Chapter 4 Risks of Financial Institutions

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Chapter 4 Risks of financial institutions
Bank Management (Western Sydney University)
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Chapter 4 Risks of financial institutions
Student: ___________________________________________________________________________
1.
If an FI is long-funded it means that the:

A. maturity of assets equals the maturity of liabilities
B. bank holds more long-term assets than short-term assets
C. maturity of liabilities is less than the maturity of assets
D. maturity of liabilities is longer than the maturity of its assets

2.
An FI that invests $100 million into corporate bonds is exposed to the following risks:

A. credit and interest rate risk
B. liquidity and technology risk
C. solvency and technology risk
D. off-balance-sheet and interest rate risk

3.
An FI that holds more short-term assets relative to long-term liabilities is:

A. exposed to refinancing risk
B. exposed to restructuring risk
C. exposed to reinvestment risk
D. not exposed to any risks

4.
An example of refinancing risk is a case in which an FI:

A. funds two-year maturity assets with one-year maturity liabilities
B. funds one-year maturity assets with two-year maturity liabilities
C. funds two-year maturity assets with two-year maturity liabilities
D. None of the listed options are correct.

5.
A decrease in interest rates means that the discount rate on cash flows is:

A. decreased and thus the market value of an FI's assets and liabilities decreases.
B. increased and thus the market value of an FI's assets and liabilities decreases.

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C. increased and thus the market value of an FI's assets and liabilities increases.
D. decreased and thus the market value of an FI's assets and liabilities increases.

6.
An increase in interest rates means that the discount rate on cash flows is:

A. decreased and thus the market value of an FI's assets and liabilities decreases
B. increased and thus the market value of an FI's assets and liabilities decreases
C. increased and thus the market value of an FI's assets and liabilities increases
D. decreased and thus the market value of an FI's assets and liabilities increases

7.
Market risk is defined as the risk:

A. incurred by granting loans to companies that do not hold a large market share
B. incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices
C. that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices
D. that an FI loses market share

8.
The market risk of an FI increases with:

A. increasing volatility of asset prices
B. increasingly large unhedged short positions in bonds, equities and other commodities
C. increasingly large unhedged long positions in bonds, equities and other commodities
D. All of the listed options are correct.

9.
Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed
funds and general insurance companies?

A. Because the average maturities of their assets are longer than those of money market managed funds/general
insurance companies.
B. Because the average maturities of their assets are shorter than those of money market managed funds/general
C. They are not exposed to more risk.
D. Because they are not specialised in credit risk management.

10.
Non-performing loans are defined as loans that:

A. are either in default or close to being in default and are at least 90 days in arrears
B. have been written off and loans that are at least 80 days in arrears
C. are either in default or close to being in default and are at least 60 days in arrears

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D. have been written off and loans that are at least 60 days in arrears

11.
What does systematic credit risk mean?

A. The risk of default of the borrowing firm that arises from the borrowing firm's specific projects.
B. The risk of default associated with microeconomic conditions affecting some borrowers.
C. The risk of default associated with general macroeconomic conditions affecting all borrowers.
D. The risk of default associated with general macroeconomic conditions affecting some borrowers.

12.
The major difference between firm-specific credit risk and systematic credit risk is that:

A. FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified.
B. FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified.
C. None of the listed options are correct, as FIs can diversify both types of credit risk.
D. None of the listed options are correct, as FIs cannot diversify either type of credit risk.

13.
can be reduced by diversification.

A. Firm-specific credit risk
B. Systematic credit risk
C. Firm-specific and systematic credit risks

14.
A high-quality loan book for Australian banks during the global financial crisis (GFC) meant that:

A. their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC
B. their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the
GFC
C. Australian banks' profitability fell and Australian FIs were severely impacted by the GFC
D. Australian banks' profitability was maintained and Australian FIs were not severely impacted by the GFC

15.
Which of the following are typical off-balance-sheet activities?

A. letters of credit
B. loan commitments
C. forward contracts, swaps and other derivative securities


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16.
What are the major objectives of technological expansion?

A. To lower operating costs, increase profits and capture new markets.
B. To stabilise operating costs, increase profits and capture new markets.
C. To lower operating costs, stabilise profits and capture new markets.
D. To lower operating costs, increase profits and stabilise the existing market share.

17.
What type of risk focuses upon future contingencies?

A. liquidity risk
B. interest rate risk
C. credit risk
D. off-balance-sheet risk

18.
Which of the following is a suitable description of the term 'economies of scope'?

A. the use of several inputs to produce one common output
B. the ability to generate cost savings by producing more than one output with the same inputs
C. the ability to lower average operating costs by expanding its output of financial services
D. the ability to lower average operating costs by lowering its output of financial services

19.
Which of the following is a suitable description of the term 'economies of scale'?


20.
Which of the following are typical operational risk sources?

A. employee fraud
B. back-office failures
C. general technological glitches

21.
In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar?

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A.
The FI holds !00 million in assets and !70 million in liabilities.
B.
C.
The FI holds 70 million in assets and !100 million in liabilities.
D.
The FI does not hold any assets or liabilities in euros, but considers doing so in the future.
22.
An Australian FI that invests !50 million in three-year maturity loans and partially funds these loans with !30 million one-year
deposits is exposed to the following risks.

