Class Exercise Packet

FIN: 5330 Bank Management

NAME: ________________________

• It needs to be handwritten.
• The score for late submission will be reduced by 20%
• The primary purpose of this exercise is to keep up up-to-date
date with the material and help you grasp the material. So,
please work on them throughout the semester and not wait
until the last week before it is due.

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 Class Exercise 1
FIN 5330 Bank Management
Chapter 1: An overview of the Changing Financial-Services Sector

Name: ______________________________________________________________________________

1. The purpose of banks is to act as a financial intermediary and allocate capital efficiently. What does it
mean to allocate capital efficiently, and why are banks suited for it?

2. The reason financial intermediaries have prospered in the last few centuries is that they have a superior
ability to evaluate information, they are uniquely suited to engage in risky arbitrage, and they perform the
role of delegated monitors. Explain why banks are better at these activities.

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3. What does this picture tell us about the banking industry?

4. a. What does this picture tell us?

b. What has happened in the last 25 years that the number of small banks have declined?

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 Class Exercise 2
FIN 5330 Bank Management
Chapter 2: The Impact of Government Policy and Regulation on Banking and Financial-Service Industry

Name: ______________________________________________________________________________

1. What does a social planner want to achieve with the banking industry?

2. Why and how does the central bank try to control the interest rate in the economy?

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3. When the Central bank sells securities (i.e. Treasury bill, bond and notes) the interest rates increases?
(Hint: it will decrease money supply). Here is a useful link:
https://www.investopedia.com/ask/answers/06/openmarketoperations.asp

4. When Central bank buys securities (i.e. Treasury bill, bond and notes) interest rate decreases—why?

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 Class Exercise 3
FIN 5330 Bank Management
Chapter 3: The Organization and Structure of Banking and Financial-Services Industry
Name: ____________________________________________________________________________

1. What was that act that made Financial Holding company possible? What was the main idea behind
passing such an Act?

2. What are the advantages of turning into a Financial Holding company?

3. What are the disadvantages of turning into to a Financial Holding company?

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4. What is this picture trying to communicate?

5. Larry wall is an economist at the Federal Reserve Bank of Atlanta. Below is an excerpt of his
interview to Ton Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine
Source: https://www.frbatlanta.org/podcasts/transcripts/economy-matters/170105-discussion-
bankings-too-big-to-fail-problem
Heintjes: Let me ask you: Why are some financial firms treated as too big to fail?

Wall: I think the fear on the part of policymakers is that the failure of a major financial firm or firms
could lead to a breakdown in the provision of financial services to the rest of the economy. This
breakdown could lead to a deeper recession, or even a depression. For example, several estimates
find that the collapse of the financial system after Lehman's failure [in 2008] resulted in trillions of
dollars of lost GDP. Moreover, these are not just abstract numbers; many individuals and families
were financially devastated by the Great Recession that followed Lehman.

Confronted with the risk of such a collapse, and typically having little time to craft a solution,
policymakers often perceive the lowest cost way to avert a financial system collapse is to bail out the
distressed banks.

Heintjes: Well, if TBTF policies avoid the risk of such large losses, why are so many opposed to
TBTF? Is it just because such policies seem unfair to the rest of society?

Wall: TBTF policies certainly seem unfair to those who are paying the costs. The people who made
the decisions that resulted in the banks getting into trouble receive the bailout, while the bill is paid
by people who had no say in the decisions.

Heintjes: So, in one sense, TBTF is seen as a fairness issue.

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Wall: Yes, it is a fairness issue, but it's more than just a fairness issue. TBTF also distorts competition
by giving larger firms a competitive advantage. Too big to fail also distorts investment decisions by
encouraging banks to fund higher-risk projects.

A common way of expressing this concern is that the banks can take the attitude of "heads, I win and
my bank earns big profits; tails, the taxpayers take big losses."

But I think the problem is actually a bit more subtle, because I don't think bank managers think that
way when they're making decisions most of the time. I think it's more like the dog that didn't bark in
Sir Arthur Conan Doyle's The Hounds of the Baskervilles.

Bank depositors and other creditors should charge higher risk premiums to the more risky banks. But
if the bank is TBTF, they aren't so much at risk so they don't charge the premiums. The people that
then are running the banks observe that they can invest in higher-return assets without paying for the
risks those assets generate. If the bank does so, they can boost shareholder returns and so they take
advantage of the opportunity. Thus, one consequence of too big to fail policies is that it results in
larger, riskier banks that would make a future crisis more likely.

