Q&A Hero

Q: A well-managed bank tries to keep the ratio of nonperforming loans to total loans at about 8% to 10%.

Q: Gross debt service usually must be greater than 30% before a residential mortgage will be approved.

Q: Provision for loan losses, net charge-offs, and the percentage of nonperforming loans all increased dramatically in 2007.

Q: Why is bank lending to large corporations more difficult than making loans to small or mid-size firms? What additional factors are involved? Do banks have some additional tools to help in assessing credit risk of large firms? What are some examples?

Q: A bank can charge a corporate borrower 6.25% on a loan. The borrower is asking for a $600,000 loan. The extreme loss rate on this loan type is 4.0% and when default occurs, about 15% of the loan amount is recovered. The interest and noninterest cost of the loan is 5.85%. What is the RAROC of the loan? Under what circumstances should the bank make the loan?

Q: A bank has a base loan rate of 4.75% and for the loan under consideration it would apply a 2% risk premium. The bank also requires compensating balances (non-interest-bearing) equal to 5% of the loan amount. The bank's reserve requirements are 10%. The bank charges 1% of the loan amount as an origination fee. The borrower is asking for a $500,000 loan. Calculate the ROA on the loan.

Q: Why won't a loan officer usually approve a loan solely on the basis of collateral?

Q: A corporate loan applicant has had a growing cash account for the last 3 years but cash flow from operations has been negative in every year. Would this concern you if you were the loan officer charged with approving the loan? If so, why? If not, why not?

Q: What are the five Cs of credit? Briefly describe each.

Q: Describe the credit analysis process for a mid-market corporate loan applicant.

Q: A $40,000 one-year loan with a 1% origination fee and a 7.50% interest rate is funded with money on which the bank owes 3%. What is the expected pretax dollar spread on the loan? If the bank needs to net at least 3.5% on the funds lent to make its ROE, how many dollars can the bank spend on credit investigation, loan servicing, etc.? Would the bank be able to spend more if the loan amount was greater? What does this example suggest about credit analysis?

Q: For most business loans, growing earnings are not a sufficient reason to grant a loan. Why?

Q: Explain the purpose/benefits in adding a credit-scoring model to evaluate a loan application.

Q: Explain how the KMV model predicts bankruptcy probability.

Q: Before allowing the lender to actually acquire the funds for a mid-market collateralized loan, what must the lender ensure? What type of monitoring occurs by the lender after the loan is granted?

Q: BALANCE SHEET BIG VALLEY ENTERPRISES Interest is Big Valley's only fixed cash charge.Big Valley's market value of equity to book value of debt ratio = 1.5 A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55%. The 1-year loan interest rate is 8.00% and the bank must pay 7.40% to raise the funds. The cost to service the loan is 0.3%. If the loan defaults, 92% of the money lent will be lost. Based on historical default rates, the extreme worst-case loss scenario is about 5%. Should the bank make the loan? Why or why not?A. Yes, because the RAROC is 7.11%.B. No, because the RAROC is 7.11%.C. Yes, because the RAROC is 6.52%.D. No, because the RAROC is 6.52%.E. No, because the RAROC is more than 7.55%.

Q: Big Valley's fixed asset efficiency is ___________ the typical firm in the industry.A. the same asB. lower thanC. higher than

Q: GDS cutoff: 30%TDS cutoff: 35%A corporate loan applicant has cash of $40, receivables of $50, and inventory of $20. The applicant also has current debts of $65. If the bank's policy requires a current ratio of 1.75 or better and an acid test ratio of 1.25 or better would the applicant receive the loan?A. Yes, because the applicant's current ratio and acid test ratios are acceptable.B. No, because the applicant's current ratio and acid test ratios are both unacceptable.C. No, because although the applicant's current ratio is acceptable, its acid test ratio is not.D. No, because although the applicant's acid test ratio is acceptable, its current ratio is not.

Q: GDS cutoff: 30%TDS cutoff: 35%Individual credit scoring models typically include all of the following information exceptA. income.B. length of time in residence.C. credit history.D. age.E. ethnic background.

Q: GDS cutoff: 30%TDS cutoff: 35%Using only the TDS criteria, which one of the following statements is true?A. Joe gets the loan but not Bill.B. Bill gets the loan but not Joe.C. Both get the loan.D. Neither gets the loan.