A. A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest
rates in the Eurozone.
B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest
C. A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing
interest rates in the Eurozone.
D. A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the
Eurozone.

23.
Sovereign risk refers to the risk that repayments from:

A. local borrowers are interrupted because of interference from foreign governments
B. foreign borrowers are interrupted because of interference from local governments
C. foreign borrowers are interrupted because of interference from foreign governments

24.
Which of the following is an effective measure for claimholders if a foreign government prohibits repayment of debt obligations to an
international lender?

A. The claimholder can recover its outstanding debt through local courts.
B. The claimholder can recover its outstanding debt through international courts
C. The claimholder cannot do anything.
D. The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future
loans or supply of funds.

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25.
Unanticipated diseconomies of scale and scope are a result of:

A. technology risk
C. foreign exchange risk
D. credit risk

26.
The major source of risk exposure resulting from issuance of standby letters of credit is:

A. technology risk
C. credit risk

27.
Politically motivated limitations on payments of foreign currency may expose the FI to:

A. sovereign or country risk
C. credit risk
D. foreign exchange risk

28.
The risk that a debt security's price will fall, subjecting the investor to a capital loss is:

A. credit risk
B. political risk
C. currency risk
D. market risk

29.
The risk that interest income will increase at a slower rate than interest expense is:

A. credit risk
B. political risk
C. currency risk
D. interest rate risk

30.

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The risk that borrowers are unable to repay their loans on time is called:

A. credit risk
B. sovereign risk
C. currency risk
D. liquidity risk

31.
A letter of credit is:

A. a credit guarantee issued by an FI's customer to pay a predetermined amount of money to the FI at a future point in
time
B. an on-balance-sheet transaction for the issuing FI
C. a credit guarantee issued by an FI on which payment is contingent on some future event occurring

32.
A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 per cent annually. It has assets of
$5 million with an average maturity of five years earning interest rates of 6 per cent annually. To what risk is the bank exposed?

A. reinvestment risk
B. refinancing risk
C. interest rate risk
D. refinancing risk and interest rate risk

33.
Matching the foreign currency book protects the FI from:

A. sovereign country risk
C. liquidity risk

34.
An FI that finances a German euro loan with US dollar deposits is exposed to:

A. technology risk
C. credit risk

35.
An example of a discrete risk is sudden changes in:

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A. the interest rate
B. banking regulations
C. foreign exchange rates
D. commodity prices

36.
Event risks such as earthquakes, fraud and theft:

A. do not have an impact on an FI's performance
B. are easy to measure and to predict
C. form a normal cost of doing business for FIs
D. may have a significant and negative impact on an FI's performance but are difficult to measure and to predict

37.
During periods of high and volatile inflation, an FI's:

A. interest rate risk exposure and credit risk exposure tends to decrease
B. interest rate risk exposure and credit risk exposure tends to increase
C. interest rate risk exposure and credit risk exposure tends to be unaffected

38.
An FI with a low level of leverage, such as a high level of capitalisation:

A. is generally less profitable
B. is better able to withstand losses
C. has improved ability to remain solvent

39.
Credit risk puts both the principal loaned and expected interest payments at risk. As a result, FIs issue financial claims that have a
risk–return profile with:

A. high probability of fixed upside return
B. high probability of large downside risk
C. low probability of large downside risk
D. both high probability of fixed upside return and low probability of large downside risk

40.
The collapse of the US bank IndyMac Bank was an example of:

A. market risk
B. operational risk
C. insolvency risk

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D. insolvency and liquidity risk

41.
Technological risk:

A. can only lead to an FI's short-term distress
B. refers to the scenario that technological investments produce the anticipated cost savings
C. can result in major losses and the long-term viability of the FI
D. refers to the scenario that technological investments do not produce the anticipated savings, and can cause major
losses and impact on the viability of the FI

42.
The Bank for International Settlements:

A. defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes,
people, and systems or from external events
B. does not include technology risk in its categorisation of operational risk
C. is the principal organisation of central banks in the minor economies of the world

43.
A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for
one of her friends. The loan was subsequently added to a loan pool, securitised and sold. Which of the following risks applies to the
false documentation by the employee?

A. market risk
B. credit risk
C. operational risk
D. technological risk

44.
Which function of an FI involves buying primary securities and issuing secondary securities?

A. brokerage
B. asset transformation
C. investment research
D. trading

45.
Which of the following may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus
causing an FI's equity to approach zero?

