Chapter 06 Measuring and Evaluating the Performance of Banks and Their

Principal Competitors Answer Key

Fill in the Blank Questions

1. The equity multiplier measures the amount of _____________________ for a bank and is one
principal component of the bank's ROE.

leverage (debt)

2. __________________________ risk is one that deals with the quality of the bank's assets and, in
particular, the bank's loans.

Credit

3. A phenomenon wherein interest rates and security prices in the financial marketplace move
against a troubled firm, forcing it to make crucial adjustments in policies and performance in order
to calm investors' worst fears is often referred to as __________________ by economists.

market discipline

4. __________________________ assets of a financial institution are those that will mature or be

repriced within a set period of time.

Interest-sensitive

5. __________________________ is the risk that the value of the financial institution's asset
portfolio will decline due to falling market prices.

Market risk

6. For a bank, sources of funds like Eurodollars, Fed funds, repurchase agreements, and large CDs
are categorized as ____________________.

purchased funds

7. __________________________ is the risk that a financial institution may not be able to meet the
needs for cash of its depositors.

Liquidity risk
8. __________________________ assets, including loans, are those which are past due by 90 days
or more.

Nonperforming

9. One of the principal components of evaluating ROE is _____________________ ratio, which

reflects a bank's portfolio management policies and the mix and yield on its assets.

asset utilization

10. __________________________ reflects the effectiveness of the expense management of a bank

and is one of the principal components of evaluating ROE.

Net profit margin

11. __________________________ measures the return to stockholders on their investment in a

bank. It is the product of net profit margin, asset utilization, and the equity multiplier.

Return on Equity (ROE)

12. __________________________ measures the amount of debt or leverage a bank has and is one
part of the evaluation of the bank's ROE. It is generally a number larger than one.

Equity multiplier

13. The __________________________ is a standardized report provided by federal regulators

which reports the balance sheet, income statement, and other data for all federally supervised
banks. It also contains information on peer institutions.

Uniform Bank Performance Report

14. The cumulative impact of all the risks (market risk, credit risk, operational risk, and legal and
compliance risk) put together that can affect a financial firm's long-run survival is often referred to
as _________________________.

capital risk

15. __________________________ is the risk that shifting interest rates in the market will adversely
affect a financial institution's net income or the value of its assets or equity.

Interest rate risk

16. The ____________________ Act restricts combined auditing and consulting relationships in order
to promote auditor independence and objectivity.

Sarbanes-Oxley
17. ________________________ is one of the most widely respected private institutions that rates
the credit quality of financial institutions.

Thomson's BankWatch, Inc.

18. ________________________ refers to the uncertainty regarding a financial firm's earnings due to
failures in computer systems, errors, misconduct by employees, lightning strikes, and similar
events.

Operational (transactional) risk

19. ________________________ refers to variability in earnings resulting from actions taken by the
legal system including unenforceable contracts, lawsuits, and adverse judgements.

Legal risk

20. ________________________ includes violations of rules and regulations. It can include failure to
hold adequate capital which can lead to costly corrective actions.

Compliance risk

21. ________________________ is the uncertainty associated with public opinion. Negative publicity
(whether true or not) can affect a financial firm's earnings by dissuading customers from using the
services of the institution.

Reputation risk

22. As data processing of financial information becomes more important, managers of financial firms
can realize cost savings from _______________________, transferring tasks from inside the firm
to other firms specializing in information technology.

outsourcing

23. One of the traditional measures of earnings efficiency is ________________________ or total

interest income over total earnings assets less total interest expenses over total interest bearing
bank liabilities. It measures the effectiveness of a firm's intermediation function in the borrowing
and lending of money.

earnings spread

24. One part of ROE is ________________________ or net income divided by pre-tax net operating
income, which measures a financial firm's use of security gains and losses and other tax
management tools to minimize tax exposure.

tax management efficiency

25. Net profit margin can be split into two parts, ________________________ and tax management
efficiency. The first part is pre-tax net operating income over total operating revenue which looks
at how many dollars of revenue survive after operating expenses are removed.

expense control efficiency

True / False Questions

26. Financial institutions that pursue the "quiet life" as a goal face less risk of losing earnings or
market share.

TRUE

27. Basic principles of financial management suggest that attempting to maximize a bank's stock
value is the key objective for banks which should have priority over all other goals.

