Solution Manual for Financial Institutions Management: A Risk Management Approach, 8th Edition

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Chapter 01-Why Are Financial Institutions Special?1-1Solutions for End-of-Chapter Questions and Problems: Chapter One1.What arefive risks common toallfinancial institutions?Default or credit risk of assets, interest rate risk caused by maturity mismatches between assetsand liabilities, liability withdrawal or liquidity risk, underwriting risk, and operatingrisks.2.Explain how economic transactions between household savers of funds and corporate usersof funds would occur in a world without financial institutions.In a world without FIs the users of corporate funds in the economy would have todirectlyapproach the household savers of funds in order tosatisfy their borrowing needs.This processwould be extremely costly because of the up-front information costs faced by potential lenders.Cost inefficiencies would arise with the identification of potential borrowers, the pooling ofsmall savings into loans of sufficient size to finance corporate activities, and the assessment ofrisk and investment opportunities.Moreover, lenders would have to monitor the activities ofborrowers over each loan's life span.The net result would be an imperfect allocation of resourcesin an economy.3.Identify and explain three economic disincentives thatwoulddampen the flow of fundsbetween household savers of funds and corporate users of funds in an economic worldwithout financialinstitutions.Investors generally are averse todirectlypurchasing securities because of (a) monitoring costs,(b) liquidity costs, and (c) price risk.Monitoring the activities of borrowers requires extensivetime, expense, and expertise.As a result, households would prefer to leave this activity to others,and by definition, the resulting lack of monitoring would increase the riskiness of investing incorporate debt and equity markets.The long-term nature of corporate equity and debtsecuritieswould likely eliminate at least a portion of those households willing to lend money, as thepreference of many for near-cash liquidity would dominate the extra returns which may beavailable.Finally, the price risk of transactions on the secondary markets would increase withoutthe information flows and services generated by high volume.4.Identify and explain the two functions FIsperformthatwouldenable the smooth flow offunds from household savers to corporate users.FIs serve as conduits between users and savers of funds by providing a brokerage function andby engaging inanasset transformation function.The brokerage function can benefit both saversand users of funds and can vary according to the firm. FIs may provide only transaction services,such as discount brokerages, or they also may offer advisory services which help reduceinformation costs, such as full-line firms likeMerrill Lynch.The asset transformation function isaccomplished by issuing their own securities, such as deposits and insurance policies that aremore attractive to household savers, and using the proceeds to purchase the primary securities ofcorporations.Thus, FIs take on the costs associated with the purchase of securities.

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Chapter 01-Why Are Financial Institutions Special?1-25.In what sense are the financial claims of FIs consideredsecondary securities, while thefinancial claims of commercial corporations are consideredprimary securities?How doesthe transformation process, or intermediation, reduce the risk, or economic disincentives, tothe savers?Funds raised by the financial claims issued by commercial corporations areused to invest in realassets.These financial claims, which are considered primary securities, are purchased by FIswhose financial claims therefore are considered secondary securities.Savers who invest in thefinancial claims of FIs are indirectly investing in the primary securities of commercialcorporations.However, the information gathering and evaluation expenses, monitoring expenses,liquidity costs, and price risk of placing the investments directly with the commercial corporationare reduced because of the efficiencies of the FI.6.Explain how financial institutions act as delegated monitors.What secondary benefits oftenaccrue to the entire financial system because of this monitoring process?By putting excess funds into financialinstitutions, individual investors give to the FIs theresponsibility of deciding who should receive the money and of ensuring that the money isutilized properly by the borrower.In this sense,depositors have delegated the FI to act as amonitor on their behalf.Further, the FI can collect information more efficiently than individualinvestors.The FI can utilize this information to create new products, such as commercial loans,that continually update the information pool.This more frequent monitoring process sendsimportant informational signals to other participants in the market, a process that reducesinformation imperfection and asymmetry between the ultimateproviders and users of funds inthe economy.7.What are five general areas of FI specialness that are caused by providing various servicesto sectors of the economy?First, FIs collect and process information more efficiently than individual savers. Second, FIsprovide secondary claims to household savers which often have better liquidity characteristicsthan primary securities such as equities and bonds.Third, by diversifying the asset base FIsprovide secondary securities with lower pricerisk conditions than primary securities.Fourth, FIsprovide economies of scale in transaction costs because assets are purchased in larger amounts.Finally, FIs provide maturity intermediation to the economy which allows the introduction ofadditional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.8.What are agency costs?How do FIs solve the information andrelated agency costsexperiencedwhen household savers invest directly in securities issued by corporations?Agency costs occur when owners or managers take actions that are not in the best interests oftheequity investor or lender.These costs typically result from the failure to adequately monitor theactivities of the borrower.If no other lender performs these tasks, the lender is subject to agencycosts as the firm may not satisfy the covenants in the lending agreement. Because the FI invests

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Chapter 01-Why Are Financial Institutions Special?1-3the funds of many small savers, the FI has a greater incentive to collect information and monitorthe activities of the borrower.9.How do large financial institutions solve the problem of high information collection costsforlenders, borrowers, and financial markets?Oneway financial institutions solve this problemisthat theydevelop ofsecondary securities thatallowforimprovements in the monitoring process.An example is the bank loan that is renewedmore quickly than long-term debt. The renewal process updates the financial and operatinginformation of the firm more frequently, thereby reducing the need for restrictive bond covenantsthat may be difficult and costly to implement.10.How do FIs alleviate the problem of liquidity risk faced by investors who wish tobuysecurities issued bycorporations?Liquidity risk occurs when savers are not able to sell their securities on demand. Commercialbanks, for example, offer deposits that can be withdrawn at any time. Yet,the banks make long-term loans or invest in illiquid assets because they are able to diversify their portfolios and bettermonitor the performance of firms that have borrowed or issued securities. Thus,individualinvestors are able to realize the benefits of investing in primary assets without accepting theliquidity risk of direct investment.11.How do financial institutions help individual savers diversify their portfolio risks?Whichtype of financial institution is best able to achieve this goal?Money placed in any financial institution will result in a claim ona more diversified portfolio.Banks lend money to many different types of corporate, consumer, and government customers.Insurance companies have investments in many different types of assets. Investmentsin a mutualfund may generate the greatest diversification benefit because of the fund’s investment in a widearray of stocks and fixed income securities.12.How can financial institutions invest in high-risk assets with funding provided by low-riskliabilities from savers?Diversification of risk occurs with investments in assetswhose returnsare not perfectlypositively correlated.One result of extensive diversification is that the average risk of the assetbase of an FI will be less than the average risk of the assets in whichthe individualhas invested.Thus,individual investors realize some of the returns of high-risk assets without accepting thecorresponding risk characteristics.13.How canindividual savers use financial institutions to reduce the transaction costs ofinvesting in financial assets?By pooling the assets of many small investors, FIs can gain economiesof scale in transactioncosts.This benefit occurs whether the FI is lending to a corporate or retail customer, orpurchasing assets inthe money and capital markets.In either case, operating activities that are

