Faculty of Foreign Languages Banking and Finance
Full Name: ..................................... Class: .................................. Student Code: .............................
Mark:
TEST 3
UNIT 3: BANKING AND MANAGEMENT OF FINANCIAL INSTITUTIONS
SECTION 1 - Match the terms with the explanations
Terms Explanations
1 Asset management A The risk that changes in market interest rates will cause
fluctuations in a bond's price. Also, the risk of suffering
losses as a result of unanticipated changes in market
interest rates.
2 Balance sheet B Trading financial instruments, and the generation of fee
income, involves trading financial instruments and
generating income that affect bank profits but do not
appear on the bank's balance sheet
3 Credit risk C how a bank handles its loans and other assets
4 Interest-rate risk D Commercial banks uses of funds
5 Liability management E An accounting device used to analyze transactions
6 Liquidity management F Financial risk that an obligation will not be paid and a
loss will result.
7 Off balance sheet G the decision made by a bank to maintain sufficient
activities liquid assets to meet the bank's obligations to depositors.
8 Bank liabilities H Commercial banks sources of funds
9 Bank assets I a record of the financial situation of an institution on a
particular date by listing its assets and the claims against
those assets
10 T-account K type of management where bank relies on its liabilities
to provide liquidity; supplements asset management, but
does not replace it.
SECTION 2 - Multiple Choice Questions
1) All else the same, if a bank has more rate-sensitive liabilities than assets, then a(n) _____ in
interest rates will _____ bank profits.
A) increase; increase B) increase; reduce
C) decline; reduce D) decline; not affect
2) 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 high interest rates, but who are also good credit
risks
Faculty of Foreign Languages Banking and Finance
C) acquiring funds at a relatively low cost, so that profitable lending opportunities can be
realized
D) all of the above
3) Duration analysis involves comparing the average duration of the bank's _____ to the average
duration of its _____.
A) securities portfolio; non-deposit liabilities
B) loan portfolio; non-deposit liabilities
C) loan portfolio; deposit liabilities
D) assets; liabilities
4) Examples of off-balance-sheet activities include
A) loan sales.
B) foreign exchange market transactions.
C) trading in financial futures.
D) all of the above.
5) 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) all of the above.
6) Which of the following statements is true?
A) A bank’s assets are its uses of funds.
B) A bank’s assets are its sources of funds.
C) A bank’s liabilities are its uses of funds.
D) Only (B) and (C) of the above are true.
7) 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
8) 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.
9) 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.
10) In general, banks make profits by selling _____ liabilities and buying _____ assets.
A) long-term; shorter-term.
B) short-term; longer-term.
Faculty of Foreign Languages Banking and Finance
C) illiquid; liquid.
D) risky; risk-free.
11) The following tools help solve ADVERSE SELECTION PROBLEMS in financial markets:
A) private production and sale of credit ratings for individuals and firms
B) government regulation to increase information to investors
C) use of financial intermediaries that specialize in the gathering of information about would-
be borrowers
D) inclusion of collateral requirements in loan contracts as a quality signal
E) all of the above
12) Which of the following is NOT a tool used by corporations to reduce PRINCIPAL-AGENT
PROBLEMS
A) Stockholders engage in costly state verification by auditing an observing management.
B) Venture capital firms provide funds to new firms in exchange for equity and membership
on the board of directors.
C) Firms issue equity instead of debt because principal-agent problems are smaller with
equity.
D) Governments regulate firms by imposing standard accounting principles and punishing
fraud
13) PRINCIPAL-AGENT PROBLEMS are said to occur in financial markets when
A) ownership of assets is separated from the control of these assets.
B) people who do not pay for information take advantage of the information that other people
have paid for by observing their behavior.
C) high-risk borrowers are successfully able to pass themselves off as low-risk borrowers
when applying for loans.
D) the cost per dollar loaned declines as the size of the loan increases.
14) Most U.S. FINANCIAL CRISES have begun with one or more of the following “trigger
events”:
A) a rise in interest rates.
B) a decline in the stock market.
C) a deterioration in banks’ balance sheets.
D) an increase in uncertainty resulting, for example, from a failure of a prominent financial or
nonfinancial institution.