Heintjes: Larry, you say that policymakers perceive the lowest-cost solution to be a bailout, but
given the bad consequences of "too big to fail," should we ask if bailouts are really needed to protect
the economy—and if not, maybe we would be better off by banning all bailouts?

Wall: Answering whether bailouts really are needed is difficult. As a practical matter, it's very hard to
prove beyond all doubt they are needed, but it's often just as difficult to prove they are not. One
needs to forecast what would have happened had the government not taken the action, such as what
would have happened if the government didn't provide a bailout when actually it did provide a
bailout.

The only clean-cut case we have is where no bailout is provided, and the financial system remains
stable. Then it's pretty clear no bailout was needed. Otherwise, there's lots of moving parts that could
determine whether the bailout was needed to preserve financial stability.

Heintjes: Right...and it's always hard to prove a hypothetical. What does, for example, the decision
not to bail out Lehman Brothers show us?

Wall: Lehman, arguably, shows the cost of getting the decision wrong. There were enough moving
parts so that it's possible to argue—and some do—that Lehman was not the cause of the collapse of
other parts of the financial system and that allowing Lehman to fail was the right decision. But I
think most policymakers around the world take the opposite view: that the failure to provide Lehman
with a bailout was an enormously costly mistake.

(i) What did you learn from this interview?

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 (ii) Why do you think most economist take the view that the failure to provide Lehman with a
bailout was an enormously costly mistake?

(iii) Are banks too big to fail likely to take more risk? According to Larry Wall, why?

6. What is the main idea behind Raghuram Rajan’s argument of why the financial crisis occurred? Hint:
Draw a picture.

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Through a cloud, brightly
Obituary: Paul Volcker died on December 8th

The chairman of the Fed and conqueror of inflation in America was 92

IN HIS SPELLS of leisure time, when he had any, Paul Volcker liked to go fishing. Towering above a river in his
jerkin and waders, fly cast, cigar firmly in mouth, was a good way to ruminate on big decisions. And he believed in
rumination. “Procrastinate and flourish” was a favourite motto. Another, from George Washington, which his father
had kept above his desk when he was city manager of Teaneck, New Jersey, was: “Do not suffer your good
nature…to say yes when you ought to say no.” So when he was asked in 1974 to be president of the New York Fed,
he went off on a fishing trip to chew it over. And in meetings and congressional-committee hearings later, as
chairman of the Federal Reserve from 1979 to 1987, he hid his bald head in smoke-clouds, as if he was slowly
weighing up what answers he could possibly give.

His salvo against America’s inflation in 1979, which slew the dragon for decades, therefore seemed unusually abrupt.
The times certainly required it, with annual inflation then at 12%. And his measures, announced at an extraordinary
press conference in the boardroom of the Federal Reserve building in Washington, were drastic. From then on the
Fed would control not the price of money, by adjusting the interest rate, but its supply, leaving interest rates to be
set by the market. He would force America into recession to cure people of their expectations that since prices would
keep on rising, they must keep on spending. The downturn that followed—double-dip, because he briefly took his
foot off the brake—brought soaring unemployment, reaching 10.8% in 1982, and a federal funds rate of over 20%,
the highest in history, before both rates and prices eased. By 1983 inflation was less than 4%.

Yet he had been ruminating about the beast, and how to subdue it, since his Princeton student days. He was struck
by Friedrich Hayek’s observation that the only way inflation cured unemployment was by disguising cuts in real
wages. This linked inflation and deception indelibly in his head. Price instability destroyed trust, not only in the dollar
but in government; and trust that officials would work for the common good, as his father had selflessly worked in
Teaneck, was basic to the social contract. These feelings, more than any strong commitment to monetarism,
convinced him that gentle rate-raising would not be enough. And with inflation running at well over 5% for most of
the 1970s, he arrived at the Fed ready to tighten until interest rates went through the roof.

This caused fury and despair. As consumers stopped spending, home-building tanked and businesses closed down.
Angry crowds and farmers on tractors besieged the Fed; the keys to cars that dealers could not sell were sent to him
in the mail. Though he had doubts, and wore out his office carpet with anxious pacing, he kept at it: not just because
expectations would leap back up if he relented, but because persistence was a virtue in itself. And he stayed on guard,
so much so that during Ronald Reagan’s 1984 campaign he was ordered by Reagan himself not to dare raise interest
rates before the election, even though, by then, he was not intending to.