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Chapter 01-Why Are Financial Institutions Special?1-4designed to deal in large volumes typically are more efficient than those activities designed forsmall volumes.14.What ismaturity intermediation?What are some of the ways in which the risks of maturityintermediation are managed by financial institutions?If net borrowers and net lenders have different optimal time horizons, FIs can service bothsectors by matching their asset and liability maturities through on-and off-balance sheet hedgingactivities and flexible access to the financial markets.For example, the FI can offer the relativelyshort-term liabilities desired by households and also satisfy the demand for long-term loans suchas home mortgages.By investing in a portfolio of long-and short-term assets that have variable-and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities thathave similar variable-and fixed-rate characteristics, or by using futures, options, swaps, andother derivative products.15.What are five areas of institution-specific FI specialnessand which types of institutions aremost likely to be the service providers?First, commercial banks and other depository institutions are key players for the transmission ofmonetary policy from the central bank to the rest of the economy.Second, specific FIs often areidentified as the major source of financingfor certain sectors of the economy.For example,savingsinstitutionstraditionally serve the credit needs of the residential real estate market.Third, life insurancecompaniesand pension funds commonly are encouraged to providemechanisms to transfer wealth across generations.Fourth, depository institutions efficientlyprovide payment services to benefit the economy.Finally, mutual funds provide denominationintermediation by allowing small investors to purchase pieces of assets with large minimum sizessuch as negotiable CDs and commercial paper issues.16.How do depository institutions such as commercial banks assist in the implementation andtransmission of monetary policy?The Federal Reserve Board candirectlyinvolve commercial banks in the implementation ofmonetary policy through changes in the reserve requirements and the discount rate.The openmarket sale and purchase of Treasury securities by the Fed involves banks in the implementationof monetary policy in a less direct manner.17.What is meant bycredit allocation regulation?What social benefit is this type of regulationintended to provide?Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of theeconomy which are considered to be socially important.These may include housing and farming.Presumably the provision of credit to make houses more affordable or farms more viable leads toa more stable and productive society.

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Chapter 01-Why Are Financial Institutions Special?1-518.Which intermediaries best fulfill theintergenerational wealth transfer function?What isthis wealth transfer process?Life insurancecompaniesand pension funds often receive special taxation relief and othersubsidies to assist in the transfer of wealth from one generation to another.In effect, the wealthtransfer process allowsforthe accumulation of wealth by one generation to be transferreddirectly to one or more younger generations by establishing life insurance policies and trustprovisions in pension plans.Often this wealth transfer process avoids the full marginal taxtreatment that a direct payment would incur.19.What are two of the most important payment services provided by financial institutions?Towhat extent do these services efficiently provide benefits to the economy?The two most important payment services are check clearing and wire transfer services.Anybreakdown in these systems would produce gridlock in the payment system with resultingharmful effects to the economy at both the domestic and potentially the international level.20.Whatis denomination intermediation?How do FIs assist in this process?Denomination intermediation is the process whereby small investors are able to purchase piecesof assets that normally are sold only in large denominations.Individual savers often investsmallamounts in mutual funds.The mutual funds pool these small amounts and purchasea welldiversified portfolio of assets.Therefore,small investors can benefit in the returns and low riskwhich these assets typically offer.21.What isnegative externality? In what ways do the existence of negative externalities justifythe extra regulatory attention received by financial institutions?A negative externality refers to the action byone party that has an adverse effect onanotherparty who is not part of the original transaction.For example, in an industrial setting, smokefrom a factory that lowers surrounding property values may be viewed as a negative externality.For financial institutions, one concern is the contagion effect that can arise when the failure ofone FI can cast doubt on the solvency of otherFIs.22.If financial markets operated perfectly and costlessly, would there be aneed for financialinstitutions?To a certain extent, financialinstitutionsexist because offinancial market imperfections.Ifinformation is available costlessly to all participants, savers would not need FIs to act as eithertheir brokers or their delegated monitors.However, if there are social benefits to intermediation,such as the transmission of monetary policy or credit allocation, then FIs would exist even in theabsence of financial market imperfections.

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Chapter 01-Why Are Financial Institutions Special?1-623.Why are FIs among the most regulated sectors in the world?When isthenet regulatoryburden positive?FIs are required to enhance the efficient operation of the economy.Successful financialinstitutions provide sources of financing that fund economic growth opportunitiesthat ultimatelyraise the overall level of economic activity.Moreover, successful financialinstitutionsprovidetransaction services to the economy that facilitate trade and wealth accumulation.Conversely, distressed FIs create negative externalities for the entire economy.That is, theadverse impact of an FI failure is greater than just the loss to shareholders and other privateclaimants on the FI's assets.For example, the local market suffers if an FI fails and other FIs alsomay be thrown into financial distress by a contagion effect.Therefore, since some of the costs ofthe failure of an FI are generally borne by society at large, the government intervenes in themanagement of these institutions to protect society's interests.This intervention takes the form ofregulation.However, the need for regulation to minimize social costs mayimpose private costs to the FIsthat would not exist without regulation. This additional private cost is defined as a net regulatoryburden. Examples include the cost of holding excess capital and/or excess reserves and the extracosts of providing information.Although they may be socially beneficial, these costs add toprivate operating costs.To the extent that these additional costs help to avoid negativeexternalities and to ensure the smooth and efficient operation of the economy, the net regulatoryburden is positive.24.What forms of protection and regulation do regulators of FIs impose to ensure their safetyand soundness?Regulators have issued several guidelines to insure the safety and soundness of FIs:a.FIs are required to diversify their assets.For example, banks cannot lend more than10percent of their equity to a single borrower.b.FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.In the case of banks, the Basle standards require a minimum core and supplementarycapitalbased on the size of an FIs’risk-adjusted assets.c.Regulators have set up guaranty funds such asDIF for commercial banks, SIPC forsecurities firms, and state guaranty funds for insurance firms to protect individual investors.d.Regulators also engage in periodic monitoring and surveillance, such as on-siteexaminations, and request periodic information from the FIs.25.In the transmission of monetary policy, what is the difference betweeninside moneyandoutside money?How does the Federal Reserve try to control the amount of inside money?How can this regulatory position create a cost for the depository institutions?

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Chapter 01-Why Are Financial Institutions Special?1-7Outside money is that part of the money supply directly produced and controlled by the Fed, forexample, coins and currency.Inside money refers to bank deposits not directly controlled by theFed.The Fed can influence this amount of money byadjustingreserve requirement and discountrate policies. In cases where the level of required reserves exceeds the level considered optimalby the FI, the inability to use the excess reserves to generate revenue may be considered a tax orcost of providing intermediation.26.What are some examples of credit allocation regulation?How can this attempt to createsocial benefits create costs to aprivate institution?The qualified thrift lender test (QTL)requires thrifts to hold 65 percent of their assets inresidential mortgage-related assets to retain the thrift charter.Some states have enacted usurylaws that place maximum restrictions on the interest rates that can be charged on mortgagesand/or consumer loans.These types of restrictions often create additional operating costs to theFI and almost certainly reduce the amount of profit that could be realized without suchregulation.27.What is the purpose of theHome Mortgage Disclosure Act?What are the social benefitsdesired from the legislation?How does the implementation of this legislation create a netregulatory burden on financial institutions?The HMDA was passed by Congress to prevent discrimination in mortgage lending.The socialbenefit is to ensure that everyone who qualifies financially is provided the opportunity topurchasea house should they so desire.The regulatory burden has been to require a writtenstatement indicating the reasons whycredit was or was not granted.28.What legislation has been passed specifically to protect investors who use investmentbanks directly or indirectly to purchase securities?Give some examples of the types ofabuses for which protection is provided.The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed byCongress to protect investors against possible abuses such as insider trading, lack of disclosure,outright malfeasance, and breach of fiduciary responsibilities.29.How do regulations regarding barriers to entry and the scope of permitted activities affectthecharter valueof financial institutions?The profitability of existing firms will be increased as the direct and indirect costs of establishingcompetition increase.Direct costs include the actual physical and financial costs of establishing abusiness. In the case of FIs, the financial costs include raising the necessary minimumcapital toreceive a charter.Indirect costs include permission from regulatory authorities to receive acharter.Again in the case of FIs this cost involves acceptableleadership to regulators.As thesebarriers to entry are stronger, the charter value for existing firms ishigher.