E) all of the above
15) Some of the key reasons why banks and other financial intermediaries are able to reduce or
eliminate information problems and transaction costs include:
A) banks can spread their loan costs over large pools of depositors (lenders).
B) bank loans are typically made in private, which gives bankers a greater incentive to engage
in costly information gathering.
C) banks can include collateral requirements in loan contracts, which can act as a signal
regarding the type of borrower (high or low risk).
D) all of the above.
Faculty of Foreign Languages Banking and Finance
SECTION 3 – Answer questions
Task 1:
Question 1: Rank the following bank assets from most to least liquid:
a. Commercial loans
b. Securities
c. Reserves
d. Physical capital
Question 2: “Bank managers should always seek the highest return possible on their assets.” Is this
statement true, false, or uncertain? Explain your answer.
Question 3: Why do equity holders care more about ROE than about ROA?
Question 4: What steps can a bank take to improve its liquidity during a financial crisis?
Question 5: Apply the concept of credit risk assessment to evaluate the potential risk of lending to a
new corporate client.
Task 2:
Question 1: How would an increase in reserve requirements impact a bank’s lending ability?
Question 2: How would a bank implement a strategy to diversify its loan portfolio?
Question 3: What kinds of information do you need to provide to the financial institution when you
apply for a business loan? Why are you asked to do that?
Task 3:
Question 1: If the president of VP bank told you that the bank was so well run that it has never had
to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to
buy VP bank’s stock? Why or why not?
Question 2: Alien is a small business operating in the field of information technology. Because the
business is going well, it decides to apply for a loan to expand its operations. What steps might the
bank take to assess the risk of this loan, and how does it decide on the terms of the loan?
Question 3: VP bank needs to raise funds to support its lending activities. What are some of the
methods it might use to acquire these funds?
Question 4: If Seabank doubles the amount of its capital and ROA stays constant, what will
Question 5: If MB bank finds that its ROE is too low because it has too much bank capital, what
can it do to raise its ROE?
Question 6: If LP bank is falling short of meeting its capital requirements by $1 million, what three
things can it do to rectify the situation?
Question 7: If the bank you own has no excess reserves and a sound customer comes in asking for a
loan, should you automatically turn the customer down, explaining that you don’t have any excess
reserves to loan out? Why or why not? What options are available for you to provide the funds your
customer needs?
Question 8: If you are a banker and expect interest rates to rise in the future, would you want to
make short-term or long-term loans?
Faculty of Foreign Languages Banking and Finance
SECTION 4 – Gap Filling
Task 1: Fill in the gaps in the text below using the correct terms from the given table. Each
term can only be used once, and five terms will not be used.
banks balance sheet securities gains asset transformation
income liabilities risk ROA capital requirements
services deposits fees ROE off-balance-sheet activities
assets liquidity credit NIM financial instruments
reserves equity holders expenses loans regulatory authorities
Banking plays a crucial role in ensuring that the financial system and the economy operate
smoothly and efficiently by channeling funds to borrowers with productive investment
opportunities. In the U.S., (1) ____ provide over $6 trillion in (2) ____ annually. They offer (3)
____ to businesses, finance college educations, and help purchase cars and homes, while also
providing (4) ____ like checking and savings accounts.
The (5) ____ of commercial banks can be seen as a list of the sources and uses of bank funds. A
bank's (6) ____ are its sources of funds, including checkable deposits, time deposits, discount loans
from the Fed, borrowings from other banks and corporations, and bank capital. The bank's (7) ____
are its uses of funds, which consist of (8) ____, cash items in the process of collection, deposits at
other banks, (9) ____, loans, and other assets. Banks earn profits through the process of (10) ____:
borrowing short and lending long. When a bank takes in additional (11) ____, it gains an equal
amount of reserves; when it pays out deposits, it loses an equal amount of reserves.
Despite more liquid assets earning lower returns, banks still prefer to hold them. They manage their
assets to maximize profits by seeking the highest returns possible on loans and securities while
simultaneously trying to reduce risk and maintain adequate provisions for (12) ____. While liability
management was once a conservative practice, large banks now actively seek sources of funds by
issuing liabilities such as negotiable CDs or borrowing from other banks and corporations. Banks
manage the amount of capital they hold to avoid bank failure and meet the (13) ____ set by the (14)
____. However, holding too much capital can reduce the returns to (15) ____.
And (16) ____ include trading (17) ____ and generating income from (18) ____ and loan sales,
which impact bank profits but do not appear on bank balance sheets. These activities increase
banks' risk, requiring careful risk assessment procedures and internal controls to prevent excessive
risk-taking. A bank's net operating (19) ____ equals operating income minus operating expenses.
