Commercial Banking 4389.01 Final Exam Review Fall 2005

1
Commercial Banking (4389.01) Final Exam Review
Fall 2005
2
What are the three key functions of bank capital?

• bank capital is a long-term source of funds to
  finance start-up costs and bank expansion.
• it serves as a cushion to absorb unexpected
  operating losses.
• bank capital must be adequate from a regulatory
  standpoint, which is concerned with the safety
  and soundness of the banking system.

3
How does bank regulation differ from bank
supervision?

• Regulation refers to the establishment of rules
  by bank regulators.
• Supervision is concerned with the safety and
  soundness of banks, making sure that the rules
  followed. Supervision also includes compliance
  with existing laws.

4
In relation to banking, what causes agency costs?

• Conflicts of interest between shareholders and
  managers

5
What is the difference between core deposits and
purchased deposits?

• Core deposits generally are deposits of regular
  customers that are residents in the trade area of
  the bank. They are a more stable and long-term
  source of funds than purchased deposits, which
  are acquired from the financial markets by
  offering competitive interest rates.

6
What are Federal Funds (Fed funds)?

• Short-term, unsecured transfers of immediately
  available funds between depository institutions
  for use in one business day

7
Explain the concepts of asymmetric risk and
adverse selection in connection with commercial
lending.

• Asymmetric information means that the borrower
  has more information about his or her condition
  than the lender. Because of imperfect
  information, lenders charge rates that reflect
  the average risk of all borrowers. This reduces
  high-risk borrowers to take advantage of the
  relatively low (average) rates (adverse
  selection).

8
Which method produces the higher APR on a 50,000
loan, an add-on rate or a discount loan rate?
Why?

• Discount loan rate produces the higher APR
  because the customer does not receive the full
  amount of the funds borrowed (i.e., interest owed
  is subtracted from the amount borrowed), while
  interest is computed on the total amount
  borrowed.

9
What are brokered deposits?

• These are deposits that are obtained by banks
  from middlemen who split up deposit funds in
  excess of 100,000 into separate deposit accounts
  at different banks in order to get the entire
  amount federally insured.

10
What are the 3 components of bank deregulation?

• Prices (e.g., interest rate paid on deposits)
• Products (e.g., investment banking)
• Geographic location (Interstate banking)

11
What is a balloon loan?

• It is a partially amortized, fixed rate loan
  (mortgage or other type of loan), where only a
  portion of the debt is paid off in periodic
  payments, and the unamortized amount is paid off
  in lump sum, or balloon payment at maturity.

12
How do banks that do not have international
departments normally serve their customers intl
needs.

• They use correspondent banks.

13
What is relationship banking?

• Looking at the total banking products used by a
  client ( hence the total earnings from the
  client) to determine the pricing of a particular
  product.

14
What is an interest rate swap? How can it be used
to hedge interest rate risk?

• A swap is an agreement between two parties to
  exchange cash flows. Swaps are used to reduce
  interest rate and currency risk. In an interest
  rate swap, one party usually pays a fixed amount
  (based upon notional principal) and receives a
  floating or variable payment while the other
  party pays floating and receives fixed.

15
How does pledging accounts receivable differ
from factoring?

• With pledging, the borrower retains ownership of
  the receivables. With factoring, the accounts
  receivable are sold to a factor, which is a bank
  or some other type of financial institution.

16
What is the principal difference between a credit
card and a debit card?

• Debit cards do not extend credit, while credit
  cards do.

17
Distinguish between the incremental gap and the
cumulative gap.

• The incremental gap measures the difference
  between rate sensitive assets and rate sensitive
  liabilities over increments of the planning
  horizon.
• The cumulative gap measures this difference over
  a more extended period, i.e., it is the sum of
  the incremental gaps.

18
What is the difference between a finance charge
on a loan and the APR?

• The finance charge is the difference between the
  amount borrowed and the amount repaid. It
  includes interest, service charges, fees, and
  most other items charged to obtain the loan. The
  APR is the percentage cost of credit on an annual
  basis.

19
Describe the secondary mortgage market.

• Pools of mortgage loans are bought and sold. Some
  of the mortgage pools are enhanced by guarantees
  from government agencies, such as GNMA, or by
  private firms. Major participants are FNMA, GNMA,
  FHLMC.

20
Differentiate between pledging and factoring
receivables.

• Pledging borrower retains ownership but lender
  can call in the event of default.
• Factoring the sale of accounts receivables to a
  bank or finance company (the factor). Receivable
  now belongs to lender (customer notified) who
  will advance a portion of the face value. The
  credit risk is now the factors.

21
What are the 6 Cs in loan evaluation?

• Character is the borrower honest and
  trustworthy.
• Capacity borrowers success in running
  business, especially in relation to cash flow.
• Capital net worth of the borrower.
• Collateral pledged assets.
• Conditions economic climate.
• Compliance with laws regulation (drug
  trading).

22
What method of computing interest charges on
credit cards produces the largest finance
charges? Why?

• Average daily balance including current
  transactions. This method includes current
  transactions (i.e., no grace period).

