Question 1

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

Accepted Answer

By providing loan commitments, the FI is showing its willingness to lend and its confidence in its ability to manage its risk. This indicates to borrowers that the FI has a lower risk portfolio, as it is willing to lend to them and is confident in its ability to manage the associated risks.

Question 2

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

Accepted Answer

Takedown risk refers to the risk that the interest rates will increase between the time a borrower commits to a loan and the time the loan is actually funded or taken down, not the uncertainty involving the parties.

Question 3

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

Accepted Answer

Standby letters of credit act as a guarantee of payment to the beneficiary if the applicant fails to fulfill their obligations, similar to how commercial and trade letters of credit provide a guarantee of payment for goods and services.

Question 4

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

Accepted Answer

Contingent credit risk is a real risk when using derivative products because there is always the chance that the counterparty may default on their obligation.

Question 5

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

Accepted Answer

The back-end fee typically refers to a fee charged when exiting an investment or finalizing a transaction, not for making funds available through a loan commitment.

Question 6

Commercial letters of credit are used only in international trade.

Accepted Answer

Commercial letters of credit are primarily used in international trade to reduce risks such as unfamiliarity with the foreign party and customs issues, but they can also be used in domestic transactions to mitigate risks between unfamiliar parties.

Question 7

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.

Accepted Answer

Commercial letters of credit are primarily used to facilitate international trade by guaranteeing payment to the seller upon fulfillment of specified terms, while standby letters of credit serve as a backup payment mechanism for financial or performance obligations, potentially covering more severe and less predictable contingencies.

Question 8

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

Accepted Answer

Standby letters of credit (SLCs) and loan commitments both provide a level of assurance to a borrower that funds will be available when needed. Both are issued by banks and can be used to support a wide range of financing needs. However, there are also some key differences between the two, such as the terms and conditions under which they can be drawn upon.

Question 9

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.

Accepted Answer

The answer of One way to completely protect the lender...

Question 10

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.

Accepted Answer

LCs and SLCs are often used in international trade transactions and can contribute to a higher concentration of credit exposure in a particular industry or geographic region.

Question 11

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.

Accepted Answer

The statement accurately defines a loan commitment agreement.

Question 12

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

Accepted Answer

Standby letters of credit can also be issued by other financial institutions such as savings banks, credit unions, and foreign banks.

Question 13

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

Accepted Answer

An upfront fee is a fee charged by a lender at the time a loan is made. It is not related to the unused balance of a loan commitment.

Question 14

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

Accepted Answer

Derivative products used in managing contingent credit risk can be acquired both as over-the-counter arrangements and through exchanges.

Question 15

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

Accepted Answer

The aggregate commitment funding risk refers to the risk that a lender or investor may not be able to meet its commitment to fund a borrower or issuer, leading to increased costs or disruptions in funding. This risk can increase the cost of funds above normal levels.

Question 16

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

Accepted Answer

Basis risk refers to the risk that arises when the spread between the pricing index and the cost of funds changes, causing the lender to potentially earn a different net interest margin than expected. This can happen on a loan commitment (a promise to lend money at a future date) if the spread moves between the time of commitment and the time the loan is actually made.

Question 17

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.

Accepted Answer

An up-front fee on a loan commitment compensates the financial institution for the risk it takes in committing to lend a certain amount over a specified time period. It rewards the FI for its willingness to make that commitment available to the borrower.

Question 18

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

Accepted Answer

Loan commitment activities involve the commitment of funds to borrowers that may not be immediately available to the financial institution (FI). If borrower defaults increase or market conditions change, the FI may be unable to honor these commitments, leading to insolvency risk. Therefore, loan commitment activities can increase the insolvency exposure of FIs.

Question 19

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.

Accepted Answer

This statement is true. FIs include an adverse material change clause in loan commitments to protect themselves from significant declines in borrower creditworthiness. This clause allows them to either cancel or renegotiate the terms of the commitment if certain negative events occur.

Question 20

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.

Accepted Answer

SLCs are often used as a form of financial guarantee to cover contingencies such as non-payment or non-performance on a contract. They are not necessarily tied to any specific trade transaction, unlike LCs which are primarily used to facilitate international trade.

Quiz 16: Off-Balance-Sheet Risk