Chapter 20 Managing credit risk

True/False Questions


1. Larger banks are more likely to accept riskier loans than smaller banks.

Answer: True Page: 547-548 Level: Easy


2. Non-perIorming loans are loans that are past due 60 days that are not accruing interest.

Answer: False Page: 547-548 Level: Medium


3. Gross debt service usually must be greater than 30 beIore a residential mortgage will be
approved.

Answer: False Page: 550 Level: Medium


4. The gross debt service ratio is equal to annual accommodation expenses divided by
annual gross income.

Answer: True Page: 550 Level: Easy


5. Individuals with higher levels oI income must have higher GDS and TDS ratios to qualiIy
Ior a loan.

Answer: False Page: 551 Level: Medium


6. Collateral on a mortgage is normally only considered iI the applicant has enough income
to service the loan.

Answer: True Page: 553 Level: Easy


7. The Iive Cs oI credit are character, mental capacity, collateral, conditions, and capital.

Answer: False Page: 554 Level: Medium


8. Credit analysis oI a midmarket corporate borrower diIIers Irom the analysis oI a small
business in that the analysis oI the midmarket borrower is more Iocused on the business
itselI and less on the business owners.

Answer: True Page: 554 Level: Medium


9. PerIecting collateral is the process oI taking the proceeds oI the Iorced sale oI a mortgage
property to satisIy the debt in the event oI Iailure to repay the mortgage.

Answer: False Page: 553 Level: Medium


10. Approving a loan Ior a customer with negative cash Ilow Irom operations is not a concern
to a bank loan oIIicer as long as cash Ilow Irom Iinancing is positive.

Answer: False Page: 555 Level: Medium


11. Liquidity ratios include the current ratio, the quick ratio and the sales to working capital
ratio.

Answer: False Page: 557-558 Level: Easy


12. A rising sales to working capital ratio may indicate a potential borrower is using its net
current assets more eIIiciently.

Answer: True Page: 558 Level: Easy


13. The more variable are a borrower's cash Ilows, the greater the Iixed charge coverage ratio
should be to limit risk.

Answer: True Page: 558-559 Level: Easy


14. Corporate credit agreements are usually reviewed at least annually.

Answer: True Page: 561 Level: Easy


15. A borrower's EDF is a better prediction oI deIault than either its Z score or S&P rating.

Answer: True Page: 564 Level: Medium

16. Compensating balances are a cost to the borrower and generate income to the lender.

Answer: True Page: 566 Level: Easy


17. RAROC is the expected deIault Irequency oI a particular borrower.

Answer: False Page: 562 Level: Easy


18. Compensating balances usually earn interest.

Answer: False Page: 566 Level: Medium


19. Asset management ratios are used in credit analysis to help understand the borrower's
ability to generate sales Irom the amount invested in some asset category.

Answer: True Page: 558 Level: Medium


20. The base loan rate accounts Ior the credit risk on the loan.

Answer: False Page: 566 Level: Medium




Multiple Choice Questions


21. Which one oI the Iollowing 5 C's oI credit is NOT correctly deIined?
A) Capacity Whether the borrower has enough other credit available to pay oII the
loan in the event oI cash Ilow problems.
B) Capital The borrower's equity.
C) Character A measure oI the borrower's intention/willingness to repay the loan.
D) Conditions Assessing how economic conditions could aIIect the borrower's ability
to repay the loan.
E) Collateral An asset oI the borrower which the lender may seize in the event oI
deIault on the loan.

Answer: A Page: 554 Level: Medium


&se the Iollowing to answer questions 22-23:

A corporate customer obtains a $5 million line oI credit Irom a bank. The customer agrees to
pay a 6 interest rate and agrees to make compensating balances oI 5 oI the total credit line
and 2 oI the amount actually borrowed. These will be held in non-interest bearing transactions
deposits at the bank Ior one year. The bank charges a 1 loan origination Iee on the amount
borrowed and a 0.30 commitment Iee on the unused line oI credit. The expected draw down
(loan amount) is 70 oI the line Ior one year. Reserve requirements are 10.