Adding (20) ____ (or losses) on securities and net extraordinary items to net operating income and
then subtracting taxes yields net income.
Task 2: Fill in the gaps in the text below using the correct terms from the given table. Each
term can only be used once, and five terms will not be used.
financial system securities subtracting capital regulatory authorities
balance sheet checkable deposits sources NIM off-balance-sheet activities
physical capital asset transformation reserves taxes financial instruments
operating expenses extraordinary items loans ROA productive investment
income risk assessment liquidity ROE liability management
Banks are essential for the smooth operation of the (1) ____ and the overall economy by directing
funds to borrowers with (2) ____ opportunities. In the U.S., banks provide over $6 trillion in credit
each year, offering (3) ____ to businesses, financing college educations, and supporting the
purchase of homes and cars, along with services like checking and savings accounts.
Faculty of Foreign Languages Banking and Finance
The (4) ____ of commercial banks lists the (5) ____ and uses of bank funds. The bank's liabilities,
which include (6) ____, time deposits, discount loans from the Fed, and borrowings from other
banks and corporations, are its sources of funds. The bank's assets, including (7) ____, cash items in
process of collection, deposits at other banks, (8) ____, loans, and other assets like (9) ____,
represent its uses of funds.
Banks generate profits through (10) ____, where they borrow short-term by accepting deposits and
lend long-term by making loans. More liquid assets generally yield lower returns, but banks still
hold them for insurance against deposit outflows. They manage their assets to achieve high returns
on loans and securities while minimizing risk and ensuring adequate (11) ____.
Modern (12) ____ involves large banks actively seeking funds by issuing liabilities such as
negotiable CDs or borrowing from other banks. Managing the amount of (13) ____ is crucial to
prevent bank failure and meet requirements set by (14) ____. Holding too much capital can,
however, reduce returns to equity holders. (15) ____ involve trading (16) ____ and generating
income from fees and loan sales, which affect bank profits but are not shown on balance sheets.
These activities increase banks' risk, necessitating careful (17) ____ procedures and internal
controls.
Net operating (18) ____ for a bank is calculated by (19) ____ operating expenses from operating
income. Adding gains or losses on securities and net (20) ____ to net operating income and then
subtracting taxes yields net income (profits after taxes).
SECTION 5: True/False
1. Banks make profits by selling liabilities with one set of characteristics and using theproceeds to
buy assets with a different set of characteristics.
2. Liquidity management involves ensuring that a bank has sufficient liquid assets to meet its short-
term obligations.
3. Credit risk management involves assessing the likelihood that borrowers will default on their
loans.
4. Banks acquire funds primarily through the issuance of equity.
5. The primary source of income for banks is through transaction fees and service charges.
6. Banks do not use capital markets to acquire funds.
7. Off-balance-sheet activities involve trading financial instruments and generating income from
fees and loan sales, activities that affect bank profits but do not appear on bank balance sheets.
8. To maximize its profits, a bank must simultaneously seek the highest returns possible on loans
and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets.
9. Liability management focuses on managing the bank’s sources of funds.
10. Banks do not need to maintain reserves.
11. Banks cannot generate income from non-interest activities.
12. Banks make profits by charging an interest rate on their liabilities holdings of securities and
loans that is lower than the interest and other expenses on their assets.
13. For the most part, banks took their liabilities as fixed and spent their time trying to achieve an
optimal mix of assets.
14. Asset management states that the bank manager must pursue an acceptably low level of risk by
acquiring assets that have a low rate of default and by diversifying asset holdings
15. Liability management refers to acquiring funds at low cost.
16. The funds obtained from issuing assets are used to purchase income-earning liabilities.
17. Because the depositor can withdraw funds and the bank is obligated to pay, checkable deposits
are an asset for the bank.
