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exam 2 study guide Econ 3303-001
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This 14 page Study Guide was uploaded by IHUOMA ECHENDU on Tuesday March 29, 2016. The Study Guide belongs to Econ 3303-001 at University of Texas at Arlington taught by kathy kelly in Winter 2016. Since its upload, it has received 39 views. For similar materials see money and banking in Economcs at University of Texas at Arlington.
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Review for Exam 2 Chapter 6 RISK AND TERM STRUCTURE OF INTEREST RATES Default Risk: U.S. Treasury bonds are usually considered to be defaultfree bonds because the U.S. government can raise taxes or print money to pay debts. Corporations must generate revenue in order to pay their debts. Therefore if demand for treasury bonds ↑, Prices↑ and interest rates↓. On the other hand the demand for corporate bonds will↓, prices will↓ and interest rates will↑. Risk Premium: additional amount required to hold the more risky corporate bond i.e. the difference in interest rate to make you willing to take on the risk of the bond. The additional interest that must be earned in order to entice someone to hold a risky bond over a riskfree bond. The higher the potential of default; the higher the risk premium. Bond Ratings: the closer the letters are to the beginning of the alphabet, the less risky the bond is. Creditrating agencies rate the probability of default of different bonds. Investmentgrade securities have a low risk of default (generally stable) and have a rating of Baa (or BBB) or above. Speculativegrade (junk bonds) securities have a higher risk of default and thus are given a lower bond rating. Speculativegrade bonds are also sometimes called highyield bonds because they do generate higher yields if they do not default. Liquidity: Liquidity means how quickly an asset can be converted into a medium of exchange. The U.S. Treasury bond market is an extremely active market. The corporate bond market is smaller. Treasury bonds are the most liquid longterm bonds and have lower risks than corporate bonds. Therefore, if treasury bonds D↑, P↑, I↓ on the other hand corporate bonds D↓, P↓, I ↑. Tax considerations: Municipal bonds (state or local government bonds) are federalincome tax exempt. You must pay income tax on interest earned on U.S. Treasury bonds and on corporate bonds. Although treasury bonds are default risk free, sometimes the tax feature is stronger than the default risk feature. If so the interest rates on municipals will always be lower than that of treasuries. Therefore if municipal bond D↑, P↑, I ↓ on the other hand Treasury bond D↓, P↓, and I↑. Term Structure of Interest Rates: interest rates of different maturities move together over time. The time to maturity influences the interest rates on bonds that have identical risk structure factors. Yield Curve: a plot of the yields on bonds with differingterms to maturity but identical risk structure factors such as Treasury securities. The shape of a yield curve gives an idea of what people expect to happen to interest rates in future. Yield curves are more likely to have an upward slope when shortterm rates are low and a downward slope when shortterm rates are high. Yield curves usually have an upward slope, downward slopes are rare and unwanted. Expectations Theory: Bonds of differing maturities are perfect substitutes for each other. One is equally satisfied with purchasing any bond Longterm yields are an average of expected future shortterm yields. It doesn’t explain the shape of a yield curve and therefore assumes interest rates will always go up, which isn’t true because interest rates do go down sometimes, causing downward sloping yield curve. Example: If the expected future rates for the next five years are 5 6 7 8 9 Then the yield on a twoyear security using the expectations hypothesis is (5 +6)/2 = 5.5 The yield on fiveyear security using the expectations hypothesis is (5 + 6 + 7 + 8 + 9)/5 = 7 Segmented Markets Theory: Bonds of different maturities are not perfect substitutes at all. The interest rate at each maturity is determined separately. It does not explain why the rates tend to move together. It does explain that we get an upward sloping yield curve due to the demand differences in each different bond. Since people typically prefer short holding periods, there will be a higher demand for shortterm bonds and thus a higher price and lower yield for shortterm than longterm. Liquidity Premium/ term premium Theory: Bonds of differing maturities are substitutes but not perfect substitutes. It is a balance between the first two. Longterm bonds have higher interest rate risk. Risk always requires compensation. Bondholders require an additional premium to compensate for this increased risk. Example: If the term premium for the next five years is 0 .25 .5 .75 1 Then using the previous estimates for the fiveyear path of interest rates, the yield on a twoyear security using the liquidity premium theory is (5 + 6)/2 + .25 = 5.75 The yield on a fiveyear security using the liquidity premium theory is (5 + 6 + 7 + 8 + 