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Chapter 04 Testbank

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

A.
B.
C.
D.

maturity of assets equals the maturity of liabilities


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

credit and interest rate risk


liquidity and technology risk
solvency and technology risk
off-balance-sheet and interest rate risk

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

A.
B.
C.
D.

exposed to refinancing risk


exposed to restructuring risk
exposed to reinvestment risk
not exposed to any risks

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

A.
B.
C.
D.

funds two-year maturity assets with one-year maturity liabilities


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

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

A.
B.
C.
D.

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

decreased and thus the market value of an FI's assets and liabilities decreases
increased and thus the market value of an FI's assets and liabilities decreases
increased and thus the market value of an FI's assets and liabilities increases
decreased and thus the market value of an FI's assets and liabilities increases

7.
Market risk is defined as the risk:

A.
B.
C.
D.

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

8.
The market risk of an FI increases with:

A.
B.
C.
D.

increasing volatility of asset prices


increasingly large unhedged short positions in bonds, equities and other commodities
increasingly large unhedged long positions in bonds, equities and other commodities
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.
B.
C.
D.

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

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

A.
B.
C.
D.

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

11.
What does systematic credit risk mean?

A.
B.
C.
D.

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

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

13.
can be reduced by diversification.

A.
B.
C.
D.

Firm-specific credit risk


Systematic credit risk
Firm-specific and systematic credit risks
None of the listed options are correct.

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

A.
B.
C.
D.

their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC
their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the GFC
Australian banks' profitability fell and Australian FIs were severely impacted by the GFC
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.
B.
C.
D.

letters of credit
loan commitments
forward contracts, swaps and other derivative securities
All of the listed options are correct.

16.
What are the major objectives of technological expansion?

A.
B.
C.
D.

To lower operating costs, increase profits and capture new markets.


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

17.
What type of risk focuses upon future contingencies?

A.
B.
C.
D.

liquidity risk
interest rate risk
credit risk
off-balance-sheet risk

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

A.
B.
C.
D.

the use of several inputs to produce one common output


the ability to generate cost savings by producing more than one output with the same inputs
the ability to lower average operating costs by expanding its output of financial services
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'?

A.
B.
C.
D.

the use of several inputs to produce one common output


the ability to generate cost savings by producing more than one output with the same inputs
the ability to lower average operating costs by expanding its output of financial services
the ability to lower average operating costs by lowering its output of financial services

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

A.
B.
C.
D.

employee fraud
back-office failures
general technological glitches
All of the listed options are correct.

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

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

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

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 rates in the
Eurozone.
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.
B.
C.
D.

local borrowers are interrupted because of interference from foreign governments


foreign borrowers are interrupted because of interference from local governments
foreign borrowers are interrupted because of interference from foreign governments
None of the listed options are correct.

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

A.
B.
C.
D.

technology risk
interest rate risk
foreign exchange risk
credit risk

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

A.
B.
C.
D.

technology risk
interest rate risk
credit risk
off-balance-sheet risk

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

A.
B.
C.
D.

sovereign or country risk


interest rate risk
credit risk
foreign exchange risk

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

A.
B.
C.
D.

credit risk
political risk
currency risk
market risk

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

A.
B.
C.
D.

credit risk
political risk
currency risk
interest rate risk

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

A.
B.
C.
D.

credit risk
sovereign risk
currency risk
liquidity risk

31.
A letter of credit is:

A.
B.
C.
D.

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
an on-balance-sheet transaction for the issuing FI
a credit guarantee issued by an FI on which payment is contingent on some future event occurring
None of the listed options are correct.

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.
B.
C.
D.

reinvestment risk
refinancing risk
interest rate risk
refinancing risk and interest rate risk

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

A.
B.
C.
D.

sovereign country risk


interest rate risk
liquidity risk
foreign exchange risk

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

A.
B.
C.
D.

technology risk
interest rate risk
credit risk
foreign exchange risk

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

A.
B.
C.
D.

the interest rate


banking regulations
foreign exchange rates
commodity prices

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

A.
B.
C.
D.

do not have an impact on an FI's performance


are easy to measure and to predict
form a normal cost of doing business for FIs
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.
B.
C.
D.

interest rate risk exposure and credit risk exposure tends to decrease
interest rate risk exposure and credit risk exposure tends to increase
interest rate risk exposure and credit risk exposure tends to be unaffected
None of the listed options are correct.

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

A.
B.
C.
D.

is generally less profitable


is better able to withstand losses
has improved ability to remain solvent
All of the listed options are correct.

