Deck 1: Financial Institutions As Social Value Creators and Financial Risk Takers

Question 1

Should managers of financial institutions be concerned about other stakeholders (i.e. regulators, depositors, uninsured debt-holders, community, employees, customers)? Explain how problems for corporate cultures for financial institutions contributed to serious problems for financial institutions and their customers and other stakeholders giving a recent example.

Answer 1

Financial institutions have obligations to consider repercussions of their strategies and actions for all stakeholders that determine their reputation and success including stockholders, regulators, depositors, uninsured debt-holders, community, and customers. This is particularly the case for depository institutions that are chartered to serve their communities and to abide by federal and state regulations. The U.S. Subprime Loan Crisis is an example of the serious repercussions when financial institution managers fail to have good corporate governance, and corporate cultures that value all stakeholders that add to the success and reputation of a financial institution.
By having cultures that encouraged short-term profits and provided bonuses for making quantities of loans versus the quality of loans and ability for borrowers to repay loans, for instance contributed to huge numbers of bankruptcies when housing prices collapsed. Wells Fargo's scandal in September 2016 is another example where managers did not consider customers as stakeholders and a corporate culture was created pushing employees for sales goals versus serving customers' best interests. Wells Fargo managers imposed a high-pressure tactics on employees to push products on customers to hit sales goals. This led to fraudulent behavior by employees, where 2 million customer accounts were opened without customers' knowledge. When this scandal was uncovered, Wells Fargo's stock price plunged, and Wells Fargo had serious reputational damage losing major clients and customers. Wells Fargo was given a $185 million fine, and 5,300 employees were fired, and a new CEO put in place. Under the Sarbanes-Oxley Act, Wells Fargo also violated the requirement that executives personally required to certify that a bank has financial and operational controls in place.

Question 2

In setting strategies for risk/return for a financial institution, what would be the likely respective opinions of different stakeholders (stockholders, uninsured debt-holders, regulators, managers, and insured depositors) for taking on more or less risk? Explain why some stakeholders prefer more risk than others.

Answer 2

Stockholders with limited liability with a maximum loss their investment may prefer greater risk-taking with in effect a put option where future returns on a small investment are unlimited, but the investment loss is limited to the amount a shareholder invests. Uninsured debt-holders, in contrast, would prefer that managers take less risk to ensure that they will be paid back. Similarly, regulators would prefer that managers take less risk to protect the financial system from financial institution failures, and to ensure against losses for deposit insurance funds. Managers may or may not prefer more or less risk taking depending on bonuses, salary incentives, and the culture of the organization, desiring to protect their own human capital, in terms of their jobs. During the Subprime Loan Crisis, with bonus and fee incentives to make a large volume of loans versus the quality of loans, lenders were encouraged to engage in greater risk taking. Depositors would prefer lower risk taking to protect the bank against failure, but have less incentive to monitor the bank than other debt holders for insured deposits.

Question 3

Given the quote at the beginning of Chapter 1: "At its most basic definition, finance is the act of allocating capital to individuals and businesses that want to make productive use of it. In short finance creates social value," discuss how financial institutions provide benefits to individual, businesses, and an economy, giving examples for different types of financial institutions.

Answer 3

Financial institutions, when they are working well, create social value by providing funds to businesses and individuals that these borrowers in turn can use for productive purposes. Examples include banks providing financing and guidance for small as well as medium sized, and large businesses. This in turn provides a stimulus for economic growth. Banks also provide social value by ensuring a stable and safe payments mechanism and by encouraging savings. Mutual funds provide diversified investments and the means for consumers to save for future goals, such as retirement, dream vacations, college tuition for their children, and other financial needs. Life/Health insurance companies provide protection in the event of adverse events and health coverage payments, and P/L companies provide protection against property damage and liability protection in the event of adverse events. Venture capital firms provide funds for start-ups including new innovations, such as new disruptive technologies to help solve environmental challenges, among other examples.

Question 4

Give an example of direct finance and an example of indirect finance and the benefits provided by financial intermediaries giving examples for depository institutions, mutual funds, and contractual financial institutions.

Question 5

Discuss how technology has affected financial institutions, giving examples of both increased opportunities and risks for FIs with new technologies. Give some examples.