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Chapter 01-Why Are Financial Institutions Special?1-830.What reasons have been given for the growth ofinvestment companies at the expense of“traditional” banks and insurance companies?The recent growth of investment companies can be attributed to two major factors:a.Investors have demanded increased access to directinvestment insecurities markets.Investment companies allow investors to take positions in securities markets while stillobtaining the risk diversification, monitoring, and transactional efficiency benefits offinancial intermediation.Some experts would argue that this growth is the result ofincreased sophistication on the part of investors.Others would argue that the ability to usethese markets has caused theincreased investor awareness.The growth in these assets isinarguable.b.Recent episodes of financial distress in both the banking and insurance industries have ledto an increase in regulation and governmental oversight, thereby increasing the netregulatory burden of “traditional” companies.As such, the costs of intermediation haveincreased, which increases the cost of providing services to customers.31.What events resulted in banks’ shift from the traditional banking model of “originate andhold” to a model of “originate and distribute?”As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result wasa dramatic increase in systemic risk of the financial system, caused in large part by a shift in thebanking model from that of “originate and hold” to “originate to distribute.” In the traditionalmodel, banks take short term deposits and other sources of funds and use them to fund longerterm loans to businesses and consumers. Banks typically hold these loans to maturity, and thushave an incentive to screen and monitor borrower activities even after a loan is made. However,the traditional banking model exposes the institution to potential liquidity, interest rate, andcredit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs,banks shifted to an underwriting model in which they originated or warehoused loans, and thenquickly sold them. Indeed, most large banks organized as financial service holding companies tofacilitate these new activities.More recently activities of shadow banks, nonfinancial servicefirms that perform banking services, have facilitated the change from the originate and holdmodel of commercial banking to the originate and distribute banking model.These innovationsremoved risk from the balance sheet of financial institutions and shifted risk off the balance sheetand to other parts of the financial system. Since the FIs, acting as underwriters, were not exposedto the credit, liquidity, and interest rate risks of traditional banking, they had little incentive toscreen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to actas specialists in risk measurement and management.

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Chapter 01-Why Are Financial Institutions Special?1-932.How did the boom in the housing market in the early and mid-2000s exacerbate FI’stransition away from their role as specialists in risk measurement and management?The boom (“bubble”) in the housing markets began building in 2001, particularly after theterrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was tocreate stability in the financial markets by providing liquidity to FIs. For example, the FederalReserve lowered the short-term money market rate that banks and other financial institutions payin the Federal funds market and even made lender of last resort funds available to non-bank FIssuch as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidityprovided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporatedebt financing. Demand for residential mortgages and credit card debt rose dramatically. As thedemand for mortgage debt grew, especially among those who had previously been excluded fromparticipating in the market because of their poor credit ratings, FIs began lowering their creditquality cut-off points. Moreover, to boost their earnings, in the market now popularly known asthe “subprime market,” banks and other mortgage-supplying institutions often offered relativelylow “teaser” rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates,but with substantial step-up in rates after the initial rate period expired two or three year later andif market rates rose in the future. Under the traditional banking structure, banks might have beenreluctant to so aggressively pursue low credit quality borrowers for fear that the loans woulddefault. However, under the originate-to-distribute model of banking, asset securitization andloan syndication allowed banks to retain little or no part of the loans, and hence the default riskon loans that they originated. Thus, as long as the borrower did not default within the firstmonths after a loan’s issuance and the loans were sold or securitized without recourse back to thebank, the issuing bank could ignore longer term credit risk concerns. The result was deteriorationin credit quality, at the same time as there was a dramatic increase in consumer and corporateleverage.The following questions and problems are based on material in Appendix 1Bto the Chapter.33.What are the tools used by the Federal Reserve to implement monetary policy?The tools used by the Federal Reserve to implement its monetary policy include open marketoperations, the discount rate, and reserve requirements. Open market operations are the FederalReserves’ purchases or sales of securities in theU.S. Treasury securities market. The discountrate is the rate of interest Federal Reserve Banks charge on “emergency” or “lender of lastresort” loans to depository institutions in their district. Reserve requirements determine theminimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) thatdepository institutions must maintain by law to back transaction deposits held as liabilities ontheir balance sheets. This requirement is usually set as a ratio of transaction accounts, e.g., 10percent.34.Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities.Show the result of this transaction on the balance sheets of the Federal Reserve System andcommercial banks.

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Chapter 01-Why Are Financial Institutions Special?1-10For the purchase of $1 billion in securities, the balance sheet of the Federal Reserve System andcommercial banks is shown below.Change in Federal Reserve’s Balance SheetAssetsLiabilitiesTreasury securities+ $1 bReserve account of+ $1 bsecurities dealers’ banks----------------------------------------------------------------------------------------------------Change in Commercial Bank Balance SheetsAssetsLiabilitiesReserve accounts+ $1 bSecurities dealers’ demand+ $1 bat Federal Reservedeposit accounts35.Explain how a decrease in the discount rate affects creditavailability and the moneysupply.Changing the discount rate signals to the market and the economy that the Federal Reservewould like to see higher or lower rates in the economy. Thus, the discount rate is like a signal ofthe FOMC’s intention regarding the tenor of monetary policy. For example, raising the discountrate “signals” that the Fed would like to see a tightening of monetary conditions and higherinterest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate“signals” a desire to see more expansionary monetary conditions and lower interest rates ingeneral.36.Whatchanges didthe Fed implement to itsdiscount windowlending policy in the early2000s?In January 2003, the Fed implemented changes to its discount window lending that increased thecost of borrowing but eased the terms. Specifically, three lending programs are now offeredthrough the Feds discount window.Primary credit is available to generally sound depositoryinstitutions on a very short-term basis, typically overnight, at a rate above the Federal OpenMarket Committee's (FOMC) target rate for federal funds.Primary credit may be used for anypurpose, including financing the sale of fed funds. Primary credit may be extended for periods ofup to a few weeks to depository institutions in generally sound financial condition that cannotobtain temporary funds in the financial markets at reasonable terms.Secondary credit is availableto depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit isavailable to meet backup liquidity needs when its use is consistent with a timely return to areliance on market sources of funding or the orderly resolution of a troubled institution.Secondary credit may not be used to fund an expansion of the borrower’s assets. The FederalReserve's seasonal credit program is designed to assist small depository institutions in managingsignificant seasonal swings in their loans and deposits. Seasonal credit is available to depositoryinstitutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs.

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Chapter 01-Why Are Financial Institutions Special?1-11Eligible institutions are usually located in agricultural or tourist areas. Under the seasonalprogram, borrowers may obtain longer term funds from the discount window during periods ofseasonal need so that they can carry fewer liquid assets during the rest of the year and make morefunds available for local lending.With the change, discount window loans to healthy banks would be priced at 1 percentabove the fed funds rate rather than below as it generally was in the period preceding January2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changeswere not intended to change the Fed’s use of the discount window to implement monetarypolicy, but significantly increase the discount rate while making it easier to get a discountwindow loan. By increasing banks=use of the discount window as a source of funding, the Fedhopes to reduce volatility in the fed funds market as well. The change also allows healthy banksto borrow from the Fed regardless of the availability of private funds. Previously, the Fedrequired borrowers to prove they could not get funds from the private sector, which put a stigmaon discount window borrowing. With the changes, the Fed will lend to all banks, but the subsidyof below fed fund rate borrowing will be gone.37.Bank Three currently has $600 million in transaction deposits on its balance sheet. TheFederal Reserve has currently set the reserve requirement at 10 percent of transactiondeposits.a.Supposethe Federal Reserve decreases the reserve requirement to 8 percent. Show thebalance sheet of Bank Three and the Federal Reserve System just before and after the fulleffect of the reserve requirement change. Assume Bank Three withdraws all excessreserves and gives out loans, and that borrowers eventually return all of these funds toBank Three in the form of transaction deposits.Panel A: Initial Balance SheetsFederal Reserve BankAssetsLiabilitiesSecurities$60mReserve accounts$60m---------------------------------------------------------------------------------------------Bank ThreeAssetsLiabilitiesLoans$540mTransaction deposits$600mReserve deposits60mat Fed

