MANAGEMENT OF FINANCIAL INSTITUTIONS COURSE – FIN 460

MID-TERM EXAM QUESTIONS

Time: 90 minutes

Part 1: True or False. Choose the best answer and explain why (30 marks)
1.1. The Central Bank sales of securities could reduce lending interest rate charged by commercial
banks (CBs).
1.2. Regulations imposed by Central Bank will hinder the growth of commercial banks.
1.3. Commercial banks should concentrate on mobilizing the cheapest deposits from the public.
1.4. The use of non-deposit borrowing should be limited to liquidity demand rather than expanding
credit.
1.5. Interest rates on non-deposits are highly volatile.
1.6. Bad loans normally do affect future income.
1.7. Allowance for Loan Losses (ALL) is the asset item, and Provision for Loan Losses (PLL) is the
non-cash expense item before profit loss.
1.8. Off-balance sheet items of banks do not expose to risks.
1.9. In looking at comparative balance sheets, it can be seen that large banks rely more heavily on
non-deposit borrowings while small banks rely more heavily on deposits.
1.10. The number one source of revenue for a bank based on volume is usually loan income.
1.1 T When a central bank sells securities, it typically absorbs money from the banking
system. This decreases the overall money supply available to commercial banks,
making it more challenging for them to lend money. To attract borrowers in a more
competitive lending environment, commercial banks may lower their interest rates,
resulting in reduced lending rates for consumers and businesses.
1.2 F Regulations imposed by the Central Bank are designed to ensure the stability and
integrity of the banking system rather than hinder the growth of commercial banks.
These regulations are put in place to protect depositors, maintain financial stability,
and prevent risky behaviors that could lead to financial crises.
1.3 F Attracting low-cost deposits boosts bank profitability, but banks must also prioritize
customer service, reputation, competitive interest rates, and deposit insurance to
influence deposit decisions, impacting deposit mobilization. The statement, while
partly accurate, doesn't encompass all bank considerations.
1.4 F Non-deposit borrowing isn't just for liquidity; it funds lending, supporting credit
expansion, driving growth, and increasing bank profitability.
1.5 T Interest rates on non-deposit sources of funding can be highly volatile. These rates
are influenced by various market factors and may change rapidly, making it
challenging for banks to predict their funding costs accurately.
1.6 T Bad loans lead to provisions for expected losses, recorded as expenses, reducing a
bank's profits and impacting future income.
1.7 T Allowance for Loan Losses (ALL) is a balance sheet asset, representing potential
unrepaid loans. Provision for Loan Losses (PLL) is a non-cash expense, reducing
reported profits.
1.8 F This statement is incorrect, as off-balance sheet items, such as derivatives or loan
commitments, can expose banks to various risks, including credit risk, market risk,
and operational risk
1.9 F Banks' funding sources depend on factors like their business models, customer base,
access to deposits, and regulatory requirements. Large banks may diversify with
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non-deposit sources, but some can access cheaper deposits. Small banks may rely
more on deposits, but not always. Individual bank strategies can vary significantly.
1.10??? F While interest income from loans is indeed a significant source of revenue for most
commercial banks, it's not the sole source, and the importance of other revenue
streams should not be underestimated, including fees, trading, investments, and
wealth management.

Part 2: Multiple Choice Questions. Choose the best answer and explain (10 marks)
2.1. Bank assets fall into each of the following categories except:
A) Loans.
B) Investment securities.
C) Demand deposits.
D) Noninterest cash and due from banks.
E) Other assets
Explain: Demand deposits are a liability for banks, not an asset. They represent the money that
customers have deposited into the bank and can withdraw on demand. The other
options - Loans, Investment securities, Noninterest cash and due from banks, and
Other assets - are all categories of assets for a bank. These represent resources owned
by the bank that can generate future economic benefits.
2.2. Banks perform the indispensable task of:
A) Creating money without making loan.
B) Absorbing the excess liquidity created by other financial institutions
C) Intermediating between surplus-spending individuals or institutions and deficit-
spending individuals or institutions
D) Issuing risky deposits
E) None of the above
Explain: Banks play a crucial role in the financial system by intermediating between entities that
have surplus funds (savers) and those that need funds (borrowers). This process of intermediation
facilitates the flow of funds in the economy, supporting economic activity. The other options do not
accurately describe the primary function of banks.
2.3. Which of the following has become the principal tool of central bank monetary policy today?
A) Open market operations
B) Changing the discount rate
C) Changing reserve requirements
D) Using moral suasion
E) None of the above
Explain: Open market operations, which involve the buying and selling of government securities,
have become the principal tool of central bank monetary policy today. This is because they allow
central banks to influence the supply of money in the economy in a flexible and precise manner.
The other options - changing the discount rate, changing reserve requirements, using moral
suasion - are also tools of monetary policy, but they are not used as frequently or as extensively as
open market operations.
2.4. The Central bank buys Treasury Bills in the open market. This will tend to:
A) Cause interest rates in the market to rise
B) Cause interest rates in the market to fall
C) Cause reserves held at the Federal Reserve to decrease
D) Cause a decrease in the growth of deposits and loans
E) All of the above

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Explain: When the central bank buys Treasury Bills in the open market, it injects money into the
banking system. This increase in the money supply tends to lower interest rates in the market
because there is more money available for lending, and increased competition among banks for
borrowers puts downward pressure on interest rates.
2.5.The difference between such sources of bank income as service charges on deposits and trust-service
fees and such sources of bank expenses as salaries and wages and overhead expenses divided by total
assets or total earning assets is called the:
A) Net profit margin
B) Net operating margin
C) Net noninterest margin
D) Net return on assets
E) None of the above
Explain: This term refers to the difference between noninterest income (such as service charges on
deposits and trust-service fees) and noninterest expenses (such as salaries and wages and
overhead expenses), divided by total assets or total earning assets. It’s a measure of a bank’s
profitability from its noninterest operations.

Part 3: Assignment: (30 marks)

3.1. (10 marks) How are the balance sheets and income statements of finance companies, insurers,
and securities firms similar to those of banks, and in what ways are they different? What might
explain the differences you observe?

Finance Companies, insurers and securities firms Banks

Similarity to provide a snapshot of a company's financial position at a specific point in time (balance
sheet) and to track the company's revenues and expenses over a specific period (income
statement)
Assets - Finance companies might have more Banks' assets are primarily made up of
investments in securities. loans and reserves
- Insurers' assets often include premiums
receivable and investments
- Securities firms might have significant
assets tied up in trading account assets
Liabilities - Finance companies might have more debt Banks rely heavily on deposits as their
due to borrowing to finance their primary source of funds
operations.
- Insurers have significant liabilities in the
form of policyholder claims payable
- Securities firms might have trading account
liabilities
Revenues - Finance companies earn interest from their Banks earn interest from loans and
investments and loan portfolios. fees from services
- Insurers earn premiums from their insurance
policies
- Securities firms earn commissions from
trading activities
Expense - Finance companies and securities firms Banks have interest expenses on
have high operating expenses due to the deposits and loans, operational
cost of underwriting and servicing loans and expenses, and provisions for loan
securities. losses
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- Insurers' expenses are primarily claiming
payments and policyholder benefits

Explaining Differences:

The variations in the financial statements of these entities can be ascribed to their distinctive business
models, regulatory contexts, and risk profiles. To illustrate, insurers are compelled to uphold substantial
reserves to meet future claims, influencing the structure of their assets and liabilities. Securities firms, on
the other hand, adopt a more transactional and trade-oriented approach, which impacts their sources of
income and risk exposure. Banks tend to lean towards conventional banking activities, like lending and
deposit-taking, affecting the composition of their balance sheets and revenue streams.

Differences in financial institutions arise from unique business models, regulations, and risk profiles. For
example, insurers maintain reserves for claims. Securities firms focus on trading, affecting income and
risk. Banks emphasize lending and deposits, impacting balance sheets and revenue.

3.2. (20 marks) “Financial institutions play a facilitating role in the economic process”. Do you
agree with this statement? Why? – topic 1 debate

I hold a dissenting viewpoint regarding the assertion that "Financial institutions serve as facilitators in
the economic process," and I base my disagreement on three primary grounds: Financial Fraud,
Centralized Power Risks, and Economic Inequality.

The assertion that financial institutions play a facilitating role in the economic process is subject to
scrutiny due to significant challenges they pose, namely financial fraud, centralized power risks, and
economic inequality. One major facet of financial fraud combines financial reporting fraud,
speculative investment, and money laundering. Financial reporting fraud entails the manipulation of
financial reports, deceiving shareholders and causing substantial losses. Simultaneously, speculative
investment diverts resources into short-term trading, undermining sustainable economic development.
Money laundering not only fosters instability but also tarnishes a nation's international image, eroding
investor trust and diminishing its appeal for economic development.

Centralized power risks are another critical concern. The interconnectedness of financial institutions
means that the failure of one can swiftly impact others, leading to a domino effect of market crashes.
The contagion effect further exacerbates this problem by causing panic and loss of confidence,
potentially resulting in bank runs and liquidity crises. This concentration of power threatens the
stability of the financial system and the broader economy.

Economic inequality is exacerbated by financial institutions, which often offer preferential treatment
based on creditworthiness and collateral. This preferential treatment excludes financially
disadvantaged individuals and businesses, limiting their access to credit and participation in economic
activities. Additionally, financial institutions' profit-making activities contribute to the concentration
of wealth among a select few, further widening the wealth gap between the rich and the poor. Limited
financial inclusion, particularly for underprivileged communities and individuals with minimal
financial history, hampers socio-economic mobility and perpetuates inequalities.

In conclusion, the assertion that financial institutions play a facilitating role in the economic process
is debatable due to the significant risks they pose, including financial fraud, centralized power risks,
and economic inequality. These factors can hinder economic growth, erode investor trust, and

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perpetuate socio-economic disparities. While financial institutions do indeed serve important
functions in the economy, it is crucial to address these issues and carefully consider their broader
impact on society and the economy.

Part 4: calculation: (30 marks)

4.1. The ABC Bank is developing a list of off-balance-sheet items for its call report. Please fill in the
missing items from its statement shown below. Using Table 5-5 – p. 143, describe how ABC compares
with other banks in the same size category regarding its off-balance sheet activities.

Off-balance-sheet items for ABC Bank (in millions of $)

Total unused commitments $7,000

Standby letters of credit and foreign office
guarantees $1,350
(Amount conveyed to others) ($50)
Commercial Letters of Credit $48
Securities Lent $2,200
$97,00
Derivatives (total) 0
$22,00
Notional Amount of Credit Derivatives 0
Interest Rate Contracts 54000
Foreign Exchange Rate Contracts ?
Contracts on other commodities and equities $1,200
All other off - balance -sheet liabilities $49
Total off-balance-sheet Items ?
$10,50
Total Assets (on-balance sheet) 0
Off-balance-sheet assets ÷ on-balance-sheet
assets ?

ANSWER:

- Foreign exchange rate contracts = Total derivatives – All other derivatives

= $97,000 – ($22,000+ $54,000+ $1200)
=$19,800

- Total off-balance-sheet Items

- =The sum of all of the off-
balance sheet items
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- =$7,000 + $1,350 – $50 + $48 +
$2,200 + $97,000 + $49
- =$107,597
- Total off-balance-sheet Items
- =The sum of all of the off-
balance sheet items
- =$7,000 + $1,350 – $50 + $48 +
$2,200 + $97,000 + $49
- =$107,597
- Total off-balance-sheet Items
- =The sum of all of the off-
balance sheet items
- =$7,000 + $1,350 – $50 + $48 +
$2,200 + $97,000 + $49
- =$107,597
- Total off-balance-sheet items = The sum of all the off-balance-sheet items
= $7,000 + $1,350 – $50 + $48 + $2,200 + $97,000 + $49
= $107,597
- Off-balance-sheet assets ÷ on-balance-sheet assets = $107,597 ÷ $10,500 = 1025%

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- This looks very similar to other banks of the same size

4.2. Please fill in the missing items from its statement shown below (all figures in millions of dollars):

Report of Income

Total Interest Income $120

Total interest expense = Total Interest income
Total Interest Expense ? 80 – Net Interest income = 120 - 40
Net Interest Income 40
Provision for Loan and Lease Losses = Net
interest income + Total Non-interest Income -
Total Non-interest expense – Pretax Net -
operating income
Provision for Loan and Lease Losses ? 7 = 40 + 58 -77 – 17
Total Noninterest Income 58
Fiduciary Activities 8
Service Charges on Deposit Accounts 6
There are four areas of Total noninterest
income and only one is missing and the total is
Trading Account Gains and Fees ? 14 given = 58 - 8 – 6 -30
Additional Noninterest Income 30
Total Noninterest Expense 77
There are three areas of Total noninterest
expense and only one is missing and the total
Salaries and Benefits ? 47 is given: 77 – 10 – 20
Premises and Equipment Expense 10
Additional Noninterest Expense 20
Pretax Net Operating Income 17
Securities Gains (Losses) 1
Applicable Income Taxes 5
= Pretax income + Security gains – Taxes
Income Before Extraordinary Items ? 13 = 17 + 1 - 5
Extraordinary Gains – Net 2
= Income before extraordinary items +
Extraordinary gains – net
Net Income ? 15 = 13 + 2

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