that interest rates for all maturities are the same. That means that the yield curve is A) flat. B) slightly upward sloping. C) steeply upward sloping. D) downward sloping. Answer: A 10.8 Web Appendix 2: Measuring Bank Performance 1) Most of a bank's operating income results from A) interest on assets. B) service charges on deposit accounts. C) off-balance-sheet activities. D) fees from standby lines of credit. Answer: A 2) All of the following are operating expenses for a bank except A) service charges on deposit accounts. B) salaries and employee benefits. C) rent on buildings. D) servicing costs of equipment such as computers. Answer: A 3) When a bank suspects that a $1 million loan might prove to be bad debt that will have to be written off in the future the bank A) can set aside $1 million of its earnings in its loan loss reserves account. B) reduces its reported earnings by $1, even though it has not yet actually lost the $1 million. C) reduces its assets immediately by $1 million, even though it has not yet lost the $1 million. D) reduces its reserves by $1 million, so that they can use those funds later. Answer: A 4) For banks, A) return on assets exceeds return on equity. B) return on assets equals return on equity. C) return on equity exceeds return on assets. D) return on equity is another name for net interest margin. Answer: C 5) The quantity interest income minus interest expenses divided by assets is a measure of bank performance known as A) operating income. B) net interest margin. C) return on assets. D) return on equity. Answer: B 6) Looking at the Net Interest Margin indicates that the poor bank performance in the late 1980s A) was not the result of interest-rate movements. B) was not the result of risky loans made in the early 1980s. C) resulted from a narrowing of the gap between interest earned on assets and inters paid on liabilities. D) resulted from a huge decrease in provisions for loan losses. Answer: A Chapter 11 Economic Analysis of Financial Regulation 11.1 Asymmetric Information and Financial Regulation 1) Depositors lack of information about the quality of bank assets can lead to ________. A) bank panics B) bank booms C) sequencing D) asset transformation Answer: A 2) The fact that banks operate on a "sequential service constraint" means that A) all depositors share equally in the bank's funds during a crisis. B) depositors arriving last are just as likely to receive their funds as those arriving first. C) depositors arriving first have the best chance of withdrawing their funds. D) banks randomly select the depositors who will receive all of their funds. Answer: C 3) Depositors have a strong incentive to show up first to withdraw their funds during a bank crisis because banks operate on a A) last-in, first-out constraint. B) sequential service constraint. C) double-coincidence of wants constraint. D) everyone-shares-equally constraint. Answer: B 4) Because of asymmetric information, the failure of one bank can lead to runs on other banks. This is the A) too-big-to-fail effect. B) moral hazard problem. C) adverse selection problem. D) contagion effect. Answer: D 5) The contagion effect refers to the fact that A) deposit insurance has eliminated the problem of bank failures. B) bank runs involve only sound banks. C) bank runs involve only insolvent banks. D) the failure of one bank can hasten the failure of other banks. Answer: D 6) During the boom years of the 1920s, bank failures were quite A) uncommon, averaging less than 30 per year. B) uncommon, averaging less than 100 per year. C) common, averaging about 600 per year. D) common, averaging about 1000 per year. Answer: C 7) To prevent bank runs and the consequent bank failures, the United States established the ________ in 1934 to provide deposit insurance. A) FDIC B) SEC C) Federal Reserve D) ATM Answer: A 8) The primary difference between the "payoff" and the "purchase and assumption" methods of handling failed banks is A) that the FDIC guarantees all deposits when it uses the "payoff" method. B) that the FDIC guarantees all deposits when it uses the "purchase and assumption" method. C) that the FDIC is more likely to use the "payoff" method when the bank is large and it fears that depositor losses may spur business bankruptcies and other bank failures. D) that the FDIC is more likely to use the purchase and assumption method for small institutions because it will be easier to find a purchaser for them compared to large institutions. Answer: B 9) Deposit insurance has not worked well in countries with A) a weak institutional environment. B) strong supervision and regulation. C) a tradition of the rule of law. D) few opportunities for corruption. Answer: A 10) When one party to a transaction has incentives to engage in activities detrimental to the other party, there exists a problem of A) moral hazard. B) split incentives. C) ex ante shirking. D) pre-contractual opportunism. Answer: A 11) Moral hazard is an important concern of