Chapter 14: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Explain how liquidity risk can lead to a bank’s failure.
Solution: If a bank has insufficient funds to meet its depositor’s withdrawals, it must close its doors.
Banks fail, therefore, because they are unable to meet their legal obligations to depositors and other
2. What defines a bank’s insolvency? What characteristic of a bank’s balance sheet makes it vulnerable
Solution: Banks are thinly capitalized. Therefore, a slight depreciation in the value of the bank’s 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 don’t 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 bank’s 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
5. What asset accounts comprise secondary reserves? What role do these accounts serve in an asset
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
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 bank’s 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
bank’s funds will increase faster than the rates it earns on its assets. This will result in a decrease in net
2. If a bank’s 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 have—
positive 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 bank’s 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
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