A. insolvency risk
B. sovereign risk

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C. currency risk

D. liquidity risk

46.
The BIS definition 'the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external
events' encompasses which of the following risks?

A. credit risk and liquidity risk
B. operational risk and technology risk
C. credit risk and market risk
D. technology risk and liquidity risk

47.
The increased opportunity for a bank to securitise loans into liquid and tradable assets is likely to affect which type of risk?

A. sovereign risk
B. market risk
C. insolvency risk

48.
Which of the following situations pose a refinancing risk for an FI?

A. An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
B. An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
C. An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
D. An FI matches the maturity of its assets and liabilities.

49.
The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:

A. liquidity risk
B. reinvestment risk
C. credit risk

50.

A. interest rate risk
B. credit risk

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51.
The positive difference between an FI's contingent liabilities and contingent assets represents:

A. an additional obligation, or claim, on the FI's net worth
B. an additional profit for the FI
C. an increase in assets

52.
The potential exercise of unanticipated contingencies can result in:

A. technology risk
B. interest rate ris.
C. credit risk

53.
Matching the foreign currency book does not protect the FI from:

C. liquidity risk

54.
A small local bank failed because of a housing market collapse following the departure of the area's largest employer. What type of
risk applies to the failure of the institution?

A. firm-specific risk
B. technological risk
C. operational risk
D. insolvency risk

55.
Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

True False

56.

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An FI that only operates domestically is never exposed to foreign exchange rate risk.

True False

57.
An FI that matches the maturities of its assets and liabilities is perfectly hedged against interest rate risk.

True False

58.
A short-funded FI is exposed to increasing interest rates.

True False

59.
When analysing an FI's performance, it is not important to consider its off-balance-sheet activities as they have no current or future
impact on the FI's financial standing.

True False

60.
Firm-specific credit risk can be reduced by diversification.

True False

61.
Systematic credit risk can be reduced by diversification.

True False

62.
Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.

True False

63.
Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.

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True False

64.
Technological failure, employee fraud and employee errors are all sources of operational risk.

True False

65.
An Australian FI that holds a net short asset position in $US is exposed to foreign exchange rate risk if the $US appreciates against
the $A over the investment period.

True False

66.
A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.

True False

67.
Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the
foreign government that are out of the control of the foreign corporation.

True False

68.
Many of the various risks, such as interest rate risk, market risk, credit risk and off-balance-sheet risk, faced by an FI often are
interrelated with each other.

True False

69.
FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy
bonds with short maturity liabilities.

True False

70.
If the difference between an FI's contingent liabilities and contingent assets is positive then there is an additional obligation, or claim,
on the FI's net worth.

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True False

71.
Economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the equity
holders' stake in an FI.

True False

72.
Economically speaking, contingent assets and liabilities are not contractual claims that directly impact the economic value of the
equity holders' stake in an FI.

True False

73. Assume that you are a financial advisor to ABC Bank. The bank wishes to invest $50 million in loans with an average
maturity of three years. The average interest rate on these loans is 12 per cent per annum. The bank can either grant the
loans at a variable rate or at a fixed rate for the time of the investment. ABC Bank has the choice of funding these loans
through either at-call deposits or through five-year maturity term deposits. Explain the different types of risks that ABC
Bank faces when funding its loans.

74.
One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-
balance-sheet risk. Explain what is meant by off-balance-sheet activities and the risk associated with it using an example.

75. Based on the case of Indymac Bank, explain how liquidity risk and insolvency risk caused a bank failure despite
deposit insurance. Outline the chain of events that led to this financial institution's illiquidity and eventual closure.

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76. The Reserve Bank of Australia believes that operational risk could lead to severe financial distress for FIs. Outline
what is meant by operational risk and how it can impact on a financial institution. In particular, illustrate your answer with
recent cases of bank operational risk, for example: retail bank system failures, trading loss fraud and Ponzi scheme
fraud.

Chapter 04 Testbank Key

1.
If an FI is long-funded it means that the:

A. maturity of assets equals the maturity of liabilities
B. bank holds more long-term assets than short-term assets
C. maturity of liabilities is less than the maturity of assets
D. maturity of liabilities is longer than the maturity of its assets

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

2.
An FI that invests $100 million into corporate bonds is exposed to the following risks:

A. credit and interest rate risk

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B. liquidity and technology risk

C. solvency and technology risk
D. off-balance-sheet and interest rate risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1–3
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

3.
An FI that holds more short-term assets relative to long-term liabilities is:

A. exposed to refinancing risk
B. exposed to restructuring risk
C. exposed to reinvestment risk
D. not exposed to any risks

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

4.
An example of refinancing risk is a case in which an FI:

A. funds two-year maturity assets with one-year maturity liabilities
B. funds one-year maturity assets with two-year maturity liabilities
C. funds two-year maturity assets with two-year maturity liabilities

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

5.
A decrease in interest rates means that the discount rate on cash flows is:

A. decreased and thus the market value of an FI's assets and liabilities decreases.
B. increased and thus the market value of an FI's assets and liabilities decreases.
C. increased and thus the market value of an FI's assets and liabilities increases.
D. decreased and thus the market value of an FI's assets and liabilities increases.