9)/5 + 1 = 8 Yield curve and market expectations: Steep upwardslope – participants in this market expect higher interest rates (possibly because of inflation) Mild upwardslope (usual/typical shape) expect interest rates to stay about the same (they do not expect interest rates to go up in the future). Since they aren’t so sure whether or not interest rates will increase, compensation is still necessary. Flat expect interest rates to fall some in the future. Therefore they buy long terms now before they reduce/go down. Downwardslope (inverted yield curve) expect interest rates to fall sharply/a significant decline in the future (possibly because of a recession). The yield curve will not invert 1year to 18 months before recession. People lock down short terms now to sell at premium when interest rates go down. 8. Predict what will happen to interest rates on a corporation’s bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on treasury securities? The corporation’s bond is now riskfree. The interest rate on the corporate bond will fall. The interest rate on Treasury securities will increase because the corporate bond now has the same risk as the Treasury. 11. If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities? If the income tax exemption for municipal bonds is eliminated, the interest rate on municipals will increase. The interest rate on Treasury securities will decrease. The municipals would now have a higher interest rate than the Treasuries because the municipals carry more risk of default. 19. If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future? I expect interest rate to increase in the future. A steep upwardslope to the yield curve indicates that market participates are expecting higher interest rates. 20. Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longerterm treasury securities over the following six months. What effect might this policy have on the yield curve? The yield curve should flatten or slope downward. A flat yield curve means that interest rates are expected to fall slightly. A downwardsloping yield curve means that interest rates are expected to fall significantly in the future. Chapter 7 THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS, AND THE EFFICIENT MARKET HYPOTHESIS . Stockholders are owners of a corporation. Rights of stockholders: • Right to vote • Be the residual claimant • Right to sell the stock Residual claimant: refers to the economic agent who has the sole remaining claim on an organization's net cash flows, i.e. he/she receives whatever remains after all other claims against the firm’s assets have been satisfied e.g. the deduction of precedent agents' claims, and therefore also bears the residual risk. Dividend: payments made periodically, usually every quarter, to stockholders. Stockholders are paid dividends from the net earnings of the corporation. Dividends and sales price are cash flows a stockholder might earn from stock. Oneperiod valuation model: Purchase stock today, hold it for one period and get paid a dividend, then sell the stock. P₀ = current price of the stock Div₁= dividend paid at the end of year 1 Kₑ = required return on investments in equity (an increase in this reduces the current price of the stock and vice versa) P₁ = price at the end of the first period (assumed sales price) P₀ = Div₁ / (1 + kₑ) + P₁ / (1 + kₑ) Example: What price would you be willing to pay today for a stock that pays a $1/year dividend and that you expect to sell in a year for $20? Assume a required return of 15%. P₀ = 1/ (1+.15) + 20/ (1+.15) = $18.26 Req. return on investments in equity: The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project Gordon Growth Model: a model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. The growth rate is assumed to be less than the required return on equity. P₀ = Div₁ / (kₑ g) Where: “g”= expected constant growth rate in dividends. How the Market Sets stock/security Prices: 1. The price is set by the buyer willing to pay the highest price (not necessarily the price the buyer is willing to pay, but the highest price bided). 2. The market price will be set by the buyer who can take best advantage of the asset. 3. Superior information about an asset can increase its value by reducing its risk. The buyer who has the best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain. When new information is released about a firm, expectations change and with them prices change. Adaptive expectations: using past information/experience. Changes in expectations will occur slowly over time as past data changes. Rational expectations: expectations identical to optimal forecasts (the best guess of the future) using all available information. Just because a forecast is rational, doesn’t mean it is correct or accurate. Two reasons a forecast may not be rational: Ignoring available information, Unaware of available information. Note that if information is unavailable (cannot be attained) an incorrect forecast is still rational. Implications of rational expectations theory 1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change also. 2. Forecast errors of expectations will on average be zero and