TRUE

28. If the expected stream of future dividends for a bank's shareholder rises, the bank's stock price
should also rise, other factors held constant.

TRUE

29. If the discount factor associated with the value of a bank's stock rises, the bank's stock price
should rise, other factors held constant.

FALSE

30. A bank's ROA equals its ROE times the ratio of total assets divided by total equity capital.

FALSE

31. According to the textbook, a bank's asset-utilization ratio reflects the mix and yield on a bank's
portfolio of assets.

TRUE

32. A bank's profit margin or ratio of net after-tax income to total operating revenue is a measure of
financial leverage for a bank.

FALSE
33. According to the text, the ratio of a bank's net after-tax income to pre-tax net operating income is a
measure of tax management efficiency.

TRUE

34. According to the textbook, the ratio of a bank's pre-tax net operating income to total operating
revenues is a measure of expense-control efficiency.

TRUE

35. The ratio of non-performing assets to total loans and leases is a measure of credit risk in banking
industry.

TRUE

36. One of the measures of a bank's efficiency and return is "earnings spread". It is calculated by the
ratio of total interest income to total liabilities as reduced by the ratio of total interest expenses to
total assets.

FALSE

37. In recent years, the U.S. banking industry's equity multiplier has generally risen in response to
regulatory pressure to raise more capital.

FALSE

38. If a bank adds more full-time employees and posts the same net operating income, its employee
productivity ratio, as defined in the text, must fall.

TRUE

39. According to the textbook, the most profitable U.S. banks in terms of both ROA and ROE are
medium-size institutions in the asset size range of $100 million to $10 billion.

TRUE

40. ROA measures how capably the management of a financial institution has been converting the
institution's assets into net earnings.

TRUE

41. The noninterest margin is generally positive for most banks.

FALSE

42. The ratio of nonperforming assets to total loans and leases is considered to be a measure of a
bank's market risk.

FALSE
43. Charge-offs represent the securities a bank decides to sell because they have declined in value.

FALSE

44. Loans past due for 90 days or more are classified as nonperforming assets.

TRUE

45. The ratio of cash and government securities to total assets is considered to be a measure of
liquidity risk in banking.

TRUE

46. The ratio of uninsured deposits to total deposits is considered to be a measure of credit risk in
banking.

FALSE

47. The interest rate spread between market yields on bank debt issues (such as capital notes and
CDs) and the market yields on government securities of the same maturity is considered to be a
measure of market risk in banking.

FALSE

48. The ratio of a bank's net operating income to the number of a bank's full-time-equivalent
employees is called the employee productivity ratio.

TRUE

49. Smaller banks usually have fewer liquid assets than larger banks.

FALSE

50. A bank's asset utilization ratio reflects the effectiveness of the bank's expense management.

FALSE

51. The FDIC is a private credit rating company which provides credit ratings on the short term and
long term securities issued by banks.

FALSE

52. During the 1980s, the Comptroller of the Currency, the Federal Reserve and the FDIC created a
new tool called the Uniform Bank Performance Report to help them analyze the financial condition
of banks.

TRUE
53. Liquidity risk examines the quality of a bank's assets and, in particular, the quality of the bank's
loans.

FALSE

54. A bank's degree of asset utilization (AU) or the ratio of total operating revenues to total assets is a
measure of asset management efficiency, especially in terms of the mix and yield on assets.

TRUE

55. The main reason behind the failure of Superior Bank of Chicago and eventual FDIC's takeover of
this institution in 2001 was attributed to misleading accounting practices of inflating asset values
and revenues deflating liabilities and expenses.