insurance arrangements because the existence of insurance A) provides increased incentives for risk taking. B) is a hindrance to efficient risk taking. C) causes the private cost of the insured activity to increase. D) creates an adverse selection problem but no moral hazard problem. Answer: A 12) When bad drivers line up to purchase collision insurance, automobile insurers are subject to the A) moral hazard problem. B) adverse selection problem. C) assigned risk problem. D) ill queue problem. Answer: B 13) Deposit insurance is only one type of government safety net. All of the following are types of government support for troubled financial institutions except A) forgiving tax debt. B) lending from the central bank. C) lending directly from the government's treasury department. D) nationalizing and guaranteeing that all creditors will be repaid their loans in full. Answer: A 14) Although the FDIC was created to prevent bank failures, its existence encourages banks to A) take too much risk. B) hold too much capital. C) open too many branches. D) buy too much stock. Answer: A 15) A system of deposit insurance A) attracts risk-taking entrepreneurs into the banking industry. B) encourages bank managers to decrease risk. C) increases the incentives of depositors to monitor the riskiness of their bank's asset portfolio. D) increases the likelihood of bank runs. Answer: A 16) The government safety net creates ________ problem because risk-loving entrepreneurs might find banking an attractive industry. A) an adverse selection B) a moral hazard C) a lemons D) a revenue Answer: A 17) Since depositors, like any lender, only receive fixed payments while the bank keeps any surplus profits, they face the ________ problem that banks may take on too ________ risk. A) adverse selection; little B) adverse selection; much C) moral hazard; little D) moral hazard; much Answer: D 18) Acquiring information on a bank's activities in order to determine a bank's risk is difficult for depositors and is another argument for government ________. A) regulation B) ownership C) recall D) forbearance Answer: A 19) The existence of deposit insurance can increase the likelihood that depositors will need deposit protection, as banks with deposit insurance A) are likely to take on greater risks than they otherwise would. B) are likely to be too conservative, reducing the probability of turning a profit. C) are likely to regard deposits as an unattractive source of funds due to depositors' demands for safety. D) are placed at a competitive disadvantage in acquiring funds. Answer: A 20) In May 1991, the FDIC announced that it would sell the government's final 26% stake in Continental Illinois, ending government ownership of the bank that it had rescued in 1984. The FDIC took control of the bank, rather than liquidate it, because it believed that Continental Illinois A) was a good investment opportunity for the government. B) could be the Chicago branch of a new governmentally-owned interstate banking system. C) was too big to fail. D) would become the center of the new mid-west region central bank system. Answer: C 21) If the FDIC decides that a bank is too big to fail, it will use the ________ method, effectively ensuring that ________ depositors will suffer losses. A) payoff; large B) payoff; no C) purchase and assumption; large D) purchase and assumption; no Answer: D 22) Federal deposit insurance covers deposits up to $100,000, but as part of a doctrine called "too-big-to-fail" the FDIC sometimes ends up covering all deposits to avoid disrupting the financial system. When the FDIC does this, it uses the A) "payoff" method. B) "purchase and assumption" method. C) "inequity" method. D) "Basel" method. Answer: B 23) The result of the too-big-to-fail policy is that ________ banks will take on ________ risks, making bank failures more likely. A) small; fewer B) small; greater C) big; fewer D) big; greater Answer: D 24) A problem with the too-big-to-fail policy is that it ________ the incentives for ________ by big banks. A) increases; moral hazard B) decreases; moral hazard C) decreases; adverse selection D) increases; adverse selection Answer: A 25) The too-big-to-fail policy A) reduces moral hazard problems. B) puts large banks at a competitive disadvantage in attracting large deposits. C) treats large depositors of small banks inequitably when compared to depositors of large banks. D) allows small banks to take on more risk than large banks. Answer: C 26) Regulators attempt to reduce the riskiness of banks' asset portfolios by A) limiting the amount of loans in particular categories or to individual borrowers. B) encouraging banks to hold risky assets such as common stocks. C) establishing a minimum interest rate floor that banks can earn on certain assets. D) requiring collateral for all loans. Answer: A 27) A well-capitalized financial institution has ________ to lose if it fails and thus is ________ likely to pursue risky activities. A) more; more