Q: GDS cutoff: 30%TDS cutoff: 35%Using only the GDS criteria, which one of the following statements is true?A. Joe gets the loan but not Bill.B. Bill gets the loan but not Joe.C. Both get the loan.D. Neither gets the loan.

Q: A corporate customer obtains a $1.5 million loan from a bank. The customer agrees to pay a 6.25% interest rate and agrees to make compensating balances of 4% of the loan amount. These will be held in non-interest-bearing transactions deposits at the bank for one year. The bank charges a 1% loan origination fee on the amount borrowed. Reserve requirements are 10%. What is the expected rate of return to the bank (k) (to the nearest basis point)? A. 6.95% B. 7.52% C. 7.99% D. 8.01% E. 8.45%

Q: Which one of the following 5 Cs of credit is NOT correctly defined? A. Capacity - Whether the borrower has enough other credit available to pay off the loan in the event of cash flow problems. B. Capital - The borrower's equity. C. Character - A measure of the borrower's intention/willingness to repay the loan. D. Conditions - Assessing how economic conditions could affect the borrower's ability to repay the loan. E. Collateral - An asset of the borrower that the lender may seize in the event of default on the loan.

Q: The base loan rate accounts for I. the firm's cost of funds. II. the firm's required return on equity. III. the credit risk of the loan. A. I only B. I and II only C. II and III only D. I and III only E. I, II, and III

Q: Which one of the following is usually the better predictor of default? A. Standard & Poor's credit rating B. Moody's credit rating C. Altman Z-score D. KMV's EDF E. All of the above are equally effective at predicting default.

Q: _____________________ is the process of taking possession of the mortgaged property to satisfy the debt in the event of failure to repay the mortgage and foregoing claim to any deficiency. A. Perfecting collateral B. Foreclosure C. Power of sale D. Conditions precedent E. Lien enforcement

Q: Non-performing loans are loans that are past due ___________ that are not accruing interest. A. 30 days B. 60 days C. 90 days D. 120 days E. 180 days

Q: Asset management ratios are used in credit analysis to help understand the borrower's ability to generate sales from the amount invested in some asset category.

Q: A firm's cash account grew by $300 over the year when the firm had cash flow from financing of -$150 and cash flow from investing of $100. The firm's operating cash flow must have been +$250.

Q: If you are a lender evaluating a loan application and you calculate the following ratio: (EBIT + Lease payments)/[Interest + Lease payments + (Sinking Fund/(1-T))] then you are calculating a debt service ratio and it should be less than one in order to approve the loan.

Q: If you were a loan officer evaluating a small business credit application for a loan secured by working capital, you would generally want to see a higher (rather than lower) number of days in inventory and number of days' sales in receivables.

Q: Issuance of short-term debt would result in an increase in cash flow from operations on the statement of cash flows.

Q: The more variable are a borrower's cash flows, the lower the fixed charge coverage ratio should be to limit risk.

Q: A rising sales to working capital ratio may indicate a potential borrower is using its net current assets more efficiently.

Q: As long as overall cash flow growth is positive, a bank loan officer would not be concerned if cash flow from operations was projected to be negative over the term of the loan.

Q: Credit analysis of a mid-market corporate borrower differs from the analysis of a small business in that the analysis of the mid-market borrower is more focused on the business itself and less on the business owners.

Q: The five Cs of credit are financial capacity, collateral, conditions, connections with the bank, and capital.

Q: Collateral on a mortgage is normally only considered if the applicant has enough income to service the loan.

Q: Characterize each of the following according to the type of risk it primarily represents:I. loan defaultII. unexpected deposit withdrawalsIII. losses on foreign currency holdingsIV. losses on standby letters of creditV. reduction in earnings after an interest rate increaseIndicate which of the risks could cause insolvency of the FI.

Q: What is insolvency risk? How can liquidity risk and credit risk cause insolvency? What are the two best protections against insolvency at an FI?

Q: What are the three major objectives of technological investments at FIs? What are the major risks involved with these investments?

Q: What is sovereign risk? How is this different from credit risk on a domestic loan? How can sovereign risk be limited?

Q: How does foreign exchange risk arise for an FI?

Q: Why would an FI be willing to issue a letter of credit guarantee to a municipal bond issuer?

Q: Should regulators of FIs be concerned about the increased trading activity of FIs?

