Question 1

The Perdue Bank of Houston,has just hired a new manager who has a reputation of anticipating potential problems and acting quickly to prevent those problems so that the bank stays healthy and profitable.What defense against risk is this bank making?

Accepted Answer

Quality management, including the ability to anticipate potential problems and taking preventative actions, is an effective defense against risk for any organization including banks. The fact that the bank hired a new manager with a reputation for this approach suggests that they are making a concerted effort to minimize risk in their operations. Choices A, B, and D may also be effective strategies for managing risk, but they are not directly related to the actions of the new manager in this scenario.

Question 2

Why do regulators prefer higher capital requirements?

Accepted Answer

Regulators prefer higher capital requirements in order to protect the deposit insurance fund from serious losses. Higher capital requirements ensure that banks have enough equity to absorb potential losses and prevent the need for a bailout, which ultimately protects depositors and taxpayers.

Question 3

A bank has issued $5,000,000 in long term debt and since that time interest rates have risen so that it will only cost the bank $3,000,000 to buy the long term debt back.The bank decides to issue $3,000,000 in new stock and use the proceeds to retire the long term debt.What way of meeting their capital needs is the bank taking?

Accepted Answer

The bank is swapping stock for debt instruments. By issuing $3,000,000 in new stock and using the proceeds to buy back $5,000,000 in long term debt, the bank is essentially swapping out its debt for equity. This can benefit the bank by lowering its overall debt levels and reducing the interest payments it must make, while also leveraging equity to meet its capital needs.

Question 4

The Norton Bank of Illinois,has just issued trust preferred stock.What defense against risk is this bank making?

Accepted Answer

By issuing trust preferred stock, the Norton Bank of Illinois is increasing its owners' capital, which can act as a buffer against potential losses and risks. Trust preferred stock is a hybrid security that has characteristics of both debt and equity, and it can help the bank boost its Tier 1 capital ratio, which measures the bank's ability to absorb losses. Therefore, the best choice is D. A, B, C, and E are not relevant as they do not relate to the bank's strategy of issuing trust preferred stock to defend against risks.

Question 5

The Third State Bank of Denton has decided to issue stock through a trust company and borrow the funds from the trust company.This stock pays a fixed dividend and because of the way the stock has been issued it is tax deductible.What way of meeting their capital needs in the bank taking?

Accepted Answer

Issuing preferred stock that pays a fixed dividend and is tax deductible will meet the bank's capital needs. This approach allows the bank to raise funds without diluting ownership or control, and the fixed dividend payments provide a predictable source of income for investors. Additionally, the tax-deductible status of the dividend payments reduces the overall cost of capital for the bank.

Question 6

Why do banks generally prefer lower capital requirements?

Accepted Answer

Banks prefer lower capital requirements because it allows them to leverage their equity investment and increase their return on equity (ROE). With lower capital requirements, the bank's shareholders can provide less equity funding while still generating a high return on their investment. This is beneficial for the bank because it allows them to maximize profits and increase shareholder value.

Question 7

A bank has capital to risk-weighted assets of 9.2%,Tier 1 capital to risk-weighted assets of 4.5% and a leverage ratio of 3.7%.What type of bank is this?

Accepted Answer

The answer of A bank has capital to risk-weighted assets...

Question 8

The First National Bank of Tucson has determined that the value of their property in Tucson has tripled in the last three years.They decide that they would like to use this property to raise funds and will rent space from the new owners of the building.What way of meeting their capital needs is the bank taking?

Accepted Answer

The bank is selling their property and leasing space from the new owners, which suggests that they are raising funds by selling assets and leasing facilities. This is a common way for companies to meet their capital needs. Options A and B (issuing common or preferred stock) involve issuing new shares of ownership in the company and would not be related to selling property. Option C (issuing subordinated notes and debentures) involves issuing debt instruments, which is not mentioned in the scenario. Option E (swapping stock for debt instruments) also involves a transaction with existing shares of stock, not property.

Question 9

There are three pillars of Basel II.One of them is to make market discipline a powerful force compelling risky banks to lower their risk exposure.What does Basel II want to do to make this happen?

Accepted Answer

Basel II aims to enhance market discipline by requiring greater public disclosure of each bank's true financial condition, allowing market participants to better assess the risk profile of banks.

Question 10

The Michelson Bank of Stetson,wants to protect itself from risk.It decides to make loans in Florida,Georgia,Texas,and Oklahoma as well as invest in municipal bonds from California and Oregon.What defense against risk is this bank making?