cannot be predicted ahead of time. Efficient Markets Theory: Application of rational expectations to the pricing of securities. Prices of securities in financial markets fully reflect all available information. All unexploited profit opportunities will be QUICKLY eliminated. Stock market prices constantly change as news/information that affects fundamental values becomes available. If new information leads investors to change their opinions about the risk, liquidity, information costs, or tax treatment of the returns from owning a stock, the price of the stock will change. A key implication of the efficient markets hypothesis is that stock prices are not predictable. The best forecast of the price of a stock tomorrow is its price today because the price today reflects all relevant information that is currently available. Unexploited profit opportunity: returns on any security that are larger than what is justified by the characteristics of that security. In an efficient market, all unexploited profit opportunities will be eliminated. Random walk: Stock prices follow a random walk, that is, on any given day they are as likely to rise as to fall. Practical Guide: If the stock market is efficient, then Publicly available information cannot help you outperform the market. Information in published reports is readily available to many market participants and is already reflected in the market price. Only the first individuals to gain information such as a hot tip will be able to benefit from it. The market price will adjust very quickly to any new information. Stock prices move when expectations change. If the actual event is what had been expected, there will be no change in the stock price. If good news is not as good as had been expected, the stock price will fall. Buy and Hold Strategy: Purchase stocks that their prices might be low and hold them for long periods of time. This will lead to the same returns, on average, but the investor’s net profit will be higher because fewer brokerage commissions will have to be paid. Investors are advised to pursue this strategy since they can’t outperform the market using hot tips, public info and/or expected info. Diversifying, that is, owning stock in many industries compared to owning stock in just one industry is seen to be a good thing. Investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. Behavioral Finance: the application of concepts from other fields such as psychology and sociology to try to explain security pricing. Loss aversion: the pain of a dollar lost is greater than the pleasure from a dollar gained. Reluctance to admit mistakes by selling losing investments. Overconfidence in own judgments – we trade on beliefs rather than on pure facts. Social contagion: (herd behavior) – imitate the behavior of others. Bubbles: a situation in which the price of an asset differs from its fundamental market value. 5. “Forecasters’ predictions of inflation are notoriously inaccurate so their expectations of inflation cannot be rational.” Is this statement true, false or uncertain? Explain your answer. False. An inaccurate forecast can still be a rational expectation forecast. As long as the forecaster is using all available information, the forecast is rational. 10. If the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced? The stock price should increase. The news, although bad, was better than expected. The public had expected worse news so this smaller actual loss will be viewed favorably. Chapter 9 (chapter 10 if you are using 10 edition textbook)h BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS Bank Balance sheet: a list of the bank’s liabilities (sources of a bank’s fund) and assets (uses to which the funds are put). Total assets = total liabilities + capital Assets: interest payments earned on assets are what enable banks to make profits. Reserves deposits held in an account at the Fed. Res. plus vault cash (currency held by banks). As a bank, you don’t want to have too much reserves because checkable deposits cost you (interests are charged). Required reserves fraction of checkable deposits that must be kept as reserves. The required reserve ratio is 10%. Excess reserves additional reserves that banks hold to meet checkclearing obligations Total Reserves = required reserves + Excess reserves Cash Items in Process of Collection accounting transaction until anticipated funds are physically received from another bank. It is a claim on another bank for funds that will be paid in few days. Deposits at other banks – small banks hold deposits in larger banks in exchange for a variety of services e.g. check collection, foreign exchange transactions, and help with security purchases. This is called correspondent banking. Deposits at other banks are used by smaller banks to provide a broader array of services for the smaller banks' customers. Reserves + cash items in process of collection + deposits at other banks = CASH ITEMS. Securities bank holdings of U.S. government and agency securities (most liquid because they can easily be traded and changed to cash with low transactions cost), municipal i.e. state and local government