Q: In general terms explain why certain types of derivatives such as options, futures, swaps, and other exotic contracts can generate such catastrophically large losses and even insolvency for users at times. Does this mean that corporate or institutional use of derivatives should be limited or otherwise regulated? Explain.

Q: A bank has $150 million in 1-year loans earning a fixed rate equal to 4.75%. The assets are funded by $150 million in liabilities that have a cost of 4.25% and a maturity of 3 years. If all interest rates are projected to fall 100 basis points by next year, by how much will the bank's profits and loan NIM change in year two? Does this bank face refinancing risk or reinvestment risk? Explain.

Q: Why do banks continue to make credit card loans even though credit card default rates are often at least twice as high as other loan types?

Q: In May 2007, the largest known credit card theft was discovered when it was revealed that 200 million card numbers were stolen from TJX Company. This is an example of A. credit risk. B. operational risk. C. liquidity risk. D. technological risk. E. regulatory risk.

Q: A guarantee issued by an FI that obligates the FI to pay if the purchaser of the letter defaults on a debt is called a A. loan commitment. B. forward rate agreement. C. credit swap agreement. D. collar. E. none of the above

Q: Which one of the following intermediaries is likely to engage in more asset liability maturity matching? A. Banks B. Savings associations C. Savings banks D. Life insurers

Q: If a bank is exposed to refinancing risk, its profitability is reduced if interest rates __________________ and if it is exposed to reinvestment risk, its profitability is reduced if interest rates ________________. A. rise; fall B. rise; rise C. fall; rise D. fall; fall E. rise; stay the same

Q: A bank has invested in U.S. Treasury investments that mature in 2 years. They will be held until maturity. The investments are funded with 3-year maturity time deposits. The primary risk this bank faces is A. refinancing risk. B. reinvestment risk. C. liquidity risk. D. credit risk. E. off-balance-sheet risk.

Q: The Fed allowed nonbank financial institutions to borrow money from the discount window during the mortgage crisis and even allowed nonbanks to swap mortgages for Treasury securities. This was an attempt by the Fed to reduce ________________ at institutions. A. operational risk B. technological risk C. liquidity risk D. foreign exchange risk E. diversifiable risk

Q: Regulator's overall evaluation of the riskiness of a depository institution is measured by the _______________. A. Basel Accord B. CRA rating C. CAMELS rating D. Exposure scale E. FFIEC score

Q: Having longer maturity assets than liabilities causes banks to bear which of the following risks? I. Interest rate risk II. Liquidity risk III. Credit risk A. I only B. I and II only C. I and III only D. II and III only E. I, II, and III

Q: The terrorist attacks on the World Trade Center in 2001 are an example of ______________. A. regulatory risk B. liquidity risk C. credit risk D. insolvency risk E. event risk

Q: CHIPS and ACH are A. potato products of Frito Lay. B. check clearing systems run by the Federal Reserve. C. retail payment systems used in Europe. D. international bank regulators. E. wholesale electronic payment systems.

Q: A bank invests $250 million to add the ability to provide online bill paying for its customers. Usage of the new service is at about 50% of expected usage. This is an example of A. technological risk. B. operational risk. C. market risk. D. credit risk. E. derivative risk.

Q: Argentina has refused to pay loans made to it by foreign institutions three times. This is an example of A. operational risk. B. liquidity risk. C. foreign exchange risk. D. sovereign risk. E. insolvency risk.

Q: The is worth 1.2569 euros and the euro is worth $1.5568. Statistical analysis indicates that when the euro rises 1% against the dollar, the pound rises 0.5% against the euro and vice versa. A U.S. bank has assets of 40 million that mature in one year funded with liabilities of 55 million due in 6 months. The bank would be hurt by: I. an increase in the value of the euro against the dollar. II. a decrease in the value of the euro against the dollar. III. an increase in euro interest rates relative to pound interest rates. IV. an increase in pound interest rates relative to euro interest rates. A. I only B. I and II only C. I and III only D. II and IV only E. II and III only

Q: A bank has on-balance-sheet assets with a book value of $940 million and a market value of $985 million and on-balance-sheet liabilities with a book value of $900 million and a market value of $930 million. The bank also has off-balance-sheet assets currently valued at $150 million and off-balance-sheet liabilities worth $160 million. Stockholder's net worth should be valued at _________________ million. A. $30 B. $40 C. $45 D. $50 E. $55