Reagan’s men thought he wanted to hold the economy back, and tried to dislodge him. He opposed the president’s
tax cut in 1981 unless it was matched by cuts in spending, but this was not political; deficits led to inflation. Besides,
to a man who believed in frugality and discipline, they were also offensive. He was happy, even at the Fed, to wear
crumpled suits, live in a students’ apartment block and fly coach back to New York and the family at weekends. (His
salary had fallen by half when he went from the New York Fed to Washington, and even when he returned to Wall
Street in 1987, making $1m a year, he kept his old pinchpenny ways.) As for discipline, he smoked AC Grenadier

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cigars not only because they were cheap, at a quarter each, but also because he had trained himself to like only what
he could afford.
Discipline was something he wanted banks to show, too. He battled to get them better regulated, though the weight
of lobbying from the Washington swamp and, under Reagan, the pressure of the president’s advisers, made this hard.
He mightily defended the Glass-Steagall Act which, since the 1930s, had prevented banks from trading in securities,
but lost. His failure to clamp down on reckless lending, either at home or to foreign countries, showed up in a string
of debt crises during and after his tenure, culminating in the Great Recession of 2008-09. At that low point he was
called in again, the ever-reliable disciplinarian, to chair Barack Obama’s Economic Recovery Advisory Board.
Although he much disliked having his name on things, it was pinned to the Volcker Rule of 2010, which barred
banks from playing fast and loose with customer deposits just to boost their bottom lines.

Behind almost everything he did lay concern about trust in the dollar, which also meant trust in America as the leader
of the free world. In his time as a Treasury official in the 1960s he had laboured to maintain the Bretton Woods
agreement of 1944, which had built an international monetary system round pegging the dollar to gold at $35 an
ounce. When this began to founder he went along with a temporary suspension and then, in 1973, with decisive
decoupling, but longed for some system of fixed exchange rates. Instead, the dollar was allowed to float. To him
floating exchange rates were fundamentally dangerous, an open invitation to countries to manipulate their
currencies—and so inherently unstable that they undermined the stability of governments, too.

It was probably his wartime adolescence that made him yearn for such a rules-based world. But in so far as he
managed to impose rules himself, they were a success. After 1983 the economy mostly grew without inflation and
political leaders, by and large, learned to defer to the central bank on monetary policy. What worried him more as
the years passed was a growing lack of trust in and respect for institutions in general, from the Supreme Court to
Congress to the presidency. America sometimes seemed to be in a mess in every direction. Every direction, that was,
except the coast of Florida, where he might get a big plump tarpon on his line, or the sparkling, ever-beckoning
salmon rivers of Maine.

Questions to Answer:
1. According to Paul Volcker—what is the biggest price the society pays for inflation?

2. Do you notice any tussle between the President and The Federal reserve chairman? Why do they exist?

3. What was his view on the Glass Stegall Act?

What is the Volcker rule?

The rule was designed to prevent banks that receive federal and taxpayer backing in the form of deposit insurance
and other support from engaging in risky trading activities. The rule was named after Paul Volcker, a former
chairman of the Federal Reserve Board. Read more about the Volcker rule at:
https://www.investopedia.com/terms/v/volcker-rule.asp

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 Class Exercise
FIN 5330 Bank Management
Chapter 5: Financial Statements of Banks and Their Principal Competitors
Name: ____________________________________________________________________________

1. Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year, charges
current income for a $250,000 provision for loan losses, charges off worthless loans of $150,000, and
recovers $50,000 on loans previously charged off. What will be the balance in the allowance for loan
losses at year-end?

2. What are off-balance-sheet items and why are they important to some financial firms?

3. Why are bank accounting practices under attack right now? In what ways could financial institutions
improve their accounting methods?

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 FIN 5330 Bank Management
Class Exercise
Chapter 6: Measuring and Evaluating the Performance of Banks and Their Principal Competitors

Name:________________________________________________________________________
1. a) Mathematically,
ROE = (Net Income/Pre-tax net operating income) X (Pre-tax net operating income/Total
operating revenue) X (Total Operating Revenue/Total Assets) X (Total Assets/Total Equity
Capital) ------ equation (i)

Suppose Detroit community bank(TCB) has the following ratio:

0.090 = 0.520 X 0.033 X 0.316 X 16.6; where the ratio correspond to equation ---(i)
and are in order.

And, International Bank of Commerce(IBC) has the following ratios;

0.090 = 0.650 X 0.023 X 0.402 X 15.1
where the number correspond to equation ---(i) and are in order.
i. Who is managing sales better? What ratio tells us this—write down the ratio.

ii. Who is managing expense better? What ratio tells us this—write down the ratio.

iii. Which bank is more risky? What ratio tells us this—write down the ratio.

iv. Who is managing tax better? What ratio tells us this—write down the ratio.