18. Non-transaction deposits are the primary use of bank funds
19. Capital adequacy management states that the manager must decide the amount of capital the
bank should maintain and then acquire the needed capital.
Faculty of Foreign Languages Banking and Finance
20. Credit cards issued by banks are a form of lending.
21. Deposits are the primary source of funding for most banks.
22. Time deposits have a non-fixed maturity length, ranging from several months to over
five years, and assess substantial penalties for early withdrawal.
23. Bank capital, the bank’s net worth, equals the difference between total assets
and equity capital.
24. Banks try to purchase securities with low returns and low risk.
25. Banks primarily make loans to businesses and consumers to generate operating income.
26. Banks manage their assets to ensure they have enough liquidity to meet depositors’ withdrawal
demands.
27. Banks manage their liabilities by issuing various types of deposits and borrowing from other
financial institutions.
28. Given the return on assets, the higher the bank capital, the higher the return for the owners of
the bank.
29. Most of a bank’s operating income is generated by interest on its liabilities,
particularly loans.
30. An important component of a bank’s operating expenses is the interest payments that it must
make on its assets, particularly on its deposits.
31. One way banks manage their liabilities is by adjusting the interest rates they offer on deposits.
32. Banks must maintain a certain level of reserves as mandated by central bank regulations.
33. Banks make profits through the difference between interest rate on their asset holdings of
securities and loans and the interest and other expenses on their liabilities.
34. Banks make profits through the difference between interest rate on their liabilities holdings of
securities and loans and the interest and other expenses on their assets.
35. Savings accounts were once the most common type of transaction deposit.
36. The funds obtained from issuing liabilities are used to purchase income-earning assets.
37. Checkable deposits are bank accounts that allow the owner of the account to write checks to
third parties.
38. Checkable deposits and money market deposit accounts are payable on demand
39. A checkable deposit is an asset for the depositor because it is part of his or her wealth.
40. Because the depositor can withdraw funds and the bank is obligated to pay, checkable deposits
are a liability for the bank.
41. Non-transaction deposits are the primary source of bank funds
42. Savings accounts were once the most common type of non-transaction deposit.
43. Time deposits have a fixed maturity length, ranging from several months to over
five years, and assess substantial penalties for early withdrawal.
44. In the U.S, banks also obtain funds by borrowing from the Federal Reserve System,
the Federal Home Loan banks, other banks, and corporations.
45. Bank capital, the bank’s net worth, equals the difference between total assets
and liabilities.
46. A bank uses the funds that it has acquired by issuing liabilities to purchase income-earning
assets.
47. Excess reserves are the most liquid of all bank assets.
48. Banks hold state and local government securities because state and local governments are more
likely to do business with banks that hold their securities.
49. Banks make their profits primarily by issuing loans.
50. In general terms, banks make profits by selling liabilities with one set of characteristics and
using the proceeds to buy assets with a different set of characteristics. This process is often referred
to as asset transformation.
Faculty of Foreign Languages Banking and Finance
51. Asset transformation refers to selling liabilities with one set of characteristics and using the
proceeds to buy assets with a different set of characteristics.
52. When a bank receives additional deposits, it gains an equal amount of reserves; when
it loses deposits, it loses an equal amount of reserves.
53. If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other
parts of its balance sheet.
54. Excess reserves are insurance against the costs associated with deposit outflows. The higher the
costs associated with deposit outflows; the more excess reserves banks will want to hold.
55. Banks try to find borrowers who will pay high interest rates and are unlikely to default on their
loans.
56. Banks try to purchase securities with high returns and low risk.
57. The bank must manage the liquidity of its assets so that it can satisfy its
reserve requirements without bearing huge costs.
58. Bank capital helps prevent bank failure.
59. Bank failure refers to a situation in which the bank cannot satisfy its obligations to pay its
depositors and other creditors and so goes out of business.
60. A bank maintains bank capital to lessen the chance that it will become insolvent.
61. Given the return on assets, the lower the bank capital, the higher the return for the owners of the
bank.
62. Most of a bank’s operating income is generated by interest on its assets,
particularly loans.
63. Operating expenses are the expenses incurred in conducting the bank’s ongoing operations.
64. An important component of a bank’s operating expenses is the interest payments that it must
make on its liabilities, particularly on its deposits.