Q: Which of the following would normally be banking book assets rather than trading book assets? A. Capital B. Short position in bonds C. FX forward contracts D. Long-term loans E. Options on interest rates

Q: A bank has book value of $5 million in liquid assets and $95 million in nonliquid assets. Large depositors unexpectedly withdraw $9.5 million in deposits. To cover the withdrawals the bank sells all of its liquid assets at book value. To raise the additional funds needed the bank sells the necessary amount of nonliquid assets at 80 cents per dollar of book value. As a result, the bank's equity will _____________. A. remain unchanged B. fall $4.5 million C. fall $3.6 million D. fall $1.4 million E. fall $5.0 million

Q: In October 2005, the Bankruptcy Reform Act was signed into law. This law primarily A. made it easier for many debtors to receive bankruptcy protection. B. made it more difficult for many debtors to receive bankruptcy protection. C. applied only to corporations. D. applied only to corporations and financial institutions. E. made it easier for foreign debtors to seek debt relief under U.S. law.

Q: Present value uncertainty is the risk that A. the market value of equity will decline if interest rates change. B. interest income will rise by more than interest expense when rates increase. C. assets will be insufficient to cover loan losses. D. bank capital will be insufficient to cover loan losses. E. real interest rates will exceed nominal rates.

Q: In year one, a bank facing reinvestment risk earns 11% on its assets and pays 10% on its liabilities. In year two, the bank had a negative profit spread of 100 basis points. Which of the following is true? In year two, A. rates rose 100 basis points. B. rates rose 200 basis points. C. rates fell 100 basis points. D. rates fell 200 basis points. E. none of the above

Q: A thrift makes long-term fixed-rate mortgages funded with short-term deposits and then interest rates rise. Which of the following is true? A. Profitability would decline. B. Profitability would increase. C. The market value of equity increases. D. Interest income would fall. E. Both B and C would occur.

Q: Repurchase agreements (repos) are used extensively to finance security holdings. In 2007, many investment banks and other financial institutions were unable to roll over their maturing repurchase agreements during the subprime mortgage crisis. This inability to get new repo financing is an example of A. credit risk. B. liquidity risk. C. sovereign risk. D. technological risk. E. operational risk.

Q: Rank order the net charge-off rates from high to low for the following loan types: I. C&I loans. II. credit card loans. III. real estate loans. A. I, II, III B. I, III, II C. II, I, III D. II, III, I E. III, I, II

Q: MONDEX spent $50 million to develop the Smart Card, but tests of prototypes in New York and Canadian cities revealed very little consumer interest. This is an example of A. credit risk. B. liquidity risk. C. stupidity risk. D. technological risk. E. operational risk.

Q: Second Bank now offers web banking services. Last week a computer glitch posted all web deposit transfers to the wrong accounts. This is an example of A. credit risk. B. liquidity risk. C. stupidity risk. D. technological risk. E. operational risk.

Q: Interest rate risk is probably greatest at which of the following intermediaries? A. Commercial banks B. Savings institutions C. Life insurers D. Pension funds

Q: The risk that an unanticipated increase in liability withdrawals may cause an FI to have to sell assets at fire sale prices is an example of A. credit risk. B. liquidity risk. C. interest rate risk. D. sovereign risk. E. technology risk.

Q: A bank has total assets of $620 million and $68.2 million in equity. The managers of the bank realize that $18.6 million of its $372 million loan portfolio will not be repaid. After the bank charges off these unexpected bad loans the bank's equity to asset ratio will be __________________. A. 11.00% B. 10.64% C. 9.77% D. 8.25% E. 8.00%

Q: Breakdowns of ATMs and fraudulent use of information stored on a bank's computer system are examples of operational risk.

Q: A U.S. bank has 700 million in loans it has made to corporate customers and it has 850 million in deposits. The net foreign exchange exposure from these accounts may be hedged by selling 150 million pounds forward.

Q: Assets in a bank's trading book tend to be held for a longer time than assets held in the banking book.

Q: Rising interest rates decrease the value of fixed-income assets and increase the value of fixed-income liabilities.

Q: A bank that has made floating rate loans funded by longer maturity deposits is at risk from falling interest rates.