FINAN 4300 Problem Set 11

Which financial statement should the allowance for loan losses appear in?

The allowance for loan losses (ALLL, now typically called the allowance for credit losses under CECL) appears on the balance sheet as a contra-asset account to loans. It reduces gross loans to arrive at net loans.

Identify two nondeposit sources of funds for a bank.

• repurchase agreements (repos)

• Federal Home Loan Bank (FHLB) advances or central bank advances

Of the nondeposit sources of funds, which is considered a choice of last resort?

Borrowing from the central bank (Federal Reserve discount window, or similar facilities) is typically a last resort. It signals liquidity stress and may carry stigma in markets and among supervisors

What is the difference between a REPO and a Reverse REPO?

A repo (repurchase agreement) is a liability the bank borrows cash and provides securities as collateral, agreeing to repurchase them later. A reverse repo is an asset the bank lends cash and takes securities as collateral, agreeing to resell them later.

Identify and explain two off-balance sheet accounts.

• Loan commitments

• Derivatives such as swaps, options, or futures.

• Each creates contingent exposures that can require funding or capital support even though not booked as traditional assets or liabilities.

What is another name for retained earnings that is used in a bank’s financial statement?

Retained earnings = undivided profits / accumulated earnings in bank statements

They represent cumulative profits that have not been paid out as dividends and form part of common equity

What is the difference between interest income and interest expense called?

Net Interest Income (NII) = difference between interest income and interest expense

Net Interest Margin (NIM) = When scaled to average earning assets

What is the name of the system that affects the money supply through money creation?

The traditional answer is the fractional reserve banking system, in which banks keep only a fraction of deposits in reserve and lend the rest. In modern practice, since 2020 the U.S. has a 0% reserve requirement, so money creation is constrained by capital and liquidity regulations, not statutory reserves

What is the key ingredient in the money creation formula that enables the creation process?

In modern banking, with a reserve requirement of zero, this formula no longer binds; instead, the key constraints are capital adequacy (CET1/RWA) and liquidity requirements (LCR/NSFR).

What impact does provision for loan losses have for a bank?

Higher provisions signal credit deterioration and can significantly reduce profitability even if actual charge-offs are low in the short run.

A bank’s deposits are considered assets because they represent cash that can be lent out to generate revenue.

False

Deposits are liabilities because they represent money owed to customers. Banks must be prepared to return deposits on demand, but they use them as funding to create assets like loans. They are valuable to the bank because they are stable and low-cost, not because they are assets

Cash and due from banks typically make up a significant portion of a large bank’s balance sheet, often more than 10%.

False

Cash and due from banks make up a very small share of assets, usually under 1% at large banks. Holding too much cash hurts profitability because cash earns little relative to loans or securities

Securities classified as held-to-maturity (HTM) are marked to market each period, and changes in value flow through Other Comprehensive Income (OCI).

False

Held-to-maturity (HTM) securities are reported at amortized cost and not marked to market. Available -for-sale (AFS) securities are marked to market with unrealized gains and losses flowing through Other Comprehensive Income (OCI). This distinction became important after SVB’s collapse.

A reverse repo is an asset for the bank because it represents a loan of cash secured by collateral.

True

In a reverse repo, the bank is lending cash and receiving securities as collateral. Because the bank is extending funds and will get them back, this appears as an asset.

The allowance for credit losses reduces the reported value of loans on the balance sheet and reflects expected future loan losses.

True

The allowance for credit losses (ACL) reduces the reported loan balance and represents expected future loan defaults under CECL accounting. It ensures the balance sheet reflects not the gross but the net realizable value of the loan book.

Off-balance sheet commitments and guarantees are recorded as assets or liabilities because they represent future obligations

False

Off-balance sheet items such as undrawn loan commitments or standby letters of credit are contingent and therefore not recorded as assets or liabilities. They only move onto the balance sheet if the loan is drawn or the guarantee is triggered

The Statement of Changes in Shareholders Equity links the income statement to the balance sheet by recording net income, dividends, and OCI flows.

True

The Statement of Changes in Shareholders Equity records flows into and out of equity: net income adds to retained earnings, dividends and buybacks reduce it, and OCI items bypass the income statement but still affect equity. It is the bridge between the income statement and the balance sheet.

