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Money and Banking exam 2 Study Guide

by: Xinhui Li

Money and Banking exam 2 Study Guide 95098

Marketplace > Rensselaer Polytechnic Institute > Economcs > 95098 > Money and Banking exam 2 Study Guide
Xinhui Li

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A study guide for ECON 4130 Money and Banking exam 2, which covers chapters 10, 9, and 13. I hope this is helpful! Exam 2 is due on LMS on 3/27 by midnight!
Money and Banking 4130-01
Sarah Parrales
Study Guide
Economics, Money and Banking, Study Guide
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This 8 page Study Guide was uploaded by Xinhui Li on Saturday March 5, 2016. The Study Guide belongs to 95098 at Rensselaer Polytechnic Institute taught by Sarah Parrales in Spring 2016. Since its upload, it has received 55 views. For similar materials see Money and Banking 4130-01 in Economcs at Rensselaer Polytechnic Institute.


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Date Created: 03/05/16
Money and Banking Exam 2 Study Guide (Chapters 10, 9, 13) Chapter 10:  Banking and Management of Financial Institutions The Balance Sheet shows the financial position on a particular day for a firm or an individual Assets(uses of funds) Liabilities(sources of funds) Value owned by the bank Various debt  Bank capital Assets = Liabilities + Bank Capital  When assets ↑, bank profits; when assets↓, bank becomes insolvent  When assets < liabilities + BC    insolvent Assets:  Reserves ­ Vault cash (no interest earned) ­ Deposits kept at Fed Reserve (small interest rate paid)  Securities ­ Securities issued by US Treasury and other government agencies ­ Some municipal bonds and corporate bonds ­ Mortgage­backed securities ­ In US, banks cannot buy common stock and they can’t use funds from checkable  deposits to buy corporate bonds  Loans  greater default risk and transaction costs ­ Commercial & industrial loans  loans to businesses ­ Consumer loans  for cars, furniture and other high cost items ­ Real estate loans  mortgage loans  1. Residential mortgage – buy homes 2. Commercial mortgage – buy commercial buildings Liabilities: 1. Deposits  Checkable deposits ­ regular checking accounts (highly liquid, no interest paid to  depositor); liability to bank, asset to depositor  Non­transaction deposits – deposits not used in frequent transactions such as  savings accounts & certificates of deposit 2. Borrowings   Makes profit when interest rate it earns by offering loans is greater than the  interest rate they pay to borrow  Federal Funds – overnight loans from other banks  Loans from a bank’s foreign branches, subsidiaries or affiliates  Repurchase agreement  Discount loan – funds borrowed from Fed Reserve Bank Capital (Shareholder’s equity):  Funds the bank owners have contributed  ­ Purchase of bank stock/investment of financial capital ­ Accumulated retained profit  Acts as protection against insolvency and bankruptcy Basic Operations of a commercial bank  T­account – an accounting tool used to show changes in balance sheet categories Bank Profits  Profit = Revenue – Costs  Revenue: o Interest paid to the bank on securities it owns o Interest paid to the bank on loans it has made o Fees from credit/debit cards o Fees for servicing accounts o Fees from providing financial advice/wealth o Management services Measures of Profit  Return on Assets (ROA) = after tax profit/value of assets (total value of bank assets)  Return on Equity (ROE) = after tax profit/bank capital  Equity multiplier  assets/bank capital o A high ratio of equity multiplier has the effect of magnifying return on equity  when assets are rising in value o A high ratio of equity multiplier has the effect of magnifying a negative return on  equity when assets are falling in value o It’s a measure of bank debt  The higher the ratio, the greater is the debt  The lower the ratio, the smaller is the debt  Leverage: the use of borrowed funds for the purpose of investment High leverage magnifies swings in profit as measured by ROE, and  increases the degree of risk financial firms are exposed to o What will cause an increase in (assets/capital)?  ↑assets  ↓capital  Best option… acquire more assets  Example. 