Note: Please complete this exam and submit the solutions as homework.

Please
keep a copy for yourself.
Management of Depository Institutions 213/3505
for Final
Spring 2011

Sample Questions

1. The following are the total asset (TA) and average cost (AC) data for three
FIs. AC is calculated as cost per dollar of asset:

Alpha
Mortgage
bank
Beta
Life Ins. co
Gamma
Pension fund
Merged Entity

TA

AC

TC

300M

20%

AC
(merged)
XXXXX

400M

30%

XXXXX

400M

25%

XXXXX

Gamma knows it can reduce its average cost by taking over Alpha and Beta and
cutting costs but is unsure about the magnitude of the cost reduction.
a. Calculate the total cost (TC) of each firm and the total cost of the merged
entity if no cost cutting occurs. How would you judge if the merger justified?
Discuss.
b. If operating costs fall by $60M after the merger, what will be the average
cost of the combined firm?
c. What can be the sources of the decline in costs in this merger?
2. A corporation is planning to issue $10M of 9-month commercial paper (CP) or
an effective yield of 5 percent. The corporation expects to save 30 basis points
per annum on the interest rate by using either an SBLC or a loan commitment as
backup for the issue.
a. What are the net savings to the corporation if a bank agrees to provide a 270day SBLC for an up-front fee of 20 basis points to back the commercial paper
issue?
(You can review Q 19 from chapter 13. It is similar to this).
b. What are the net savings to the corporation if a bank agrees to provide a 270day loan commitment to back the issue? The bank will charge 10 basis points for

an up-front fee and 10 basis points for a back-end fee for any unused portion of
the loan. The fees are one time charges. Assume the loan will not be needed.

Multiple Choice Questions

1. Using a modified discriminant function similar to Altmans, a bank
estimates the following scoring model for its portfolio of loans:
Z=
1.4X1 + 1.09X2 + 1.5X3
where X1 = debt to asset ratio; X2 = net income and X3 = dividend payout
ratio. Using Z*=1.81 as the cut-off rate, suppose net income is 10 percent,
and the dividend payout ratio is 70 percent, what should be the debt to
asset ratio of the firm in order for the bank to approve the loan?
a.
b.
c.
d.
e.

40.0 percent
46.5 percent
51.5 percent
54.0 percent
65.0 percent

Use the following information for questions 2-4. A $100 million loan commitment
has an up-front fee of 10 basis points (BP) and a back-end fee of 30 bp on the
unused portion.
2. The up-front fee is
a.
$150,000
b.
$1,000,000
c.
$100,000
d.
$325,000
e.
$225,000
3. If 50 percent of the commitment is taken down, the back-end fee is
a.
$150,000
b.
$1,000,000
c.
$100,000
d.
$325,000
e.
$225,000
4. If 25 percent of the commitment is taken down, the total fees are
a.
$150,000
b.
$1,000,000
c.
$100,000
d.
$325,000
e.
$225,000

Use the following information for questions 5-7. A corporation is planning to

issue $10M worth of a 6-month commercial paper. In order to reduce the interest
rates by % (per annum), it plans to back this issue with a standby letter of credit
(SBLC) or a loan commitment. The standby letter of credit is available for 20

basis points to be paid up-front. The loan commitment for $10M is available for
an up-front fee of 15 basis points and a 5 basis points back-end fee (fees are
assessed on the entire loan amount).
5.
What is the net saving to the corporation if it obtains a standby letter of
credit to back its $10 million issue of commercial paper?
a.
$1250
b.
$2500
c.
$3,750
d.
$5,000
e.
$6,250
6.

What is the net saving to the corporation if it obtains a loan commitment to

back its $10 million issue of commercial paper?
a.
b.
c.
d.
e.

7.

$1,250
$50,000
$3,750
$5,000
$6,250

Which method is preferable, between the loan commitment and the

SBLC?
a.
a.
b.
c.
e.

Neither method is preferable over the other.

The standby letter of credit is preferable because the savings are
greater.
The loan commitment is preferable it has a lower risk of default.
The SBLC is preferable because it has a lower risk of default.
The loan commitment is preferable because the back-end fee is
payable at the end of the period.

Use the following information for questions 8-10. Consider the following two FIs:
Company A has $125 million in total assets and total costs equal to $50 million.
Company B has $15 million in total assets and total costs equal to $6 million.
8.

What are average costs per dollar of assets for each FI?
a.
b.
c.
d.
e.

$0.40 for A and $2.50 for B.

$0.40 for both A and B.
$2.50 for both A and B.
$2.50 for A and $0.40 for B.
insufficient information.

9. What can you conclude about the cost structure of the market consisting of the
2 FIs?

a.
b.
c.
d.
e.
10.

There are economies of scale because A and B coexist.

There is a natural monopoly condition in the banking industry
There are no scale economies because unit costs are fixed
There are scale economies because unit costs decline as size
increases.
There are no scale economies because the unit costs increase with
size.