AACSB: Analytic

lOMoARcPSD|6189550
Difficulty: Hard
Est time: 1–3

6.
An increase in interest rates means that the discount rate on cash flows is:

A. decreased and thus the market value of an FI's assets and liabilities decreases
B. increased and thus the market value of an FI's assets and liabilities decreases
C. increased and thus the market value of an FI's assets and liabilities increases
D. decreased and thus the market value of an FI's assets and liabilities increases

AACSB: Analytic
Difficulty: Hard
Est time: 1–3

7.
Market risk is defined as the risk:

A. incurred by granting loans to companies that do not hold a large market share
B. incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices
C. that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices
D. that an FI loses market share

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3
Learning Objective: 4.2 Understand the significance of market risk for FIs

8.
The market risk of an FI increases with:

A. increasing volatility of asset prices
B. increasingly large unhedged short positions in bonds, equities and other commodities
C. increasingly large unhedged long positions in bonds, equities and other commodities

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

9.

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Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed
funds and general insurance companies?

A. Because the average maturities of their assets are longer than those of money market managed funds/general
B. Because the average maturities of their assets are shorter than those of money market managed funds/general
C. They are not exposed to more risk.
D. Because they are not specialised in credit risk management.

AACSB: Analytic
Difficulty: Hard
Est time: 1–3

10.
Non-performing loans are defined as loans that:

A. are either in default or close to being in default and are at least 90 days in arrears
B. have been written off and loans that are at least 80 days in arrears
C. are either in default or close to being in default and are at least 60 days in arrears
D. have been written off and loans that are at least 60 days in arrears

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

11.
What does systematic credit risk mean?

A. The risk of default of the borrowing firm that arises from the borrowing firm's specific projects.
B. The risk of default associated with microeconomic conditions affecting some borrowers.
C. The risk of default associated with general macroeconomic conditions affecting all borrowers.
D. The risk of default associated with general macroeconomic conditions affecting some borrowers.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: 1–3

12.
The major difference between firm-specific credit risk and systematic credit risk is that:

A. FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified.

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B. FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified.
C. None of the listed options are correct, as FIs can diversify both types of credit risk.
D. None of the listed options are correct, as FIs cannot diversify either type of credit risk.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

13.
can be reduced by diversification.

A. Firm-specific credit risk
B. Systematic credit risk
C. Firm-specific and systematic credit risks

AACSB: Analytic
Difficulty: Medium
Est time: <1

14.
A high-quality loan book for Australian banks during the global financial crisis (GFC) meant that:

A. their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC
B. their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the
GFC
C. Australian banks' profitability fell and Australian FIs were severely impacted by the GFC
D. Australian banks' profitability was maintained and Australian FIs were not severely impacted by the GFC

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

15.
Which of the following are typical off-balance-sheet activities?

A. letters of credit
B. loan commitments
C. forward contracts, swaps and other derivative securities

AACSB: Analytic
Bloom's: Knowledge

lOMoARcPSD|6189550
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

16.
What are the major objectives of technological expansion?

A. To lower operating costs, increase profits and capture new markets.
B. To stabilise operating costs, increase profits and capture new markets.
C. To lower operating costs, stabilise profits and capture new markets.
D. To lower operating costs, increase profits and stabilise the existing market share.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

17.
What type of risk focuses upon future contingencies?

A. liquidity risk
C. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

18.
Which of the following is a suitable description of the term 'economies of scope'?


AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3


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19.
Which of the following is a suitable description of the term 'economies of scale'?


AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

20.
Which of the following are typical operational risk sources?

A. employee fraud
B. back-office failures
C. general technological glitches

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

21.
In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar?

A.
B.
C.
The FI holds 70 million in assets and !100 million in liabilities.
D.
The FI does not hold any assets or liabilities in euros, but considers doing so in the future.

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AACSB: Analytic
Difficulty: Hard
Est time: 1–3
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

22.
An Australian FI that invests !50 million in three-year maturity loans and partially funds these loans with !30 million one-year
deposits is exposed to the following risks.

A. A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest
B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest
C. A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing
interest rates in the Eurozone.
D. A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the
Eurozone.

AACSB: Analytic
Difficulty: Hard
Est time: 1–3

23.
Sovereign risk refers to the risk that repayments from:

A. local borrowers are interrupted because of interference from foreign governments
B. foreign borrowers are interrupted because of interference from local governments
C. foreign borrowers are interrupted because of interference from foreign governments

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3
Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers

24.
Which of the following is an effective measure for claimholders if a foreign government prohibits repayment of debt obligations to an
international lender?