securities, and investmentgrade corporate securities. Banks cannot hold stock so therefore, securities are made up of debt instruments for commercial banks. They own a lot of Tbills because they are very liquid and are secondary securities. Short term U.S. govt. securities are called secondary reserves. Loans primary source of income/revenue for banks. Wide variety of loans. They can’t be turned into cash until the load matures, therefore, they are less liquid than other assets. They have higher probability of default risk than other assets and therefore the bank earns high returns on loans. Other assets physical assets such as buildings, equipment, artwork. When a bank fails, FDIC sells these to pay bank debts. Liabilities: a bank acquires funds by selling liabilities e.g. deposits; and funds obtained from here are used to buy incomeearning assets. Examples of liabilities: Checkable deposits/ transactions deposits (payable on demand): bank accounts that allow the owner to write checks to third parties. They used to be bank’s main source of funds and are usually the cheapest source of funds. Nontransaction deposits: they are a primary source of bank funds. Interest paid on these are higher than checkable deposits. Savings deposits/account – funds can be added or withdrawn any time. They used to be the most common nontransaction deposit. Transactions and interest payment are recorded in a passbook or monthly statement held by the owner of the account. Smalldenomination time deposits – less than $100,000 for a fixed time period. It cannot be resold. Less liquid than passbook savings earn higher interests and are more costly sources of funds for banks. Largedenomination time deposits (negotiable CDs “certificate of deposit”) – $100,000 or more purchased by corporations and financial institutions. Can be resold again in secondary markets before they mature and are primary sources for banks. They are held as alternative assets to Tbills and other shortterm bonds. Borrowings: you borrow at a given time and pay back at a given time with interest. Discount loans/advances – loans from the Federal Reserve to a bank that are extremely shortterm. Federal funds loans – loans from one bank to another bank, borrowed from the federal funds market. They borrow funds overnight to have enough deposits at the fed reserve to meet the required amount by the Fed. They have interest rates called the federal funds rate. Loans from parent companies (bank holding companies) Repurchase agreements (loan agreement with corporations) Borrowing of Eurodollars deposits dominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks. Bank Capital: it is the bank’s net worth, which is calculated as Total assets – total liabilities. It is raised by selling new equity (stock) or from retained earnings. It is a cushion against a drop in the value of a bank’s assets, which could force the bank into insolvency (having liabilities in excess of assets, meaning that the bank can be formed into liquidation). Failed banks occur when liabilities > assets. Both liabilities and assets should be equal on a bank’s balance sheet. Basic Banking: selling liabilities to buy assets is called asset transformation. Remember that when a bank gains deposits, they gain reserves of an equal amount and vice versa. Deposit outflow: lost deposits due to withdrawals and payment demand by depositors. Liquidity management: the acquisition of sufficient liquid assets to meet the bank’s obligations to depositors. Do I have access to funds quickly so that I can clear transactions and keep regulations if need be? Precaution against unexpected deposit outflow: When a deposit outflow occurs, holding excess reserves allows banks to escape costs of items starred below. If a bank has ample excess reserves, a deposit out flow doesn’t necessitate changes in other parts of its balance sheet (loans, securities, bank capital…) except reserves and checkable deposits. Excess reserves are insurance against costs associated with deposit outflows. If this doesn’t work, and a deposit outflow results in reserves falling below the required amount, banks must quickly eliminate the shortfall by using the other options. *if banks borrow from other banks (federal funds) the reserves increases on the asset side while borrowings increase on the liabilities side. Same as when banks borrow discount loans (costs associated with this is the interest rate that must be paid to the fed called the discount rate) from the Federal Reserve, only that they are two different lenders. *some banks don’t borrow, instead they sell previously purchased securities. This decreases the securities amount on the asset side and increases reserve amount on the asset side. *some other banks reduce loans. It is the costliest method and last option. They do this by calling in loans, that is, not renewing some loans when due. Banks lose a lot of customers this way. They can also sell of the loans to other banks. This makes changes to the loans and reserves on the asset side of the balance sheet. Asset management: bank manager must pursue an acceptably low level of risk by acquiring assets that have low rate of default and diversifying asset holdings. 