MGMT 1022 – Introduction to Banking

Semester II 2023/2024
Mid-term Examination – 30% (50 marks)
Time: 2 hours
Answer all questions.
Financial and scientific non-programmable calculators allowed.

Section A
1. The largest use of funds for a commercial bank is:
a. savings deposits
b. loans
c. time deposits
d. securities

2. Which of the following is most important to commercial bank management?

a. increasing the bank’s total size
b. maintaining a minimum amount of risk
c. profits from financial services (adjusted for risk)
d. out-performing other depository institutions

3. Banks are regulated in order to do all of the following EXCEPT.

a. achieve desired social goals
b. achieve concentration of banks
c. prevent monopoly
d. prevent banking market failure

4. Which of the following is not a function generally provided by commercial banks?

a. provide a means of payment
b. provide management services for commercial real estate
c. provide for intermediation between savings and borrowers
d. provide trust services

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5. A high equity multiplier can increase ROE and the growth rate of the bank as long as ROA
is:
a. increasing
b. decreasing
c. positive
d. negative

6. Which of the following groups have an interest in evaluating bank performance?

a. bank shareholders
b. bank management
c. bank regulators
d. all of the above.

7. The return on equity is the product of:

a. return on assets multiplied by the ratio of equity to assets
b. the return on assets multiplied by the inverse of the ratio of equity to assets
c. the profit margin multiplied by the asset utilization
d. none of the above.

8. Cash assets include which of the following?

a. vault cash
b. deposits at the Federal Reserve and at other commercial banks
c. cash items in the process of collection
d. all of the above.

9. If a bank has a return on assets of 1% and a ratio of equity to assets of 5%, its return on
equity will be:
a. 5%
b. 20%
c. 25%
d. none of the above.

10. If a bank has more interest rate-sensitive liabilities than interest rate-sensitive assets, then
it has a:
a. positive dollar gap
b. negative dollar gap
c. positive duration gap
d. negative duration gap

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11. The change in a bank's net income that occurs due to changes in interest rates equals the
overall change in market interest rates (in percentage points) times ____________.
a. volume of interest-sensitive assets
b. price risk of the bank’s assets
c. price risk of the bank’s liabilities
d. size of the bank’s cumulative gap
e. None of the options is correct.

12. If the Federal Reserve increases the minimum reserve ratio that private banks are required
to hold, the following will occur:
a. The banks can make more loans and the money supply decreases.
b. The banks can make more loans and the money supply increases.
c. The banks can make fewer loans and the money supply increases.
d. The banks can make fewer loans and the money supply decreases.

13. The control the Federal Reserve has in manipulating the money supply by setting the
minimum reserve ratio is limited because:
a. Banks can decide to hold more cash than the minimum reserve ratio requires.
b. More people use credit cards than cash.
c. People might not hold their money in banks, which limits the loanability of that cash.
d. a and c.
e. a and b.

14. The money multiplier is a relationship between which two drivers?

a. Reserves in a banking system and the money supply.
b. Reserves in the banking system and the interest rate.
c. Reserves loaned out by banks and the total reserves.
d. Required reserves and the money supply.

15. When $1,000 gets deposited into the banking system, and the reserve ratio is 10%, what is
the increase in the money supply?
a. $9,000
b. $1,000
c. $5,000
d. $7,500

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16. The balance sheet of a bank is shown below:

How do excess reserves change if the Central Bank lowers the reserve requirement from
25% to 20%.
a. Excess reserves don’t change.
b. Excess reserves decrease by $5,000.
c. Excess reserves decrease by $8,000.
d. Excess reserves increase by $5,000.
e. Excess reserves increase by $8,000.

17. The ratio that equals total interest income divided by total earning assets less total interest
expense divided by total interest-bearing liabilities is known as the:
a. earnings base.
b. earnings spread.
c. net income margin.
d. net return prior to special transactions.
e. None of the options is correct.

Questions 18-20 relate to the following:

The Tidewater State Bank has $1,000 in total assets (all of which are earning assets), $700 of
which will be repriced within the next 90 days. This bank also has $800 in total liabilities, $400 of
which will be repriced within the next 90 days. Currently, the bank is earning 8 percent on its
assets and is paying 5 percent on its liabilities.