A. The claimholder can recover its outstanding debt through local courts.
B. The claimholder can recover its outstanding debt through international courts
C. The claimholder cannot do anything.
D. The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future
loans or supply of funds.


lOMoARcPSD|6189550
AACSB: Analytic
Difficulty: Medium
Est time: 1–3

25.
Unanticipated diseconomies of scale and scope are a result of:

A. technology risk
D. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

26.

A. technology risk
C. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

27.
Politically motivated limitations on payments of foreign currency may expose the FI to:

A. sovereign or country risk
C. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1


lOMoARcPSD|6189550
28.
The risk that a debt security's price will fall, subjecting the investor to a capital loss is:

A. credit risk
B. political risk
C. currency risk
D. market risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

29.
The risk that interest income will increase at a slower rate than interest expense is:

A. credit risk
B. political risk
C. currency risk
D. interest rate risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

30.
The risk that borrowers are unable to repay their loans on time is called:

A. credit risk
B. sovereign risk
C. currency risk
D. liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

31.
A letter of credit is:

A. a credit guarantee issued by an FI's customer to pay a predetermined amount of money to the FI at a future point in

lOMoARcPSD|6189550
time
B. an on-balance-sheet transaction for the issuing FI
C. a credit guarantee issued by an FI on which payment is contingent on some future event occurring

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

32.
A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 per cent annually. It has assets of
$5 million with an average maturity of five years earning interest rates of 6 per cent annually. To what risk is the bank exposed?

A. reinvestment risk
B. refinancing risk
C. interest rate risk
D. refinancing risk and interest rate risk

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

33.
Matching the foreign currency book protects the FI from:

C. liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

34.
An FI that finances a German euro loan with US dollar deposits is exposed to:

A. technology risk
C. credit risk


lOMoARcPSD|6189550
AACSB: Analytic
Difficulty: Easy
Est time: <1

35.
An example of a discrete risk is sudden changes in:

A. the interest rate
B. banking regulations
C. foreign exchange rates
D. commodity prices

AACSB: Analytic
Difficulty: Medium
Est time: <1
Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs

36.
Event risks such as earthquakes, fraud and theft:

A. do not have an impact on an FI's performance
B. are easy to measure and to predict
C. form a normal cost of doing business for FIs
D. may have a significant and negative impact on an FI's performance but are difficult to measure and to predict

AACSB: Analytic
Difficulty: Hard
Est time: 1–3

37.
During periods of high and volatile inflation, an FI's:

A. interest rate risk exposure and credit risk exposure tends to decrease
B. interest rate risk exposure and credit risk exposure tends to increase
C. interest rate risk exposure and credit risk exposure tends to be unaffected

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

38.

lOMoARcPSD|6189550
An FI with a low level of leverage, such as a high level of capitalisation:

A. is generally less profitable
B. is better able to withstand losses
C. has improved ability to remain solvent

AACSB: Analytic
Difficulty: Hard
Est time: 1–3
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks

39.
Credit risk puts both the principal loaned and expected interest payments at risk. As a result, FIs issue financial claims that have a
risk–return profile with:

A. high probability of fixed upside return
B. high probability of large downside risk
C. low probability of large downside risk
D. both high probability of fixed upside return and low probability of large downside risk

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

40.
The collapse of the US bank IndyMac Bank was an example of:

A. market risk
B. operational risk
C. insolvency risk
D. insolvency and liquidity risk

AACSB: Analytic
Difficulty: Hard
Est time: 1–3
Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs

41.
Technological risk:

A. can only lead to an FI's short-term distress
B. refers to the scenario that technological investments produce the anticipated cost savings
C. can result in major losses and the long-term viability of the FI
D. refers to the scenario that technological investments do not produce the anticipated savings, and can cause major
losses and impact on the viability of the FI

lOMoARcPSD|6189550
AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

42.
The Bank for International Settlements:

A. defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes,
people, and systems or from external events
B. does not include technology risk in its categorisation of operational risk
C. is the principal organisation of central banks in the minor economies of the world

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 1–3

43.
A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for
one of her friends. The loan was subsequently added to a loan pool, securitised and sold. Which of the following risks applies to the
false documentation by the employee?

A. market risk
B. credit risk
C. operational risk

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

44.
Which function of an FI involves buying primary securities and issuing secondary securities?

A. brokerage
B. asset transformation
C. investment research
D. trading

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge

lOMoARcPSD|6189550
Difficulty: Easy
Est time: <1

45.
Which of the following may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus
causing an FI's equity to approach zero?

A. insolvency risk
B. sovereign risk
C. currency risk
D. liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

46.
The BIS definition 'the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external
events' encompasses which of the following risks?

A. credit risk and liquidity risk
B. operational risk and technology risk
C. credit risk and market risk
D. technology risk and liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: 1–3

47.
The increased opportunity for a bank to securitise loans into liquid and tradable assets is likely to affect which type of risk?