1. Seek the highest possible returns on loans and securities (assets). 2. Reduce/manage risk 3. Have adequate liquidity Liability management: acquiring funds quickly at low cost. Capital Adequacy management: manager must decide the amount of capital the bank should maintain and then acquire the needed capital. Banks make decisions about the capital it holds for three reasons: • Capital helps to prevent bank failure • The amount of capital held impacts the returns for the owners • Regulators require a minimum amount of capital How the Amount of Bank Capital Impacts Returns to Equity Holders: Return on Assets (ROA) = the net profit after taxes per dollar of assets Return on Equity (ROE) = the net profit after taxes per dollar of equity (bank) capital Equity Multiplier (EM) = the amount of assets per dollar of equity capital ROE = ROA x EM Given the return on assets, the lower the bank capital, the higher is the return for the owners of the bank. Tradeoff between safety and returns to owners – higher capital means a safer bank, but lowers the returns to the owners. Managing credit risk: credit risk is the risk arising because borrowers may default. Ways in which a bank can reduce the adverse selection (beforethose who are more likely to default on loans are the ones who go get loans) and moral hazard (after borrowers invest in other things than the initial need for the loan and is unfavorable to lenders) problems inherent in making loans and still make a profit: • Screening – gather information to reduce adverse selection problem. • Specialize in lending – specialized information helps to reduce the adverse selection problem. • Monitoring and Enforcement of Restrictive Covenants – reduce the moral hazard problem by making sure the borrower is following the requirements of the loan contract. • LongTerm Customer Relationships – reduce the cost of collecting information by looking at past activities of a borrower who has had an account with a bank for a long time. Helps with unanticipated moral hazard issues. • Loan commitments – a bank’s commitment to provide a firm with loans up to a given amount at an interest rate tied to some market interest rate to reduce the cost of collecting information. • Collateral and compensating balances – collaterals are properties promised to a lender as compensation if a borrower defaults. It reduces lenders loss in the case of a default. It lessens the consequences of adverse selection because a lender can sell the collateral and use its proceeds to make up for its losses on the loan. • Credit rationing – two types. Denying someone a loan even if they are willing to pay back on high interest because it sounds risky reduces adverse selection and giving someone less than what they asked for helps reduce moral hazard problems. Restrictive covenant: things you can and cannot do when given a loan. Compensating balance: a firm receiving a loan must keep a required minimum amount of funds in a checking account at a bank. Credit rationing: refusing to make loans even if borrowers are willing to pay the stated interest rate or even higher. Managing interestrate risk: the riskiness of earnings and returns on bank assets that result from interestrate changes. When comparing taccounts for interest rates, always compare rate sensitive assets and liabilities. Rate sensitive assets: anything adjustable or variable. Short term assets e.g. Tbills (quick turnover and change easily). Liabilities: MMDA, variables and short term CDs. Fixed rate assets: reserves, long term assets …they don’t change. Liabilities: checkable deposits, savings deposits, equity capital, long term CDs… REMEMBER: if a bank has more rate sensitive liabilities than assets, a rise in interest rates will reduce bank profits and vice versa. If a bank has more rate sensitive assets than liabilities, a rise in interest rates will increase bank profits and vice versa. Offbalance sheet activities: Activities that impact a bank’s profits but that do not appear on bank balance sheets such as trading financial instruments and generating income from fees and loan sales. Loan Sales (Secondary Loan participation): sells all or part of the cash stream from a specific loan, thereby removing the loan so that it no longer is an asset on the banks’ balance sheet. Generation of Fee Income: that bank receives for performing services like Foreign exchange trades for customers Servicing mortgagebacked securities Providing backup lines of credit Trading Activities: contains the most risk and dramatic bank failures. Requires more capital here. 15. “Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans.” Is this statement true, false, or uncertain? Explain your answer. False. Specializing in making loans can help to reduce adverse selection problems. Any information that can help to judge risks should be used. The bank should still diversify among many categories of loans while they may specialize in a specific type of loan for one category. 