Question 6

Discuss how bank asset and liabilities differ from those of a firm with physical assets, such as a manufacturing firm. What are typical assets and liabilities for a bank? What special risks does a bank have because of the nature of its assets and liabilities?

Question 7

The Silver Mountain Bank has interest revenue of 10%, interest expense of 6%, a provision for loan loss to assets of 1%, noninterest expense of 4%, and noninterest revenue of 2%, and equity to total assets of 10%. What is the bank's NIM%, Burden%, OROA, and what is its OROE? If the bank's equity to total assets ratio went up to 11%, what would be the new OROE?

Question 8

The Go Broncos Bank has the following questions it would like to ask you about its bank. The bank's balance sheet is as follows:

a. What is the bank's expected net interest income $(NII) and expected net interest margin (NIM)? [Hint: NII = Sum (Each asset x its rate) - Sum (Each liability x its rate) and NIM = NII / Earning Total Assets (excludes cash)]
b. If the bank has the NIM% that you calculated above, a PLL% of 0.50%, and a Burden% of 1.50%, what is the bank's operating ROA before taxes (NIM - Burden% - PLL%)? (OROA) _______1.90%________
c. What is the equity multiplier (EM) for the bank? (Hint: EM = total assets/equity)
d. Using this equity multiplier, what is the bank's Operating ROE?
(Hint: ROE = OROA x EM)
e. What is the bank's 1-year income (funding) gap (Rate Sensitive Assets (RSA) for 1 year - Rate Sensitive Liabilities (RSL) for 1 year?
f. Given this funding gap if rates go up by 1%, what is the expected change in the bank's NII $? (Hint: Change NII $ = Funding Gap x Change Rate)

Question 9

Briefly discuss different balance sheet indicators for credit risk including loan risk indicators and loan loss allowance and earnings coverage ratios. Why is it important also to look at the loan mix that a bank has to examine its credit risk?

Question 10

Why is it important when examining liquidity risk for banks to look at the asset side, liability side, and off-balance sheet side?

Question 11

What is a bank's efficiency ratio and how is it calculated as an overall measure of a bank's operating risk?

Question 12

In the aftermath of the U.S. Subprime Crisis, there have been many challenges to the theory of stockholder's wealth maximization, arguing an expansion of the fiduciary duty of directors to manage in the interests of a broad range of stakeholders, who benefit from the long-run success of the corporation (e.g., stockholders, employees, creditors, managers, local governments, that contribute to a firm's ability to succeed). Explain the pros and cons of this view provided by Chandler (2015), Samuelson and Padro (2015), and others.

Question 13

In recent years, there has been greater emphasis made for strategic decisions to include other stakeholders including the consideration of environmental, social, governance (ESG) factors in the decision-making framework. Research has also shown additional benefits with empirical findings that if firms include ESG factors in decisions, firms will maximize shareholders' wealth by attracting better and more loyal employees and customers. Explain why incorporating ESG factors in decision-making could help improve the reputation and long-term performance of a financial institution.

Question 14

Explain why financial institution managers of depository institutions have a balancing act in managing multiple stakeholders including a discussion of the different stakeholders and managerial objectives associated with each of these.

Question 15

When financial markets and institutions are working well:

A) They create social value by providing funds to businesses and individuals that can be used for productive purposes.
B) A financial crisis occurs.
C) Managers engage in managerial expense preference behavior buying lavish furniture for their offices and taking high travel expenses and getting other perks.
D) Managers get large fees from pushing products on consumers and making large volumes of subprime loans.

Question 16

Financial intermediation is beneficial to an economy by:

A) Lowering transaction costs.
B) Providing investment diversification.
C) Providing liquidity and risk reduction services.
D) All of the above.

Question 17

Which is the best answer for the most defining characteristic of a depository institution that distinguishes it from other types of financial institutions?

A) Depository institutions take deposits (as liabilities on their balance sheet) that are used to make loans (that are assets on their balance sheets).
B) Depository institutions have large vaults for cash.
C) Depository institutions offer credit cards.
D) Depository institutions provide check-writing services.

Question 18

If a customer comes to the bank and starts a savings account, for the
Customer and for the bank, this is respectively:

A) A financial asset for the bank and a financial liability for the customer.
B) A financial asset for the customer and a financial liability for the bank.
C) A financial liability for both the customer and the bank.
D) An off-balance sheet account for both the customer and the bank.