A. sovereign risk
B. market risk
C. insolvency risk

AACSB: Analytic
Difficulty: Medium
Est time: <1


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48.
Which of the following situations pose a refinancing risk for an FI?

A. An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
B. An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
C. An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-
year maturity.
D. An FI matches the maturity of its assets and liabilities.

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

49.
The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:

A. liquidity risk
B. reinvestment risk
C. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

50.

A. interest rate risk
B. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

51.
The positive difference between an FI's contingent liabilities and contingent assets represents:

lOMoARcPSD|6189550

A. an additional obligation, or claim, on the FI's net worth
B. an additional profit for the FI
C. an increase in assets

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

52.
The potential exercise of unanticipated contingencies can result in:

A. technology risk
B. interest rate ris.
C. credit risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

53.
Matching the foreign currency book does not protect the FI from:

C. liquidity risk

AACSB: Analytic
Difficulty: Medium
Est time: <1

54.
A small local bank failed because of a housing market collapse following the departure of the area's largest employer. What type of
risk applies to the failure of the institution?

A. firm-specific risk
B. technological risk
C. operational risk
D. insolvency risk


lOMoARcPSD|6189550
AACSB: Analytic
Difficulty: Medium
Est time: 1–3

55.
Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1

56.
An FI that only operates domestically is never exposed to foreign exchange rate risk.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: <1

57.
An FI that matches the maturities of its assets and liabilities is perfectly hedged against interest rate risk.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: <1

58.
A short-funded FI is exposed to increasing interest rates.

TRUE

AACSB: Analytic
Difficulty: Medium
Est time: <1

lOMoARcPSD|6189550

59.
When analysing an FI's performance, it is not important to consider its off-balance-sheet activities as they have no current or future
impact on the FI's financial standing.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: <1

60.
Firm-specific credit risk can be reduced by diversification.

TRUE

AACSB: Analytic
Difficulty: Medium
Est time: <1

61.
Systematic credit risk can be reduced by diversification.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: <1

62.
Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1


lOMoARcPSD|6189550
63.
Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

64.
Technological failure, employee fraud and employee errors are all sources of operational risk.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

65.
An Australian FI that holds a net short asset position in $US is exposed to foreign exchange rate risk if the $US appreciates against
the $A over the investment period.

TRUE

AACSB: Analytic
Difficulty: Medium
Est time: <1

66.
A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: <1


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67.
Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the
foreign government that are out of the control of the foreign corporation.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 1–3

68.
Many of the various risks, such as interest rate risk, market risk, credit risk and off-balance-sheet risk, faced by an FI often are
interrelated with each other.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1

69.
FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy
bonds with short maturity liabilities.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

70.
If the difference between an FI's contingent liabilities and contingent assets is positive then there is an additional obligation, or claim,
on the FI's net worth.

TRUE

AACSB: Analytic
Difficulty: Medium
Est time: 1–3


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71.
Economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the equity
holders' stake in an FI.

TRUE

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

72.
Economically speaking, contingent assets and liabilities are not contractual claims that directly impact the economic value of the
equity holders' stake in an FI.

FALSE

AACSB: Analytic
Difficulty: Medium
Est time: 1–3

73. Assume that you are a financial advisor to ABC Bank. The bank wishes to invest $50 million in loans with an average
maturity of three years. The average interest rate on these loans is 12 per cent per annum. The bank can either grant the
loans at a variable rate or at a fixed rate for the time of the investment. ABC Bank has the choice of funding these loans
through either at-call deposits or through five-year maturity term deposits. Explain the different types of risks that ABC
Bank faces when funding its loans.
In mismatching the maturities of assets and liabilities as part of their asset transformation function, FIs potentially expose themselves to
interest rate risk. If ABC Bank finances its loans with average maturities of three years through at-call deposits (which is short term in
nature) then the bank can be viewed as being ‘short-funded’. That is, the maturity of its liabilities is less than the maturity of its assets.
As a result, it potentially exposes itself to refinancing risk. This is the risk that the cost of rolling over or re-borrowing funds could be
more than the return earned on asset investments.
In the second case, the bank loans (average three years maturity) are financed through five-year maturity term deposits. Here the bank
is exposed to reinvestment risk; by holding shorter term assets relative to liabilities it faced uncertainty about the interest rate at which it
could reinvest funds borrowed for a longer period. This exposure is more evident when the bank borrows fixed-rate deposits while
investing in floating-rate loans—that is, loans whose interest rates are changed or adjusted in line with market movements in interest
rates. In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, ABC Bank faces market value
risk as well. Mismatching maturities by holding longer term assets than liabilities means that when interest rates rise, the market value
of the FI’s assets falls by a greater amount than its liabilities. This exposes the FI to the risk of economic loss and potentially the risk of
insolvency.

