Chapter 13

Chapter 13 Regulation of Commercial Banks True/False Questions 1. Banks are generally prohibited from making loans exceeding more than 10 percent of their own equity capital to any one company or borrower. Answer: True Page: 383-384 Level: Medium 2. The layers of regulation imposed on banks to protect depositors against bank failure are termed credit allocation regulations. Answer: False Page: 383 Level: Easy 3. The part of the money supply produced by the private banking system is called inside money. Answer: True Page: 385 Level: Easy 4. The difference between the private costs of regulations and the private benefits for the producers of financial services is called the net regulatory burden. Answer: True Page: 384 Level: Easy 5. The quantity of notes and coin in the economy is called inside money but the bulk of the money supply is outside money. Answer: False Page: 385 Level: Medium 6. The Investment Company Act of 1940 and the Securities Acts of 1933 and 1934 are examples of investor protection regulations. Answer: True Page: 386 Level: Easy 7. A financial intermediary that can engage in a broad range of financial service activities is termed a universal FI. Answer: True Page: 387 Level: Easy 8. A securities subsidiary of a bank holding company that engages in investment banking is called a Reigle-Neal affiliate. Answer: False Page: 388 Level: Easy

176

9. Restricting the number of institutions that can enter an industry increases profitability of firms already in the industry. Answer: True Page: 386 Level: Easy 10. A bank that offers demand deposits or makes commercial loans, but does not do both is called a nonbank bank. Answer: True Page: 391 Level: Easy 11. Unit banking states are states that do not allow interstate branch banking, but allow the creation of intrastate branch banks. Answer: False Page: 392 Level: Medium 12. States that only allow unit banking often still allow existing banks to create new de novo branches. Answer: False Page: 392 Level: Medium 13. The Glass-Steagall Act came about due to concerns about excessive risk taking at banks and conflicts of interest between commercial and investment banking activities. Answer: True Page: 388 Level: Easy 14. Beginning in 1987 a bank could establish a Section 20 affiliate to underwrite all types of insurance. Answer: False Page: 388 Level: Easy 15. There were a greater number of bank failures from 1980 to 1990 inclusive than from 1933 to 1979. Answer: True Page: 393-394 Level: Medium

177

Multiple Choice Questions 16. A bank that has an equity to asset ratio equal to 12% can normally lend no more than _____ of its assets to any one borrower. A) 1.20% B) 1.05% C) 12.00% D) 1.50% E) 2.25% Answer: A Page: 383-384 Level: Medium 17. The FDIC manages the A) Bank insurance fund B) Savings association insurance fund C) National credit union share insurance fund D) All of the above E) A and B only Answer: E Page: 384 Level: Medium 18. The reduction in deposit funds cost brought about by government insurance is an example of the A) Social benefit of regulation B) Private cost of regulation to DIs C) Private benefits of regulation to DIs D) Net regulatory burden E) None of the above Answer: C Page: 384 Level: Medium 19. U.S. depository institutions may be subject to as many as ____ separate regulators. A) 4 B) 5 C) 6 D) 7 E) 8 Answer: A Page: 387 Level: Medium

178

20. FDIC deposit insurance is limited to ___________ per depositor per bank. A) $50,000 B) $100,000 C) $150,000 D) $200,000 E) $250,000 Answer: B Page: 384 Level: Easy 21. The Glass-Steagall Act prohibited affiliations between commercial and investment banking activities with three major securities underwriting exemptions. Which one of the following underwriting activities was not exempted A) Issues of treasury bills, notes, and bonds B) Issues of municipal general obligation bonds C) Private placements of all types D) Issues of municipal revenue bonds E) All of the above were exempted Answer: D Page: 388 Level: Difficult 22. Major provisions of the Financial Services Modernization Act of 1999 include all of the following except: A) Allowing bank holding companies to open insurance underwriting affiliates and vice versa B) Allowing bank holding companies to open or merge with investment banks C) Created one regulator to oversee all activities of financial service firms D) All of the above are included Answer: C Page: 389-390 Level: Easy 23. Which of the following would increase the value of a bank charter? I. Tightening restrictions on new charters II. Broadening the activities banks can engage in III. Increasing documentation requirements on loan activity A) B) C) D)