20. What happens to reserves at the first national bank if one person withdraws $1,000 of cash and another person deposits $500 of cash? Use Taccounts to explain your answer. First National Bank Assets Liabilities Reserves $500 Checkable Deposits $500 The first person withdrew $1000 from their checkable deposits, which decreased reserves by $1000. The second person deposited $500 to their checkable deposits, which added $500 to reserves. The net effect is that checkable deposits decrease by $500 and reserves decrease by $500. Chapter 10 (chapter 11 if you are using 10 edition textbook)th ECONOMIC ANALYSIS OF FINANCIAL REGULATION Bank panics and need for safety net: due to bank failures, back then depositors had to wait until a bank was liquidated before they got their deposit funds and sometimes didn’t get their full amount. People were then reluctant to put their money into banks and they lacked information about the quality of their bank’s assets. This uncertainty caused bank panics and the failure of one bank led the failure of another (contagion effect). There then arose a government safety net for depositors which could short circuit runs on banks and bank panics by providing protection for depositors and overcoming reluctance to put funds into banks through the FDIC. FDIC: Federal Deposit Insurance Corporation government deposit insurance program covering bank accounts, originally put in place in 1934 Payoff method: a method used by FDIC to deal with failed institutions whereby the FDIC allows the bank to fail and then pays off deposits up to the $250,000 insurance limit (it pays off from funds acquired from insurance premium paid by banks who bought insurance from the FDIC). After bank is liquidated, FDIC along with other creditors gets their share of the proceeds from the liquidated assets. Typically when this method is used, if you have more than the max (250,000) a bank failure could mean you still lose some funds. Purchase and assumption method: here, the FDIC finds a willing merger to take over the bank’s liabilities so that no one loses their money, even if it’s over the $250,000 limit. Problems created by safety net Adverse Selection: those more likely to take advantage of the insurance are those that produce adverse outcomes. Moral Hazard: with the presence of an insurance, depositors tend to take more risks that might be unfavorable since they have a coverage when damages occur. “Too Big to Fail”: government provided guarantees of repayment of large uninsured creditors of the largest banks so that no depositor would suffer a loss even when they weren’t entitled to this guarantee. They did this because of fear of failure of such large banks which could lead to a major financial disruption. FDIC did this using the purchase and assumption method and this increased the moral hazard problem. Regulations Restrictions on asset holdings: e.g. of risky assets are common stock. It is directed at minimizing the moral hazard problem which could cost taxpayers. Capital requirements: another way of reducing moral hazard problem is by imposing capital requirements. When an institution hold more capital, it stands to lose more if the bank fails. All banks must maintain the leverage ratio Banks involved in risky offbalance sheet activities must hold additional capital based on the amount of risk Prompt corrective action if a bank does not have sufficient capital Chartering: to open a bank you need a charter (state or national), a bank’s permission to open up. Proposals for new institutions are screened to prevent undesirable people from controlling them. It deals with the adverse selection problem. It doesn’t matter where it comes from because they all have the same rules. Examining: mostly once a year, regular onsite examinations allow regulators to monitor whether the institution is complying with capital requirements and restrictions on asset holding, also function to limit moral hazard. National charters are examined by the office of the comptroller of currency who is responsible for examining institutions depending on the location of their headquarters. State banks are examined by the state banking authority. Banks are given CAMELS RATINGS by bank examiners based on six areas assessed. The lower the CAMELS rating, the better; 1 being the best and 5 being the worst. All banks file periodic reports. C Capital adequacy: sizing up cushion against losses A Asset quality: likelihood that loans can be paid off M Management capability: controls and strategy E Earnings quality: measuring source and steadiness of profit L Liquidity adequacy: how long a bank can go without raising money in the market? S Sensitivity to market risk: would a market stock create outside losses? Risk management: assessing a financial institution taking excess risks to reduce moral hazard problem. Stress test the fed uses this to push lenders into building up capital buffers, by ensuring they can face a downfall and still function. Companies that fail this might be subject to shut down. Scenarios are changed each year to prevent cheating the system. Disclosure requirements: More public information reduces excessive risk taking Consumer protection: Provide information and Reduce discrimination to protect consumers, provided he or she has good credit and meets the requirement to get a loan. Restrictions on Competition: McFadden Act 1927: prohibited branching of banks along state lines. Eliminated in 1994. GlassSteagall Act 1933: separated commercial banks from investment banks. Was repealed in 1999 by the Gramm leach Bliley act 7. Why does imposing bank capital requirements on banks help limit risk taking? Higher bank capital means that the owners will lose more if the bank fails. The owners will not want the bank to undertake too much risk and will monitor the managers more closely. 