2. Read the article below and answer the following questions:

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Risky Business in China’s Financial System

By Sian Fenner
Source: The Wall Street Journal Blog (June 12, 2014)

Is China heading for a financial crisis? Some risk indicators have risen markedly over the past twelve
months: Interbank rates are more volatile, with liquidity shortages increasingly common; there have
been a few minor bank runs; and the country experienced its first corporate default in recent history
earlier this year.

Moreover, though official figures suggest that just 1% of loans are non-performing, bank balance
sheets likely aren’t as healthy as they seem.

Evidence from a range of countries suggests that credit booms – as China experienced from 2009-
‘13 – result in substantially higher levels of non-performing loans (NPLs). A more realistic
assumption that 10%-20% of total loans might go bad implies total NPLs of RMB6-12 trillion
(US$1-1.9 trillion). The higher end of the range would suggest a bad-asset problem comparable in
scale to the one that followed the U.S. subprime loan crisis.

That’s risky enough — even before taking into account the rapidly expanding shadow banking
sector. Shadow banking, which is more lightly regulated than conventional banking, now accounts
for around 15% of total financing to China’s economy, up from less than 5% in 2005.

The existence of such a large shadow-banking sector is a warning sign about the true extent of
financial-market risk. The shadow banking sector largely developed to help banks circumvent
government restrictions, so asset quality there is likely lower than in the formal banking sector.

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Indeed, non-bank lending institutions have been key factors in other regional financial crises,
notably in Thailand in 1996-97 and Korea in 2003.

What might trigger a crisis in China? The drift downward in property prices could accelerate as the
economy cools, leaving substantial oversupply. Property and land are often used in China as
collateral for loans, so a sharp fall in house prices would damage bank balance sheets; liquidity would
dry up; and institutions with high rollover needs might struggle to find funding.

Higher interest rates also would increase debt-service payments, and banks could see their deposit
bases erode as corporate deposits shrink. The growing importance of the shadow-banking system
would likely exacerbate these effects.

Such a crisis would have major economic implications not only for China but — through financial
and trade linkages – for the whole world. The Oxford Economics Global Economic Model
estimates that, in such a scenario, Chinese gross domestic product would grow less than 2% in 2015,
and world growth would drop as low as 1%.

Of course, that’s a worst-case scenario, and odds of it happening are only about 10%. With China’s
overall government debt relatively low and foreign exchange reserves at an all-time high, authorities
have the means to intervene on a large scale if necessary.

Still, as long as interest on deposits is capped by the government, Chinese savings will continue to be
invested in riskier and higher-yielding products, adding to distortions in the financial system.

That means the risk of a financial crisis will remain until the government introduces reforms to the
financial sector, and manages its way out of the credit boom in an organized fashion.

–Sian Fenner is Senior Economist at Oxford Economics.

Questions on next page…

(i) The article has a graph that shows that as the ratio of annual growth in credit to GDP
rises, the ratio of non-performing loans to good loans also increases. Why do you think
such is as the case? [Hint: annual growth in credit is the same as annual growth in loans]

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(ii) The article refers to shadowy banks, and writes “The shadow banking sector largely
developed to help banks circumvent government restrictions, so asset quality there is
likely lower than in the formal banking sector.” Explain why what the author is saying
might be correct?

(iii) The author writes: “Still, as long as interest on deposits is capped by the government,
Chinese savings will continue to be invested in riskier and higher-yielding products,
adding to distortions in the financial system.” Why? Explain

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(iv) The author concludes by writing, “That means the risk of a financial crisis will remain
until the government introduces reforms to the financial sector, and manages its way out
of the credit boom in an organized fashion”. What would some of these reforms be?
Explain briefly how it would prevent a crisis.

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 FIN 5330 Bank Management
Class Exercise
Chapter 7: Risk Management for Changing Interest Rate

Name: ________________________________________________________________________

1. What forces cause interest rates to change? What kinds of risk do financial firms face when
interest rates change? (Concept check question 7-3 from the book)

2. Commerce National Bank reports interest-sensitive assets of $870 million and

Interest-sensitive liabilities of $625 million during the coming month. Is the bank asset
sensitive or liability sensitive? What is likely to happen to the bank’s net interest margin if
interest rates rise? If they fall? (Problems and projects 7-3 from the book)