18. If interest rates do not change in the next 90 days, what is this bank's net interest margin?
a. 8 percent
b. 5 percent
c. 4 percent
d. 1.4 percent
e. 3 percent

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19 What is the dollar interest-sensitive gap of this bank?
a. $200
b. $100
c. $200
d. $300
e. $600

20. If interest rates on both assets and liabilities rise by 2 percent in the next 90 days, what
would be the bank's net interest margin?
a. 4 percent
b. 4.4 percent
c. 4.6 percent
d. 2.4 percent
e. 6 percent

-------------------------Section B -------------------------

Question 1
Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12.
(a) What is its ROE? (1 mark)
ROE = .8% * 12 = 9.6%

(b) Suppose this bank’s ROA falls to 0.60 percent. What size equity multiplier must it have to
hold its ROE unchanged? (2 marks)
= 9.6 / .6 = 16

Question 2
Suppose a stockholder-owned thrift institution is projected to achieve a 1.10 percent ROA during
the coming year.
(a) What must its ratio of total assets to equity capital be if it is to achieve its target ROE of 12
percent? (2 marks)
= 12 / 1.1 = 10.9

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(b) If ROA unexpectedly falls to 0.80 percent, what assets-to-capital ratio must it then have to
reach a 12 percent ROE? (2 marks)
12 / .8 = 15

Question 3
(a) An investor holds the stock of Foremost Financials and expects to receive a dividend of
$5.75 per share at the end of the year. Stock analysts recently predicted that the bank’s
dividends will grow at approximately 3 percent a year indefinitely into the future. If this is
true, and if the appropriate risk-adjusted cost of capital (discount rate) for the bank is 12.25
percent, what should be the current price per share of Foremost Financials’ stock?
(2 marks)
P0 = 5.75 / (.1225 - .03) = 62.16

(b) Ace Inc. paid a $4.75 dividend last year. At a constant growth rate of 6.5%, what is the
value of the common stock if the investors require a 15 percent rate of return?
(2 marks)
P0 = (4.75 × 1.065) / (.15 - .065) = 59.51

(c) Suppose investors expect a bank to pay a $5 dividend at the end of period 1, $10 at the
end of period 2, and then plan to sell the stock for a price of $150 per share.
(3 marks)

= 5 / 1.15 + 10 / 1.152 + 150 / 1.152 = 125.33

Question 4
Crochett National Bank has experienced the following trends over the past five years (all figures
in millions of dollars):

Determine the figure for ROE, profit margin, asset utilization, and equity multiplier for this bank.
(4 marks)

Profit margin = 2.7 / 26.50 = 10.2%

Asset utilization = 26.5 / 300 = 8.83%
Equity multiplier = 300 / 27 = 11.11
ROA = 10.2 * 8.83 * 11.11 = 10% or ROA = 2.7 / 27 = 10%

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Question 5
Consider the following balance sheet for ABC Savings, Inc. (in millions):

(a) What is ABC’s expected net interest income at year-end? (3 marks)

Interest income = 50 * 10% + 50 * 7% = 5 + 3.5 = 8.5

Interest expense = 70 * 6% + 20 * 7% = 4.2 + 1.4 = 5.6
NII = 8.5 – 5.6 = 2.9

(b) What will net interest income be at year-end if interest rates rise 2 percent? (3 marks)

Interest income = 50 * 12% + 50 * 7% = 6 + 3.5 = 9.5

Interest expense = 70 * 8% + 20 * 7% = 5.6 + 1.4 = 7
NII = 9.5 – 7 = 2.5

(c) Using the cumulative repricing gap model, what is the expected net interest income for a
2 percent increase in interest rates? (4 marks)
Change in NII = Gap * change in interest rate = -20 * .02 = 0.4 decrease

Hence new NII = 2.9 – 0.4 = 2.5

(d) Give 2 weaknesses of the repricing model. (2 marks)

• Ignores market value effects of interest rate changes.

• Overaggregative. (Distribution of assets and liabilities within individual buckets is not
considered)
• Ignores effects of rate-insensitive runoffs
• Off-balance-sheet items are not included when considering cash flows. Example:
Futures contracts.

END OF TEST