2012 Total assets all banks = $12.9 trillion Bank capital all banks = $1.5 trillion Assets/B.C. = 12.9/1.5 = 8.6 ROA = 2% ROE = ROA x (assets/bank capital) = 0.02(8.6) = 17.2% If (assets/capital) increases to 15: ROE = 0.02(15) = 30% If it’s increased to 35: ROE = 0.02(35) =70% Risks faced by banks:  High leverage  Liquidity risk o The possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost o Can minimize it by holding fewer loans & securities       Managing Liquidity risk  Asset Management: ways in which the bank can lend funds for a very  short time  Lending funds in federal funds market  Reverse repurchase agreement  Liability management: involves determining the best mix of borrowings  to obtain the funds needed to meet a deposit outflow  Can borrow from other banks in deferral funds market  Borrow using repurchase agreements  Borrow from Fed by taking out a discount loan  Credit risk o Borrowers might default on their loans o To reduce credit risk  Diversification  Credit risk analysis  Collateral  Credit rationing – grants loan but limits size of the loan  Interest rate risk o Effect on bank profit & capital of a change in market interest rates o Variable rate assets or liability(usually short term): interest rate changes at least  once per year  o Fixed rate assets or liability(usually long term): interest rate changes less often  than once per year o How to measure interest rate risk  Gap Analysis: how sensitive bank profit is to changes in market int. rate; Gap = value of var. rate assets – value of var. rate liabilities Example. Market i.r.↑ 2%... bank profit? Extra earnings on V.R.assets = 0.02($150m) = $ 3 m Extra money paid out on V.R.L = (0.02)($210m) = $4.2 mil Change in profit = 3 – 4.2 = ­1.2 million ↑ Interest rate, ↓ bank profit ↓Interest rate, ↑ bank profit  Duration Analysis: how sensitive bank capital is to changes in market i.r. Duration gap = avg duration of assets – avg duration of liabilities If duration gap is positive, avg duration of assets > avg duration of  liabilities A change in i.r. will have a bigger effect on value of assets than values of  liabilities for banks that have a positive duration gap Chapter 9: Financial Crisis Financial Crisis – a significant disruption in the flow of funds from lenders to borrowers Key function of financial system  facilitate flow of funds from lenders to borrowers What makes commercial banks prone to crisis?  The basic activity of banks  to take in deposits and make loans  Banks face liquidity risk because they are obliged to relinquish funds to depositors upon  demand. Historical Liquidity Risk  Depositors tend to withdraw their money quickly if they suspected that their bank was in  financial trouble  Bank Run: when depositors of a bank simultaneously withdraw enough funds to force  the bank to close  Bank Panic: when multiple banks simultaneously experience bank runs  ­ banks have to start selling assets to raise funds ­ supply of those assets ↑, their prices/values ↓ ­ BC decreases because bank uses it to pay off liabilities ­ Banks are pushed to insolvency ­ Can trigger recession  period of declining production & increasing  unemployment ­ Lead to credit crisis  when households or firms can’t get credit they would  qualify for  Result 1: reduced HH spending on cars and houses  Result 2: reduced spending by firms on physical capital  Decline in demand in economy ­ Government regulation to stop BP 1. A central bank to act as a lender (established in 1913) o Providing a source of credit to which banks can turn during a panic,  making loans to solvent banks o Acts as banker’s bank 2. Fed Deposit Insurance Corporation  (established in 1934) o reassures depositors that they would get their money back even if the  bank failed o Bank panics occurred in fall 1930, spring 1931, fall 1931, spring 1933 o Ended commercial bank panic in US The Two most significant financial crises over past 100 years 1. Great Depression (1930s)  Before Great Depression, in 1920s  great economic growth fueled by:  1. monetary injections ­ encouraged borrowing and investment spending by firms by keeping  interest rates low ­ Economy’s stock of physical capital ↑, productivity ↑, prosperity↑ 2. Much speculation in stock market caused demand for stocks to ↑.             ­ Stock prices ↑ drastically.             ­ Acted as a source of prosperity for firms and investors             ­ Lead to the creation of a “bubble” in the stock market  1929 cash of stock market o Some investors sell in order to remain with a capital gain because they  believe that stocks are overpriced o Lead to “bursting of the bubble”. o Result: stock prices↓, great loss of household and firm wealth,  productivity↓, unemployment rate ↑.  Worsening factors o Smoot­Hawley Tariff Act 1930: to protect US jobs  Other countries reacted and levied their own tariffs.  