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3. Sparkle Savings Association has interest-sensitive assets of $400 million, interest-sensitive
liabilities of $325 million, and total assets of $500 million. What is the bank’s dollar interest-
sensitive gap? What is Sparkle’s relative interest-sensitive gap? What is the value of its interest-
sensitivity ratio? Is it asset sensitive or liability sensitive? Under what scenario for market
interest rates will Sparkle experience a gain in net interest income? A loss in net interest
income? (Problems and projects 7-10 from the book)

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4. A government bond currently carries a yield to maturity of 6 percent and a market price of
$1,168.49. If the bond promises to pay $100 in interest annually for five years, what is its
current duration? (Problems and projects 7-17 from the book)

5. Carter National Bank holds $15 million in government bonds having a duration of 12 years.
If interest rates suddenly rise from 6 percent to 7 percent, what percentage change should
occur in the bonds’ market price? (Problems and projects 7-18 from the book)

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6. Conway Thrift Association reports an average asset duration of 7 years and an average liability
duration of 4 years. In its latest financial report, the association recorded total assets of $1.8
billion and total liabilities of $1.5 billion. If interest rates began at 5 percent and then suddenly
climbed to 6 percent, what change will occur in the value of Conway’s net worth? By how
much would Conway’s net worth change if, instead of rising, interest rates fell from 5 percent
to 4.5 percent? (Problems and projects 7-13 from the book)

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 FIN 5330 Bank Management
Class Exercise
Chapter 8: Risk Management- Financial Futures, Options, Swaps, and Other Hedging Tools

Name: ________________________________________________________________________
1. (Question 8-7 from the book, concept check)
Suppose a bank wishes to sell $150 million in new deposits next month. Interest rates today on
comparable deposits stand at 8 percent but are expected to rise to 8.25 percent next month.
Concerned about the possible rise in borrowing costs, management wishes to use a futures contract.
What type of contract would you recommend? If the bank does not cover the interest rate risk
involved, how much in lost potential profits could the bank experience? [Assume 360 days in a year]

[HINT 1: A futures contract is a legal agreement to buy or sell a particular commodity or asset at a
predetermined price at a specified time in the future. Futures contracts are standardized for quality
and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on
the obligation to buy the underlying asset when the futures contract expires. The seller of the futures
contract is taking on the obligation to provide the underlying asset at the expiration date.] [HINT 2:
A short hedge is structured to create profits from future transactions in order to offset losses
experienced on a financial institution’s balance sheet if the market interest rates rise. A long hedger
offsets risk by buying financial futures contracts before the time new deposits are expected to flow in
and interest rates are expected to decline. ]

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2. (Question 8-16 from the book)
A financial firm plans to borrow $100 million in the money market at a current interest rate of 4.5
percent. However, the borrowing rate will float with market conditions. To protect itself, the firm
has purchased an interest-rate cap of 5 percent to cover this borrowing. If money market interest
rates on these funds sources suddenly rise to 5.5 percent as the borrowing begins, how much interest
in total will the firm owe and how much of an interest rebate will it receive, assuming the borrowing
is for only one month?

[HINT: An interest rate cap is a type of interest rate derivative in which the buyer receives payments
at the end of each period in which the interest rate exceeds the agreed strike price. An example of a
cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end
of each period in which the interest rate is below the agreed strike price.]

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 FIN 5330 Bank Management
Class Exercise

Chapter 15: The Management of Capital

Question 1 (15-4 from the book)

Using the following information for Gold Star National Bank, calculate that bank’s ratios of Tier 1 capital-to-
risk-weighted assets and total-capital-to-risk-weighted assets. Does the bank have sufficient capital according
to Basel I?

On-Balance-Sheet Items (Assets) Off-Balance-Sheet Items

Standby letters of credit
backing repayment of
Cash $ 4.0 million commercial paper $ 20.5 million
Long-term unused loan
commitments to corporate
U.S Treasury securities 30.6 million customers 25.5 million
Deposit balances due
from other banks 4.0 million Total off-balance-sheet items 46.0 million
Loans secured by first
liens on residential
property (1- to 4-
family dwellings) 66.0 million Tier 1 capital 7.5 million
Loans to corporations 105.3 million Tier 2 capital 5.8 million
Total assets $209.9 million

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Solution to Question 1:

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Question 2
Watch and discuss the following:
https://www.youtube.com/watch?v=AWs4W9J_JDQ

(Charlie Rose Stiglitz and Ackman part 1 of 3)

• What are they talking about?

• What is a stress test?

• What is the most difficult aspect of bank to estimate?

• What is Ackman solutions?

• What did you learn from this video?

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