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Chapter 01-Why Are Financial Institutions Special?1-12Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve RequirementFederal Reserve BankAssetsLiabilitiesSecurities$60mReserve accounts$60m---------------------------------------------------------------------------------------------------Bank ThreeAssetsLiabilitiesLoans$690mTransaction deposits$750m($750m-$60m)($60mx0.08)Reserve deposits60mat Fedb.Redo part (a) using a 12 percent reserve requirement.Panel A: Initial Balance SheetsFederal Reserve BankAssetsLiabilitiesSecurities$60mReserve accounts$60m---------------------------------------------------------------------------------------------Bank ThreeAssetsLiabilitiesLoans$540mTransaction deposits$600mReserve deposits60mat FedPanel B: Balance Sheet after All Changes Resulting from Decrease in Reserve RequirementFederal Reserve BankAssetsLiabilitiesSecurities$60mReserve accounts$60m---------------------------------------------------------------------------------------------------Bank ThreeAssetsLiabilitiesLoans$440mTransaction deposits$500m($500m-$60m)($60m x0.12)Reserve deposits60mat Fed

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Chapter 01-Why Are Financial Institutions Special?1-1338.Which of the monetary tools available to the Federal Reserve is most often used? Why?The Federal Reserve uses mainly open market operations to implement its monetary policy.Adjustments to the discount rate are rarely used because it is difficult for the Fed to predictchanges in bank discount window borrowing when the discount rate changes and because inaddition to their effect on the money supply, discount rate changes often have great effects on thefinancial markets. Further, because changes in the reserve requirements can result inunpredictable changes in the money base (depending on the amount of excess reserves held bybanks and the willingness of the public to redeposit funds at banks instead of holding cash (i.e.,they have a preferred cash-deposit ratio)), the reserve requirement is rarely used by the FederalReserve as a monetary policy tool. The unpredictability comes from at least two sources. First,there is uncertainty about whether banks will actually convert excess reserves (created from adecrease in the reserve requirement) into new loans. Second, there is uncertainty about whatportion of the new loans will be returned to depository institutions in the form of transactiondeposits. Thus, like the discount window rate, the use of the reserve requirement as a monetarypolicy tool increases the probability that a money base or interest rate target set by the FOMCwill not be achieved.39.Describe how expansionary activities conducted by the Federal Reserve impact creditavailability, the money supply, interest rates, and security prices. Do the same forcontractionary activities.Expansionary Activities: We described three monetary policy tools that the Fed can use toincrease the money supply. These include open market purchases of securities, discount ratedecreases, and reserve requirement decreases. All else constant, when the Federal Reservepurchases securities in the open market, reserve accounts of banks (and thus, the money base)increase. When the Fed lowers the discount rate, this generally results in a lowering of interestrates in the economy. Finally, a decrease in the reserve requirements, all else constant, results inan increase in reserves for all banks. In two of the three cases (open market operations andreserve requirement changes), an increase in reserves results in an increase in bank deposits andassets. One immediate effect of this is that interest rates fall and security prices to rise. In thethird case (a discount rate change), the impact of a lowering of interest rates is more direct.Lower interest rates encourage borrowing. Economic agents spend more when they can getcheaper funds. Households, business, and governments are more likely to invest in fixed assets(e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g.,automobiles, appliances). State and local government spending increases (e.g., new roadconstruction, school improvements). Finally, lower domestic interest rates relative to foreignrates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies.As the dollar’s (foreign) exchange value drops, U.S. goods become relatively cheaper comparedto foreign goods. Eventually, U.S. exports increase. The increase in spending from all of thesemarket participants results in economic expansion, stimulates additional real production, andmay cause inflation to rise. Ideally, the expansionary policies of the Fed are meant to beconducive to real economic expansion (economic growth, full employment, sustainableinternational trade) without price inflation. Indeed, price stabilization can be viewed as theprimary objective of the Fed.

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Chapter 01-Why Are Financial Institutions Special?1-14Contractionary Activities: We also described three monetary policy tools that the Fed can use todecrease the money supply. These include open market sales, discount rate increases, and reserverequirement increases. All else constant, when the Federal Reserve sells securities in the openmarket, reserve accounts of banks (and the money base) decrease. When the Fed raises thediscount rate, interest rates generally increase in the open market. Finally, an increase in thereserve requirement, all else constant, results in a decrease in excess reserves for all banks. In allthree cases, interest rates will tend to rise. Higher interest rates discourage credit availability andborrowing. Economic participants spend less when funds are expensive. Households, business,and governments are less likely to invest in fixed assets. Households decrease their purchases ofdurable goods. State and local government spending decreases. Finally, a decrease in domesticinterest rates relative to foreign rates may result in an increase in the (foreign) exchange value(rate) of the dollar. As the dollar’s exchange rate increases, U.S. goods become relativelyexpensive compared to foreign goods. Eventually, U.S. exports decrease. The decrease inspending from all of these market participants results in economic contraction, (depressingadditional real production) and causes prices to fall (causing the rate of inflation to fall).

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Chapter 02-Financial Services: DepositoryInstitutions2-1Solutions for End-of-Chapter Questions and Problems: Chapter Two1.What are the differences between community banks, regionalbanks, and money-centerbanks?Contrast the business activities, location, and markets of each ofthese bank groups.Community banks typically have assets under $1 billion and serve consumer and small businesscustomers in local markets.In 2012, 91.5percent of the banks in the United States wereclassified as community banks. However, these banks held only9.0percent of the assets of thebanking industry.In comparison with regional and money-center banks, community bankstypically hold a larger percentage of assets in consumer and real estate loans and a smallerpercentage of assets in commercial and industrial loans.These banks also rely more heavily onlocal deposits and less heavily on borrowed and international funds.Regional banks range in size from several billion dollars to several hundred billion dollars inassets.The banks normally are headquartered in larger regional cities and often have offices andbranches in locations throughout large portions of the United States.Although these banksprovide lending products to large corporate customers, many of the regional banks havedeveloped sophisticated electronic and branching services to consumer and residentialcustomers.Regional banks utilize retail deposit bases for funding, but also develop relationshipswith large corporate customers and international money centers.Money center banks rely heavily on nondepositor borrowed sources of funds.Some of thesebanks have no retail branch systems and most money centerbanks are major participants inforeign currency markets.These banks compete with the larger regional banks for largecommercial loans and with international banks for international commercial loans.Most moneycenter banks have headquarters in New York City.2.Use the data in Table 2-5for banks in the two asset size groups (a) $100 million-$1 billionand (b)more than$10 billion to answer the following questions.a.Why have the ratios for ROA and ROE tended to increase for both groups over the1990-2006period,decrease in 2007-2009, andincrease in 2010-2012?Identify anddiscuss the primary variables that affect ROAand ROE as they relate to these two sizegroups.The primary reason for the improvements in ROA and ROEfrom1990sthrough2006may berelated to the continued strength of the macroeconomy that allowed banks to operate withreducedbad debts, or loan charge-off problems.In addition, the continued low interest rateenvironment provided relatively low-cost sources of funds, and a shifttoward growth in feeincomeprovided additional sources ofrevenue in many product lines.Finally, a growingsecondary market for loansallowed banks to control the size of the balance sheet by securitizingmany assets.You will note some variance in performance in the last three years as the effects ofa softer economyand rising interest rateswere felt in the financial industry.