Accepted Answer

The bank is spreading its investments and loans across different geographic locations, which is a strategy known as geographic diversification. This helps in reducing the risk that comes from economic downturns or natural disasters affecting a single region.

Question 11

What type of preferred stock has appeared recently that carry a lower cost?

Accepted Answer

Trust preferred stock has appeared more recently and is known for carrying a lower cost compared to traditional forms of preferred stock. This is because it combines the features of both debt and equity, offering tax advantages and flexibility in terms of cost.

Question 12

A bank has capital to risk-weighted assets of 9.2%,Tier 1 capital to risk-weighted assets of 5% and a leverage ratio of 4.8%.What type of bank is this?

Accepted Answer

The bank is considered "Adequately capitalized" based on its capital ratios, which meet the minimum requirements but do not exceed the thresholds that would classify it as "Well capitalized."

Question 13

A bank has capital to risk-weighted assets of 5.5%,Tier 1 capital to risk-weighted assets of 2.8% and a leverage ratio of 2.6%.What type of bank is this?

Accepted Answer

The answer of A bank has capital to risk-weighted assets...

Question 14

A bank has capital to risk-weighted assets of 1.8%.What type of bank is this?

Accepted Answer

A bank with a capital to risk-weighted assets ratio of 1.8% is considered critically undercapitalized according to regulatory standards, which typically require a minimum of 2% to avoid this classification.

Question 15

Even if individual banks are good at forecasting risk using VaR models,there may still be problems because losses may occur at several banks at the same time due to the interdependency of the financial system,magnifying each bank's risk exposure and possibly causing a major problem for regulators.The book calls this:

Accepted Answer

The scenario described in the question refers to systemic risk, which is the risk of a widespread financial crisis or collapse due to the interconnectedness of financial institutions and markets. VaR models may not account for systemic risk, and losses at multiple banks could trigger a domino effect that affects the entire financial system, making it difficult for regulators to contain the damage.

Question 16

Which of the following is not a weakness of Basel I risk-based capital standards?

Accepted Answer

Basel I risk-based capital standards did not ignore credit risk, but it was only partially included. The other options (A, B, C, and E) are all weaknesses of Basel I, as it did not consider interest rate risk, changes in currency and commodity prices, and market value.

Question 17

The Northwest Bank of Charlotte has decided to issue new securities that have five years to maturity that have claims to assets that follow the claims of depositors.What way of meeting their capital needs is the bank taking?

Accepted Answer

The bank is issuing subordinated notes and debentures, as they are securities that have claims to assets that follow the claims of depositors. Issuing common stock or preferred stock involves selling ownership stakes in the bank, while selling assets and leasing facilities would reduce the bank's assets and capabilities. Swapping stock for debt instruments would involve exchanging one form of capital for another, which is not the same as issuing new securities. Therefore, C is the best choice.

Question 18

A bank has decided to retain more of their earnings,moving their retention ratio from 40% to 70%.What way of meeting their capital needs is the bank taking?

Accepted Answer

By changing their retention ratio from 40% to 70%, the bank is deciding to retain more of their earnings instead of paying them out as dividends. This means they will have more funds available to meet their capital needs without having to issue new securities or sell assets. Therefore, the bank is taking the option of changing their dividend policy as a way to meet their capital needs.

Question 19

The Second National Bank of Lincoln has decided that,to raise funds it is going to issue new common equity through a pre-emptive rights offering,so that current owners will not have that ownership diluted.What way of meeting their capital needs is the bank taking?

Accepted Answer

The bank is going to issue new common equity through a pre-emptive rights offering, which indicates that they are issuing common stock to raise funds.

Question 20

A bank has capital to risk-weighted assets of 11.5%,Tier 1 capital to risk-weighted assets of 7.2% and a leverage ratio of 5.8%.What type of bank is this?

Accepted Answer

To be considered well capitalized according to regulatory guidelines, a bank must have a capital to risk-weighted assets ratio of at least 10%, a Tier 1 capital to risk-weighted assets ratio of at least 6%, and a leverage ratio of at least 5%.

In this case, the bank's ratios are all above the regulatory guidelines for being well capitalized, with a capital to risk-weighted assets ratio of 11.5%, a Tier 1 capital to risk-weighted assets ratio of 7.2%, and a leverage ratio of 5.8%. Therefore, the bank is well capitalized.

Quiz 15: The Management of Capital