BUSINESS FINANCE 4265: EXAM 1, 2024
Section I. True/False Questions (1.5 points each) – 24 points in total
1. Large banks tend to make business decisions based on personal (“soft”) knowledge of customer’s
creditworthiness and business conditions in the local communities. F
2. Finance companies differ from banks in that they do not accept deposits. T
3. The maturity structure of commercial banks’ assets tends to be shorter than that of their liabilities. F
4. People should not use transaction deposits instead of non-transaction deposits, which pay much higher
interest rates. F
5. Finance companies generally lend to riskier borrowers than do commercial banks. T
6. In Open Market Operations (OMO), the Fed injects new reserves into the banking sector without purchasing
any assets. F
7. Deposit insurance is often considered to increase moral hazard and encourage FIs to accept more risk in the
asset selection process. T
8. Requiring higher capital ratios is often proposed as a method to reduce the incentive to take excessive risk
because the moral-hazard risk-taking incentives are thought to decrease as equity increases. T
9. Deutsche Bank’s acquisition of Postbank was part of its strategy to expand further in investment banking. F
10. Insured depositors can be covered for much more than $250,000 at any given FI under the FDIC systemic
risk exception. T
11. Historically, banks only fail when their Tier 1 capital ratio is considered not adequate. F
12. When there is no deposit insurance, banks that invest a greater percentage of assets into illiquid investments
such as loans have a lower likelihood of a run. F
13. Seasoned equity offerings are usually the most value-enhancing way for a bank to raise new capital. F
14. Regulators are concerned about excessive risk-taking by universal banks because the deposits of
commercial bank subsidiaries are insured. T
15. Money market mutual funds (MMFS) are subject to runs even though their liabilities are not technically
deposits. T
16. Depositors of banks absorb losses before equity holders because depositors are junior to equity holders in
bankruptcy. F
Section II. Multiple Choice Questions (~3 points)
17.
As of year-end 2009, Bank of Texas had an ROA of .5% and an ROE of 19%, while Bank of River
Valley had an ROA of .5% and an ROE of 16%. What could explain the difference in ROE between
these two financial institutions?
A. Bank of Texas is significantly less leveraged than Bank of River Valley
B. Bank of Texas earns higher yields on its earning assets
C. Bank of River Valley is significantly more leveraged than Bank of Texas
D. There is not enough information to answer the question
Bank of Texas is more leveraged than Bank of River Valley so none of the above answer choices is
correct. Everyone gets full credit.
18.
The merger and consolidation wave of commercial banks in the United States was driven by:
A. Financial Modernization Act of 1999
B. Deregulation of interstate banking.
C. The Glass-Steagall Act of 1933.
D. Both A and B.
Feedback: Glass-Steagall required that commercial and investment banks split up, not merge.
19. What is the primary function of finance companies?
A. Protect individuals and corporations from adverse events.
B. Make loans to both individuals and corporations.
C. Extend loans to banks and other financial institutions.
D. Pool the financial resources of individuals and companies and invest in diversified portfolios of
assets.
E. Assist in the trading of securities in the secondary markets.
20. What is the benefit of a regulatory insurance program for liability holders of financial institutions (FIs)?
A. It decreases the likelihood of contagious runs.
B. It increases concerns about the asset quality of FI.
C. It increases concerns about the solvency of an FI.
D. It provides incentives to liability holders to engage in bank runs.
E. It provides preference to those who are first in line to withdraw funds over those last in line.
21. Bank assets tend to have _____________ maturities and _____________ liquidity than/as bank liabilities.
A. Longer; greater
B. Longer; lower
C. Shorter; greater
D. Shorter; lower
E. Equal; equal
Assets
$900
Insured Deposits
Uninsured Deposits
$300
$400
22. The above bank has failed and is taken into FDIC custodianship. What are the total losses to uninsured
depositors in the FDIC failure resolution?
A. $0.
B. $100 million.
C. $200 million.
D. $300 million.
E. $400 million.
Feedback: This bank has enough asset value to cover all the claims of both insured and uninsured
deposits.
23. During the S&L crisis, what policy decision did not ultimately lead to greater government losses
A. Regulatory approval of accounting gimmicks
B. An increase in capital requirements for savings and loan institutions
C. Relaxation of asset requirements that allowed for riskier investments
D. The decision to allow them to continue operating after their net worth became negative
Feedback: There was no increase in capital requirements for savings and loan institutions at the time.