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AACSB: Analytic
Bloom's: Comprehension
Difficulty: Medium
Est time: 10–15

74.
One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-
balance-sheet risk. Explain what is meant by off-balance-sheet activities and the risk associated with it using an example.
One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-balance-
sheet risk.
An off-balance-sheet activity, by definition, does not appear on an FI’s current balance sheet since it does not involve holding a current
primary claim (asset) or the issuance of a current secondary claim (liability). Instead, off-balance-sheet activities affect the future shape
of an FI’s balance sheet in that they involve the creation of contingent assets and liabilities that give rise to their potential (future)
placement on the balance sheet. Thus, accountants place them ‘below the bottom line’ of an FI’s asset and liability balance sheet. A
good example of an off-balance-sheet activity is the issuance of standby letter of credit guarantees by insurance companies and banks
to back the issue of a bond issue or a trade contract. Many foreign trade transactions do not take place without bank or insurance
company letter of credit guarantees that promise payment to suppliers should the buying organisations default on future obligations.
Similarly, many corporate bond issues would not take place without such guarantees. Nothing appears on the FI’s balance sheet today
or in the future. However, the fee earned for issuing the letter of credit guarantee appears on the FI’s income statement. As a result, the
ability to earn fee income while not loading up or expanding the balance sheet has become an important motivation for FIs to pursue
off-balance-sheet business.
Unfortunately, this activity is not risk free. Suppose the corporate bond issuer defaults on its bond interest and principal payments.
Then the contingent liability or guarantee the FI issued becomes an actual or real liability that appears on the FI’s balance sheet. That
is, the FI has to use its own equity to compensate investors in the corporate bonds it guaranteed with its letter of credit.
AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 10–15

75. Based on the case of Indymac Bank, explain how liquidity risk and insolvency risk caused a bank failure despite
deposit insurance. Outline the chain of events that led to this financial institution's illiquidity and eventual closure.
In the middle of 2008, the US IndyMac Bank failed, in part due to a bank run that continued for several days, even after it was taken
over by the US Federal Deposit Insurance Corporation (FDIC). The events which preceded this were as follows:
IndyMac Bank announced on Monday 7 July 2008 that due to its deteriorating capital position its mortgage operations would cease and
it would operate only as a retail bank. IndyMac had been operating under close regulatory scrutiny since January 2008. The bank lost

lOMoARcPSD|6189550
US$614.8 million in 2007 and US$184.2 million during the first quarter of 2008, largely as the result of losses on home loans.
News reports over the following days suggested the possibility that IndyMac Bank would become the largest bank failure in more than
20 years. Worried that they would not have access to their money, bank depositors rushed to withdraw money from IndyMac, even
though their deposits were insured up to US$100 000 by the FDIC. The run on deposits was so large that by the weekend of the week
of the original announcement, the FDIC stepped in and took over the bank. Citing a massive run on deposits, regulators shut its main
branch three hours early, leaving customers stunned and upset. Further, the bank’s 33 branches were closed over the weekend, and
the FDIC advised that the bank would reopen on Monday. Customers were not able to undertake any phone or internet transactions
over the weekend but were able to continue to use ATMs, debit cards and cheques.
The failure of IndyMac Bank was the second largest FI failure in the US at that time, following only Continental Illinois Bank, which had
assets of about $40 billion before it closed in 1984. IndyMac's failure had been widely expected and as the bank was shutting offices
and laying off employees, deposit withdrawals amounted to $100 million a day, causing the bank’s share price to plummet to less than
$1 as analysts built into the stock price the expected losses. The bank, which had employed 10 000 staff, fell prey to a classic 'run on
the bank' and regulators suggested that injudicious reporting of events helped to fuel massive withdrawals. The Office of Thrift
Supervision director John M. Reich stated that ‘this institution failed today due to a liquidity crisis. Although this institution was already in
distress, the deposit run pushed IndyMac over the edge'.
AACSB: Reflective thinking

Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 10–15

76. The Reserve Bank of Australia believes that operational risk could lead to severe financial distress for FIs. Outline
what is meant by operational risk and how it can impact on a financial institution. In particular, illustrate your answer with
recent cases of bank operational risk, for example: retail bank system failures, trading loss fraud and Ponzi scheme
fraud.
Operational risk is partly related to technology risk and can arise whenever existing technology malfunctions or back-office support
systems break down. Even though such computer glitches are rare, their occurrence can cause major dislocations in the FIs involved
and potentially disrupt the financial system in general. For example, in March 2011, Commonwealth Bank ATMs allowed customers to
overdraw their accounts due to a technical glitch. As customers learned of this, some took advantage of the perceived opportunity to
withdraw what they thought was ‘free money’. When the bank requested the return of the funds, many were unable to do so. The
opposite happened a few months later when customers were unable to withdraw funds from ATMs, make EFTPOS payments or access
their online accounts, during which time many were not paid salaries and other payments owed to them. A similar problem had occurred
at National Australia Bank in 2010 and at Westpac later in 2011.
Operational risk is not exclusively the result of the failure of technology. For example, employee fraud and errors constitute a type of
operational risk that often negatively affects the reputation of an FI. An example of employee fraud was in 2012, where a Sydney
woman was convicted of defrauding ING Australia of more than $45 million by siphoning funds from corporate accounts at the bank to
her personal account at the ANZ Bank. This was the largest fraud by an individual in Australia.
Another example of employee fraud is the trading loss fraud incurred by a trader at the French bank, Société Générale, in February
2008 and resulted in a US$7.2 billion in trading losses. The trader, Jérôme Kerviel, traded futures on the European stock indexes and
took large positions on the expectation that European markets would continue to rise. At the end of 2007 the trades were profitable. But
at the beginning of 2008 the market turned against him, as the global financial crisis hit, and European markets fell sharply. The result
was the largest market-risk related loss by any trader at any time. The operational risk occurred as Mr Kerviel was able to circumvent
the bank’s controls because he had previously worked in the bank's 'back office' and had prior knowledge of the processing of trades.
Operational risk can occur from external frauds such as the Ponzi scheme fraud committed in the US by Bernie Madoff, a hedge fund
manager, in 2009. Bernie Madoff lost US$65 billion in client funds as a part of a giant Ponzi scheme, the largest investor fraud ever

lOMoARcPSD|6189550
committed by an individual in the US.
AACSB: Reflective thinking

Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 10–15

Chapter 04 Testbank Summary
Category # of Question
s
AACSB: Analytic 74
AACSB: Reflective thinking 2
Bloom's: Application 36
Bloom's: Comprehension 1
Bloom's: Knowledge 39
Bloom's: Knowledge 39
Difficulty: Easy 15
Difficulty: Hard 12
Difficulty: Medium 49
Est time: 1–3 40
Est time: 10–15 4
Est time: <1 32
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance 14
Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing manag 4
ers of modern FIs
Learning Objective: 4.2 Understand the significance of market risk for FIs 4
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs 13
Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers 4
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs 8
Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs 3
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management 12
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs 12
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks 5

Chapter 4 Risks of Financial Institutions

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Chapter 4 Risks of financial institutions

Bank Management (Western Sydney University)

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Chapter 4 Risks of ﬁnancial institutions

If an FI is long-funded it means that the:

An FI that holds more short-term assets relative to long-term liabilities is:

An example of reﬁnancing risk is a case in which an FI:

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Market risk is deﬁned as the risk:

The market risk of an FI increases with:

Non-performing loans are deﬁned as loans that:

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What does systematic credit risk mean?

can be reduced by diversiﬁcation.

Which of the following are typical off-balance-sheet activities?

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What are the major objectives of technological expansion?

What type of risk focuses upon future contingencies?

Which of the following is a suitable description of the term 'economies of scope'?

Which of the following is a suitable description of the term 'economies of scale'?

Which of the following are typical operational risk sources?

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The FI holds !00 million in assets and !70 million in liabilities.

The FI holds !100 million in assets and !100 million in liabilities.

The FI holds 70 million in assets and !100 million in liabilities.

Sovereign risk refers to the risk that repayments from:

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Unanticipated diseconomies of scale and scope are a result of:

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A letter of credit is:

Matching the foreign currency book protects the FI from:

An example of a discrete risk is sudden changes in:

Downloaded by Huy?n Trân Tr?n Nguy?n (trannguyen29052001@gmail.com)

Event risks such as earthquakes, fraud and theft:

During periods of high and volatile inﬂation, an FI's:

An FI with a low level of leverage, such as a high level of capitalisation:

The collapse of the US bank IndyMac Bank was an example of:

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D. insolvency and liquidity risk

The Bank for International Settlements:

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C. currency risk

Which of the following situations pose a reﬁnancing risk for an FI?

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C. foreign exchange risk

The potential exercise of unanticipated contingencies can result in:

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A short-funded FI is exposed to increasing interest rates.

Firm-speciﬁc credit risk can be reduced by diversiﬁcation.

Systematic credit risk can be reduced by diversiﬁcation.

Downloaded by Huy?n Trân Tr?n Nguy?n (trannguyen29052001@gmail.com)

Downloaded by Huy?n Trân Tr?n Nguy?n (trannguyen29052001@gmail.com)

Downloaded by Huy?n Trân Tr?n Nguy?n (trannguyen29052001@gmail.com)

Chapter 04 Testbank Key

If an FI is long-funded it means that the:

Downloaded by Huy?n Trân Tr?n Nguy?n (trannguyen29052001@gmail.com)

B. liquidity and technology risk

An FI that holds more short-term assets relative to long-term liabilities is:

An example of reﬁnancing risk is a case in which an FI: