Deck 16: Off-Balance-Sheet Risk

Question 1

All call options are eventually exercised and the underlying asset must be delivered.

Answer 1

False

Question 2

Even though an FI may have off-balance-sheet activities, the true net worth is equal to on-balance sheet assets minus on-balance sheet liabilities.

Answer 2

False

Question 3

If an FI enters into a loan commitment, it is essentially entering into a forward contract.

Answer 3

False

Question 4

The present value of an off-balance-sheet item is referred to as its notional value.

Question 5

The Federal Reserve requires banks to complete schedule L with their quarterly call reports to list the notional size and variety of off-balance-sheet activities.

Question 6

The extremely high growth of OBS activities since the early 1990s has caused regulators to recognize the potential risk exposure to FIs from their use.

Question 7

The current market value of an off-balance-sheet item is determined by finding the current market value of the underlying item.

Question 8

Off-balance-sheet activities are an important source of fee income for many FIs.

Question 9

All off-balance-sheet items will eventually move on to the balance sheet at some point in time.

Question 10

The delta of an option is the sensitivity of an option's value to a unit change in the value of the underlying asset.

Question 11

Off-balance sheet activities can have both positive and negative effects on the risk of the FI.

Question 12

Interest rate risk is part of the loan commitment contingent risk because of the uncertainty of changes in interest rates before the borrower exercises his option to borrow.

Question 13

The current market value or contingent claim value of OBS items overestimates their notional value.

Question 14

An FI can protect itself against insolvency resulting from off-balance sheet activities by purchasing insurance.

Question 15

A default option is exercised when the holder requests a draw on the loan commitment.

Question 16

The use of an up-front fee by a bank eliminates the contingent risk on a loan commitment.

Question 17

Off-balance-sheet items often are called contingent assets and liabilities because they may, or may not, affect the balance sheet in the future.

Question 18

Off-balance-sheet activities generally have risk-reducing attributes, but seldom have risk-increasing attributes.

Question 19

Off-balance sheet positions are risky because they may yield negative future cash flows.

Question 20

Off-balance-sheet items can generate cash flows that immediately impact the bank's financial performance.

Question 21

The ability to provide loan commitments is a signal to borrowers that the FI has a lower risk portfolio.

Question 22

Takedown risk is the uncertainty involved with the parties involved in the takedown of a loan commitment.

Question 23

Standby letters of credit perform an insurance function similar to that of commercial and trade letters of credit.

Question 24

Contingent credit risk occurs with the use of derivative products and involves the potential default by a counterparty.

Question 25

The back-end fee is the fee charged for making funds available through a loan commitment.

Question 26

Commercial letters of credit are used only in international trade.

Question 27

Commercial letters of credit are guarantees that are issued to cover contingencies that are potentially more severe and less predictable than those covered by standby letters of credit.

Question 28

In many ways, standby letters of credit (SLCs) perform similar functions for a borrower as do loan commitments.

Question 29

One way to completely protect the lender against interest rate risk on a loan commitment is for the lender to price the loan at a variable rate against some index.

Question 30

The use of letters of credit (LCs) and standby letters of credit (SLCs) may result in an FI having a higher concentration ratio than desired for a particular industry.

Question 31

A contractual commitment to make a loan up to a stated amount at a given interest rate in the future is a loan commitment agreement.

Question 32

In the U.S., commercial banks are the only issuers of standby letters of credit.

Question 33

An upfront fee is the fee imposed on the unused balance of a loan commitment.

Question 34

Derivative products used in managing contingent credit risk can only be acquired as over-the-counter arrangements.

Question 35

The aggregate commitment funding risk can increase the cost of funds above normal levels.

Question 36

Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

Question 37

An up-front fee on a loan commitment rewards the FI for its willingness to stand ready to lend the commitment amount during some agreed upon time period.

Question 38

Loan commitment activities increase the insolvency exposure of FIs that engage in such activities.

Question 39

To avoid being exposed to dramatic declines in borrower creditworthiness over the commitment period, most FIs include an adverse material change in conditions clause by which the FI can cancel or reprice a loan commitment.

Question 40

As compared to letters of credit (LCs), standby letters of credit (SLCs) typically are used to cover contingencies that potentially are more severe and which may not be trade related.

Question 41

The estoppel argument used in bank failures is based on the concept of financial unsophistication.

Question 42

If a commercial bank engages in OBS activities, there are no additional capital requirements imposed by regulators.
6 Credit derivatives allow FIs to hedge credit risk on individual assets, but not on portfolios of assets.

Question 43

Funds transferred on Fedwire are settled at the end of the day.

Question 44

The ability to form financial holding companies for the purpose of creating full-service financial institutions has caused an increase in affiliate risk.

Question 45

The source of strength doctrine involving failed FIs in multibank holding company corporate structures has been widely accepted by the courts.

Question 46

When-issued trading involves the commitment to buy and sell securities before they are issued.

Question 47

Settlement risk on wire transfers involves intraday credit risk.

