Chapter 11 Commercial Banks: Industry Overview
True/False Questions1. The merger of banks with assets of $1 billion or more in total assets is called a megamerger.
Answer: True Page: 331 Level: Easy
2. Business loans have dropped in importance since 1990 as measured by the proportion of these loans on the bank balance sheet.
Answer: True Page: 324 Level: Medium
3. Loans comprise the single largest asset category for a bank. Answer: True Page: 322-323 Level: Easy
4. The major risk faced by commercial banks today is credit risk. Answer: True Page: 324 Level: Easy
5. Banks are more highly leveraged than most non-financial firms. Answer: True Page: 324 Level: Easy
6. Revenue economies of scale are cost reductions that occur as banks add related product lines.
Answer: False Page: 331 Level: Medium
7. Nontransaction deposits at banks include NOW accounts and demand deposits. Answer: False Page: 325 Level: Easy
8. The majority of banks are nationally chartered and insured by the FDIC. Answer: False Page: 342 Level: Easy
9. Since 1980 the number of banks in the U.S. has been increasing dramatically due to deregulation of the industry.
10. If average costs to produce a given product are lower for larger firms, cost economies of scope exist.
Answer: False Page: 331-332 Level: Medium
11. The proportion of industry assets controlled by small banks has increased over the last 10 years.
Answer: False Page: 334 Level: Easy
12. Commercial letters of credit are off balance sheet items that are used to back issues of commercial paper by corporate borrowers.
Answer: False Page: 329 Level: Difficult
13. The risks of issuing standby letters of credit cover are not as predictable and may be potentially more severe than the risks of commercial letters of credit.
Answer: True Page: 329 Level: Medium
Multiple Choice Questions
14. Major liabilities for banks include A) Business loans
B) Interest expense paid on deposits C) Deposits
D) Equity capital
E) Securities held for sale
Answer: C Page: 324-325 Level: Medium
15. A decline in the average cost of producing bank services as the size of the bank expands is called
A) Cost economies of scope B) Revenue economies of scope C) Cost economies of scale D) Revenue economies of scale E) X efficiencies
16. A decrease in unit costs after a merger due to joint use of inputs in producing multiple products is an example of:
A) Cost economies of scope B) Revenue economies of scope C) Cost economies of scale D) Revenue economies of scale E) X efficiencies
Answer: A Page: 332-333 Level: Medium
17. Revenue or cost reduction resulting in gains from mergers that are not due to scale or scope economies are called
A) Cost economies of scope B) Revenue economies of scope C) Cost economies of scale D) Revenue economies of scale E) X efficiencies
Answer: E Page: 331 Level: Medium
18. Banks with total assets under _____ are normally called community banks. A) $50 million
B) $100 million C) $500 million D) $1 billion
Answer: D Page: 334 Level: Medium 19. A money center bank is a bank that is
A) Large
B) Operates in a major financial center C) Rely on non-deposit sources of funds D) A. and C. only
E) A. B. and C.
20. In comparison to small banks, larger banks typically have A) More equity capital
B) More core deposits
C) More off balance sheet activities D) Larger net interest margins E) All of the above
Answer: C Page: 335 Level: Medium
21. In terms of profitability, a well run bank usually has an ROA of A) 0.5-3%
B) 3-5% C) 5-10% D) 10-15% E) 15-20%
Answer: A Page: 337 Level: Medium
22. A card that has a chip implanted in the card that allows the customer to store and spend money for various transactions is called a
A) POS card B) Smart card C) Debit card D) ATM card
E) Platinum credit card
Answer: B Page: 340 Level: Easy
23. As a percentage of the typical bank's balance sheet, over the last 50 years _________ have risen and ___________ have fallen.