23
What is an assumable mortgage?

• The mortgage can be passed on to new buyer if the
  buyer meets the lenders credit criteria and pays
  an assumption fee.

24
Distinguish between open- and closed-end consumer
loans. Example

• Open-end loans have no finite maturity. Credit
  card loans are one example of open-end credit.
  Closed- end loans, such as loans for automobiles,
  have a finite maturity.

25
What is meant by a short/long futures contract?
How is each affected by changes in interest rates?

• A short position represents the sale of a futures
  contract / long purchase. Interest rates and
  prices are inversely related, so a short position
  will benefit from an interest rate increase and
  be harmed from an interest rate decrease.

26
What does mark-to-market mean?

• Futures contracts are evaluated daily at their
  market values and gains or losses are added to or
  subtracted from the margin balance each day.

27
Differentiate between Funding Liquidity Risk and
Market Liquidity Risk.

• Funding Liquidity Risk Refers to maintaining
  sufficient cash to meet investment objectives
  such as hedging against interest rate changes or
  taking advantage of investment opportunities.
• Market Liquidity Risk Refers to liquidity
  pressures from market disruptions or volatility.

28
If a bank earns 5 on a tax-free municipal
security, and the bank is in the 35 federal
income tax bracket, the tax equivalent yield on
the security is

• 5 / .65 7.69

29
As the growth rate of dividends increases, the
market price of bank stock will ..

• increase

30
Differentiate between Core deposits and Purchased
deposits.

• Core Deposits are funds from the banks customers
  that provide stable long-term source of funds.
• Purchased Deposits are acquired from the
  financial markets and serve primarily for
  liquidity purposes.

31
What does it mean to unbundle loans?

• Split the loan process into 4 distinct
  businesses.
• Originating loans
• Packaging loans for sale
• Servicing loan portfolios
• Investing in loan-backed credit instruments

32
Off-balance sheet risk taking involves

• generating fee income by assuming contingent
  liabilities

33
What is Seigniorage?

• The interest saved by the Treasury from having
  currency circulate as a medium of exchange. It is
  calculated as the difference between the face
  value of the notes coins and the cost of
  production. Since notes coins do not attract
  interest, the Treasury saves the interest on this
  source of borrowing.

34
Differentiate between a Graduated Payment
Mortgage and a Growing Equity Mortgage.

• Graduated Payment Mortgage initial payments are
  low and rise over time. There is negative
  amortization initially and the borrower could end
  up owing more than amount borrowed.
• Growing Equity Mortgage (GEMs) 15-year loans
  that have successively higher monthly payments
  (start with pmt of 30-year loan).

35
What is meant by a short position and a long
position in financial futures? How is each
affected by changes in interest rates?

• A short position represents the sale of a futures
  contract. A long position represents the purchase
  of a futures contract. Since interest rates and
  the prices of fixed income instruments move
  inversely, a short position will benefit if
  interest rates increase but will be harmed by
  falling interest rates. Conversely, a long
  position will benefit from falling rates and will
  be harmed by rising rates.

36
What are the 5 ways that the FDIC uses to address
a bank failure?

• Depositor payoff (within 1 week)
• Purchase assumption (stronger bank buys the
  bank and FDIC picks up losses from merger)
• Provision of Financial Aid
• Charter of a Deposit Insurance National Bank
  (bridge bank)
• Reorganization

37
What usually happens to the price of a buyers
(bidders) stock in a bank merger?

• It declines (overpayment theory)

38
The proportion of assets, deposits, and loans
held by a bank in its business region relative to
other banks is called

• Market share

39
Investment securities are held by commercial
banks to produce income in the forms of _________
and __________.

• interest capital gains.

40
Under what circumstances is a loan charged off,
and what does it mean? What is the effect on
earnings?

• A loan is charged-off when it is no longer of
  sufficient quality to remain on the books of the
  bank. When it is charged-off, and removed from
  the balance sheet, the reserves for loan losses
  is reduced. The charge off has no effect on
  earnings. Earnings are affected when the
  provision for loan losses on the income
  statement was charged.

41
List at least 5 ways banks get new loans.

• Loan solicitation (e.g., mailings)
• Loan purchase
• Loan commitments
• Loan brokers
• Overdrafts
• Refinancing
• Customer requests

42
As a rule of thumb, how much is one point
expressed as a percentage ?

• 1

43
The risk associated with not being able to sell a
financial asset quickly without loss of value is
called

• Marketability risk

44
What are derivatives?

• Off balance sheet transactions that result in
  contingent assets or liabilities.

45
Give a brief description of Electronic banking.

• Any banking activity accessed by electronic means
  such as ATMs, PCs (Internet) automated call
  centers.

46
Why is the Fed called the lender of last resort?

• Under the banking act, the Fed can create an
  elastic currency, i.e., the Fed stands ready to
  lend to a commercial bank in the event that it
  has liquidity problems.

47
Forget the parties this weekend and prepare
well.Thats a sure way to ace the test!!