I only II only I and II only II and III only

Answer: D Page: 386 Level: Easy

179

24. The law that largely repealed the Depression era banking laws was the A) Depository Institution Deregulation and Monetary Control Act of 1980 B) FDIC Improvement Act C) FIRRE Act D) International Banking Act E) None of the above Answer: E Page: 389-390 Level: Medium Rationale: Financial Services Modernization Act of 1999 25. Which act has led to interstate banking in the U.S.? A) Glass-Steagall Act B) DIDMCA C) McFadden Act D) Riegle-Neal Act E) Financial Services Modernization Act Answer: D Page: 393 Level: Easy 26. Among other things, the Financial Institutions Reform, Recovery and Enforcement Act stipulated the creation of the A) FDIC B) OCC C) SAIF D) Warren Commission E) CRA Answer: C Page: 395 Level: Medium 27. Revised CRA rules are designed to provide better measures of A) Bank capital adequacy B) Interest rate risk management C) Internal controls to manage risk D) Community involvement E) Off balance sheet risks Answer: D Page: 386 Level: Easy

180

28. Deposit insurance A) Reduces bank runs B) Helped cause the insolvency of the FSLIC C) Is free for the safest banks D) All of the above Answer: D Page: 395-397 Level: Easy 29. All banks located in the European Union offer deposits that are insured for __________ Euros, although depositors are subject to a _________________ in the event of loss. A) 100,000; 2.5% insurance premium B) 50,000; 95% recovery rate C) 20,000; 10% deductible D) 45,000; 5% fine E) 75,000; 90% recovery rate Answer: C Page: 398 Level: Medium 30. To be classified as an adequately capitalized bank, the bank must have a leverage ratio of at least _____%, Tier I capital to risk adjusted asset ratio of at least _____ % and a total risk based capital ratio of at least _____ % and does not meet the definition of a well capitalized bank. A) 4; 4; 8 B) 5; 6; 10 C) 3; 3; 8 D) 4; 8; 4 E) 4; 6; 10 Answer: A Page: 399, Table 13-4 Level: Difficult 31. To be well capitalized a bank must have a leverage ratio of at least _____%, Tier I capital to risk adjusted asset ratio of at least _____ % and a total risk based capital ratio of at least _____ %. A) 4; 4; 8 B) 5; 6; 10 C) 3; 3; 8 D) 4; 8; 4 E) 4; 6; 10 Answer: B Page: 399, Table 13-4 Level: Difficult

181

32. The FDIC may require an undercapitalized bank to I. Provide the FDIC with a capital restoration plan II. Cease acquiring brokered deposits III. Obtain FDIC approval for all acquisitions IV. Suspend dividends and management fees V. Suspend payments on subordinated debt A) B) C) D) E)

I and II only III only I, II, III and IV only I, II, III, IV and V I, II, III and V only

Answer: C Page: 403 Level: Difficult 33. Basel II consists of three overlapping areas that are designed to bolster the safety and soundness of the financial system. The three areas are I. Regulatory capital requirements for credit, market and operational risk. II. Eliminating complex risk based capital requirements for on and off balance sheet accounts. III. Ensuring that banks have sound internal control procedures in place to measure and limit risk. IV. Requirements to disclose to market participants the institution's capital structure, risk exposure and capital adequacy. V. Increasing deposit insurance premiums on all accounts. A) B) C) D) E)

I, II and III I, III and IV II, III and V I, IV and V II, III and IV

Answer: B Page: 400-401 Level: Difficult

182

34. Recent regulation such as the Reigle-Neal Act of 1994 has removed some of the federal banking laws that formerly constrained profitable opportunities for commercial banks. The Reigle-Neal Act removes the major restrictions on banks' ability to _____. A) Diversify geographically B) Diversify their product line C) Engage in securities underwriting D) Engage in insurance underwriting E) Engage in loan brokerage Answer: A Page: 393 Level: Easy 35. Tier I (core) capital includes all but which one of the following? A) Common stockholders' equity B) Qualifying cumulative and noncumulative perpetual preferred stock C) Minority interest in equity accounts of consolidated subsidiaries D) Allowance for loan and lease losses E) All of the above may be counted as Tier I capital. Answer: D Page: 402, Table 13-5 Level: Medium 36. Mandatory provisions for undercapitalized banks under the FDIC Improvement Act include which of the following? A) Suspend payment of dividends and management fees B) Require the bank to file a capital restoration plan C) Restrict the bank's ability to increase assets D) Require FDIC approval before the bank may acquire another institution E) All of the above are mandatory provisions Answer: E Page: 403, Table 13-6 Level: Medium 37. Requiring foreign banks to operate under the same rules as domestic banks is termed A) Favored status B) IBA clause C) National treatment D) NAFTA E) Post-patriotism requirement Answer: C Page: 406 Level: Easy