foreign demand for US exports ↓ o Immigration restrictions put in place by US government  spending on housing ↓ o Recession begins as productivity ↓and unemployment ↑ o Debt­Deflation made the economy worse  Debt­deflation: asset prices ↓ & prices of goods and  services ↓   2. Recession of 2007­2009  Events leading up to the recession: o 2000 ­ 2007 mortgage rates low; demand for housing ↑ ,housing prices  rose by 60% o Lenders began lending to subprime borrowers for profit o The securitization of mortgage became very profitable for banks o Securitization: when a loan is turned into a marketable security o Subprime borrowers default on mortgages  Banks put homes for sale.  Supply of houses ↑, prices of houses↓  In 2006, prices of homes began to fall  Prime borrowers default as they owe more money on  mortgage than the house is worth (“under water”)   Spillover effects o Many banks faced credit risk  o Home prices fall, so banks can only gain a fraction of amounts back o Many banks held mortgage­backed securitiesvalue falls o Result: heavy loss in the value of assets held by ban “deterioration of  the bank’s balance sheet”  some became insolvent and failed  lenders became unwilling to lend o how credit crisis affected the economy: 1. Lenders overly tightened requirements for loan applicants 2.  ­ Demand for goods and services ↓ 3.  ­ Firms reduced investment in physical capital; productivity growth ↓ 4. Banks with mortgage­backed­securities bank panic 5. ­ Lenders required repayment of short­term loans but banks can’t  Government reaction o Fed Reserve implemented monetary injections, money supply ↑ interest  rates↓ o By December 2008, federal funds rate was near zero o Banks could borrow very cheaply to meet liquidity needs o Troubled Asset Relief Program  $700 billion allocated by Fed and Treasury to purchase mortgages  and mortgage­backed securities  Chapter 13: The Federal Reserve System Origins of the Fed Reserve  Bank of the United States (1791) o First attempt at a central bank; was given a 20 year charter o Purpose: to act as the US gov’s bank, to help stabilize the financial  system by lending to commercial banks & enforcing capital requirements. o Received little public support. o In 1811, the charter was not renewed  Second Bank of the United States(1816) o 20 year charter o President Jackson and President of the Second Bank, Nicholas Biddle,  disagreed over the renewal of the charter o 1832: Jackson vetoed Congress bill to renew, bank closed in 1836 o The nation was without a central bank for 77 years o severe financial panics/recessions occurred: 1873, 1884, 1893, 1907 o Federal Reserve Act 1913  established the Fed Reserve System as the central bank of the US Fed Reserve     Original Purpose  1. Act as a lender of last resort by making discount loans  2. Implement monetary policy by controlling the quantity of money in circulation     Division of power 1. Federal Reserve District Banks (12) o Primary function: make discount loans to member banks in its region o Fed Reserve Bank ­ a district bank of Fed Reserve system that conducts  discount lending among other activities 2. Private commercial member banks o Member banks are private commercial banks located in the district,  they must buy stock in the Fed Reserve Bank when they join o Commercial member banks elect 9 directors of Board of Directors  Class A directors: 3 bankers  Class B directors: 3 leaders in industry/agriculture/commerce  Class C directors: 3 public interest directors  Directors elect Fed Bank’s President o Depository Institutions Deregulation and Monetary Control Act 1980  Required that ALL banks be subject to reserve requirement  Gave member and non­member banks equal access to discount  loans   in October 2008, Fed began paying banks interest of .25% on  reserves 3. Board of Governors  Headquartered in Washington D.C.  7 governors appointed by President, confirmed by Senate; each serves 14 years   One of these governors is appointed as chairperson, who has a 4 year term and  may be reappointed for a total of five terms   Who are board members?  Economists from business, academia, government  Functions o Decide on monetary policy  o Influences economic policy decisions o Administrative duties of District Banks o Financial regulation  Fed’s Dual Mandate o Maximum employment o Unemployment rate = 5.5% o Stable prices o Inflation rate = 2% o 4. Federal Open Market Committee (FOMC)  12 members: 7 members of Board of Governors; 5 presidents of  district Fed Banks; President of NY Fed is always a member  Other 11 presidents serve 1 year on a rotating basis  They meets 8 times a year to set the federal funds rate according to  directives for monetary policy given by the Board of Governors


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