39.
Credit risk puts both the principal loaned and expected interest payments at risk. As a result, FIs issue financial claims that have a riskreturn
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.
B.
C.
D.

market risk
operational risk
insolvency risk
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
D. All of the listed options are correct.
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.
B.
C.
D.

market risk
credit risk
operational risk
technological risk

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

A.
B.
C.
D.

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

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

credit risk and liquidity risk


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

sovereign risk
market risk
insolvency risk
technological 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.
B.
C.
D.

liquidity risk
reinvestment risk
credit risk
foreign exchange risk

50.
The major source of risk exposure resulting from issuance of standby letters of credit is:

A.
B.
C.
D.

interest rate risk


credit risk
foreign exchange risk
off-balance-sheet risk

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

A.
B.
C.
D.

an additional obligation, or claim, on the FI's net worth


an additional profit for the FI
an increase in assets
None of the listed options are correct.

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

A.
B.
C.
D.

technology risk
interest rate ris.
credit risk
off-balance-sheet risk

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

A.
B.
C.
D.

sovereign country risk


interest rate risk
liquidity risk
foreign exchange 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.
B.
C.
D.

firm-specific risk
technological risk
operational risk
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.
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.

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.

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.

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.
B.
C.
D.

maturity of assets equals the maturity of liabilities


bank holds more long-term assets than short-term assets
maturity of liabilities is less than the maturity of assets
maturity of liabilities is longer than the maturity of its assets

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
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.
B.
C.
D.

credit and interest rate risk


liquidity and technology risk
solvency and technology risk
off-balance-sheet and interest rate risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance
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.
B.
C.
D.

exposed to refinancing risk


exposed to restructuring risk
exposed to reinvestment risk
not exposed to any risks

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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

A.
B.
C.
D.

funds two-year maturity assets with one-year maturity liabilities


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

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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

A.
B.
C.
D.

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

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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

A.
B.
C.
D.

decreased and thus the market value of an FI's assets and liabilities decreases
increased and thus the market value of an FI's assets and liabilities decreases
increased and thus the market value of an FI's assets and liabilities increases
decreased and thus the market value of an FI's assets and liabilities increases

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

7.
Market risk is defined as the risk:

A.
B.
C.
D.

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

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.2 Understand the significance of market risk for FIs

8.
The market risk of an FI increases with:

A.
B.
C.
D.

increasing volatility of asset prices


increasingly large unhedged short positions in bonds, equities and other commodities
increasingly large unhedged long positions in bonds, equities and other commodities
All of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.2 Understand the significance of market risk for FIs

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.
B.
C.
D.

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

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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

A.
B.
C.
D.

are either in default or close to being in default and are at least 90 days in arrears
have been written off and loans that are at least 80 days in arrears
are either in default or close to being in default and are at least 60 days in arrears
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: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

11.
What does systematic credit risk mean?

A.
B.
C.
D.

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

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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

A.
B.
C.
D.

FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified.
FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified.
None of the listed options are correct, as FIs can diversify both types of credit risk.
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: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

13.
can be reduced by diversification.

A.
B.
C.
D.

Firm-specific credit risk


Systematic credit risk
Firm-specific and systematic credit risks
None of the listed options are correct.

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

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

A.
B.
C.
D.

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

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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

A.
B.
C.
D.

letters of credit
loan commitments
forward contracts, swaps and other derivative securities
All of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
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.
B.
C.
D.

To lower operating costs, increase profits and capture new markets.


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

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

17.
What type of risk focuses upon future contingencies?

A.
B.
C.
D.

liquidity risk
interest rate risk
credit risk
off-balance-sheet risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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

A.
B.
C.
D.

the use of several inputs to produce one common output


the ability to generate cost savings by producing more than one output with the same inputs
the ability to lower average operating costs by expanding its output of financial services
the ability to lower average operating costs by lowering its output of financial services

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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

A.
B.
C.
D.

the use of several inputs to produce one common output


the ability to generate cost savings by producing more than one output with the same inputs
the ability to lower average operating costs by expanding its output of financial services
the ability to lower average operating costs by lowering its output of financial services

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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

A.
B.
C.
D.

employee fraud
back-office failures
general technological glitches
All of the listed options are correct.

