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FIN 286
STUDY GUIDE FOR MID TERM
SUMMER 2008
You have the entire class period to complete the test. You are allowed to bring in one sheet of paper with any notes
or information you would like to use on one side of the sheet.
CHAPTER 1 INTRODUCTION
CALCULATIONS None
CONCEPTS AND IDEAS: What is the difference between depository institutions and non depository institutions?
What is a financial intermediary? Explain the special roles of a financial intermediary in the financial sector. For
each of the special roles be able to explain why it is important and how financial institutions function within that
role. For each role explain how the function of the intermediary can decrease risks faced by participants in the
financial sector (the roles are: Economy wide services, institution specific services, brokerage functions, asset
transformation functions, maturity intermediation, denomination intermediation, payment mechanisms, Monetary
policy transmission, intergenerational transfer of wealth, and credit allocation). What types of problems exist in the
economy if financial intermediaries did not exist? Why are intermediaries highly regulated (relate this to some or all
of the roles they play)? Be able to discuss the various reasons and ways that intermediaries are regulated (safety and
soundness, monetary policy credit allocation, consumer protection, investor protection and entry regulation). What
is the purpose of safety and soundness regulation? How has the importance of different types of financial
institutions changed over the last 100 years in the US economy? How does the role of financial institutions relate to
the economic growth of a country? What is endogenous growth in an economy? How does it relate to more
traditional theories of economic growth? How does endogenous growth relate to the role of financial institutions in
the economy?
CHAPTER 7: INTRODUCTION TO RISKS
CALCULATIONS: None
CONCEPTS AND IDEAS: Be able to explain each of the types of risks faced by financial institutions (interest rate
risk, Market risk, credit risk, off balance sheet risk, technology and operational risk, foreign exchange risk, country
risk, liquidity risk, insolvency risk, macroeconomic risk and financial intermediation risks). What are the three
types of interest rate risk? Be able to explain each and provide examples of them. What is meant by Market risk?
Is market risk the same as market value risk? Explain the difference between firm specific credit risk and systematic
credit risk. What are some of the issues that would increase the off balance sheet risk of a financial institution? Be
able to explain what letters of credit are and how the relate to off balance sheet risk. What is the difference between
technology risk and operational risk? How are the two related? Explain the difference between economies of scope
and economies of scale and how they relate to risk reduction. What is meant by a net asset long or short position
when discussing foreign exchange risk. Explain how the correlation between different exchanges rates (or lack of
correlation) can create problems when managing foreign exchange risk. How does insolvency risk relate to other
types of risk? What is a discrete risk? How do macroeconomic risks create other types of risk. For each type of
risk, which institution is it most associated with? Be able to explain why.
CHAPTER 2 DEPOSITORY INSTITUTIONS
CALCULATIONS: None
CONCEPTS AND IDEAS: What is the main criteria for a financial institution to be termed a depository institution?
How has the business practices of depository institutions changed in the last 5 to 10 years? What is the impact of
the Financial Services Modernization Act of 1999 on changing the business practices of modern financial
institutions? Be able to identify and discuss key regulatory changes in the banking sector over the last 100 years.
What is a regulatory dialectic? Be able to relate the idea of a regulatory dialectic to changes in the banking sector
over the last 50 years. When was the FDIC established? Why was the FDIC established?. Be able to identify the
different regulatory changes with the reasons for regulation (for example: How does the role of the FDIC relate to
the reasons for regulation from chapter 1? -- It promotes safety and soundness). Be able to explain the changes
brought about by the financial services modernization act in detail. How did the Fin Services Modernization Act
create a wave of mergers in the banking industry? What are issues have not been addressed by the recent regulatory
changes? What is the difference between a community bank and a money center bank? Be able to explain the
categories present on a depository institutions balance sheet. What are the largest assets? What are the largest
liabilities? How as the composition of assets and liabilities changed over the last 50 years? How do the changes
relate to regulatory changes in the banking environment? For both assets and liabilities be able to identify and
explain the different categories that show up on the balance sheet. What are off balance sheet transactions? Be able
to provide examples of off balance sheet transactions. What are some of the ways that depository institutions
generate fee income? What is meant by fiduciary duties? How are savings and Loans and credit Unions different
than commercial banks? In what ways are the two the same? Explain the benefits of mutual ownership for a credit
union. What is the difference between a mutually owned institution and a corporate (shareholder) owned
institution?