A) Securities; consumer loans B) Business loans; mortgages C) Securities; all loans D) Mortgages; securities E) Consumer loans; mortgages
24. Key federal regulators of the banking industry include: A) Office of Comptroller of Currency
B) Federal Deposit Insurance Corporation C) Federal Reserve System
D) State bank regulators E) Office of Thrift Supervision F) Only A, B, and C
Answer: F Page: 341-343 Level: Easy
25. Nationally chartered banks receive chartering and merger approval from the A) Federal Deposit Insurance Corporation
B) Office of Comptroller of the Currency C) Federal Reserve System
D) Office of Thrift Supervision
E) Any of the above may grant a charter and approve a merger Answer: B Page: 341-342 Level: Medium
26. State chartered banks _____ be members of the Federal Reserve System and nationally chartered banks _____ be members of the Federal Reserve System: A) Must, may
B) Must, must C) May, must D) May, may
Answer: C Page: 342 Level: Easy
27. The largest single category of loans on the typical bank's balance sheet in 2004 was: A) U.S. government securities
B) Commercial and industrial loans C) Consumer loans
D) Real estate loans E) Inter-bank loans
28. Deposit sources of funds at commercial banks in 2004 comprised almost _____ of liabilities and equity:
A) 55% B) 65% C) 75% D) 85% E) 95%
Answer: B Page: 323 Level: Medium
29. From 1951 to the present the fastest growing asset on the balance sheet for U.S. commercial banks has been:
A) Consumer loans B) Mortgages C) Business loans D) Securities E) Equities
Answer: B Page: 325 Level: Easy
30. The provision of banking services to other banks, such as check clearing, foreign exchange trading, etc. are examples of
A) Correspondent banking B) Trust services
C) Off balance sheet assets D) Economies of scope E) Credit derivatives
Answer: A Page: 330 Level: Medium
31. Economies of scale imply that the average cost curve is _____ with respect to bank size.
A) Downward sloping B) Upward sloping C) Flat
D) Vertical
32. A bank had average revenues of $130 million and average costs of $100 million. An insurer had average revenues of $75 million and average costs of $60 million. After a merger between the two, the new institution had average revenues of $220 million and average costs of $160 million. This is an example of
A) Cost economies of scale B) Cost economies of scope C) Revenue economies of scale D) Revenue economies of scope E) X efficiencies
Answer: D Page: 332 Level: Difficult
33. Recently, the largest off balance sheet activity by banks has been in A) Swap agreements
B) Standby letters of credit and commercial letters of credit C) Futures and forward contracts
D) Loan commitments
E) Commitments to buy/sell foreign exchange Answer: A Page: 332-334 Level: Medium
34. A contingent item that may eventually be placed on the right hand side of the balance sheet or expensed on the income statement is a/an
A) Loan commitment
B) Off balance sheet liability C) Off balance sheet asset D) Net charge off
E) Loan sold without recourse
Answer: B Page: 327 Level: Medium
35. A bank had average revenues of $140 million and average costs of $110 million. Another bank that offered similar services had average revenues of $90 million and average costs of $70 million. After a merger between the two, the new institution had average revenues of $130 million and average costs of $160 million. This is an example of
A) Cost economies of scale B) Cost economies of scope C) Revenue economies of scale D) Revenue economies of scope E) X efficiencies
36. The time interval between the deposit of a check and when the funds become available for depositor use is called
A) Lockbox delay B) Process fix C) Float D) EFT wait E) POS delay
Answer: C Page: 338 Level: Easy
37. After Bank A merged with Bank B, costs per unit actually rose rather than falling as predicted. This is an example of
