Deck 16: Off-Balance-Sheet Risk

Question 1

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

Answer 1

True

Question 2

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

Answer 2

True

Question 3

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.

Answer 3

True

Question 4

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

Question 5

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

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

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

Question 8

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

Question 9

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

Question 10

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

Question 11

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

Question 12

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

Question 13

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

Question 14

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

Question 15

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

Question 16

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

Question 17

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 18

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

Question 19

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 20

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

Question 21

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

Question 22

If a commercial bank engages in OBS activities, there are no additional capital requirements imposed by regulators.

Question 23

Commercial letters of credit are used only in international trade.

Question 24

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

Question 25

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 26

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

Question 27

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 28

In many ways, SLCs perform similar functions for a borrower as do loan commitments.

Question 29

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 30

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

Question 31

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

Question 32

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

Question 33

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

Question 34

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

Question 35

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

Question 36

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

Question 37

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 38

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

Question 39

As compared to LCs, SLCs typically are used to cover contingencies that potentially are more severe and which may not be trade related.

Question 40

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

Question 41

Credit derivatives allow FIs to hedge credit risk on individual assets, but not on portfolios of assets.

Question 42

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 43

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

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

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

Question 46

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 47

Settlement risk on wire transfers involves intraday credit risk.

Question 48

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

Question 49

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 50

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

Question 51

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

Question 52

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 53

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

Question 54

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 55

Funds transferred on CHIPS are settled immediately.

Question 56

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

Question 57

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 58

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 59

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

Question 60

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

Question 61

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 62

As of 2012, the top 25 U.S. commercial banks accounted for ________ percent of OBS derivative contracts among FDIC-insured institutions.

A)100
B)99.8
C)92.6
D)81.9
E)60.7

Question 63

Which of the following is the newest addition to the derivative securities markets?

A)Options contracts.
B)Futures contracts.
C)Swap agreements.
D)Forward contracts.
E)Credit derivatives.

Question 64

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 65

An "adverse material changes in conditions" clause is included in loan commitments to protect the FI against

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

Question 66

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 67

The effect to an FI of default by the counterparty to a derivative contract is LEAST serious with

A)options contracts.
B)futures contracts.
C)swap agreements.
D)forward contracts.
E)loan commitments.

Question 68

Which of the following statements best describe a derivative contract?

A)Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C)Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future.
D)Trading in securities prior to their actual issue.
E)Loans originated by an FI and then sold to other investors with recourse.

Question 69

Which of the following is true of the market price of an options contract over time?

A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It increases with time to expiration.
E)It is based on supply and demand.

Question 70

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 71

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 72

Which of the following is true of the market price of a futures contract over time?

A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It decreases with time to expiration.
E)It is based on supply and demand.

Question 73

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 74

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 above.

Question 75

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 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

As of June 2012, the vast majority of OBS activities of commercial banks was

A)future and forward contracts.
B)credit derivatives.
C)commitments to buy FX.
D)swap contracts.
E)loans sold with recourse.

Question 78

Which of the following is true of an 'adverse material change in conditions clause' used in a loan commitment?

A)It allows the FI to cancel or reprice a loan commitment.
B)It protects the lender against takedown risk.
C)It protects the lender against basis risk.
D)Exercise of the clause helps defaulted borrowers.
E)It is exercised frequently by most FIs.

Question 79

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 80

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.