Assume there is a third FI (company C) in the same market along with the
two FIs with $200 million in assets and total costs of $105 million. What
can you conclude about the cost structure of the FIs in this market?
a.
There are significant scale economies because companies A, B,

and C
b.
c.
d.
e.

coexist in the industry.

There are no significant economies of scale because both
companies A and C are much larger than company B.
There are no economies of scale because the unit costs are
constant.
There are scale diseconomies beyond the $125 million asset size.
There are no scale diseconomies because unit costs decrease as
size increases.

11.

Daylight overdraft risk

a.
is contributed to by the failure to price intra-day loans at market
rates.
b.
is monitored closely by international bank regulators.
c.
Should be of no concern because it is insignificant and cannot be
avoided.
d.
is largest on the weekends.
e.
results from time zone differences around the world.
12.

Technology is most important in which of the following bank lines of

business?
a.
Corporate cash-management services
b.
Residential mortgage lending
c.
Issuance of consumer certificates of deposit
d.
Credit approval for small loans
e.
None of the above

13.

Which of the following is not a wholesale banking service?

a.
Controlled disbursement accounts.
b.
Account reconciliation.
c.
Electronic funds transfer
d.
Electronic initiation of letters of credit
e.
Automated teller machines

Use the following balance sheet (Figures are in thousands) to answer questions
14-17.
Assets
Cash
Securities
Loans
Total

14.

21
369
400
790

Liabilities and Equity

Demand Deposits
Fed Funds Borrowed
Equity
Total

550
151
89
790

If the bank faces a net drain of 4% of its deposits, what is the bank's
expected liquidity requirement?
a.
b.
c.
d.
e.

$7,560
$6,040
$22,000
$16,000
$14,760

15.

How can the bank meet a net deposit drain of +4 % ?

a.
Liquidate all cash holdings.
b.
Reduce fed funds loans made.
c.
Use all of the cash and liquidate some securities holdings.
d.
Liquidate all cash and some fed funds holdings.
e.
make additional loans and deposit the proceeds to the customers'
accounts.
16.

If the bank decides to cut down on interest expenses by reducing its

dependence upon borrowed funds, what policy must the bank follow?
a.
Manage liquidity risk exclusively through asset management.
b.
Manage liquidity risk exclusively through liability management.
c.
Reduce the bank's dependence upon demand deposits.
d.
Increase interest income by increasing lending.
e.
Increase interest income by increasing securities holdings.

17

If the bank experiences a $50,000 sudden liquidity drain, what will be the
impact on the
bank's balance sheet?
a.
A reduction in cash of $21,000 and an increase in demand deposits of
$29,000.
b.
A reduction in cash of $21,000 and an increase in securities holdings of
$29,000.
c.
A reduction in cash of $21,000 and a decrease in securities holdings of
$29,000.

d.

A decrease in equity of $50,000.

18.

When an FI pre-commits to lending at a fixed rate, the fixed rate nature of

the commitment exposes the bank to:
a.
credit risk.
b.
interest rate risk.
c.
takedown risk.
d.
funding risk
e.
exchange rate risk.

19.

The fact that the holder of a loan commitment can borrow at any time
(before the maturity) exposes the lending bank to:
a.
credit risk.
b.
interest rate risk.
c.
takedown risk.
d.
aggregate funding risk
e.
exchange rate risk.
20. The exporter demands a letter of credit from the importer:
a.
to guarantee safe delivery of goods to the importer.
b.
to guarantee receipt of payment from the importer.
c.
as protection against adverse changes in foreign exchange rates.
d.
as protection against adverse changes in international interest
rates.
e.
to ascertain the take down risk of the importer.
21. Off-balance-sheet items:
a.
are items omitted from the short form balance sheet but appearing
on the long- term balance sheet.
b.
are contingent assets and liabilities.
c.
are risk-free assets and liabilities.
d.
definitely reduce the risk of balance sheet assets and liabilities.
e.
are foreign (off shore) assets and liabilities.
22. How can bank expenses be reduced by improved technological
efficiency?
a.
By improving the efficiency of management of information flows.
b.
By obtaining access to lower cost sources of funds.
c.
By replacing expensive labor by ATMs.
d.
By gathering and storing data at a lower cost.
e.
All of the above
23. How can interest expense be reduced by improved technological
efficiency?
a.
By improving the efficiency of management of information flows.

b.
c.
d.

By obtaining access to low cost sources of funds.

By improving service quality of the FI.
By innovating new interest earning products and charging fees for

e.

By charging more on loans.

them.
24. How can interest income be increased by improved technological
efficiency?
a.
By improving the efficiency of management of information flows.
b.
By obtaining access to low cost sources of funds.
c.
By charging lower fees on loans
d.
By innovating new interest earning products.
e.
By complying with all government regulations.
25. Which of the following is not a source of operational risk?
a.
Capital assets
b.
Customer relationships
c.
Technology
d.
Employees
e.
Positive duration gap

26.