183

38. When banks play the "weekend game" they are A) Minimizing deposits on Friday to help reduce required reserves B) Maximizing deposits on Friday to help make the most of required reserves C) Minimizing their tax liability by recognizing profits before the weekend D) Maximizing the reserve maintenance period with Fed funds loans E) Doing A, C and D Answer: A Page: Appendix 13C Level: Medium 39. In the U.S. regulators currently use a _____ to calculate required reserve balances A) Lagged reserve accounting system B) Contemporaneous reserve system C) Homoscedastic reserve system D) Two day computation period E) Accrual accounting period Answer: A Page: Appendix 13C Level: Medium 40. The potential exposure of an off balance sheet currency forward measures the A) Likely loss to the bank if the counter-party defaults in the future B) Replacement cost of the contract today C) Current net present value of the contract D) The maximum of B. or C. E) None of the above Answer: A Page: Appendix 13D Level: Difficult 41. Among other things, the _____________ prohibits U.S. banks from providing banking services to foreign shell banks. A) International Banking Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act Answer: C Page: 405 Level: Medium

184

42. The ________________________________________ introduced the prompt corrective action policy that requires federal intervention when a bank's capital falls below certain minimums. A) Federal Deposit Insurance Corporation Improvement Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act Answer: A Page: 399 Level: Easy 43. Tier II (supplementary) capital includes which one of the following? A) Qualifying cumulative and noncumulative perpetual preferred stock B) Common stockholder's equity C) Minority interest in equity accounts of consolidated subsidiaries D) Ten year maturity subordinated debt E) All of the above may be counted as Tier II capital. Answer: D Page: 402, Table 13-5 Level: Medium 44. The FDIC is required to collect additional insurance premiums from insured institutions if the BIF reserves fall below ______ of insured deposits. A) 1.00% B) 1.25% C) 1.50% D) 1.75% E) 2.00% Answer: B Page: 394 Level: Difficult 45. Which act allowed the establishment of full service financial institutions in the U.S? A) Riegle-Neal Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act Answer: B Page: 389-390 Level: Easy

185

Short Answer Questions 46. Discuss the four layers of regulation designed to preserve the safety and soundness of DIs. Answer: • Lending limits require diversification. • Minimum capital requirements provide a minimum level of protection against insolvency. Risk based capital requirements force banks to monitor the amount of risk undertaken, particularly in generating growth. • Deposit insurance forces the government to monitor DI safety because of the large contingent liability created by the insurance. As a result, the FDIC has broad powers to force bank managers to limit risk. • Onsite examinations and regular reporting requirements help ensure compliance and maintenance of sound banking practices. Page: 383-387 Level: Difficult 47. What three areas of bank activity does the Community Reinvestment Act attempt to assess? What measures are now used? Be specific. Answer: The CRA requires banks to be involved in the community in which they operate. The three main areas of involvement are lending, investment and delivery of service to the community. Lending measures include: geographic distribution of lending (prevention of redlining), distribution of loan types across borrowers (demographics demonstrating diversity in lending), the extent of community development lending and the use of innovative or flexible lending methods when needed. Investment measures include the institution's involvement with groups that improve or develop low income areas. Service is measured by the bank's willingness to locate banking facilities in all areas and willingness to accommodate community needs. Page: 386 Level: Difficult

186

48. A bank has risk weighted assets of $110 and equity of $6.5. If regulators require a minimum risk weighted capital ratio of 5% given the current level of equity, how many new assets with a 100% risk weight can the bank add? A 50% risk weight? Answer: 100% risk weight [$110 + New Assets] * .05 = equity [$110 + New Assets] * .05 = $6.5 New Assets = $20 Max Total Assets = $130 50% risk weight [$110 + 0.50*New Assets]*0.05 = Equity [$110 + 0.50*New Assets]*0.05 = $6.5 New Assets = $40 Max Total Assets= $150 Page: 401-403 Level: Difficult 49. Cite one law or regulation per each of the following categories: Safety and Soundness Regulation Monetary Policy Regulation Credit Allocation Regulation Consumer Protection Regulation Investor Protection Regulation Answer: Safety and Soundness Regulation: Many answers are possible here: Lending limits, minimum capital requirements, deposit insurance, risk based deposit insurance premiums, on site examinations Monetary Policy Regulation: Reserve requirements Credit Allocation Regulation: QTL test, SBA lending Consumer Protection Regulation: Community Reinvestment Act, Home Mortgage Disclosure Act Investor Protection Regulation: Investment Company Act, Securities Acts Page: 383-384 Level: Medium