B) more; less C) less; more D) less; less Answer: B 28) A bank failure is less likely to occur when A) a bank holds less U.S. government securities. B) a bank suffers large deposit outflows. C) a bank holds fewer excess reserves. D) a bank has more bank capital. Answer: D 29) The leverage ratio is the ratio of a bank's A) assets divided by its liabilities. B) income divided by its assets. C) capital divided by its total assets. D) capital divided by its total liabilities. Answer: C 30) To be considered well capitalized, a bank's leverage ratio must exceed ________. A) 10% B) 8% C) 5% D) 3% Answer: C 31) Off-balance-sheet activities A) generate fee income with no increase in risk. B) increase bank risk but do not increase income. C) generate fee income but increase a bank's risk. D) generate fee income and reduce risk. Answer: C 32) The Basel Accord, an international agreement, requires banks to hold capital based on A) risk-weighted assets. B) the total value of assets. C) liabilities. D) deposits. Answer: A 33) The Basel Accord requires banks to hold as capital an amount that is at least ________ of their risk-weighted assets. A) 10% B) 8% C) 5% D) 3% Answer: B 34) Under the Basel Accord, assets and off-balance sheet activities were sorted according to ________ categories with each category assigned a different weight to reflect the amount of ________. A) 2; adverse selection B) 2; credit risk C) 4; adverse selection D) 4; credit risk Answer: D 35) The practice of keeping high-risk assets on a bank's books while removing low-risk assets with the same capital requirement is know as A) competition in laxity. B) depositor supervision. C) regulatory arbitrage. D) a dual banking system. Answer: C 36) Banks engage in regulatory arbitrage by A) keeping high-risk assets on their books while removing low-risk assets with the same capital requirement. B) keeping low-risk assets on their books while removing high-risk assets with the same capital requirement. C) hiding risky assets from regulators. D) buying risky assets from arbitragers. Answer: A 37) Because banks engage in regulatory arbitrage, the Basel Accord on risk-based capital requirements may result in A) reduced risk taking by banks. B) reduced supervision of banks by regulators. C) increased fraudulent behavior by banks. D) increased risk taking by banks. Answer: D 38) One of the criticisms of Basel 2 is that it is procyclical. That means that A) banks may be required to hold more capital during times when capital is short. B) banks may become professional at a cyclical response to economic conditions. C) banks may be required to hold less capital during times when capital is short. D) banks will not be required to hold capital during an expansion. Answer: A 39) Overseeing who operates banks and how they are operated is called ________. A) prudential supervision B) hazard insurance C) regulatory interference D) loan loss reserves Answer: A 40) The chartering process is especially designed to deal with the ________ problem, and regular bank examinations help to reduce the ________ problem. A) adverse selection; adverse selection B) adverse selection; moral hazard C) moral hazard; adverse selection D) moral hazard; moral hazard Answer: B 41) The chartering process is similar to ________ potential borrowers and the restriction of risk assets by regulators is similar to ________ in private financial markets. A) screening; restrictive covenants B) screening; branching restrictions C) identifying; branching restrictions D) identifying; credit rationing Answer: A 42) Banks will be examined at least once a year and given a CAMELS rating by examiners. The L stands for ________. A) liabilities B) liquidity C) loans D) leverage Answer: B 43) The federal agencies that examine banks include A) the Federal Reserve System. B) the Internal Revenue Service. C) the SEC. D) the U.S. Treasury. Answer: A 44) Banks are required to file ________ usually quarterly that list information on the bank's assets and liabilities, income and dividends, and so forth. A) call reports B) balance reports C) regulatory sheets D) examiner updates Answer: A 45) Regular bank examinations and restrictions on asset holdings help to indirectly reduce the ________ problem because, given fewer opportunities to take on risk, risk-prone entrepreneurs will be discouraged from entering the banking industry. A) moral hazard B) adverse selection C) ex post shirking D) post-contractual opportunism Answer: B 46) The current supervisory practice toward risk management A) focuses on the quality of a bank's balance sheet. B) determines whether capital requirements have been met. C) evaluates the soundness of a bank's risk-management process. D) focuses on eliminating all risk. Answer: C 47) Regulations designed to provide information to the marketplace so that investors can make informed decisions are called A) disclosure requirements. B) efficient market requirements. C) asset restrictions. D) capital requirements. Answer: A 48) With ________, firms value assets on their balance sheet at what they would sell for in the market. A) mark-to-market accounting B) book-value accounting C) historical-cost accounting D) off-balance sheet accounting Answer: A 49) During times of financial crisis, mark-to-market accounting A) requires that a financial firms' assets be marked down in value which can worsen the lending crisis. B) leads to an increase in the financial firms' balance sheets since they can now get assets at bargain prices. C) leads to an increase in financial firms' lending. D) results in financial firms' assets increasing in value. Answer: A 50) Consumer protection legislation includes legislation to A) reduce discrimination in credit markets. B) require banks to make loans to everyone who applies. C) reduce the amount of interest that bank's can charge on loans. D) require banks to make periodic reports to the Better Business Bureau. Answer: A 51) An important factor in producing the subprime mortgage crisis was A) lax consumer protection regulation. B) onerous rules placed on mortgage originators. C) weak incentives for mortgage brokers to use complicated mortgage products. D) strong incentives for the mortgage brokers to verify income information. Answer: A 52) Competition between banks A) encourages greater risk taking. B) encourages conservative bank management. C) increases bank profitability. D) eliminates the need for government regulation. Answer: A 53) Regulations that reduced competition between banks included A) branching restrictions. B) bank reserve requirements. C) the dual system of granting bank charters. D) interest-rate ceilings. Answer: A 54) The ________ that required separation of commercial and investment banking was repealed in 1999. A) the Federal Reserve Act. B) the Glass-Steagall Act. C) the Bank Holding Company Act. D) the Monetary Control Act. Answer: B 55) Which of the following is not a reason financial regulation and supervision is difficult in real life? A) Financial institutions have strong incentives to avoid existing regulations. B) Unintended consequences may happen if details in the regulations are not precise. C) Regulated firms lobby politicians to lean on regulators to ease the rules. D) Financial institutions are not required to follow the rules. Answer: D 56) Who has regulatory responsibility when a bank operates branches in many countries? A) It is not always clear. B) The WTO. C) The U.S. Federal Reserve System. D) The first country to submit an application. Answer: A 57) The collapse of the Bank of Credit and Commerce International, BCCI, showed the difficulty of international banking regulation. BCCI operated in more than ________ countries and was supervised by the small country of ________. A) 70, Luxembourg B) 100, Monaco C) 70, Monaco D) 100, Luxembourg Answer: A 58) Agreements such as the ________ are attempts to standardize international banking regulations. A) Basel Accord B) UN Bank Accord C) GATT Accord D) WTO Accord Answer: A 59) The Basel Committee ruled that regulators in other countries can ________ the operations of a foreign bank if they believe that it lacks effective oversight. A) restrict B) encourage C) renegotiate D) enhance Answer: A 60) The government safety net creates both an adverse selection problem and a moral hazard problem. Explain. Answer: The adverse selection problem occurs because risk-loving individuals might view the banking system as a wonderful opportunity to use other peoples' funds knowing that those funds are protected. The moral hazard problem comes about because depositors will not impose discipline on the banks since their funds are protected and the banks knowing this will be tempted to take on more risk than they would otherwise. 11.2 The 1980's Savings and Loan and Banking Crisis 1) In the ten year period 1981-1990, 1202 commercial banks were closed, with a peak of 206 failures in 1989. This rate of failures was approximately ________ times greater than that in the period from 1934 to 1980. A) two B) three C) five D) ten Answer: D 2) During the 1960s, 1970s, and early 1980s, traditional bank profitability declined because of A) financial innovation that increased competition from new financial institutions. B) a decrease in interest rates to fight the inflation problem. C) a decrease in deposit insurance. D) increased regulation that prohibited banks from making risky real estate loans. Answer: A 3) Moral hazard problems increased in prominence in the 1980s A) as deregulation required savings and loans and mutual savings banks to be more cautious. B) following a burst of financial innovation in the 1970s and early 1980s that produced new financial instruments and markets, thereby widening the scope for risk taking. C) following a decrease in federal deposit insurance from $100,000 to $40,000. D) as interest rates were sharply decreased to bring down inflation. Answer: B 4) The Depository Institutions Deregulation and Monetary Control