16. Consider a failing bank. A deposit of $350,000 is worth how much if the FDIC uses the payoff method? The purchase and assumption method? Which is more costly to the FDIC? If the FDIC uses the payoff method, the depositor will receive $250,000 immediately and then a portion of the remaining $100,000 depending on how much the FDIC receives for the sale of the bank’s assets. If the FDIC uses the purchase and assumption method, the depositor will not lose any of the $350,000 because the bank never actually closes. It continues to function as a bank until the new owner assumes the liabilities. The purchase and assumption method is usually more expensive for the FDIC because the FDIC must write off the bad loans before the new bank will purchase the assets. With the payoff method, the FDIC only pays the depositors (after the insured amount) whatever the FDIC receives for the sale of the assets even if they sell the assets for a loss. th Chapter 12 (chapter 9 if you are using 10 edition textbook) FINANCIAL CRISIS: major disruptions in financial markets characterized by sharp declines in asset prices and firm failures. Stage 1: Start of Financial Crisis Credit boom and bust: reasons for this are below Financial innovation when an economy introduces new types of loans or other financial products it can be a good thing as long as risks are well understood. Unfortunately people carry more risk than they should. Financial liberalization: elimination of restrictions on financial markets and institutions. In the long run it promotes development and a good financial system. In the short run it can cause credit boom. Deleveraging cutting back on lending Asset price boom and bust: prices go up and cause a decline in the financial institutions asset. Increase in uncertainty: crisis have begun in periods of high uncertainty e.g. recessions, stock market crash, failure of institutions… and this only increased the uncertainty. Stage 2: Banking Crisis: large number of banks begin to fail due to bad loans and not enough capital to sustain them. Stage 3: Debt Deflation: last time U.S. had this was during the great depression. Price levels fall, people stop buying things, average prices in the economy go down, and there is a high level of unemployment. Debts get harder to pay off and most countries would rather stop at stage two because this is a very difficult situation to exit. The Great Depression Stage one: Stock Market Crash in Oct. 1929 Stage two: Bank panics begin in Nov. 1930. Rumors about failed banks made people take their money out of banks (bank runs). The fed refused to give loans and banks began to hold excess reserves. Eventually onethird of U.S. commercial banks fail. Stage three: Debt deflation. Price level declined by 25%. Money supply shrinks because no one is putting their money into banks and banks are holding excess reserves. Global Financial Crisis 20072009 Causes Financial Innovation in Mortgage Markets Agency Problems in the Mortgage Markets CreditRating Agencies and Conflict of Interest Effects • Boom and bust in the residential housing market; many borrowers “underwater”, they owed more loans than they could sell their houses for. • Deterioration of financial institutions’ balance sheets; deleveraging • Run on the shadow banking system, nondepository institutions heavily involved in the mortgage industry • Global financial markets impacted • Failure of highprofile firms Recovery and government intervention: Emergency Economic Stabilization Act 2008: set in motion funds needed to keep up industries. TARP “troubled asset relief plan” which made treasury spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or inject capital to these institutions, was included in this act. Economic Stimulus Act 2008: didn’t help as much American Recovery and Reinvestment Act 2009: stabilized the financial system and got people back to work. Financial Regulation after Crisis: Microprudential Regulation/supervision focuses on the safety and soundness of individual financial institutions. Macroprudential Regulation/supervision focuses on the safety and soundness of the financial system in the aggregate. DoddFrank Wall Street Reform and Consumer Protection Act of 2010 (August) Consumer Protection Resolution Authority Systemic Risk Regulation Volcker Rule Derivatives 11. What role does weak financial regulation and supervision play in causing financial crises? Weak financial regulation and/or supervision allows for more risktaking. The adverse selection and moral hazard problems increase which worsen the crisis when a contraction occurs.
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