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Chapter 02-Financial Services: DepositoryInstitutions2-2In the late 2000s, the U.S. economy experienced its strongest recession since the GreatDepression. Commercial banks’ performance deteriorated along with the economy.As mortgageborrowers defaulted on their mortgages, financial institutions that held these “toxic” mortgagesand “toxic” credit derivatives (in the form of mortgage backed securities) started announcinghuge losses on them. Losses from the falling value of OBS securities reached over $1 trillionworldwide through 2009.Bigger banks held more ofthese toxic assets and, thus, experiencedlarger losses in incomein 2008. As a result, they tended to see lower, and even negative,ROAsand ROEs during this period.Losses resulted in the failure, acquisition, or bailout of some of thelargest FIs and a near meltdown of the world’s financial and economic systems.As the economy recovered in 2010-2012, ROA and ROE returned closer to their pre-crisis levels.The recovery occurred quicker for bigger banks that received more government assistance andmonitoring throughout the crisis. The biggest banks’ ROAs and ROEs returned to positive by2009, while the smaller banks’ ROAs and ROEs remained negative until 2010.b.Why is ROA for the smaller banks generally larger than ROA for the large banks?Small banks historically have benefited from a larger spread between the cost of funds and therate on assets, each of which is caused by the less severe competition in the localized markets.Inaddition, small banks have been able to control credit risk more efficiently and to operate withless overhead expense than large banks.c.Why is the ratio for ROE consistently larger for the large bank group?ROE is defined as net income divided by total equity, or ROA times the ratioof assets to equity.Because large banks typically operate with less equity per dollar of assets, net income per dollarof equity is larger.d.Using the information on ROE decomposition in Appendix 2A, calculate the ratio ofequitytototalassets for each of the two bank groups for the period 1990-2012.Whyhas there been such dramatic change in the values over this time period, and why isthere a difference in the size ofthe ratio for the two groups?

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Chapter 02-Financial Services: DepositoryInstitutions2-3ROE = ROA x (Total Assets/Equity)Therefore, (Equity/Total Assets) = ROA/ROE$100 million-$1 BillionOver $10 BillionYearROEROATA/EquityEquity/TAROEROATA/EquityEquity/TA19909.95%0.78%12.767.84%6.68%0.38%17.585.69%199513.48%1.25%10.789.27%15.60%1.10%14.187.05%200013.56%1.28%10.599.44%14.42%1.16%12.438.04%200112.24%1.20%10.209.80%13.43%1.13%11.888.41%200312.80%1.27%10.089.92%16.37%1.42%11.538.67%200612.20%1.24%9.8410.16%13.40%1.35%9.9310.07%200710.34%1.06%9.7510.25%9.22%0.92%10.029.98%20083.68%0.38%9.6810.32%1.70%0.16%10.629.41%2009-0.15%-0.01%15.006.67%1.44%0.15%9.7110.29%20103.35%0.36%9.3110.75%6.78%0.75%9.6010.42%20128.36%0.78%10.729.33%8.97%1.01%8.8811.26%The growth in the equity to total assets ratio has occurred primarily because of the increasedprofitability of the entire banking industry and(particularly during the financial crisis)theencouragement ofregulators to increase the amount ofequity financing in the banks.Increasedfee income, reduced loan loss reserves, and a low, stable interest rate environment have producedthe increased profitability which in turn has allowed banks to increase equity through retainedearnings.Smaller banks tend to have a higher equity ratio because they have more limited asset growthopportunities, generally have less diverse sources of funds, and historically have had greaterprofitability than larger banks.3.What factors caused the decrease in loan volume relative to other assets on the balancesheets of commercial banks?How has each of these factors been related to the change anddevelopment of the financial services industry during the 1990s and2000s?What strategicchanges have banks implemented to deal with changes in the financial servicesenvironment?Corporations have utilized the commercial paper markets with increased frequencyrather thanborrow from banks.In addition, many banks have sold loan packages directly into the capitalmarkets (securitization) as a method to reduce balance sheet risks and to improve liquidity.Finally, the decrease in loan volume during the early 1990s and 2000s was due in part to theshortrecession in2001 and the much stronger recession and financial crisis in 2007-2009.Further, as deregulation of the financial services industry occurred during the 1990s, the positionof banks as the primary financial services providereroded.Banks of all sizes have increased theuse of off-balance-sheet activities in an effort to generate additional fee income.Letters of credit,futures, options, swaps,and other derivative products are not reflected on the balance sheet, butdo provide fee income for the banks.

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Chapter 02-Financial Services: DepositoryInstitutions2-44.What are the major uses of funds for commercial banks in the United States?What are theprimary risks toabank caused by each ofthese?Which of the risks is most critical tothecontinuing operation of abank?Loans and investment securities continue to be the primary assets of the banking industry.Commercial loans are relatively more important for the larger banks, while consumer, smallbusiness loans, and residential mortgages are moreimportant for small banks.Each of thesetypes of loans creates credit, and to varying extents,liquidity risks for the banks.The securityportfolio normally is a source of liquidity and interest rate risk, especially with the increased useof various types of mortgage-backed securities and structured notes.In certain environments,each of these risks can create operational and performance problems for a bank.5.What are the major sources of funds for commercial banks in the United States?How is thelandscape for these funds changing and why?The primary sources of funds are deposits and borrowed funds.Small banks rely more heavily ontransaction, savings, and retail time deposits, while large banks tend to utilize large, negotiabletime deposits and nondeposit liabilities such as federal funds and repurchase agreements.Thesupply of nontransaction deposits is shrinkingbecause of the increased use by small savers ofhigher-yielding money market mutual funds.6.What are the three major segments of deposit funding? How are these segments changingover time? Why?What strategic impact do these changes have on the profitable operationof a bank?Transaction accounts include deposits that donot pay interest and NOW accounts that payinterest. Retail savings accounts include passbook savings accounts and small, nonnegotiabletime deposits.Large time deposits include negotiable certificates of deposits that can be resold inthe secondary market.The importance of transaction and retail accounts is shrinking due to thedirect investment in money marketmutual funds by individual investors.The changes in thedeposit markets coincide with the efforts to constrain the growth on the asset side of the balancesheet.7.How does the liability maturity structure of a bank’s balance sheet compare with thematurity structure of the asset portfolio?What risks are created or intensified by thesedifferences?Deposit and nondeposit liabilities tend to have shorter maturities than assets such as loans.Thematurity mismatch creates varying degrees of interest rate risk and liquidity risk.8.The following balance sheet accounts(in millions of dollars)have been taken from theannual report for a U.S. bank.Arrange the accounts in balance sheet order and determinethe value of total assets. Based on the balance sheet structure, would you classify this bankas a community bank, regional bank, or money center bank?