22. What is the expected rate oI return to the bank (to the nearest basis point)?
A) 8.13
B) 8.86
C) 9.51
D) 8.95
E) 9.50

Answer: B Page: 567 Level: DiIIicult
Response: |(700,000*0.07) (700,000*0.01) (300,000*0.0030)| / |700,000 (0.90*
((0.05*1,000,000) (0.02*700,000))|


23. What is the expected cost rate to the corporate customer (to the nearest basis point)?
A) 8.13
B) 8.86
C) 9.51
D) 8.95
E) 9.50

Answer: D Page: 567 Level: DiIIicult
Response: |(700,000*0.07) (700,000*0.01) (300,000*0.0030)| / |700,000
(0.05*1,000,000) (0.02*700,000)|


24. Most loan policies speciIy a maximum loan to value (LTV) ratio on real estate loans.
The LTV is a ratio oI
A) Book/market value oI the loan
B) Loan amount/borrower's personal equity
C) &nused credit line/total line oI credit
D) Loan/collateral value
E) Loan/maximum amount oI consumer debt

Answer: D Page: None Level: Medium


&se the Iollowing to answer questions 25-26:




25. &sing only the GDS criteria, which one oI the Iollowing statements is true?
A) Joe gets the loan but not Bill
B) Bill gets the loan but not Joe
C) Both get the loan
D) Neither get the loan

Answer: A Page: 551 Level: Medium


26. &sing only the TDS criteria, which one oI the Iollowing statements is true?
A) Joe gets the loan but not Bill
B) Bill gets the loan but not Joe
C) Both get the loan
D) Neither get the loan

Answer: D Page: 551 Level: Medium


27. Individual credit scoring models typically include all oI the Iollowing inIormation except:
A) Income
B) Length oI time in residence
C) Credit history
D) Age
E) Ethnic background

Answer: E Page: 551 Level: Medium


Mortgage Gross Annual Projected Monthly Annual Other Monthly
Applicant Income Mortgage Pymt. Property Taxes Debt Pymts.
Bill $90,000 $2,100 $3,000 $500
Joe $50,000 $1,000 $2,000 $400
GDS cutoII: 30
TDS cutoII: 35

28. A corporate loan applicant has cash oI $30, receivables oI $20 and inventory oI $50. The
applicant also has current debts oI $50. II the bank's policy requires a current ratio oI 2
or better and an acid test ratio oI 1.5 or better would the applicant receive the loan?
A) Yes because the applicant's current ratio and acid test ratios are acceptable.
B) No because the applicant's current ratio and acid test ratios are both unacceptable.
C) No because although the applicant's current ratio is acceptable, its acid test ratio is
not.
D) No because although the applicant's acid test ratio is acceptable, its current ratio is
not.

Answer: C Page: 551 Level: Medium



&se the Iollowing to answer questions 29-33:

BALANCE SHEET BIG VALLEY ENTERPRISES

Assets Liabilities and Equity Income Statement
Accounts receivable 75 Current Liabilities 150 Cash Sales 200
Inventory 125 Long Term Debt 200 Credit sales 500
Fixed Assets 400 Common Stock 100 Operating Expenses 500
Retained Earnings 150 Depreciation 100
Total 600 Total 600 Interest 25
Taxes 30
Interest is Big Valley`s only Iixed charge NI
Big Valley`s market to book ratio 1.5


Peer Average Ratios
Current Ratio 1.5
Days Sales in Receivables 45
Sales to Working Capital 14
Sales to Fixed Assets 1.9
Fixed Charge Coverage Ratio 7
Debt to Asset Ratio 50
Return on equity 15



29. Big Valley's Iixed charge ratio and debt to asset ratio indicate that Big Valley has a
percentage oI debt than their peers and Big Valley has a ability to cover
their Iixed charges than their peers.
A) higher ; greater
B) higher ; lower
C) lower ; greater
D) lower ; lower
E) similar ; similar

Answer: B Page: 557-559 Level: Medium


30. Big Valley's return on equity indicates that the Iirm generates a return to their
shareholders than their peers.
A) 3 higher
B) 15 higher
C) 5 lower
D) 2 lower
E) 20 higher