Which of the following best describes economies of scale?

a.
Occur when the average cost decreases as the level of output
increases.
b.
Cost effects due to managerial ability and other hard-to-quantify
factors.
c.
Occur when cost savings are realized from using many of the same
inputs to produce multiple products.
d.
Occur when the average cost increases as the level of output
increases.
e.
Occur when cost increases are realized from using many of the
same inputs to produce multiple products.
27. Which of the following statements is false?
a.
The Fed operates the Fedwire while CHIPS is a private network.
b.
Fedwire is owned by U.S. commercial banks and CHIPS is owned
by the government.
c.
The Fed guarantees all payments on Fedwire while CHIPS
transfers are provisional until settlement.
d.
Daylight overdrafts are incurred on both Fedwire and CHIPS.
e.
Fedwire does not charge market interest rate for daylight
overdrafts.
28. CHIPS

a.
b.
c.
settlement.
d.
e.

stands for clearing house interbank payment system.

manages settlement risk by screening participating banks.
manages settlement risk by making transfers provisional until
is owned privately.
All of the above.

29. Settlement risk on CHIPS is important because:

a.
failure of one member of CHIPS to settle certain large items may
lead to failure of other large banks to settle and collapse of the
system.
b.
CHIPS is guaranteed by some European countries and this exerts
an extraordinary impact on sovereign country risk.
c.
Fed wire failure to settle may induce countries to limit the freedom
of international capital flows.
d.
CHIPS will have to hold more reserves with the Fed.
e.
the Fed guarantees all payment instructions sent through CHIPS .
Use the following information for questions 30-34. The following information is
available on the average costs of the three major banks in a given local market.
Bank A has assets of $5 million and average costs are 15 percent, Bank B has
assets of $10 million and average costs of 13 percent while Bank C has assets of
$15 million with average costs of 12 percent. Average costs are measured as a
proportion of total assets.
30. The above figures indicate that
a.
There are significant economies of scale still present in the local
markets.
b.
There are significant scale diseconomies still present in the local
markets.
c.
There are significant economies of scope still present in the local
markets.
d.
There are significant scope diseconomies still present in the local
markets.
e.
There is not enough information to determine economies of scale or
scope.
31. Bank B plans to acquire Bank A and to cut the costs by $50,000 in the
process. What is the combined banks average costs?
a.
12.00 percent
b.
12.67 percent
c.
13.00 percent
d.
13.33 percent
e.
15.00 percent
32. How much more should the bank cut the operating costs in order to stay
competitive in the local market, ceteris paribus?
a.
$450,000

b.
c.
d.
e.

$300,000
$200,000
$250,000
$150,000

33. A disadvantage of using liability management to manage a FI's liquidity

risk is
a.
the resulting shrinkage of the FI's balance sheet.
b.
the high cost of purchased liabilities.
c.
the accessibility of international money markets.
d.
increased profitability
e.
the increased flexibility of using purchased funds.
34. A disadvantage of using asset management to manage a FI's liquidity risk
is
a.
the resulting shrinkage of the FI's balance sheet.
b.
the high cost of purchased liabilities.
c.
the accessibility of international money markets.
d.
increased profitability
e.
increased dependence upon purchased liabilities.
35. An FI has $5 million in cash reserves with the Fed in excess of its reserve
requirements, $5 million in T-Bills, and a credit line of $10 million to borrow in the
repo market. It currently has lent $2 million in the Fed Funds market and
borrowed $1 million from the Federal discount window to meet its seasonal
needs.
Which of the following is False?
a. the banks sources of liquidity add up to $22 million
b. the banks current uses of liquidity add up to $1 million
c. the net liquidity of the bank is $21 million
d. a and b and c are correct.
e. the net liquidity of the bank is $22 million

Formulae
Duration: D = nt=1[Ct t/(1+r)t]/ nt=1 [Ct/(1+r)t]

D = {[PV1 1 + PV2 2 + .+ PVn n]/ P}

Interest rate sensitivity of bond prices:

(P/P)/(R/R) = -D[R/(1+R)]
dP/P = -D[dR/(1+R)]
A/A = -DA [R/(1+R)]
L = -DL x L x (R/(1+R))
D

A - DLk]A(R/(1+R))

Modified duration: MD = D/(1+R).

DEAR = dollar value of position (-MD) adverse move in daily yield

DEAR (FX) = dollar value of position price volatility

DEAR (portfolio) = [DEARa2 + DEARb2 + DEARc2 + 2ab DEARa DEARb +

2ac DEARa DEARc + 2bc DEARb DEARc]1/2

Contractually promised gross return (k) per dollar (when compensating

balances are required and reserve requirements are in effect) :
k = (of + (BR + m ))/(1-[b(1-RR)])

Altmans model: Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5

Expected loan payoff under credit risk = p(1+k) + (1-p) [ (1+k)] = 1 + i

Marginal mortality rate (default):

MMR1 =

L)

L = -DL x L x (R/(1+R))

Liquidity index : I = wi(Pi /Pi*)