Question 19

A depository institution differs from a non-financial firm in which of the following ways?

A) A depository institution has primarily financial vs. real assets.
B) A depository institution has much higher financial leverage.
C) A depository institution uses deposits to fund loans.
D) A depository institution generally has lower operating leverage.
E) All of the above.

Question 20

A bank has total assets of $100 million including loans of $50 million that pay an interest rate of 10% financed by $40 million of deposits paying an interest rate of 5% and $10 million in equity. What is the bank's Net Interest Margin (NIM)?

A) 2%
B) 3%
C) 5%
D) 4%

Question 21

A savings and loan has a return on assets (ROA) of 1.5%, and an equity to asset ratio of 8%. What is ROE?

A) 12%
B) 15%
C) 18.75%
D) 20%

Question 22

A credit union has a net interest margin (NIM) of 4%, a Burden of 1%, a Provision for Loan Loss % of 0.50%, and an equity multiplier (assets to equity) of 10. As a non-profit organization, it does not pay taxes, what are the credit union's ROA and ROE?

A) 2.5% and 25%
B) 10% and 150%
C) 15% and 150%
D) 3% and 30%

Question 23

A bank has rate sensitive assets of $100 and rate sensitive liabilities of $200, which of the following answers is correct for the bank?

A) It has a negative funding gap and will have a lower NIM if rates fall.
B) It has a positive funding gap and will have a lower NIM if rates rise.
C) It has a positive funding gap and will have a lower NIM if rates fall.
D) It has a negative funding gap and will have a lower NIM if rates rise.

Question 24

Depository institutions have the lowest interest-rate risk of all the types of financial institutions.

Question 25

If two banks A and B have the same positive ROA, but Bank B has higher financial leverage (i.e. a lower equity to asset ratio), Bank A will have a higher ROE than Bank

Question 26

To measure credit risk, which of the following are indicators of greater credit risk for a bank's loan portfolio relative to another bank.

A) A higher % of commercial real estate and construction development loans.
B) A large % of net loan losses.
C) A low earnings to net loan losses ratio.
D) A low loan allowance to net losses ratio.
E) All of the above.

Question 27

Which of the following are indicators of greater liquidity risk for a bank?

A) A lower core deposit to total liabilities ratio.
B) A larger percentage of off-balance sheet loan commitments.
C) A lower percentage of short-term securities to assets.
D) All of the above.

Question 28

Financial institution managers should act in their own interests, excluding the interests of other stakeholders.

Question 29

Direct financing is preferable to indirect financing, since a financial intermediary doesn't have to be involved, and it's easy for borrowers and lenders to find each other.

Question 30

If a bank has an ROA of 1% and an equity to total assets ratio of 10%, what is the bank's equity multiplier, and what is its ROE?

A) EM of 12 and ROE of 12%
B) EM of 1 and ROE of 1%
C) EM of 10 and ROE of 10%
D) EM of 8 and ROE of 18%

Question 31

A Dupont Analysis of ROA and ROE recognizes the effects of which factors on ROE?

A) Cost efficiency as shown by the net profit margin (NPM)
B) Revenue generation as shown by asset utilization (AU)
C) Financial leverage as shown by the equity multiplier (EM)
D) All of the above.

Question 32

Banks A & B have the following overall efficiency ratios
= [Total Overhead Expense / (Net Interest Income + Noninterest Revenue)]
Bank A has an efficiency ratio of 56.5% and Bank B 66.7%.
True or False: Bank B is more efficient in its operating efficiency than Bank

Question 33

The Favorite Bank has the following balance sheet (in millions):
$\begin{array}{lr}\text { Assets: } 1 \text { year Consumer Loans (rate 10\%) } & \$ 100 \\\text { Liabs.: } 10 \text {-year Certificates of Deposit (rate 9\%) } & \$ 80 \\\text { Equity: } & \$ 20\end{array}$ True or False: The bank has a 1-year positive funding gap of $100 mil.
This implies that if rates rise, the bank's NIM will rise.

Question 34

Incorporating environmental, social, and governance (ESG) factors in decision-making by firms has generally shown these firms to have lower financial performance for firms on average.