Act of 1980 A) restricted thrift institutions to making loans for home mortgages. B) restricted the use of ATS accounts. C) imposed restrictive interest-rate ceilings on large agricultural loans. D) increased deposit insurance from $40,000 to $100,000. Answer: D 5) How did the increase in the interest rates in the early 80s contribute to the S&L crisis? Answer: The S&Ls suffered from an interest-rate risk problem. They had many fixed-rate mortgages with low interest rates. As interest rates in the economy began to climb, S&Ls began to lose profitability. Because of deregulation and financial innovation, it became possible for the S&Ls to undertake more risky ventures to try to regain their profitability. Many of them lacked expertise in judging credit risk in the new loan areas resulting in large losses. 11.3 Banking Crises Throughout the World 1) The evidence from banking crises in other countries indicates that A) deposit insurance is to blame in each country. B) a government safety net for depositors need not increase moral hazard. C) regulatory forbearance never leads to problems. D) deregulation combined with poor regulatory supervision raises moral hazard incentives. Answer: D 2) A common element in all of the banking crisis episodes in different countries is A) the existence of a government safety net. B) deposit insurance. C) increased regulation. D) lack of competition. Answer: A 3) Banking crises have occurred throughout the world. What similarities do we find when we look at the different countries? Answer: Financial deregulation with inadequate supervision can lead to increased moral hazard as banks take on more risk. Although deposit insurance was not necessarily a major factor in every country's bank crisis, there was always some kind of government safety net. The presence of the government safety net also leads to increased risk-taking from the banks. 11.4 Whither Financial Regulation After the Subprime Financial Crisis? 1) All of the following would reduce the agency problems of the originate-to-distribute model except A) encouraging more complex mortgage products. B) more stringent licensing requirements. C) clearer disclosure of mortgage terms. D) discouraging borrowers from "getting in over their head." Answer: A 2) Higher capital requirements will reduce the problems incurred when troubled ________ which had been off-balance sheet activities come back on the balance sheet. A) structured investment vehicles (SIVs) B) negotiable CDs C) Eurodollars D) Federal funds Answer: A 3) Currently, Fannie Mae and Freddie Mac are A) privately owned government-sponsored enterprises. B) privately owned enterprises with no government sponsorship. C) government agencies. D) government departments. Answer: A 4) Investment banks that are part of ________ are regulated and supervised like banks. A) bank holding companies B) insurance companies C) Freddie Mac D) Fannie Mae Answer: A 5) The inaccurate ratings provided by credit-rating agencies A) meant that investors did not have the information they needed to make informed choices about their investments. B) were irrelevant since no one pays any attention to them anyway. C) meant that investors actually took on less risk. D) will not be a problem when determining capital requirements under Basel 2.. Answer: A 6) The subprime financial crisis showed the need for increased financial regulation, however, too much or poorly designed regulation could A) choke off financial innovation. B) increase the efficiency of the financial system. C) increase economic growth. D) increase international financial integration. Answer: A 11.5 Web Appendix 1: The Savings and Loan Crisis and Its Aftermath 1) Moral hazard and adverse selection problems increased in prominence in the 1980s A) as deregulation required savings and loans and mutual savings banks to be more cautious. B) following a burst of financial innovation in the 1970s and early 1980s that produced new financial instruments and markets, thereby widening the scope for risk taking. C) following a decrease in federal deposit insurance from $100,000 to $40,000. D) as interest rates were sharply decreased to bring down inflation. Answer: B 2) The Depository Institutions Deregulation and Monetary Control Act of 1980 A) separated investment banks and commercial banks. B) restricted the use of ATS accounts. C) imposed restrictive usury ceilings on large agricultural loans. D) increased deposit insurance from $40,000 to $100,000. Answer: D 3) One of the problems experienced by the savings and loan industry during the 1980s was A) managers lack of expertise to manage risk in new lines of business. B) heavy regulations in the new areas open to S&Ls. C) slow growth in lending. D) close monitoring by the FSLIC. Answer: A 4) In the early stages of the 1980s banking crisis, financial institutions were especially harmed by A) declining interest rates from late 1979 until 1981. B) the severe recession in 1981-82. C) the disinflation from mid 