Chapter 14: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS

DO YOU UNDERSTAND?
1. Explain how liquidity risk can lead to a banks failure.
Solution: If a bank has insufficient funds to meet its depositors withdrawals, it must close
its doors. Banks fail, therefore, because they are unable to meet their legal obligations to
depositors and other creditors.
2. What defines a banks insolvency? What characteristic of a banks balance sheet makes it
vulnerable to insolvency?
Solution: Banks are thinly capitalized. Therefore, a slight depreciation in the value of the
banks assets could cause the value of liabilities to exceed the value of its assets, the
condition that defines insolvency. Given commercial banks extremely low capital position,
they are vulnerable to failure if they accept excessive credit risk or interest rate risk.
3. Explain some simple strategies banks can follow to avoid insolvency or illiquidity. Why
dont more banks adopt these strategies?
Solution: To avoid insolvency, banks could invest only in short-term, risk-free instruments,
such as Treasury bills. To avoid illiquidity, banks could invest only in the most liquid
securities or hold more cash. None of these strategies are particularly profitable because
they are risk-free. In order to earn higher returns, banks must take on more credit risk or
interest rate risk.
4. Why do banks try to minimize their holdings of primary reserves in the practice of asset
management?
Solution: Primary reserves consist of the cash assets on a banks balance sheet: vault cash,
deposits at correspondent banks, and deposits at Federal Reserve Banks. None of these
assets earn interest. Banks, therefore, prefer to minimize their holdings of cash assets to the
level required to meet immediate liquidity needs.
5. What asset accounts comprise secondary reserves? What role do these accounts serve in
an asset management strategy?
Solution: Secondary reserves consist of Treasury bills, Fed Funds sold, and short-term
agency securities. These securities are very marketable and therefore provide a good
secondary source of liquidity.
DO YOU UNDERSTAND?
1. Explain how bank capital protects a bank from failure.
Solution: Capital provides a cushion against losses in the securities and loan portfolios. If
these losses erode the banks capital below levels required by regulation, bank regulators
will close the bank.
2. Why was bank capital increased in recent years.
Solution: Bank capital has increased in recent years for two reasons. First, banks enjoyed
very good performance for the most of the 1990s. Second, the growth in off-balance-sheet
banking has allowed banks to grow their earnings faster than they grow their assets.

3. Why do you think bankers prefer to use higher leverage than regulators would like them
to?
Solution: Bank managers believe that long-term profit maximization can best be achieved if
their banks are highly leveraged. On the other hand, bank regulators are more interested in
the risk of bank failures in general than in the profits of an individual bank. Their overriding
concern is prevention of chains of bank failures and their disastrous effects on the economy.
4. Explain why the credit risk associated with a loan portfolio is less than the sum of the
credit risk associated with each of the loans in the portfolio.
Solution: All the loans in the portfolio will not default at the same time. The principals of
modern portfolio theory teach us that there are diversification benefits to diversifying our
asset portfolio.
5. Explain how loan brokerage, as discussed in Chapter 13, can be used to reduce
concentration ratios.
Solution: Banks that specialize in making loans of a certain type, to certain industries, or in
certain geographic regions can use loan brokerage to sell those loans in the secondary
market. They can use the proceeds from such loan sales to acquire loans made by other
institutions that are of a different type, to different industries or in different geographic
regions.
DO YOU UNDERSTAND?
1. What is meant by repricing? What happens to the cash flows of a bank whose liabilities
reprice before assets as interest rates increase?
Solution: Short-term assets or liabilities reprice before long-term ones in that they roll over
more frequently in a given year. If liabilities reprice before assets and interest rates are
rising, the cost of the banks funds will increase faster than the rates it earns on its assets.
This will result in a decrease in net income.
2. If a banks liability costs increase faster than yields on assets as interest rates rise, does
the bank have a positive or negative maturity GAP? What kind of duration GAP would such a
bank tend to havepositive or negative? Explain.
Solution: The bank has a negative GAP because its rate sensitive liabilities are greater than
its rate sensitive assets. If liabilities reprice more frequently than the assets then the
average duration of the liabilities is less than the average duration of assets. The bank,
therefore, has a positive duration GAP.
3. Should banks use maturity GAP or duration GAP to manage interest rate risk? What are
the important considerations in this decision?
Solution: Because it requires a great deal of computation on a continuing basis, only the
largest financial institutions use duration GAP analysis. Most smaller institutions prefer to
use maturity GAP analysis to reduce interest rate risk because of its greater simplicity. These
banks should recognize, however, that their management of interest rate risk will be less

precise because maturity GAP ignores the reinvestment risk associated with intermediate
cash flows.
4. Explain how financial futures can be used by banks to reduce interest rate risk.
Solution: A bank with a negative maturity GAP or positive duration GAP should sell futures
on interest rates to reduce interest rate risk. As interest rates increase the banks cash flows
(or value) decreases. The short position in interest rate futures, however, increases in value
when interest rates increase, offsetting the loss in value experienced by the bank.
5. What trade-offs should banks consider when choosing between a cap or a collar to
manage interest rate risk?
Solution: Caps may be preferred because the downside is limited to loss of the option
premium. Caps, however, are likely to be expensive. Banks can offset the cost of a cap by
simultaneously selling a floor. The premium income from selling a floor reduces the cost of
the cap, but exposes the bank to more downside risk.