Even though off -balance sheet exposures may be much larger than on -balance sheet items, the balance sheet remains central because it anchors regulatory capital and liquidity requirements.

True

Even when off -balance sheet exposures are larger than the balance sheet, regulators rely on the balance sheet because it anchors capital and liquidity requirements. Importantly, off -balance sheet exposures flow back onto the balance sheet when loans are drawn or guarantees triggered, so the balance sheet is still the regulatory anchor.

Net interest income is the difference between interest earned on assets and interest paid on liabilities, and it represents the core profitability of most banks.

True

Net interest income is the spread between what banks earn on loans, securities, and placements versus what they pay on deposits and debt. It is the backbone of most banks profitability.

Provisions for credit losses typically rise during economic expansions and fall during recessions.

False

Provisions generally rise in recessions when credit losses are expected to increase, and they fall or are released during expansions.

Banks with a higher share of noninterest income are generally less sensitive to changes in interest rates than banks heavily reliant on Net Interest Income

True

Noninterest income sources such as fees, trading, and wealth management diversify earnings away from interest rate sensitivity

Efficiency ratio is calculated as net interest income divided by total noninterest expense.

False

Efficiency ratio is calculated as noninterest expense ÷ total revenue (net interest income + noninterest income), not NII ÷ expense.

Return on Assets (ROA) is usually higher at large global banks than at regional banks.

False

ROA is usually lower at large global banks because their balance sheets are huge. Regionals often show similar or slightly higher ROA, even if absolute profits are smaller.

The cash flow statement of a bank is harder to interpret than a manufacturer’s because lending and securities activities straddle both operating and investing categories.

True

Bank cash flow statements are harder to interpret because core activities like lending and securities straddle operating and investing, unlike corporates where the lines are clear.

Other Comprehensive Income (OCI) can reduce equity even if a bank reports positive net income on the income statement.

True

OCI flows (like AFS securities losses) bypass the income statement but reduce equity directly, so equity can shrink even when net income is positive.

In modern banking systems, lending is constrained primarily by capital and regulatory requirements rather than reserve requirements.

True

Since March 2020 reserve requirements are zero, and in practice lending is constrained by capital adequacy, liquidity rules, and risk appetite

Which of the following best describes why bank liabilities are unique compared to corporate liabilities?

They are the raw material that funds earning assets.

Which of the following would appear as a liability on a bank’s balance sheet?

Core deposits

Which of the following securities classifications impacts equity through OCI when market values change?

Available-for-sale

Which funding source is considered to carry stigma and be used as a last resort?

Discount window borrowing

Which of the following would be deducted from Common Equity Tier 1 (CET1) capital?

Goodwill

Which of the following is most likely to generate fee income rather than interest income?

Loan commitments

Why might a bank’s reported balance sheet understate the true scale of its activities?

Because off-balance sheet exposures like commitments and derivatives are not fully recognized

Which of the following best explains how off-balance sheet items eventually affect the balance sheet?

They crystallize into assets or liabilities when exercised or triggered

Which of the following best explains why provisions for credit losses can swing bank earnings dramatically?

They are linked to forward-looking estimates of lifetime loan losses.

Which type of income is more likely to diversify a bank’s earnings away from interest rate sensitivity?

Trading and investment banking fees

Why might analysts emphasize Return on Tangible Equity (ROTE) over ROE for some banks?

It removes goodwill and intangibles to focus on true loss-absorbing capital.

Why are bank cash flow statements often less intuitive than those of corporates?

Deposit inflows/outflows show up in financing instead of operating.

Why is the statement of changes in shareholders’ equity critical for bank analysis?

It tracks how net income, dividends, buybacks, and OCI affect capital.

Which of the following is an implication of the modern view of money creation?

Loans create deposits, expanding both sides of the balance sheet instantly.

Why is noninterest expense such a key focus in bank analysis?

It is dominated by controllable categories like salaries, technology, and compliance.

Why might the traditional “money multiplier” model persist in textbooks despite being outdated?

It is simpler, elegant, and easy for teachers to demonstrate.