FALSE

Multiple Choice Questions

56. The ratio of a bank's interest income from its loans and security investments less interest
expenses on debt issued, divided by total earning assets measures a bank's:

A. net operating margin.

B. net return before special transactions.
C. net interest margin.
D. return on assets.
E. None of the options is correct

57. ROE for a bank is calculated by:

A. dividing net after-tax income by total equity capital.

B. dividing total operating revenue less operating expenses by total assets.
C. dividing net pre-tax income by total equity capital.
D. noninterest income less noninterest expenses divided by total earning assets.
E. None of the options is correct.
58. The difference between such sources of bank income as service charges on deposits and
trust-service fees, and such sources of bank expenses as salaries and wages and overhead
expenses divided by total assets or total earning assets is called the:

A. net profit margin.

B. net operating margin.
C. net noninterest margin.
D. net return on assets.
E. None of the options is correct.

59. A bank's ROE equals its ROA times its:

A. net profit margin.

B. total assets divided by total equity capital.
C. total operating revenues divided by total assets.
D. ratio of net after-tax income to total operating revenues.
E. None of the options is correct.

60. The earnings spread for a bank is equal to:

A. total interest income divided by total earning assets less total interest expense divided by total
interest-bearing bank liabilities.
B. total interest income less total interest expenses divided by earning assets.
C. total operating revenues less total operating expenses divided by total assets.
D. total cash and noncash expenses subtracted from interest and noninterest income divided by
total assets.
E. None of the options is correct.

61. The employee productivity ratio for a bank is equal to:

A. net operating revenue less total interest expenses per employee.

B. total interest and noninterest expense per employee.
C. net operating income per full-time-equivalent employee.
D. total operating earnings less salaries and wages expense per employee.
E. None of the options is correct.
62. A larger proportion of small and medium-size bank's loans tend to be:

A. lower-interest-business loans.
B. higher-interest business loans.
C. lower-interest consumer loans.
D. higher-interest consumer loans.
E. None of the options is correct.

63. A bank's stock price will tend to rise if the:

A. value of the stream of future stockholder dividends is expected to increase.

B. banking organization's perceived level of risk increases.
C. expected dividends decrease.
D. All of the options are correct.
E. None of the options is correct.

64. The ratio that equals total interest income divided by total earning assets less total interest
expense divided by total interest-bearing liabilities is known as the:

A. earnings base.
B. earnings spread.
C. net income margin.
D. net return prior to special transactions.
E. None of the options is correct

65. What do loans and security investments represent for a bank?

A. Earning assets
B. Contra-assets
C. Discretionary accounts
D. Market-valued assets
E. None of the options is correct
66. The tax-management efficiency ratio consists of:

A. total tax liabilities over net income.

B. tax-exempt assets over taxable assets.
C. net income over pre-tax net operating income.
D. taxes owed over total liabilities of a bank.
E. None of the options is correct.

67. The risk that a financial institution may be forced to borrow emergency funds excessive cost to
cover its immediate cash needs is known as:

A. credit risk
B. liquidity risk
C. market risk
D. interest-rate risk
E. None of the options is correct

68. ROE for a bank indicates:

A. how capable the management has been in converting assets into net earnings.
B. the growth of bank's interest margin.
C. the growth of bank's earnings spread.
D. the rate of return flowing to the shareholders of the bank.
E. All of the options are correct.

69. Which of the following ratios can be used to measure a bank's credit risk?

A. Net loans' duration/Total assets

B. Interest sensitive assets/Interest sensitive liabilities
C. Total assets/Number of full time employees
D. Nonperforming assets/Total loans and leases
E. Cash and equivalents/Total loans and leases
70. A bank that has a low profit margin most likely:

A. is doing a poor job of controlling expenses.

B. has a small amount of financial leverage.
C. has a small amount of liquidity risk.
D. has assets that are not very productive.
E. None of the options is correct.