A) Cost economies of scale B) Cost economies of scope C) X efficiencies
D) Diseconomies of scale E) Regulatory burden
Answer: D Page: 332 Level: Easy
38. One of the reasons for strong bank profitability in 2004 was the low _________________.
A) NCO / Loans ratio B) ROA
C) ROE
D) Net interest margin
E) Off balance sheet income ratio Answer: A Page: 337 Level: Easy
39. A technology based cash management account feature that allows almost all payments that will be made in a given day to be known in the morning is called a
A) Funds concentration account B) Electronic lockbox
C) Controlled disbursement account D) Treasury management account E) Electronic data interchange
40. Of the top 20 global banks as measured by asset size, __________ are U.S. banks. A) Two B) Three C) Five D) Six E) Nine
Answer: A Page: 344 Level: Easy
41. Which of the following is the primary regulator of bank holding company activities? A) Federal Bank Holding Company Board
B) FDIC
C) Federal Reserve
D) State regulatory agency in the chartering states E) U.S. Treasury
Answer: C Page: 343 Level: Easy
42. Banks differ from other types of depository institutions in that: I. Banks have more diversified asset portfolios
II. Banks obtain funds from more different types sources
III. The average size bank is larger than other depository institutions A) I only
B) I and II only C) I and III only D) II and III only E) I, II and III
Answer: E Page: 322 Level: Difficult
43. Advantages of going global for U.S. banks include all but which one of the following? A) Diversification of earnings
B) Greater opportunities to exploit economies of scale C) Greater sources of funds
D) Conducting business in less regulated environments E) Low fixed costs involved in international expansion Answer: E Page: 343-345 Level: Medium
44. Technological innovations in banking services are changing bank cost structures by increasing fixed costs and decreasing variable costs per unit. The effects of these changes include
I. Increased cost economies of scale and scope II. Increased dominance of large banks in the industry
III. Increased risk of excess capacity and technological breakdowns A) I only
B) I and II only C) I and III only D) II and III only E) I, II and III
Answer: E Page: 332 Level: Difficult
Short Answer Questions
45. The ROA for financial institutions such as banks is typically quite low as compared to non-financial firms. Why? With such a low ROA how can banks attract stockholders? Answer: Microeconomics tells us that firms earn positive net present values by
producing a good or service that not enough other firms can perfectly duplicate, at least not at the same cost. Because the major assets of a bank are pieces of paper (loans and securities), it is difficult for a bank to generate substantially positive NPVs and earn a large ROA. For instance, an ROA of 2% for a bank is outstanding. Trying to convince your stockholders that a 2% return on their investment is outstanding is however quite difficult! To get an acceptable ROE, (the rate of return to the
shareholder) banks must resort to using a very high amount of leverage. The debt/asset ratio at a bank is usually over 90%. Page: 322-324 Level: Difficult
46. How is technology changing wholesale and retail banking services? Give some examples of each. Which area is likely to utilize new technology more rapidly, wholesale or retail banking? Why?
Answer: Technology is beginning to provide whole new methods of accessing bank services and is creating new bank services. For example at the wholesale level, banks are offering real time working capital management methods and related items such as controlled disbursement accounts, up to the minute electronic reconciliations of accounts, electronic lockboxes and automated payments and payment authorizations using SWIFT, CHIPS, or the Fedwire as appropriate. In addition banks are offering services that reduce the cost of supply management for firms including electronic data interchange to facilitate business to business interactions such as electronic purchasing orders and invoices, electronic billing and verification of identities of transacting parties. At the retail level, the use and availability of ATMs continues to grow nationally and internationally, point of sale debit cards, home banking, automatic payment of monthly bills electronically, smart cards and online banking are just a few of the services being offered.
Wholesale electronic banking will almost assuredly progress more rapidly, individuals still need and want to have customer service to handle technical glitches, straighten out errors and assist them in their financial needs. Internet only banks have not been particularly successful for these reasons. Page: 338-341 Level: Difficult
47. Why are loans such a high percentage of total assets at the typical bank? What four broad classes of loans do banks engage in?
Answer: Loans are the highest earning asset on the bank balance sheet. In order to compete and reward its shareholders, banks must invest heavily in their highest returning asset. Prior to deregulation and increased competition, banks held much lower percentages of loans.
The four major loan categories are commercial and industrial loans (loans to businesses), mortgage loans, consumer loans and the ubiquitous "other" category. Page: 324 Level: Easy
48. Most non-financial firms would never hold as much of their assets in safe liquid securities as banks do. Why do banks maintain such a high percentage of investment in securities?
Answer: To answer this we must look at the right hand side of the balance sheet as well as the left side. A major portion of bank funds are raised through short term deposits that people can choose to withdraw at short notice. Consequently, banks must plan for withdrawals and keep a significant portion of their assets in cash or near cash investments. Likewise, banks must have cash available for loan customers and to honor previous loan commitments. So even though much of the investment portfolio earns only low rates of interest, banks must maintain liquid reserves to meet loan demand and deposit withdrawals. Page: 324-326 Level: Medium
49. What are the major sources of funds for banks? Provide a breakdown of all the major sources of funds at a bank and briefly describe the different types of deposits/non-deposit sources.