FINANCIAL STATEMENT ANALYSIS AND THE UBPR
CALCULATIONS: Be able to calculate and interpret all of the financial ratios discussed in class. Be able to set up
the basic bank balance sheet, income statement, and flow of funds statements. Be able to decompose ROE and ROA
into its components (asset utilization, profit margin, equity multiplier. Be able to decompose each of the components
into their components. Be able to interpret changes in any of the components. Given the relevant information be
able to use the component to analyze changes in the banks financial position. Be able to look at a UBPR and
interpret the information and apply ration analysis to the information in the report similar to the group homework.
CONCEPTS AND IDEAS: What is listed on the depository institutions Report of Condition? For each entry be able to
break it down and talk about the components (for example how are deposits separated by type, maturity etc…).
Should bank attempt to keep the cash account high or low? Why? What is the difference between primary reserves
and secondary reserves? Are short-term interest earning assets generally more or less liquid than long term earning
assets? How is the net loan loss provision account used? How ode the net loan loss provision account decrease the
impact of loan losses on the balance sheet? How did the tax reform act of 1986 change the use of the ALL account?
What are federal funds sold? How has the asset composition of depository institutions changed over time? Be ale to
explain the different types of liabilities especially the different types of deposits. What is the difference between
using book value accounting and market value methods. What are the arguments for and against using “fair value”
on the balance sheet? Be able to set up the report of income (or income statement). What portion of income is
generally attributable to interest income? Be able to calculate Net Interest Margin. What is shown on the flow of
funds statement? What common characteristics do you expect to see when looking at the financial statements of
banks? Explain how REO and ROA relate to the profitability of the depository institution. What is shown by the
equity multiplier? (what does it mean if it is large? What if it is small?) What are the three main components of
ROE. Be able to use and explain each component (discuss what it means if there is an increase or decrease in the
component etc). How can asset utilization be decomposed into its separate parts. Be able to explain what each are.
Be able to decompose ROA into components (net interest margin and non interest margin) what do the burden ratio,
efficiency ratio and spread tell you about the institution? What agencies are responsible for developing the UBPR?
What was the rationale for the UBPR? Be able to perform analysis of the institutions financial statements similar to
what we covered in class and in the book (Rose chapter 4 and 5). Be able to discuss comparisons to peer groups,
why comparisons are good or bad and how they should be used, and changes over time in the institutions financial
position. Be able to perform analysis similar to that required by your short group project. Be able to look at the
asset and liability mix of an institution and discuss whether the institution may want to change its mix. Be able to
relate the asset liability mix to the level of income each asset provides and the cost each liability raises (which
liabilities are a cheap source of funds? Which are an expensive source of funds? Which assets are riskier based on
liquidity risk, based on credit risk, interest rate risk? Which are higher and lower earning?