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Chapter 02-Financial Services: DepositoryInstitutions2-5AssetsLiabilities and EquityCash$ 2,660Demand deposits$ 5,939Fed funds sold110NOW accounts12,816Investment securities5,334Savings deposits3,292Net loans29,981Certificates of deposit(under $100,000)9,853Intangible assets758Other time deposits2,333Other assets1,633Short-term borrowing2,080Premises1,078Other liabilities778Total assets$41,554Long-term debt1,191Equity3,272Total liab. and equity$41,554This bank has funded the assets primarily with transaction and savings deposits.The certificatesof deposit could be either retail or corporate (negotiable).The bank has very little (5 percent)borrowed funds.On the asset side, about 72 percent of total assets is in the loan portfolio, butthere is no information about the type of loans.The bank actually is a small regional bank with$41.5 billion in assets, but the asset structure could easily be a community bankif the numberswere denominated in millions, e.g.,$41.5 million in assets.9.What types of activitiesarenormally classified as off-balance-sheet (OBS) activities?Off-balance-sheet activities include the issuance of guarantees that may be called into play at afuture time, and the commitment to lend at a future time if the borrower desires.a.How does an OBS activity move onto the balance sheet as an asset or liability?The activity becomes an asset or a liability upon the occurrence of a contingent event, whichmay notbe in the control of the bank.In most cases,the other party involved with the originalagreement will call upon the bank to honor its original commitment.b.What are the benefits of OBS activities to a bank?The initial benefit is the fee that the bank charges when making the commitment.If the bank isrequired to honor the commitment, the normal interest rate structure will apply to thecommitment as itmoves onto the balance sheet.Since the initial commitment does not appear onthe balance sheet, the bank avoids the need to fund the asset with either deposits or equity.Thus,the bank avoids possible additional reserve requirement balances and deposit insurancepremiums,while improving the earnings stream of the bank.c.What are the risks of OBS activities to a bank?

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Chapter 02-Financial Services: DepositoryInstitutions2-6The primary risk to OBS activities on the asset side of the bank involves the credit risk of theborrower.In many cases theborrower will not utilize the commitment of the bank until theborrower faces a financial problem that may alter the credit worthiness of the borrower.Movingthe OBS activity to the balance sheetmay have an additional impact on the interest rate andforeign exchange risk of the bank.Further,at the very heart of the financial crisis were lossesassociated with off-balance-sheet mortgage-backed securities created and held by FIs. Lossesresulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown ofthe world’s financial and economic systems.10.Use the data in Table 2-7to answer the following questions.a.What was the average annual growth rate in OBS total commitments over the periodfrom 1992-2012?$236,945.3= $10,075.8(1+g)20g=17.10percentb.Which categories of contingencies have had the highest annual growth rates?Category of Contingency or CommitmentGrowth RateCommitments to lend7.33%Future andforward contracts15.40%Notional amount ofcredit derivatives43.94%Standby contractsand other option contracts16.52%Commitments tobuy FX, spot, and forward8.47%Standby LCsand foreign office guarantees10.77%Commercial LCs-0.74%Securities borrowed11.79%Notional value of all outstanding swaps23.10%Credit derivativesgrew at the fastest rate of43.94percent,yet they have arelativelylowoutstandingbalance of $13,997.6billion.The rate ofgrowth in the swaps area has been thesecond strongest at23.10percent, the dollar volumeis largeat $135,555.8billionin2012.Option contractsgrew at an annual rate of16.52percent with a dollar valueoutstandingof$33,553.1billion.Clearly the strongest growth involves derivative areas.c.What factors are credited for the significant growth in derivative securities activities bybanks?The primary use of derivative products has been in the areas of interest rate, credit, and foreignexchange risk management.As banks and other financial institutions have pursued the use ofthese instruments, the international financial markets have responded by extending the variationsof the products available to the institutions.

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Chapter 02-Financial Services: DepositoryInstitutions2-711.For each of the following banking organizations, identify which regulatory agencies (OCC,FRB, FDIC, or state banking commission) may have some regulatory supervisionresponsibility.(a)State-chartered, nonmember, non-holdingcompany bank.(b)State-chartered, nonmember holdingcompany bank(c)State-chartered member bank(d)Nationallychartered non-holdingcompany bank.(e)Nationally chartered holdingcompany bankBank TypeOCCFRBFDICSBComm(a)YesYes(b)YesYesYes(c)YesYesYes(d)YesYesYes(e)YesYesYes12.What are the main features of the Riegle-Neal Interstate Banking and Branching EfficiencyAct of 1994?What major impact on commercial banking activityoccurred from thislegislation?The main feature of the Riegle-Neal Act of 1994 was the removal of barriers to interstatebanking.In September 1995 bank holding companies were allowed toacquire banks in otherstates.In 1997, banks were allowed to convert out-of-state subsidiaries into branchesof a singleinterstate bank.As a result, consolidations and acquisitions have allowed for the emergence ofvery large banks with branches across the country.13.What factors normally are given credit for the revitalization of the banking industry duringthe decade of the 1990s? How is Internet banking expected to provide benefits in thefuture?The most prominent reason was the lengthy economic expansion in both the U.S. and manyglobal economies during the entire decade of the 1990s. This expansion was assisted in the U.S.by low and falling interest rates during the entire period.The extent of the impact of Internet banking remains unknown. However, the existence of thistechnology is allowing banks to open markets and develop products that did not exist prior to theInternet. Initial efforts focused on retail customers more than corporate customers. The trendshould continue with the advent of faster, more customer friendly products and services, and thecontinued technology education of customers.

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Chapter 02-Financial Services: DepositoryInstitutions2-814.What factors are given credit for the strong performance of commercial banks in the earlyand mid-2000s?The lowest interest rates in many decades helped bank performance on both sides of the balancesheet. On the asset side, many consumers continued to refinance homes and purchase newhomes, an activity that caused fee income from mortgage lending to increase and remain strong.Meanwhile, the rates banks paid on deposits shrunk to alltime lows. In addition, thedevelopment and more comfortable use of new financial instruments such as credit derivativesand mortgage-backed securities helped banks ease credit risk off the balance sheets. Finally,information technology has helped banks manage their risk more efficiently.15.What factors are given credit for the weak performance of commercial banks in the late2000s?In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression.Commercial banks’ performance deteriorated along with the economy.Sharply higher lossprovisions and a very rare decline in noninterest income were primarily responsible for the lowerindustry profits. Things got even worse in 2008.Net income for all of 2008 was $10.2 billion, adecline of $89.8 billion (89.8 percent) from 2007. The ROA for the year was 0.13 percent, thelowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, andalmost two out of every three institutions (62.8 percent) reported lower full-year earnings than in2007. Total noninterest income was $25.6 billion (11 percent), lower as a result of the industry’sfirst ever full-year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in securitizationincome, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and otherassets. Net loan and lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of$21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge-off rate in the 25years that institutions have reported quarterly net charge-offs. As the economy improved in thesecond half of 2009, so did commercial bank performance. While rising loan-loss provisionscontinued to dominate industry profitability, growth in operating revenues, combined withappreciation in securities values, helped the industry post an aggregate net profit. Noninterestincome was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7billion) and servicing fees (up $1.9 billion).However, the industry was still feeling the effects ofthe long recession.Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutivequarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an11th consecutive quarter.