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

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

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

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

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.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
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 rates in the
Eurozone.
B. An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the
Eurozone.
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
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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

A.
B.
C.
D.

local borrowers are interrupted because of interference from foreign governments


foreign borrowers are interrupted because of interference from local governments
foreign borrowers are interrupted because of interference from foreign governments
None of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
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.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers

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

A.
B.
C.
D.

technology risk
interest rate risk
foreign exchange risk
credit risk

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

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

A.
B.
C.
D.

technology risk
interest rate risk
credit risk
off-balance-sheet risk

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

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

A.
B.
C.
D.

sovereign or country risk


interest rate risk
credit risk
foreign exchange risk

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

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

A.
B.
C.
D.

credit risk
political risk
currency risk
market risk

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

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

A.
B.
C.
D.

credit risk
political risk
currency risk
interest rate risk

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

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

A.
B.
C.
D.

credit risk
sovereign risk
currency risk
liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

31.
A letter of credit is:

A.
B.
C.
D.

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
an on-balance-sheet transaction for the issuing FI
a credit guarantee issued by an FI on which payment is contingent on some future event occurring
None of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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.
B.
C.
D.

reinvestment risk
refinancing risk
interest rate risk
refinancing risk and interest rate risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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

A.
B.
C.
D.

sovereign country risk


interest rate risk
liquidity risk
foreign exchange risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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

A.
B.
C.
D.

technology risk
interest rate risk
credit risk
foreign exchange risk

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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

A.
B.
C.
D.

the interest rate


banking regulations
foreign exchange rates
commodity prices

AACSB: Analytic
Bloom's: Application
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.
B.
C.
D.

do not have an impact on an FI's performance


are easy to measure and to predict
form a normal cost of doing business for FIs
may have a significant and negative impact on an FI's performance but are difficult to measure and to predict

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs

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

A.
B.
C.
D.

interest rate risk exposure and credit risk exposure tends to decrease
interest rate risk exposure and credit risk exposure tends to increase
interest rate risk exposure and credit risk exposure tends to be unaffected
None of the listed options are correct.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs

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

A.
B.
C.
D.

is generally less profitable


is better able to withstand losses
has improved ability to remain solvent
All of the listed options are correct.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
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 riskreturn
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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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

A.
B.
C.
D.

market risk
operational risk
insolvency risk
insolvency and liquidity risk

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks

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
AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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
D. All of the listed options are correct.
AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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.
B.
C.
D.

market risk
credit risk
operational risk
technological risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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

A.
B.
C.
D.

brokerage
asset transformation
investment research
trading

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

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.
B.
C.
D.

insolvency risk
sovereign risk
currency risk
liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks

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.
B.
C.
D.

credit risk and liquidity risk


operational risk and technology risk
credit risk and market risk
technology risk and liquidity risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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

A.
B.
C.
D.

sovereign risk
market risk
insolvency risk
technological risk

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

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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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.
B.
C.
D.

liquidity risk
reinvestment risk
credit risk
foreign exchange risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

50.
The major source of risk exposure resulting from issuance of standby letters of credit is:

A.
B.
C.
D.

interest rate risk


credit risk
foreign exchange risk
off-balance-sheet risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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

A.
B.
C.
D.

an additional obligation, or claim, on the FI's net worth


an additional profit for the FI
an increase in assets
None of the listed options are correct.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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

A.
B.
C.
D.

technology risk
interest rate ris.
credit risk
off-balance-sheet risk

AACSB: Analytic
Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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

A.
B.
C.
D.

sovereign country risk


interest rate risk
liquidity risk
foreign exchange risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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.
B.
C.
D.

firm-specific risk
technological risk
operational risk
insolvency risk

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks

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
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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

FALSE

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

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

TRUE

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

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
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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

TRUE

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

61.
Systematic credit risk can be reduced by diversification.

FALSE

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

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
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

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
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs

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
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs

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: 13
Learning Objective: 4.4 Discover why country or sovereign risk is a key concern of FI managers

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
Learning Objective: 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs

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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.3 Gain an understanding of the influence of credit risk on FIs

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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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 loansthat 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 FIs 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.

AACSB: Analytic
Bloom's: Comprehension
Difficulty: Medium
Est time: 1015
Learning Objective: 4.1 Learn about the importance of interest rate risk and its impact on FI performance

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 FIs 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 FIs 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 FIs 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 FIs balance sheet today or in the future. However, the fee earned for issuing the letter of credit guarantee appears on the FIs 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 FIs 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: 1015
Learning Objective: 4.7 Learn about the importance of off-balance-sheet risk on FI management

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 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 banks 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 banks 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: 1015
Learning Objective: 4.6 Understand the emphasis placed on liquidity risk management by FIs
Learning Objective: 4.9 Learn the importance of insolvency risk and its relationship to other risks

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, Socit Gnrale, in February 2008 and resulted
in a US$7.2 billion in trading losses. The trader, Jrme 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 banks 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 committed by an individual
in the US.

AACSB: Reflective thinking


Bloom's: Knowledge
Bloom's: Knowledge
Difficulty: Hard
Est time: 1015
Learning Objective: 4.8 Identify the importance of technology and operational risks for FIs

Chapter 04 Testbank Summary


Category
# of Questions
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: 13
40
Est time: 1015
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 managers of modern
4
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