Question 48

The Clearing House Interbank Payments System (CHIPS) is an international wire transfer system owned by the participating banks in the countries in which it is used.

Question 49

Fees from derivative products are an increasing component of noninterest income for many FIs.

Question 50

FIs generally include when-issued OBS items as part of their holdings of option contracts.

Question 51

Contingent credit risk on derivative contracts is more serious for futures contracts than for forward contracts.

Question 52

Loans sold with recourse by an FI may have future contingent liability off-balance-sheet implications for the FI.

Question 53

If an FI is a counterparty to a swap arrangement, it must record the notational value of the swap as the market value.

Question 54

Contingent credit risk is more serious for futures contracts than forward contracts because the over-the-counter arrangements necessary to replicate the guarantees at a later date.

Question 55

To be an affiliate of a holding company, the parent must own at least 50 percent of the shares of the affiliate company.

Question 56

The amount of regulations that have been proposed because of the increased use of risk-reducing OBS derivatives is increasing.

Question 57

More FIs fail as a result of credit risk exposures than either interest rate or foreign exchange (FX) risk exposure.

Question 58

Loans sold without recourse have contingent liability off-balance-sheet implications for the FI that sells the loan.

Question 59

One way to minimize contingent credit risk is to use derivative products sold on organized exchanges.

Question 60

Funds transferred on the Clearing House Interbank Payments System (CHIPS) are settled immediately.

Question 61

Which of the following situations is similar to the externality effect?

A)Exercising an adverse material change in conditions clause as a last resort, thereby canceling or repricing a loan commitment.
B)Increase in the cost of funds above normal levels while many FIs scramble for funds to meet their commitments to customers during a credit crunch.
C)In a loan commitment, the borrower takes down only part of the funds over the specified time-period.
D)The buyer of a commercial letter of credit fails to perform as promised under a contractual obligation.
E)All of the options.

Question 62

The contingent risk effects include:

A)identified-interest rate risk and takedown risk
B)credit risk and aggregate funding risk
C)Both A and B
D)Neither A or B
E)Contingent risk does not have effects

Question 63

Takedown risk in a loan commitment exposes the FI to

A)immediate liquidity risk.
B)basis risk.
C)spread risk.
D)externality effects.
E)future liquidity risk.

Question 64

The National Information Center (NIC) provides an annual list of holding companies with assets greater than $20 billion on its website.

Question 65

An exporter demands a letter of credit in order to

A)guarantee safe delivery of goods to the importer.
B)guarantee receipt of payment from the importer upon receipt of the goods.
C)protect against adverse changes in foreign exchange rates.
D)protect against adverse changes in international interest rates.
E)ascertain the creditworthiness of the importer.

Question 66

Which of the following refers to the fee charged on the unused balance of a loan commitment.

A)Up-front fee.
B)Facility fee.
C)Compensating balance.
D)Commitment fee.
E)Closing costs.

Question 67

Back-end fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.
E)interest payable on the loan commitment.

Question 68

Loan loss reserves are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 69

Up-front fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.
E)interest payable on the loan commitment.

Question 70

If a future credit crunch is possible, a loan commitment may expose the FI to

A)credit risk.
B)interest rate risk.
C)sovereign country risk.
D)funding risk.
E)exchange rate risk.

Question 71

When an FI pre-commits to lending at a fixed rate, it is exposed to

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.
E)exchange rate risk.

Question 72

Off-balance-sheet items are

A)items omitted from the short form balance sheet.
B)contingent assets and liabilities.
C)risk-free assets and liabilities.
D)exceptionally risky assets and liabilities.
E)foreign (off shore) assets and liabilities.

Question 73

Loan commitments are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 74

Rediscounted bankers' acceptances are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 75

Where are the contingent items disclosed in the financial statements?

A)On the assets side of the balance sheet.
B)On the liabilities side of the balance sheet.
C)As footnotes to financial statements.
D)In the income statement.
E)In the director's report.

Question 76

What is a possible reason behind restricted supply of spot loans to borrowers during a credit crunch?

A)Expansionary monetary policy actions of the Federal Reserve.
B)FI's increased aversion toward lending.
C)Shift to the right in the loan supply function at all interest rates.
D)Low aggregate demand from borrowers to take down loan commitments.
E)Decrease in cost of funds.

Question 77

The quantity risk exposure of a loan commitment is

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.
E)exchange rate risk.

Question 78

FIs are competing directly with loan commitments, one of their own OBS products, when they also offer:

A)Futures contracts.
B)Swaps.
C)Standby letters of credit.
D)Forward contracts.
E)When-issued trading.

Question 79

Standby letters of credit are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 80

The increased regulation of the derivatives markets was intended to achieve which of the following objectives?

A)prevent activities in those markets from posing risk to the financial system.
B)promote the efficiency and transparency of those markets
C)prevent market manipulation, fraud, and other market abuses
D)ensure that OTC derivatives are not marked inappropriately to unsophisticated parties.
E)All of the above.