187

50. Why have states placed restriction on intrastate and interstate branches? What historical laws gave this right to states? What law changed these restrictions? Answer: States have limited branching to protect small banks that feared that larger, more powerful banks would quickly force the small ones out of business. Some large banks that provided correspondent banking services to small banks also opposed branching fearing a loss of correspondent business. The McFadden Act of 1927 originally gave the states the right to establish branching and interstate restrictions. The Douglas Amendment of the Bank Holding Company Act closed a potential loophole to interstate banking. In 1994 the Riegle-Neal Act allowed interstate branching via consolidation of affiliates or by merger. (It did not allow denovo interstate branching). Page: 392 Level: Medium 51. Why were the FIRREA of 1989 and the FDICIA of 1991 passed? What were their major provisions? How did these laws differ from earlier Acts of the 1980s? Answer: These two important laws were passed to improve the safety and soundness of the thrift and banking industries. The FIRREA recapitalized the thrift insurance fund, eliminated the FSLIC, stripped the FHLBB of its power and created the new Office of Thrift Supervision. It also eliminated deceptive accounting practices at SAs and increased penalties for fraud. The FDICIA increased capital requirements at all DIs, set up prompt corrective actions for banks with insufficient capital, increased FDIC reserves and created risk based deposit insurance premiums. These laws were different than those of the early 1980s because they added restrictions to these industries instead of granting new powers to DIs. Page: 393-397 Level: Difficult 52. How did economies of scale and scope in the banking industry lead to changes in regulations on the scope of allowable bank activities and changes in geographic restrictions on bank activities? How are technology and international banking involved in these trends? Answer: Economies of scale and scope imply that larger banks that offer more types of financial services are more profitable. This encouraged banks to attempt to enter new lines of business and at the same time encouraged other financial firms to enter banking related lines of business, adding to the overall level of competition to provide financial services. Scale economies pushed banks to merge, open up new branches, and operate across state lines. Economies of scope led banks to enter into related lines of business such as investment banking, insurance and brokerage. Technology has been the driving force that created the scale and scope economies. U.S. banks increasingly have to compete with very large foreign banks that have not been restricted by regulations in terms of size and scope of activities. This also put pressure on regulators to change existing U.S. bank laws. Page: Integrative Level: Difficult

188

53. A financial service holding company operates a nationally chartered bank, an insurance firm, a securities firm and a federal savings bank. Who is the primary regulator for this company? Explain. Answer: Under the FSMA of 1999, financial conglomerates are functionally regulated. That is, the national bank would be regulated by the Federal Reserve and the Comptroller of the Currency, the insurance firm would be regulated by the appropriate state agency, the securities firm would be regulated by the SEC (and the NASD), and the federal savings bank would be regulated by the Office of Thrift Supervision. Page: 391 Level: Difficult 54. How do risk based deposit insurance premiums and risk based capital requirements help reduce the moral hazard problem of deposit insurance? (Hint: Moral hazard means that because of deposit insurance, banks may take on excessive amounts of risk.) Answer: Both force bank managers to be cognizant of the risk level they are undertaking and impose a penalty function on managers who engage in additional risk. This helps replace the lost market discipline (higher borrowing rates for banks who take on more risk) brought about by deposit insurance and the too big to fail practice. Page: Integrative Level: Medium 55. What changes to foreign bank operations in the U.S. have been brought about by the Foreign Bank Supervision and Enhancement Act of 1991? Answer: • Foreign banks must now have the Fed's approval to establish a U.S. operation. The Fed will not grant such approval unless the foreign bank is subject to home country supervision. The Fed also requires the home country regulators to supply information about the applicant bank to the Fed. • The Fed may close the U.S. operations of a foreign bank (as they did with Daiwa). • The Fed will examine each U.S. operation of a foreign bank. • Only foreign banks with access to FDIC insurance can take retail deposits. • State licensed foreign banks must adhere to Federal standards. Page: 407 Level: Medium

189

56. What are the four main components of the April 2001 FDIC proposal to reform deposit insurance? Answer: 1. Merge the bank insurance fund and the savings association insurance fund. 2. Index the level of deposit insurance to inflation. 3. Replace the current requirement that the FDIC must maintain reserves of 1.25% of insured deposits with a variable ratio ranging from 1.00% to 1.50% of reserves. 4. Change the rule prohibiting the FDIC from charging premiums to well capitalized and highly rated depository institutions if the fund is in good shape to allow the FDIC to charge regular premiums for risk at more banks, regardless of the size of the fund reserves. Page: 396-397 Level: Difficult 57. What are the three pillars of the proposed new Basel Accord (Basel II)? What are the major differences from Basel I? Answer: Pillar 1: Maintain and update regulatory capital requirements for credit, market and operational risk. The addition of capital requirements for operational risk is new; the methods of measuring credit and market risk are updated and expanded. Pillar 2: Stress the continued importance of the regulatory evaluation process in addition to capital requirements. In particular ensuring that the bank has valid internal control procedures in place to measure and manage risk. Pillar 3: Promote disclosure of the institution's capital structure, risk exposure and capital adequacy. Much of this requirement is new. Page: 400-401 Level: Difficult

190