Answer:
• Equity: Common stock, paid in capital and retained earnings
• Deposits: The main source of funding
• Transaction accounts are comprised of demand deposits (pay no interest) or NOW accounts (negotiable order of withdrawal or an interest bearing checking account)
• Retail savings and time deposits (<$100,000 in size) savings have no fixed maturity, while time deposits have a set maturity date.
• Large time deposits (>$100,000) are negotiable certificates of deposit that can be resold to other investors prior to maturity.
• Non-deposit liabilities include loans from other banks, repurchase agreements and bonds.
50. What are the major advantages a bank gains by expanding into international bank services? What are three disadvantages of international expansion?
Answer: Better diversification by expanding beyond the home market, greater economies of scale and scope, more sources of funds, a greater ability to provide banking services to large international corporate customers, ability to move into other product lines not allowed in the home country, avoiding domestic regulations and oversight. Disadvantages include higher exposure to risk. In particular foreign lending has been quite risky and has experienced much higher default rates than other loan types. It is often difficulty to properly assess a borrower's risk in other countries with less stringent accounting practices for example. The risk of having ones assets expropriated is present, and foreign banks are often used as scapegoats when
economic problems emerge, as in Argentina recently. The fixed costs of establishing foreign operations can be quite high, increasing the riskiness of foreign expansion. Page: 343-345 Level: Difficult
51. Why are banks different from other depository institutions?
Answer: Banks are the main conduit of monetary policy, they are also critical in operating the nation's payments system. The banking industry constitutes the nation's largest intermediary and is one of the major methods of allocating credit in the
economy. Banks provide risk, liquidity and maturity intermediation that encourages savers to make their money available to the system and thus encourages economic growth. Page: 322 Level: Difficult
52. What challenges face the banking industries in China and Germany?
Answer: In China, the state run banks face huge amounts of bad loans that need to be written off the books. Their banking system is not effective at allocating credit according to realistic evaluations of risk and return. China is slowly allowing more foreign ownership of banks. In Germany a weak economy is hurting bank
profitability. Moreover, regulations favoring small institutions are creating funding problems at large banks. Page: 346 Level: Difficult
53. Discuss the major differences between large banks and small banks. Which have had higher ROAs? Why?
Answer:
Large banks tend to have:
• Lower equity (%)
• Easier access to capital markets, hence they often hold a lower percentage of liquid securities.
• More business loans, business borrowers often have greater bargaining power so profitability on these loans can be low.
• Lower interest rate spreads.
• Higher salaries
• More non-interest income (and expense)
• More diversified
• More aggressively managed
• The picture that emerges is that smaller banks tend to operate in less competitive markets and are more conservatively managed. In terms of
profitability, large banks will tend to have lower ROAs but may often have higher ROEs when banks are performing well because they take more risks and have less equity.
• In periods of poorer bank performance, the more conservative tactics of smaller banks are likely to result in better ROA and ROE than large banks. Page: 334-338 Level: Difficult
54. What do economies of scale and scope imply about the long run viability of the current structure of the banking industry? In particular, do you expect to see the number of banks continue to decline in the U.S.? Why or why not?
Answer: Economies of scale and scope imply that large banks will be more profitable and will be able to outcompete smaller institutions and eventually drive them out of business. Smaller banks that specialize in customer service or other niches may survive, but it is not likely that the large number of small institutions that are now operating in the U.S. will survive in the long run, most will likely be absorbed by merger and acquisitions. On the other hand if large institutions run into large enough diseconomies of scale such as excess capacity problems, technology and cultural integration costs as they grow, small banks may be able to remain profitable enough to survive on their own. Page: 332 Level: Medium
55. Why have banks been so profitable in this decade?
Answer: Low interest rates have kept loan defaults low and encouraged borrowing. This has kept loan losses (a charge against earnings) low. Non-interest income has also improved with the growth of fee based services, many of which are off balance sheet. The boom in housing has led to growth in mortgage markets. The development of credit derivatives and mortgage securitization has allowed banks to pass on risk to other entities and continue a high pace of lending. Improvements in information technology have helped banks understand and manage risk better.