1980 to early 1983. D) the increase in energy prices in the early 80s. Answer: B 5) When regulators chose to allow insolvent S&Ls to continue to operate rather than to close them, they were pursuing a policy of ________. A) regulatory forbearance B) regulatory kindness C) ostrich reasoning D) ignorance reasoning Answer: A 6) Savings and loan regulators allowed S&Ls to include in their capital calculations a high value for intangible capital called A) goodwill. B) salvation. C) kindness. D) retribution. Answer: A 7) Reasons regulators chose to follow regulatory forbearance rather than to close the insolvent S&Ls include all of the following except A) they had insufficient funds to close all of the insolvent S&Ls. B) they were friends with the S&L owners. C) they hoped the problem would go away. D) they did not have the authority to close the insolvent S&Ls. Answer: D 8) The policy of ________ exacerbated ________ problems as savings and loans took on increasingly huge levels of risk on the slim chance of returning to solvency. A) regulatory forbearance; moral hazard B) regulatory forbearance; adverse hazard C) regulatory agnosticism; moral hazard D) regulatory agnosticism; adverse hazard Answer: A 9) Regulatory forbearance A) meant delaying the closing of "zombie S&Ls" as their losses mounted during the 1980s. B) had the advantage of benefiting healthy S&Ls at the expense of "zombie S&Ls", as insolvent institutions lost deposits to health institutions. C) had the advantage of permitting many insolvent S&Ls the opportunity to return to profitability, saving the FSLIC billions of dollars. D) increased adverse selection dramatically. Answer: A 10) The major provisions of the Competitive Equality Banking Act of 1987 include A) expanding the responsibilities of the FDIC, which is now the sole administrator of the federal deposit insurance system. B) the establishment of the Resolution Trust Corporation to manage and resolve insolvent thrifts placed in conservatorship or receivership. C) directing the Federal Home Loan Bank Board to continue to pursue regulatory forbearance. D) prompt corrective action when a bank gets in trouble. Answer: C 11) The S&L Crisis can be analyzed as a principal-agent problem. The agents in this case, the ________, did not have the same incentive to minimize cost to the economy as the principals, the ________. A) politicians/regulators; taxpayers B) taxpayers; politician/regulators C) taxpayers; bank managers D) bank managers; politicians/regulators Answer: A 12) "Bureaucratic gambling" refers to A) the strategy of thrift managers that they would not be audited by thrift regulators in the 1980s due to the relatively weak bureaucratic power of thrift regulators. B) the risk that thrift regulators took in publicizing the plight of the S&L industry in the early 1980s. C) the strategy adopted by thrift regulators of lowering capital requirements and pursuing regulatory forbearance in the 1980s in the hope that conditions in the S&L industry would improve. D) the risk that regulators took in going to Congress to ask for additional funds. Answer: C 13) That several hundred S&Ls were not even examined once in the period January 1984 through June 1986 can be explained by A) Congress's unwillingness to allocate the necessary funds to thrift regulators. B) regulators' reluctance to find the specific problem thrifts that they knew existed. C) slower growth in lending meant that less regulation was needed. D) Congress's unwillingness to listen to campaign contributors. Answer: A 14) The bailout of the savings and loan industry was much delayed and, therefore, much more costly to taxpayers because A) of regulators' initial attempts to downplay the seriousness of problems within the thrift industry. B) politicians listened to the taxpayers rather than the S&L lobbyists. C) Congress did not wait long enough for many of the problems in the thrift industry to correct themselves. D) regulators could not be fired, therefore, they didn't care if they did a good job or not. Answer: A 15) An analysis of the political economy of the savings and loan crisis helps one to understand A) why politicians aided the efforts of thrift regulators, raising regulatory appropriations and encouraging closing of insolvent thrifts. B) why thrift regulators were so quick to inform Congress of the problems that existed in the thrift industry. C) why thrift regulators willingly acceded to pressures placed upon them by members of Congress. D) why politicians listened so closely to the taxpayers they represented. Answer: C 16) Taxpayers were served poorly by thrift regulators in the 1980s. This poor performance cannot be explained by A) regulators' desire to escape blame for poor performance, leading to a perverse strategy of "bureaucratic gambling." B) regulators' incentives to accede to pressures imposed by politicians, who sought to keep regulators from imposing tough regulations on institutions that were major campaign contributors. C) Congress's