Answer: A Page: 557-559 Level: Medium


31. Big Valley covers their Iixed charges times less than the industry average.
A) 7
B) 4
C) 1.5
D) 1.75
E) 2.25

Answer: D Page: 557-559 Level: DiIIicult
Response: 7 / |(200 500 500 100) / 25)|


32. Altman's Z-score model is Z 1.2X
1
1.4X
2
3.3X
3
0.6X
4
1.0X
5


X
1
Working Capital/Total Assets
X
2
Retained Earnings/Total Assets
X
3
EBIT/Total Assets
X
4
Market Value Equity/Book Value Long Term Debt
X
5
Sales/Total Assets
&sing the Altman's Z model, Big Valley's Z-score indicates that Big Valley is
A) a high deIault risk
B) a low deIault risk
C) an indeterminate deIault risk
D) none oI the above

Answer: B Page: 563 Level: DiIIicult


33. From the data given it appears that Big Valley
I. Has greater short term insolvency risk than the industry average
II. Has less long term insolvency risk than the industry average
III. Generates Iewer sales per dollar invested in Iixed assets
A) I only
B) I and II only
C) II only
D) I and III only
E) I, II and III

Answer: D Page: 555-556 Level: Medium


34. Midmarket commercial lending may be typically deIined as borrowers
I. With sales revenue between $5 and $100 million.
II. With a recognizable corporate structure.
III. With ready access to deep and liquid capital markets.
A) I only
B) II only
C) III only
D) I and II only
E) I, II and III

Answer: D Page: 553 Level: Medium


35. In analyzing credit risk Ior a loan to a major diversiIied corporation the bank typically
has which oI the Iollowing advantages?
I. Market based models to analyze credit risk
II. Greater negotiating power due to the size oI the loan required.
III. Ratings agency measures oI deIault risk
A) I only
B) I and II only
C) II and III only
D) I and III only
E) I, II and III

Answer: D Page: 562 Level: Medium


36. A Iirm with a low Z-score has high
A) Insolvency risk
B) Interest rate risk
C) Liquidity risk
D) International risk
E) None oI the above

Answer: A Page: 562 Level: Easy


37. Business credit scoring models suIIer Irom several weaknesses. These include all but
which one oI the Iollowing?
A) Credit score models classiIy borrowers as either deIault or non-deIault with no
classiIication in between.
B) The appropriate weights on a credit score model are likely to change over time.
C) These model ignore non-quantiIiable behavioral Iactors such as a relationship with
the bank and reputation.
D) Credit scoring models do not Iully use all publicly available inIormation.
E) All oI the above are weaknesses oI business credit scoring models.

Answer: E Page: 563 Level: Medium


38. The conditions speciIied in a credit agreement that must be IulIilled beIore a drawdown is
allowed are called
A) collateral perIection
B) power oI sale conditions
C) conditions precedent
D) Ioreclosure agreements
E) audit review terms

Answer: C Page: 558 Level: Easy


39. The EDF model uses the borrower's current market value oI equity and assets and the
option pricing model to
A) Determine iI the equity is mispriced
B) Assess the implied riskiness oI the Iirm's investments
C) Calculate the market value oI the lender's investment
D) Estimate the likelihood that the Z-score model is correct

Answer: B Page: 564 Level: Medium


40. A bank charges a commercial borrower an 11 interest rate on a one year loan. The
bank also charges a 0.5 origination Iee and requires compensating balances oI 8 in
the Iorm oI demand deposits. What is the promised gross rate oI return on the loan?
A) 11.45
B) 12.39
C) 12.10
D) 11.67
E) 11.05

Answer: B Page: 568-569 Level: Medium
Response: (0.005 0.11) / |1 (0.08 * (1 0.10))|


41. A bank is using the RAROC to evaluate large business loans. The benchmark rate oI
return is 12. The one year loan earns 9 and the bank must pay 8.1 to raise the
Iunds. Expected losses are 0.4 II the loan deIaults, 90 oI the money lent will be lost.
Based on historical deIault rates, the extreme worst loss case scenario is about 5.
Should the bank make the loan? Why or why not.
A) Yes because the RAROC is 11.11
B) No because the RAROC is 11.11
C) Yes because the RAROC is 12.45
D) No because the RAROC is 12.45
E) No because the RAROC is less than 8.5

Answer: B Page: 568-569 Level: DiIIicult
Response: (0.09 0.081 0.004) / (0.05* 0.90)