71. A bank that has a high asset utilization (AU) ratio most likely:

A. is doing a poor job of controlling expenses.

B. has a small amount of financial leverage.
C. has a small amount of liquidity risk.
D. is allocating assets to the most productive investments.
E. None of the options is correct

72. Which of the following would be the best example of a ratio used to examine the cost of one of a
bank's liabilities?

A. Demand deposits/Total assets

B. Interest on time deposits/Total time deposits
C. Interest on real estate loans/Total real estate loans
D. Interest sensitive assets/Interest sensitive liabilities
E. Interest on business loans/Total business loans

73. Which of the following would be the best example of a ratio used to examine the return on one of
a bank's assets?

A. Demand deposits/Total assets

B. Interest on time deposits/Total time deposits
C. Interest on real estate loans/Total real estate loans
D. Interest sensitive assets/Interest sensitive liabilities
 E. Interest on CDs/Total CDs issued

74. Which of the following would be the best example of a ratio used to examine a bank's interest rate
risk?

A. Demand deposits/Total assets

B. Interest on time deposits/Total time deposits
C. Interest on real estate loans/Total real estate loans
D. Interest sensitive assets/Interest sensitive liabilities
E. Nonperforming assets/Total capital

75. A bank expects to pay a dividend of $3.45 next year and growth rate on dividends to be 7%. If the
appropriate discount rate is 15%, what should the bank's stock price be in the market?

A. $23.00
B. $43.13
C. $46.14
D. $49.29
E. $24.61

76. Following is the information for Carter State Bank. What is the bank's ROE?

A. 8.46 percent
B. 16.03 percent
C. 15.71 percent
D. 1.36 percent
E. None of the options is correct
77. Following is the information listed below for Carter State Bank. What is the bank's ROA?

A. 8.46 percent
B. 16.03 percent
C. 15.71 percent
D. 1.36 percent
E. None of the options is correct

78. Following is the information listed below for Carter State Bank. What is the bank's net profit
margin?

A. 8.46 percent
B. 16.03 percent
C. 15.71 percent
D. 1.36 percent
E. None of the options is correct

79. Following is the information listed below for Carter State Bank. What is the bank's asset utilization
ratio?

A. 8.46 percent
 B. 16.03 percent
C. 15.71 percent
D. 1.36 percent
E. None of the options is correct

80. The TRC Bank has a net profit margin of 7.5%, an asset utilization ratio of 18%, and an equity
multiplier of 20. What is the bank's ROA?

A. 27.00 percent
B. 1.35 percent
C. 7.50 percent
D. 1.50 percent
E. 3.6 percent

81. The TRC Bank has a net profit margin of 7.5%, an asset utilization ratio of 18%, and an equity
multiplier of 20. What is the bank's ROE?

A. 27.00 percent
B. 1.35 percent
C. 7.50 percent
D. 1.50 percent
E. 3.6 percent

82. The Smith-James Bank has an ROE of 17.5%, an asset utilization ratio of 13%, and a net profit
margin of 9%. What is the bank's ROA?

A. 14.96 percent
B. 1.58 percent
C. 1.17 percent
D. 134.62 percent
E. None of the options is correct
83. The Smith-James Bank has an ROE of 17.5%, an asset utilization ratio of 13%, and a net profit
margin of 9%. What is the bank's equity multiplier?

A. 14.96 times
B. 1.58 times
C. 1.17 times
D. 134.62 times
E. None of the options is correct

84. What is the equity multiplier for a bank whose equity is equal to 10 percent of total assets?

A. 90.0
B. 10.0
C. 1.
1
D. 110.0
E. 1.
0

85. Which of the following ratios would be a measure of credit risk?

A. Net charge-offs of loans/Total loans and leases

B. Interest on CDs/Total CDs issued
C. Interest Sensitive Assets/Interest Sensitive Liabilities
D. Equity Capital/Total Assets
E. None of the options is correct

86. Which of the following ratios would be a measure of market risk?

A. Nonperforming Loans/Net Loans

B. Net Loans/Total Assets
C. Cash and equivalents/Total assets
D. Equity Capital/Total Assets
E. None of the options is correct
87. In recent years, banks have been __________ profitable than (as) S&Ls and Savings Banks.