dogged determination to protect taxpayers from the unsound banking practices of managers at many of the nations savings and loans. D) politicians strong incentives to act in their own interests rather than the interests of the taxpayers. Answer: C 17) The Federal Home Loan Bank Board and the FSLIC, both of which failed in their regulatory tasks, were abolished by the A) Competitive Equality Banking Act of 1987. B) Financial Institutions Reform, Recovery and Enforcement Act of 1989. C) Office of Thrift Supervision. D) Office of the Comptroller of the Currency. Answer: B 18) The Resolution Trust Corporation was created by the FIRREA in order to A) manage and resolve insolvent S&Ls. B) build up trust in government regulation. C) regulate the S&L industry. D) purchase large amounts of government debt. Answer: A 19) FIRREA increased the core-capital leverage requirement for thrift institutions from 3% to A) 8%. B) 5% C) 10% D) 25% Answer: A 20) The Federal Deposit Insurance Corporation Improvement Act of 1991 A) increased the FDIC's ability to borrow from the Treasury to deal with failed banks. B) increased the FDIC's ability to use the too-big-to-fail doctrine. C) eliminated governmentally-administered deposit insurance. D) eliminated restrictions on nationwide banking. Answer: A 21) The ability to use the too-big-to-fail policy was curtailed by the passage of the FDICIA. To use this action today, the FDIC must get approval of a two-thirds majority of both the Board of Governors of the Federal Reserve and the directors of the FDIC and also the approval of the ________. A) Secretary of the Treasury B) Senate Finance Committee Chairperson C) President of the United States D) Governor of the state in which the failed bank is located Answer: A 22) The directive of prompt corrective action means that A) the FDIC will intervene earlier and more vigorously when a bank gets into trouble. B) the banks must take actions quickly to resolve reserve disputes. C) bank failures cannot occur. D) there must be an immediate response to an increase in interest rates. Answer: A 23) FDICIA ________ incentives for banks to hold capital and ________ incentives to take on excessive risk. A) increased; decreased B) increased; increased C) decreased; decreased D) decreased; increased Answer: A 11.6 Web Appendix 2: Banking Crises Throughout the World 1) As in the United States, an important factor in the banking crises in Norway, Sweden, and Finland was the A) financial liberalization that occurred in the 1980s. B) decline in real interest rates that occurred in the 1980s. C) high inflation that occurred in the 1980s. D) sluggish economic growth that occurred in the 1980s. Answer: A 2) As in the United States, an important factor in the banking crises in Latin America was the A) financial liberalization that occurred in the 1980s. B) decline in real interest rates that occurred in the 1980s. C) high inflation that occurred in the 1980s. D) sluggish economic growth that occurred in the 1980s. Answer: A 3) The Argentine banking crisis of 2001 resulted from Argentina's banks being required to A) purchase large amounts of government debt. B) pay back the value of failed loans. C) make risky real estate loans. D) make loans to only state-owned businesses. Answer: A 4) When comparing the banking crisis in the United States to the crises in Latin America, cost to the taxpayers of the government bailouts was A) higher in Latin American than in the United States. B) higher in the United States than in Latin America. C) about the same in both Latin America and the United States. D) positive in Latin America but negative in the United States. Answer: A 5) The Japanese banking system went through a cycle of ________ in the 1990s similar to the one that occurred in the U.S. in the 1980s. A) regulatory forbearance B) policy antagonism C) regulatory ignorance D) policy renewal Answer: A 6) China is trying to move its banking system from being strictly ________ owned by having them issue shares overseas. A) state B) domestic investor C) depositor D) domestic corporate Answer: A 7) The evidence from banking crises in other countries indicates that A) deposit insurance is to blame in each country. B) a government safety net for depositors need not increase moral hazard. C) regulatory forbearance never leads to problems. D) deregulation combined with poor regulatory supervision raises moral hazard incentives. Answer: D 8) Banking crises have occurred throughout the world. What similarities do we find when we look at the different countries? Answer: Financial deregulation with inadequate supervision can lead to increased moral hazard as banks take on more risk. Although deposit insurance was not necessarily a major factor in every country's bank crisis, there was always some kind of government safety net. The presence of the government safety net also leads to increased risk-taking from the banks. Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821