24. Suppose today a bank has the following balance sheet book values
Assets
Liabilities
$100
$6 Equity
Deposits
$94 (Insured)
The bank is considering investing $100 into a loan that will have the following payoffs with the stated
probabilities:
Loan
Probability Payoff
90%
$100
10%
$73
Suppose this bank has FDIC deposit insurance, and the equity holders are in charge of the decision-making at
the bank. Will the bank choose to invest in this loan? (Assume the discount rate is zero; in other words, NPVs =
expected payoffs).
A. No, because the loan has an overall negative NPV/Expected Payoff.
B. Yes, because the loan has an overall positive NPV/Expected Payoff.
C. No, because the loan creates a negative NPV/Expected Payoff for the bank equity holders.
D. Yes, because the loan creates a positive NPV/Expected Payoff for the bank equity holders.
Feedback: Equity holders will 90%*($100-$94) + 10%*Max($0,$73-$94) = 90%*($100-$94) + 10%*0=
90%*($6) = $5.4.
The equity holders started with $6 and ended up with $5.4, meaning that they will take a loss from this
loan. Therefore, equityholders should choose not to invest in the loan.
Note: It is also true that the loan overall has a negative NPV; however, ultimately, the equity holders are
the decision makers.
Free Response Questions:
25. Provide an example of why financial intermediation is valuable and explain why.
Feedback: Examples include: a) intermediaries reduce information/monitoring costs, b) intermediaries
provide liquidity to their depositors/liability holders. These features make it more advantageous to use an
intermediary than to try to finance directly.
26. If a bank has been asked to raise its tier 1 capital ratio (Tier 1/RWA) by regulators, what strategic
options does it have?
Feedback: The bank could stop dividends to increase retained earnings, issue equity through SEOs, issue
preferred equity, or reduce RWA by selling assets with higher risk-weights.
Please use the following additional information for Questions 11-12
Sigma Bank has the following off-balance sheet items. All off-balance sheet items are associated with corporate
customers (not governments or sovereigns), and hence, their risk weights are 100%.
Off balance sheet contingent liabilities:
$80 million direct-credit substitute standby letters of credit issued to a U.S. corporation (conversion factor:
100%)
$30 million commercial letters of credit issued to a corporation (conversion factor: 20%)
Off-balance sheet derivatives
$200 million 10-year interest rate swaps (conversion factor: 1.5%)
27. What is the minimum total risk-weighted capital (Tier I + Tier II) required for both of the off-balance-sheet
letters of credit under the Basel III standards? Please ignore regulatory buffers and just concentrate on the basic
Basel III regulatory capital ratios.
$2-4 million
$4-6 million
$6-8 million
$8-10 million
$10-12 million
Feedback: Off-bal RWA = Exposure*CCF*Risk-weight + max(replacement cost,0)
RWA = 80*1 + 30*.2 = 86
Min total capital required: 86*.08 = $6.88
28. What is the total risk-weighted assets value of the off-balance-sheet interest rate swaps with a replacement
cost of -$5 million (in the money by 5 million)?
$0-2 million
$2-4 million
$4-6 million
$6-8 million
$8-10 million
Feedback: Off-bal RWA = Exposure*CCF*Risk-weight + max(replacement cost,0)
200*.015 + max(-5,0) = 200*.015 + 0 =$3.
Use the following simplified bank balance sheet to answer the following three questions. Assume that the bank
has no off-balance-sheet activities.
Assets
Cash + Reserves
Treasuries
Commercial Loans BB+
Single Family Mortgages
Mortgage-Backed Securities
Commercial Loans CCC+
Reserve for Loan Losses
Deposits
Common Stock
Retained Earnings
Subordinated Debt
Book Value
$5
$60
$30
$60
$90
$50
(-$15)
Risk weight
0%
0%
100%
50%
30%
150%
N/A
Liabilities
Book
Capital
Value
Type
$280 $6 Tier 1
$4 Tier 1
$5 Tier 2
Tier 2 capital component limits:
Reserve for loan losses: maximum of 1.25% of risk-weighted assets.
Subordinated debt: maximum of 50% of Tier 1 capital.
29. How much Common-equity Tier 1 does the bank need to be adequately capitalized under Basel III?
$4-5
$5-6
$6-7
$7-8
$8-9
Feedback:
RWA = 162.
Min CET1 = .045*162 = $7.29
30. What is the Total capital adequacy ratio of the bank ?
6-8%
8-10%
10-12%
12-14%
14-16%
Feedback:
Tier 1 = 10
Tier 2 = min(.0125*162,15) + min(.5*10,5) = 2.025 +5 = 7.025
Total capital ratio = 17.025/162 = 10.5%
31. Suppose the Fed purchases $70 of MBS directly from this bank as part of quantitative easing. How will this
impact the bank’s common tier 1 ratio (CET1/RWA)?
