9. Bank size has traditionally affected the types of activities and financial performance of commercial banks. Large banks
=
relatively easy access to purchased funds and capital markets compared to small banks
=
access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits than do small banks. At the same time, large banks lend to larger corporations. This means that their interest rate spreads have usually been narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers. In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do. They also tend to diversify their operations and services more than small banks do. Large banks generate more noninterest income than small banks. Although large banks tend to hold less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years the largest banks
=
have generally improved their return on equity (ROE) and return on asset (ROA) performance relative to small banks.
12. The major types of off-balance-sheet activities are loan commitments, letters of credit, when issued securities, loans sold, and derivative securities. A loan commitment is a contractual commitment to loan a certain maximum amount to a borrower at given interest rate terms over some contractual period in the future (e.g., one year). Letters of credit are essentially guarantees that FI
=
s sell to underwrite the future performance of the buyers of the guarantees. Commercial letters of credit are used mainly to assist a firm in domestic and international trade. The FI's role is to provide a formal guarantee that it will pay for the goods shipped or sold if the buyer of the goods defaults on its future payments. Standby letters of credit cover contingencies that are potentially more severe, less predictable or frequent, and not necessarily trade related. When-issued securities are forward of future commitments to buy or sell securities (e.g., Treasury bills) before they are issued. Because the FI locks in a price on the securities before their issuance, these off-balance-sheet commitments expose it to interest rate risk. Loans sold are loans that the FI originated and then sold to other investors that can be returned to the originating
institution in the future if the credit quality of the loans deteriorates. Derivative securities are futures, forward, swap, and option positions taken by the bank for hedging and other purposes.
15. Diseconomies of scale occur when technological or other capital investments of banks result in higher average costs of financial service production. For example, if investments
=
future revenues do not cover their costs of development, they reduce the value of the bank and its net worth to the bank’s owners. On the cost side, large-scale investments may result in excess capacity problems and integration problems as well as cost overruns and cost control problems. Then small banks with simple and easily managed computer systems and/or those leasing time on large banks
=
computers without bearing the fixed costs of installation and maintenance may have an average cost advantage. In this case, technological investment of large-sized banks result in higher average costs of financial service production, causing the industry to operate under conditions of diseconomies of scale.
CHAPTER 13
3. a. Yes, the bank is in compliance with the laws. The Financial Services Modernization Bill of 1999 allows commercial banks and investment banks to own each other with no limits on income.
b. Yes, the bank is in compliance with the laws. The bank would not have been in compliance prior to the Financial Services Modernization Bill of 1999 because its revenues exceed the 25% of total revenues earned from allowable investment banking activities in the Glass-Steagall Act.
b. Average vault cash and reserves maintained = $22.7m + $2m = $24.7m
Excess over required reserves = $24.7m - $22.958m = $1.742m
The bank is in compliance with required reserves.
23. Basle I Asset BaseBasel II Asset Base Capital-Assets Base
a. $0 $0 $10 million
b. $0 $0 $50 million
c. $5 million $5 million $25 million
d. $0 $0 $5 million
e. $0 $1 million $5 million
f. $200,000 $200,000 $1 million
g. $8 million $8 million $40 million
h. $250 million $250 million $500 million
i. $500 million $500 million $500 million
j. $50,000 $10,000 $0
k. $10,000 $10,000 $0
l. $1.4 million $700,000 $0
m. $0 $0 $0
n. $1.6 million $320,000 $0
o. $8.5 million $8.5 million $0
p. $0 $0 $0
q. $30 million $30 million $0
r. $20,000 $20,000 $0
s. $4,000 $20,000 $0
t. $400,000 $800,000 $0
CHAPTER 14
7. Both specialize in providing deposit and lending services to households. They obtain their funds from small savings and demand deposits usually held by households. They utilize their deposit sources to make loans to households, usually in the form of home mortgages and consumer loans. Savings associations concentrate on home mortgages. Both savings associations and savings banks service the general consumer market. Savings banks differ from savings associations to the extent that they are allowed to diversify into corporate bonds and stocks
15. Credit unions did not suffer the same fate as the savings institutions because their portfolios were much more conservative than those of savings associations and savings banks; they specialize in making short-term consumer loans and tend to hold more government securities and less long-term residential mortgages. Their members usually belong to the credit union because of their association with work or geography, which results in more loyalty and a lower inclination to move to other institutions. Thus, the factors that led to the thrift crisis, higher interest rates and riskier investments, were not experienced by credit unions.
27. Because they do not accept deposits the way commercial banks do.
CHAPTER 15
10. The value of $10,000 deposited annually in a fund will amount to the following in ten years:
FV = 10,000(FVIFA 8%, 10) = $144,865.62
The annuities per year over the next twenty years at 8% will be:
$144,865.62 = X(PVIVA 8%, 20)
Solving for X, annual cash flows, X= $14,754.88
11. In the first case, the insurance company should charge an amount such that
Lump sum = $20,000(PVIFA 6%, 15) = $194,245.
In the second case, the company should charge
Lump sum = $20,000(PVIFA 6%, 20)= $229,398.
This problem raises the issue of whether it is fair for one individual to be charged a higher amount than another because of differences in life expectancy, especially if these differences have their basis in gender or race.
12. Insurance firms earn profits by taking in more premium income than they pay out in policy payments. Firms can increase their spread between premium income and policy payout in two ways. One way is to decrease future required payouts for any given level of premium payments. This can be accomplished by reducing the risk of the insured pool (provided the policyholders do not demand premium rebates that fully reflect lower expected future payouts). The other way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities typically are long term, the insurance company has long periods of time to invest premium payments in interest earning asset portfolios. The higher the yield on the insurance company's investments, the greater the policy payout (in the case of variable life insurance) and the greater the insurance company's profitability. Since junk bonds offer high yields, they offer insurance companies an opportunity to increase the return on their asset portfolio. However, junk bonds are much more risky and as result of the recent failures of some life insurance firms, the NAIC
=
s proposed laws limiting insurance company holdings of junk bonds in their asset portfolios.
18. a. No, because the combined ratio is 73% + 12.5% + 18% = 103.5%.
b. Yes, because the combined ratio adjusted for investment yield is 103.5% - 8% = 95.5%.
CHAPTER 16
20. The investment banker fears that interests will rise, thus lowering the value of the bonds.
21. KDO pays $70,500,000 for the shares and receives $75,000,000 on the sale. The investment bank
=
s profit is $4,500,000, and the stock price is $25 since that
=
s what the public pays.
22. MEP receives $221,550,000 (= ($54 - $1.25)
H
4,200,000), the investment banker
=
s profit is $5,250,000, and the stock price is $54 per share since that is what the public pays.
CHAPTER 17
15. a. NAV = ($14 x 200 + $140 x 200)/100 = $30,800/100 = $308
b. NAV = ($18 x 200 + $110 x 200)/100 = $25,600/100 = $256, a decline of 16.88%
c. ($18 x 200 + (P) x 200)/100 = $308
Solving for P, we get $136. The maximum decline is $4.
17. The dollar return is 3 + 4 + 5 - 2 = 10, so the rate of return is 10/100 or 10%.