A. more
B. less
C. a
s
D. much more
E. much less

88. Operational risk includes which of the following?

A. Failure of bank's computer system

B. Closure of a bank for three months due to flooding from a major hurricane
C. Embezzlement of funds of a bank by a teller of the bank
D. Closure of a bank for two weeks due to a fire from a lightning strike
E. All of the options are correct.

89. Brian Smith, the CEO of Carter National Bank, anticipates that interest rates may fall in the future
and as a result buys $100 million in 30 year Treasury Bonds for the bank's security portfolio.
Instead, interest rates rise, causing the value of these bonds to fall. This would be an example of
which of the following types of risk?

A. Operational risk
B. Legal risk
C. Compliance risk
D. Strategic risk
E. Reputation risk

90. Chaos State Bank has an old computer system which can go down for weeks at a time, leaving
customers unable to access their accounts online. Many customers have left the bank for banks
with more reliable computer systems. Which type of risk would this be an example of?

A. Operational risk
 B. Legal risk
C. Compliance risk
D. Strategic risk
E. Reputation risk

91. Carson County State Bank has a ratio of equity capital to total assets of 2.5%. The regulators
have asked all banks of similar size to maintain a capital adequacy ratio of 8%. They are making
the bank issue new stock in the market. In addition, they are not allowing the bank to issue
dividends to their current stockholders. Which type of risk would this be an example of?

A. Operational risk
B. Legal risk
C. Compliance risk
D. Strategic risk
E. Reputation risk

92. Everett Bank has just learned that there is a disgruntled former employee who has created a blog
that is telling everyone that Everett Bank has halved their customer service representatives and
therefore customers have great difficulty getting through to a relationship officer when there is a
problem with their account. Everett is worried that it may lose customers as a result of such a
write-up. Which type of risk would this be an example of?

A. Operational risk
B. Legal risk
C. Compliance risk
D. Strategic risk
E. Reputation risk

93. Norman Bank made a loan of $1,000,000 to Jarod LeFevre. Jarod has declared bankruptcy and
Norman Bank has just learned that the judge in the case has ruled that Jarod does not have to
pay any part of the loan back or forfeit any of his assets. Which type of risk would this be an
example of?

A. Operational risk
B. Legal risk
C. Compliance risk
 D. Strategic risk
E. Reputation risk

94. Forrest Fennell is planning to invest in Capital City Bank. He is examining the ratios of
nonperforming loans to total loans and leases and the provision for loan losses to total loans and
leases. What type of risk is Forrest attempting to measure with these ratios?

A. Credit risk
B. Liquidity risk
C. Market risk
D. Interest rate risk
E. Operational risk

95. Gerald Wilkens is planning to invest in the stock of Tallahassee State Bank. He is examining the
ratios of cash assets and government securities to total assets and purchased funds to total
assets. What type of risk is Gerald attempting to measure with these ratios?

A. Credit risk
B. Liquidity risk
C. Market risk
D. Interest rate risk
E. Operational risk

96. Amy Farmer is planning to invest in the stock of Guthrie National Bank. She is examining ratios of
the book value of the assets to the market value of the assets and the market value of the bonds
held by the bank to their recorded value. What type of risk is Amy attempting to measure with
these ratios?

A. Credit risk
B. Liquidity risk
C. Market risk
D. Legal risk
E. Operational risk
97. Paul Smith is planning to invest in the stock of Capital City Bank. He is examining the ratios of
interest sensitive assets to interest sensitive liabilities and uninsured deposits to total deposits.
What type of risk is Paul attempting to measure with these ratios?

A. Credit risk
B. Liquidity risk
C. Legal risk
D. Interest rate risk
E. Operational risk

98. The Garic State Bank of New Orleans has been under water for three weeks since hurricane
Katrina hit the state. The lobby is full of mud and other debris. Many of the valuables stored in the
bank's safety deposit boxes have been ruined. John Garic, the President and CEO of the bank,
has been working night and day to reopen the bank. What type of risk has John been dealing
with?

A. Credit risk
B. Liquidity risk
C. Market risk
D. Interest rate risk
E. Operational risk

Following data pertains to Castle State Bank.

99. What is Castle State Bank's ROE?

A. 20.45
%
 B. 18.33
%
C. 12.22
%
D. 7.33
%
E. 2.5
%

100. What is the bank's ROA?

A. 20.45
%
B. 18.33
%
C. 12.22
%
D. 7.33
%
E. 2.5
%

101. What is the bank's net profit margin?

A. 20.45
%
B. 18.33
%
C. 12.22
%
D. 7.33
%
E. 2.5
%
102. What is the bank's asset utilization ratio?

A. 20.45
%
B. 18.33
%
C. 12.22
%
D. 7.33
%
E. 2.5
%

103. What is the bank's equity multiplier?

A. 20.45 times
B. 18.33 times
C. 12.22 times
D. 7.33 times
E. 2.5 times

104. What is the bank's earnings spread?

A. 37.5
%
B. 22.22
%
C. 14.33
%
D. 7.89
%
E. 2.5
%
 The following financial information pertains to Harrison Bank.

105. What is the bank's ROA?

A. 1.6
%
B. 10
%
C. 12.8
%
D. 16
%
E. None of the options is correct

106. What is the bank's ROE?

A. 1.6
%
B. 10
%
C. 12.8
%
D. 16
%
E. None of the options is correct

107. What is the bank's equity multiplier?

A. 1.6 times
B. 10 times
C. 12.8 times
D. 16 times
 E. None of the options is correct

108. Harrison Bank has the following financial information:

What is the bank's asset utilization ratio?

A. 1.6
%
B. 10
%
C. 12.8
%
D. 16
%
E. None of the options is correct

109. Harrison Bank has the following financial information.

What is the bank's total operating revenue?

A. $125
B. $8,000
C. $488,281
D. $31,250,00
0
E. None of the options is correct
110. Which of the following assets are excluded from the category of risk assets?

A. Real Estate Loans

B. Commercial Paper
C. Plant and Equipment
D. Commercial and Industrial Loans
E. All of the options are correct

111. The value of a bank's stock will tend to rise if the:

A. stream of future stockholder dividends is expected to increase.

B. financial organization's perceived level of risk falls.
C. market interest rates decrease.
D. expected dividend increases are combined with declining risk, as perceived by investors.
E. All of the options are correct.

112. The Trust-worthy Bank had declared and paid a dividend of $2 last year. The dividend amount to
shareholders is expected to grow at the rate of 10 percent while the minimum acceptable rate for
the investors on the bank's stock is 15 percent. What is the price at which the stock of
Trust-worthy bank must be valued at in the market?

A. $40
B. $44
C. $38
D. $22
E. $88

113. A financial institution with a low ROA can achieve a relatively high ROE through:

A. high leverage.
B. low leverage.
C. high owner's capital.
 D. tax swap.
E. None of the options is correct.

114. Which of the following statements is true regarding Subchapter S firms?

A. These firms are liable to pay federal income taxes.

B. These firms cannot have more than 100 shareholders.
C. These firms need to pass-through at least half of their earnings to their shareholders.
D. Income from these firms is tax-exempt for its shareholders.
E. All of the options are true for Subchapter S firms.

115. Which of the following types of banks tend to enjoy the highest net-interest margins in the
industry?

A. Small-sized banks
B. Virtual banks
C. Investment banks
D. Large commercial banks
E. Federally chartered banks

116. The risk of deterioration in the value of a financial firm's assets as a result of fluctuating currency
prices is known as:

A. basis risk.
B. country risk.
C. political risk.
D. foreign-exchange risk.
E. economic risk.

117. The risk of a government's ability to repay its debt owed to international lending institutions is
known as:

A. market risk.
 B. credit risk.
C. operational risk.
D. sovereign risk.
E. legal risk.

118. Which of the following is an indicator of increasing capital risk in a bank?

A. Rise in the market yields on debt issued by a bank and market yields on government securities
of similar maturities
B. Fall in the ratio of stock price per share to earnings per share
C. Decline in the ratio of equity capital to total assets
D. Increase in purchased funds as a percentage of total liabilities
E. All of the options are correct.