CHAPTERS 8 AND 9 INTEREST RATE RISK
CALCULATIONS: Given the relevant inputs be able to calculate the standard static GAP of a FI, the cumulative
GAP, relative measures of GAP, maturity GAP and duration GAP. Be able to calculate the duration of an asset or
liability (and price)
CONCEPTS AND IDEAS: Be able to explain how the Federal Reserve conducts monetary policy using the Discount
Window, Reserve Requirements, and Open Market Operations. For each monetary policy tool be able to explain
how the Fed would use it in an effort to increase or decrease the level of interest rates in the economy. When using
open market operations what interest rate is the Fed attempting to change? Does it have the actual ability to set this
level of interest rates? Be able to use the loanable funds theory of interest rates to explain how economic changes
will cause an increase or decrease in the level of interest rates in the economy. Be able to explain how each of the
following impacts the saving and investment decision: the marginal rate of time preference, income and wealth
effects, foreign investment, and business decisions. How does the marginal productivity of capital impact the
decision to borrow and the demand for funds? Be able to explain the relationship between the level of interest rates
and savings (why is it upward sloping on the graph) be able to explain the relationship between the level of interest
rates and the level of borrowing (why is it downward sloping on the graph). Be able to discuss and show graphically
how changes in the determinants of saving or borrowing impact the level of interest rates (for example a decrease in
wealth or income). What is the “yield curve?” Be able to explain the expectations theories of the yield curve. How
do the pure expectations theory and local expectations theory differ? How are they the same? What are the
problems with the pure expectations theory? How do the problems relate to “price risk” and “reinvestment rate
risk?” How does the return to maturity expectations hypothesis differ from the pure expectations theory and local
expectations theory? Be able to explain the Liquidity, Segmented Markets, and Preferred Habitat Theories of the
yield curve. What GAP time frames are commercial banks required to report? Explain how GAP is used to measure
the level of interest rate risk faced by a FI. If a firm is asset sensitive is it’s GAP positive or negative? What if it is
Liability sensitive? How does the level of static GAP relate to the net interest income of the firm? Would you
expect a commercial bank to be asset or liability sensitive when looking at the next 6 months? next 5 years? explain
why. When using static GAP how does the use of book value accounting impact its use (how do changes in rates
impact eh balance sheet and income statement)? What is a cumulative GAP? What are the relative measures of
GAP? Be able to explain why a relative measure of GAP is preferred to the basic static measure of GAP. Be able
to explain why and how GAP is adjusted to find relative measures of GAP. What is meant by a rate sensitive asset
or liability? Should core deposits be considered as rate sensitive? (be able to argue both for and against inclusion
of core deposits). If you expect an increase in interest rates would it be better for your GAP to be positive or
negative? Explain. What is the spread effect? How does it limit the ability to use GAP? What are the strengths and
weaknesses of using static GAP? Be able to explain the weaknesses of using static GAP. What factors may impact
Net Interest Income that are not captured by GAP? (These changes do not count as weaknesses). How can the basic
GAP model be extended? What weaknesses of the standard model does maturity GAP attempt to solve? What does
it mean if the maturity GAP is positive? What if it is negative? Relate the use of maturity GAP to the balance sheet.
Does matching the maturity of assets and liabilities completely immunize a FI from interest rate changes? Explain in
detail. Be able to calculate the duration of an asset or liability. How can you use the Macaulay Duration to estimate
the price change of an asset? How is modified duration found from Macaulay Duration? How is modified duration
used to estimate the price change of an asset? How is duration related to the maturity, payments, and embedded
options of assets? Explain the idea of convexity. How is the duration Gap calculated? How does an increase or
decrease in the level of interest rates impact the firm if the basic duration gap is positive? What if it is negative? If
the duration of assets is equal to the duration of liabilities is the firm immunized from possible changes in the level
of interest rates? How dues DGAP relate to the market value of the firm’s equity? What does it mean if DGAP is
positive? What if it is negative? What are the weaknesses of using DGAP? What general problems (other than its
weaknesses) decrease the ability of a FI to use DGAP? What are some of the weaknesses / problems associated with
using duration? How does the convexity of an asset or liability impact the use of DGAP? How does default risk
impact the use of duration? What methods can you use to measure the sensitivity of demand deposits to interest rate
changes? How does prepayment risk impact mortgages and mortgage backed securities? Are off balance sheet
items accounted for in GAP analysis?
Make sure to be prepared to answer questions related to all of the readings on the first set of group reading
questions. Additionally make sure to read the following two articles.
Interest Rate Risk: What it is, why banks would want it, and how to evaluate it. Ron Feldman and Jason Schmidt
http://minneapolisfed.org/pubs/fedgaz/00-07/banking.cfm
Supervising Interest Rate Risk Management. Jose Lopez
http://www.frbsf.org/publications/economics/letter/2004/el2004-26.pdf