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Chapter 02-Financial Services: DepositoryInstitutions2-916.How do the asset and liability structures of a savingsinstitution compare with the asset andliability structures of a commercial bank?How do these structural differences affect therisks and operating performance of a savingsinstitution?What is the QTL test?The savings institution industry relies on mortgage loans andmortgage-backed securities as theprimary assets, while the commercial banking industry has a variety of loan products, includingmortgage products.The large amount of longer-term fixed rate assets continues to cause interestrate risk, while the lack of asset diversity exposes the savingsinstitutionto credit risk.Savingsinstitutionshold less cash and U.S. Treasury securities than do commercial banks.On theliability side, small time and saving deposits remain as the predominant source of funds forsavingsinstitutions, with some reliance on FHLB borrowing.The inability to nurturerelationships with the capital markets also creates potential liquidity risk for the savingsinstitutionindustry.The acronym QTL stands for Qualified Thrift Lender.The QTL test refers to a minimum amountof mortgage-related assets that asavingsinstitutionmust holdto maintain its charter as a savingsinstitution.The amount currently is 65 percent of total assets.17.How do savings banks differ from savingsassociations?Differentiate in terms of risk,operating performance, balance sheet structure, and regulatory responsibility.The asset structure of savings banks is similar to the asset structure of savings associations withthe exception that savings banks are allowed to diversify by holding a larger proportion ofcorporate stocks and bonds.Savings banks rely more heavily on deposits and thus have alowerlevel of borrowed funds.Bothare regulated at both the state and federal level, with depositsinsured by the FDIC’sDIF.18.What happened in 1979 to cause the failure of many savings institutions during the early1980s? What was the effect of this change on the operating statements of savingsassociations?The Federal Reserve changed its reserve management policy to combat the effects of inflation, achange which caused the interest rates on short-term deposits to increase dramatically more thanthe rates on long-term mortgages. As a result,for many savings institutions,the marginal cost offunds exceeded the average yield on assets.Thiscaused a negative interest spread for the savingsinstitutions. Further, because savingsinstitutions were constrained by Regulation Q on theamount of interest which could be paid on deposits, they suffered disintermediation, or depositwithdrawals, which led to severe liquidity pressures on the balance sheets.19.How did the two pieces of regulatory legislation─the DIDMCA in 1980 and the DIA in1982─change the operating profitability of savingsinstitutions in the early 1980s? Whatimpact did these pieces of legislation ultimately have on the risk posture of the savingsinstitution industry? How did the FSLIC react to this change in operating performance andrisk?

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Chapter 02-Financial Services: DepositoryInstitutions2-10The two pieces of legislation allowed savingsinstitutions to offer new deposit accounts, such asNOW accounts and money market deposit accounts, in an effort to reduce the net withdrawalflow of deposits from the institutions. In effect this action was an attempt to reduce the liquidityproblem. In addition, savingsinstitutionswere allowed to offer adjustable-rate mortgages and alimited amount of commercial and consumer loans in an attempt to improve the profitabilityperformance of the industry. Although many savingsinstitutionswere safer, more diversified,and more profitable, the FSLIC did not foreclose many of the savingsinstitutionswhich wereinsolvent. Nor did the FSLIC change its policy of assessing higher insurance premiums oncompanies that remained in high risk categories. Thus, many savingsinstitutionsfailed, whichcaused the FSLIC to eventually become insolvent.20.How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reversesome of the key features of earlier legislation?FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and theGarn-St Germain Act of 1982 by instituting the qualified thrift lender (QTL) test that requiresthat all thrifts must hold portfolios that are comprised primarily of mortgages or mortgageproducts suchas mortgage-backed securities.The Act also required thrifts to divest theirportfolios of junk bonds by 1994, and it replaced the FSLIC with a new thrift deposit insurancefund, the Savings Association Insurance Fund, which was managed by the FDIC.The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurancepremiums in 1993 to reduce excess risk-taking.FDICA also provided for the implementation ofa policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly incaseswhere insolvency is imminent.Thus,the ill-advised policy of regulatoryforbearanceshould be curbed.Finally, the Act amended the International Banking Act of 1978 by expandingthe regulatory oversight powers over foreign banks.21.What is the “common bond” membership qualification under which credit unionshavebeen formed and operated?How does this qualification affect the operational objective of acredit union?The common bond policy allows anyone who meets a specific membership requirement tobecomea member of the credit union.The requirement normally istied to a place ofemploymentor residence.Because the common bond policy has been loosely interpreted,implementation has allowed credit union membership and assets to grow at a rate that exceedssimilar growth in thecommercial banking industry.Since credit unions are mutual organizationswhere the members are owners, employees essentially use saving deposits to make loans to otheremployees who need funds.

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Chapter 02-Financial Services: DepositoryInstitutions2-1122.What are the operating advantages of credit unions that have causedconcern amongcommercial bankers?What has been the response of the Credit Union National Associationto the banks’criticisms?Credit unions are tax-exempt organizations that often are provided officespace by employers atno cost.As a result, because noninterest operating costs are very low, credit unions can lendmoney at lower rates and pay higher rates on savings deposits than can commercial banks.CUNA has respondedsayingthat the cost to tax payers from the tax-exempt status is replaced bythe additional social good created by the benefits to the members.23.How does the asset structure of credit unions compare with the asset structure ofcommercial banks and savingsinstitutions?Refer to Tables 2-6, 2-10, and 2-13toformulate your answer.The relative proportions ofall three types of depository institutionsare similar, withalmost 30percentof total assets held asinvestment securities andover 50percentasloans.Savingsinstitutions’ loans are predominantly mortgage related,nonmortgage loans of credit unions arepredominantly consumer loans, and commercial banks hold more business loans than eithersavings institutions or credit unions.On the liability side of the balance sheet, credit unions differfrom banks in that they have less reliance on large time deposits and they differ fromsavingsinstitutions in thatthey have virtuallyno borrowings from any source.The primary sources offunds for credit unions are transaction and small time and savings accounts.24.Compare and contrast the performance of theworldwidedepository institutionswith thoseof major foreign countries during the financial crisis.Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banksworldwide sawlosses driven by their portfolios of structured finance products and securitizedexposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets forthose instruments. As with U.S. banks, this led to substantial losses in their marked to marketvaluations. In Europe, the general picture of bank performance in 2008 was similar to that in theU.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerlandand the United Kingdom had net losses for the year. Banks in Ireland, Spain and the UnitedKingdom were especially hard hit as they had large investments in mortgages and mortgage-backedsecurities. Because they focused on the domestic retail banking, French and Italian banks were lessaffected by losses on mortgage-backed securities. Continental European banks, in contrast to UKbanks, partially cushioned losses through an increase in their net interest margins.

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Chapter 02-Financial Services: DepositoryInstitutions2-12A number of European banks averted outright bankruptcy thanks to direct support from thecentral banks and national governments.During the last week of September and first week ofOctober 2008, the German government guaranteed all consumer bank deposits and arranged abailout of Hypo Real Estate, the country’s second largest commercial property lender. TheUnited Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largestmortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Irelandguaranteed deposits and debt of its six major financial institutions. Iceland rescued its thirdlargest bank with a $860 million purchase of 75 percent of the banks stock and a few days laterseized the country’s entire banking system. The Netherlands, Belgium, and Luxembourg centralgovernments together agreed to inject $16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to keep it afloat.However, five days later this deal fell apart,and the bank was split up. The Dutch bought all assets located in the Netherlands forapproximately $23 billion.The central bank in India stepped in to stop a run on the country’ssecond largest bank ICICI Bank, by promising to pump in cash. Central banks in Asiainjectedcash into their banking systems as banks’ reluctance to lend to each other led the Hong KongMonetary Authority to inject liquidity into its banking system after rumors led to a run on Bankof East Asia Ltd. South Korean authorities offered loans and debt guarantees to help small andmidsize businesses with short term funding. The United Kingdom, Belgium, Canada, Italy, andIreland were just a few of the countries to pass an economic stimulus plan and/or bank bailoutplan. The Bank of England lowered its target interest rate to a record low of 1 percent hoping tohelp the British economy out of a recession. The Bank of Canada, Bank of Japan, and SwissNational Bank also lowered their main interest rate to 1 percent or below. All of these actionswere a result of the spread of the U.S. financial market crisis to world financial markets.The worldwide economic slowdown experienced in the later stages of the crisis meant thatbank losses became more closely connected to macroeconomic performance.Countries across theworld saw companies scrambling for credit and cutting their growth plans. Additionally,consumers worldwide reduced their spending. Even China’s booming economy slowed faster thanhad been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the thirdquarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmedhopes that Chinese demand could help keep world economies going. In late October, the globalcrisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bankrescue in the oil rich Gulf. Until this time, the area had been relatively immune to the worldfinancial crisis. However, plummeting oil prices (which had dropped over 50 percent between Julyand October) left the area’s economies vulnerable.In this period, the majority of bank losses weremore directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by theincrease in the amount and relative importance of loan loss provision expenses.International banks’ balance sheets continued to shrink during the first half of 2009 (although ata much slower pace than in the preceding six months) and, as in the U.S., began to recover in thelatter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomicnews reassured investors that the global economy had turned around, but investor confidenceremained fragile. For example, in late November 2009, security prices worldwide droppedsharply as investors reacted to news that government-owned Dubai World had asked for a delayin some payments on its debt.Further, throughout the spring of 2010 Greece struggled with asevere debt crisis. Early on, some of the healthier European countries tried to step in and assist