It will increase from a starting ratio of 6-7% to a new ratio of 7-8%.
It will decrease from a starting ratio of 7-8% to a new ratio of 6-7%.
It will increase from a starting ratio of 6-7% to a new ratio of 8-9%.
It will decrease from a starting ratio of 6-7% to a new ratio of 5-6%.
It will remain unchanged.
Feedback: $70 of MBS purchases will reduce MBS from $90 to $20 and increase cash and reserves from
$5 to $75
The old RWA was 162 and the new RWA is now 141. Computing CET1 ratios for both
Old CET1 ratio = 10/162 = 6.2%
New CET1 ratio = 10/141 = 7.1%
Please use the following balance sheet for the following two questions:
Assets
Cash
Securities
Loans
Other
Total
850
1925
5400
975
9150
Income Statement
interest income on loans
interest income on securities
Interest expense
noninterest income
noninterest expense
provision for loan loss
taxes
600
95
200
78
112
35
115
32.
Liab & Equity
Deposits
Other Borrowers
Equity
Total
6975
1645
530
9150
Assuming that only loans and securities count toward earnings assets, this bank has a NIM of
1-3%
3-5%
5-7%
7-9%
9-11%
Feedback: NIM = (Interest income – interest expense)/Earning Assets = (600+95-200)/(1925+5400) =
6.75%.
33.
The peer group average equity multiplier (EM) is 15. Bank A:
A. is less leveraged than its peer banks because its equity multiplier is less than 15
B. is more leveraged than its peer banks because its equity multiplier is greater than 15
C. is as leveraged as its peer banks because its equity multiplier is 15
D. cannot be determined from the information given.
EM = Assets/Equity = 9150/530 = 17.26 > 15
Please use the following additional information for Questions 18-20:
Fourth Bank has the following balance sheet (in millions) with the risk weights (under Basel III) in parentheses.
Assets
Liabilities and Equity
Cash
0.000
$30 Deposits
$192
OECD Interbank deposits
0.200
$85 Subordinated debt
$5
Mortgage loans
0.500
$50 Cumulative preferred stock
$3
Consumer loans
1.000
$60 Equity
$5
Total Assets
$205 Total Liabilities & Equity
$205
In addition, the bank has $60 million in performance-related standby letters of credit (SLCs). Credit conversion
factor and the risk weight for the standby LCs are 50% and 100%, respectively.
34. How much Tier 1 capital does this bank need to be adequately capitalized? (Hint: be sure to check all
relevant Basel III capital ratios!)
$7-8 million
$8-9 million
$9-10 million
$10-11 million
$11-12 million
Feedback: RWA = 132, Total Assets = 205
Check Tier 1 Ratio: Tier1/RWA > .06 => Tier 1 > 132*.06 = 7.92
Check Leverage Ratio:
Tier1/Assets > .04=> Tier 1 > 205*.04 = 8.2
Therefore, it must be that Tier 1 needs to be greater than 8.2
35. Suppose the above balance sheet is stated in book values. If interest rates rise and the market value of mortgage
loans declines from $50 to $30, what is the effect on tier 1 capital?
Tier 1 capital will decrease because capital equals assets minus liabilities, and the value of assets has declined.
Tier 1 capital will decrease because capital equals assets minus liabilities, and book values eventually adjust to
reflect movements in market values..
Tier 1 capital will increase because capital equals liabilities minus assets, and the value of assets has declined.
There is no effect because market values do not directly affect regulatory-defined capital ratios.
Feedback: market values have no direct effect on book value of assets, and therefore regulatory ratios
which use book values.
Formula Sheet
ROE 
Net Income
TotalAsset s

 ROA  EM
TotalAsset s Total Equity Capital
NIM 
Interest Income - Interest Expense
Investment Securities  Net Loans and Leases
Earning assets=Investment securities + Net Loans and Leases
Spread 
Interest income
Interest expense

Earning Assets Interest - bearing liabilities
Net Income
Total Oper ating Inco me

Total Operating Income
Total Asse ts
=Profit Margin * Asset Utilization
ROA 
Tier 1 risk − based capital ratio =
CET1 risk − based capital ratio =
Tier 1 capital
Risk − weighted assets
Common Equity Tier 1 capital
Risk − weighted assets
Total risk − based capital ratio =
𝐿everage (Tier 1) ratio =
Tier 1 + Tier 2 capital
Risk − weighted assets
Tier 1 capital
Total assets