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Chapter 02-Financial Services: DepositoryInstitutions2-13the debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bailout Greece with as much as $41 billion in aid began to take shape. However, in late April Greekbond prices dropped dramatically as traders began betting a debt default was inevitable, even ifthe country received a massive bailout. The selloff was the result of still more bad news forGreece, which showed that the 2009 budget deficit was worse than had been previously reported,and as a result politicians in Germany began to voice opposition to a Greek bailout. Further,Moody’s Investors Service downgraded Greece’s debt rating and warned that additional cutscould be on the way.Greece’s debt created heavy losses across the Greek banking sector. A runonGreek banks ensued. Initially,between €100 and €500 million per day was being withdrawnfrom Greek banks. At its peak, the run on Greek banks produced deposit withdrawals of as highas €750 billion a day, nearly 0.5 percent of the entire €170 billion deposit base in the Greekbanking system.Problemsin the Greek banking system then spread to other European nations with fiscalproblems, such as Portugal, Spain, and Italy.The risk of a full blown banking crisis arose inSpain where the debt rating of 16 banks and four regions were downgraded by Moody’s InvestorService.Throughout Europe, some of the biggest banks announced billions of euros lost fromwrite downs on Greek loans. In 2011,Crédit Agricolereported a record quarterly net loss of€3.07 billion ($4.06 billion U.S.) after a €220 million charge on its Greek debt. Great Britain’sRoyal Bank of Scotlandrevalued its Greek bonds at a 79 percent loss—or £1.1 billion ($1.7billion U.S.)—for 2011. Germany’s Commerzbank’s fourth quarter 2011 earnings decreased by a€700 million due to losses on Greek sovereign debt. The bank needed to find €5.3 billion eurosto meet the stricter new capital requirements set by Europe’s banking regulator. Bailed outFranco-Belgian bankDexiawarned it risked going out of business due to losses of €11.6 billionfrom its break-up and exposure to Greek debt and other toxic assets such as U.S. mortgage-backed securities. Even U.S. banks were affected by the European crisis.In late 2010, U.S. bankshad sovereign risk exposure to Greece totaling $43.1 billion. In addition, exposures to Irelandtotaled $113.9 billion, to Portugal totaled $47.1 billion, and to Spain $187.5 billion. Worldwide,bank exposure to these four countries totaled $2,512.3 billion. Default by small country likeGreece cascaded into something that threatened the world’s financial system.Worried about the affect a Greek debt crisis might have on the European Union, otherEuropean countries tried to step in and assist Greece. On May 9, 2010,in return for huge budgetcuts,Europe's finance ministers and the International Monetary Fund approved a rescue packageworth $147 billion and a “safety net” of $1 trillion aimed at ensuring financial stability acrossEurope. Through the rest of 2010 and into 2012, Eurozone leaders agreed on more measuresdesigned to prevent the collapse of Greece and other member economies. In return, Greececontinued to offer additional austerity reforms and agreed to reduce its budget deficits. At times,the extent of these reforms and budget cuts led to worker strikes and protests (some of whichturned violent), as well as changes in Greek political leadership. In December 2011,the leadersof France and Germany agreed on a new fiscal pact that they said would help prevent anotherdebt crisis. Then French President Nicolas Sarkozy outlined the basic elements of the plan toincrease budget discipline after meeting with German Chancellor Angela Merkel in Paris. Thepact, which involved amending or rewriting the treaties that govern the European Union, waspresented in detail at a meeting of European leaders and approved. Efforts by the EU andreforms enacted by the Greek and other European country governments appear to have worked.As on December 18, 2012, Standard & Poor's raised its rating on Greek debt by six notches to B

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Chapter 02-Financial Services: DepositoryInstitutions2-14minus from selective default Tuesday. S&P cited a strong and clear commitment from membersof the euro zone to keep Greece in the common currency bloc as the main reason for the upgrade.The questions and problems that follow referto Appendix 2B.25.The financial statements for First National Bank (FNB) are shown below:Balance Sheet-First National BankAssetsLiabilities and EquityCash$450Demand deposits$5,510Demand deposits from other FIs1,350Small time deposits10,800Investments4,050Jumbo CDs3,200Federal funds sold2,025Federal funds purchased2,250Loans15,525Equity2,200Reserve for loan losses(1,125)Premises1,685Total assets$23,960Total liabilities/equity$23,960Income Statement-First National BankInterest Income$2,600Interest expense1,650Provision for loan losses180Noninterest income140Noninterest expense420Taxes90a. Calculate the dollar value of FNB’s earning assets.Earning assets = investment securities + net loans= $4,050 + $2,025 + $15,525–$1,125 = $20,475b. Calculate FNB’s ROA.ROA = ($2,600–$1,650–$180 + $140–$420–$90)/$23,960 = 1.67%c. Calculate FNB’s asset utilization ratio.Asset utilization = ($2,600 + $140)/$23,960 = 11.44%d. Calculate FNB’s spread.Spread = ($2,600/$20,475)–($1,650/($10,800 + $3,200 + $2,250)) = 2.54%

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Chapter 02-Financial Services: DepositoryInstitutions2-1526.Megalopolis Bank has the following balance sheet and income statement.Balance Sheet (in millions)AssetsLiabilities and EquityCash and due from banks$9,000Demand deposits$19,000Investment securities23,000NOW accounts89,000Repurchase agreements42,000Retail CDs28,000Loans90,000Debentures19,000Fixed Assets15,000Total liabilities$155,000Other assets4,000Common stock12,000Total assets$183,000Paid in capital4,000Retained earnings12,000Total liabilities and equity$183,000Income StatementInterest on fees and loans$9,000Interest on investment securities4,000Interest on repurchase agreements6,000Interest on deposits in banks1,000Total interest income$20,000Interest on deposits9,000Interest on debentures2,000Total interest expense$11,000Operating income$9,000Provision for loan losses2,000Other income2,000Other expenses1,000Income before taxes$8,000Taxes3,000Net income$5,000For Megalopolis, calculate:a. Return on equityReturn on equity = 5,000m/28,000m= 17.86%b. Return on assetsReturn on assets = 5,000m/183,000m= 2.73%

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Chapter 02-Financial Services: DepositoryInstitutions2-16c. Asset utilizationAsset utilization = (20,000m+ 2,000m)/183,000m= 12.02%d. Equity multiplierEquity multiplier = 183,000m/(12,000m+ 4,000m+ 12,000m) = 6.54Xe. Profit marginProfit margin = 5,000m/(20,000m+ 2,000m) = 22.73%f. Interest expense ratioInterest expense ratio = 11,000m/(20,000m+ 2,000m) = 50.00%g. Provision for loan loss ratioProvision for loan lossratio = 2,000m/(20,000m+ 2,000m) = 9.09%h. Noninterest expense ratioNoninterest expense ratio = 1,000m/(20,000m+ 2,000m) = 4.55%i. Tax ratioTax ratio = 3,000m/(20,000m+ 2,000m) = 13.64%

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