FIN 321 Test

FED Funds Target Rate

.25% - .50%

What is the current discount rate at the Federal Reserve window?

1.25%

Current Rate of Inflation in CPI

2.4%

Current Unemployment Rate

4.9%

What are the major uses of funds for a bank? What are the differences between large and small banks? Explain.

A bank's major uses of funds are lending and investing. Investment securities are more important to the portfolios of smaller banks than to those of larger banks. Larger banks have access to many more sources of liquid funds than do smaller banks, and therefore they do not need to rely as heavily on investment securities for liquidity.

Distinguish between a line of credit and a letter of credit.

A line of credit authorizes the borrower to draw loan advances up to a certain limit. A letter of credit authorizes a beneficiary designated by the borrower to present drafts to the bank for payment of amounts owed the beneficiary by the borrower, up to a certain limit. These advances then become a loan balance owed the bank by the borrower.

Explain the adverse selection problem. How can lenders reduce its effect?

Adverse selection arises from asymmetric information and, in the context of debt markets, refers to borrowers of poor credit quality applying for loans (perhaps because such borrowers need the loans the most in order to survive financially). The lender may reduce adverse selection by requiring loan applicants to supply detailed financial statements and other additional information, to use differential loan pricing for borrowers of different credit quality, or to reject loan applications if the risk appears too high. To process the information they collect, lenders often develop or acquire from third party credit scoring models that help determine borrowers' creditworthiness.

Explain why the banking system was so unstable prior to establishment of the Fed in 1914.

After termination of the Second Bank of the United States in 1836, the U.S. was without a central bank until passage of the Federal Reserve Act in late 1913. Thus there was no overall control of the size or quality of the money supply. Until the National Banking and Currency Acts (1862-64), banks were largely unregulated and free not only to engage in unsound lending practices, but to issue banknotes—IOUs against themselves—without restraint.

A bank has $20,000 in reserves, $90,000 in bank loans, and $150,000 of deposits. If the reserve requirement is 10%, what is the bank's reserve position? What is the maximum dollar amount of loans the bank could make? What would happen to the nation's money supply if the Fed lowered the reserve requirement to 6 percent? Demonstrate your results with a numerical example.

Assuming reserve requirements apply to all the bank's deposits, its $20,000 of reserves comprise required reserves of $15,000 (10% of total deposits of $150,000) and excess reserves of $5,000 (total reserves of $20,000 less required reserves of $15,000): Excess Reserves: $5,000|| Loans: $90,000|| Required Reserves: 15,000|| Deposits: ||$150,000 This reserve position supports up to $5,000 of new loans. In reality, reserve requirements do not apply to all deposits. If RR were 6% instead, ER would be immensely and immediately greater. Banks would "lend up" excess reserves quickly, expanding loans and deposits until any reserves were again absorbed as RR. Dep = RRR/k

If a country named Lower Slobovia decided to use U.S. dollars as a medium of exchange and therefore withdrew $10 billion in cash from its transaction deposits in the U.S., what would happen to the U.S. monetary base? What would happen to depository institutions' actual reserve holdings? What would happen to U.S. financial institutions' net excess reserves if the Lower Slobovians withdrew their money from bank deposits subject to a 10 percent reserve requirement? What would probably happen to the U.S. money supply?

Assuming the banks replenish their cash at the Fed, the monetary base will not change. FRN will increase by $10 billion and bank reserve deposit accounts will decrease by $10 billion. With the withdrawal of $10 billion in bank deposits, the banks' required reserves would decline by $1 billion (10% of $10 billion), but their actual reserve balances would decline by $10 billion, assuming replenishment of cash. Assuming no excess reserves, the destruction of bank reserves would reduce the money supply. The Fed is likely to replenish the reserves, assuming no policy changes.

Define "bank capital". What is the economic importance of capital to a firm?

Bank capital comprises capital stock, undivided profits, and special reserve accounts (not to be confused with reserve balances at the Fed). Capital is the "cushion" against which losses—particularly loan losses—are written off. Capital is also the residual claim of owners against the firm. For regulatory purposes, subordinated capital notes (debt) may count as part of a bank's capital.

What are the major benefits of getting assets off the balance sheet through either loan sales or securitization?

Banks earn fee income for loan origination and servicing without bearing credit and interest rate risks associated with holding an asset, the cost of funding it, or the regulatory burden of carrying it. Banks have a comparative advantage in originating loans and other asset transactions, but are at a disadvantage in carrying these assets because of regulation. Banks pay a "regulatory tax" in the form of federal deposit insurance premiums, foregone interest holding required reserves, and mandatory capital requirements exceeding what would be otherwise maintained. Firms less regulated have a comparative advantage owning loans or other assets. Advances in communications and technology have also made "direct" financing a lower cost alternative to intermediation.

What steps should bank management take to manage credit risk in the bank's loan portfolio?

Banks manage credit risk of their loan portfolios by (1) diversifying the portfolios across regions, industries, and types of loans, (2) conducting a careful credit analysis of potential borrowers, and (3) continually monitoring the borrowers over the life of the loan or investment. Banks develop and follow lending policies which set guidelines for lending officers.

Why does the Fed not use the discount rate to conduct monetary policy? How does the Fed use the discount rate?

Before, when FED was formed, discount rate was primary tool of monetary policy. BUT now, as the money market has evolved, discounting is now faded into history. Changes in discount rate merely signal policy intent. Open market operations directly increase or reduce the money supply.

What are borrowed funds? Give some specific examples. Have borrowed funds become more or less important as a source of funds for banks?

Borrowed funds are non-deposit borrowings which support lending or investing. Examples include fed funds, Eurodollars, repurchase agreements, Discount Window loans, and bankers' acceptances. Borrowed funds have become more important as other financial institutions have competed successfully to attract the short-term transactional and savings balances of the depositing public.

Why do corporations issue commercial paper?

Commercial paper is short-term corporate debt; it is issued to meet corporate short-term cash obligations.

What are the major differences between large banks and small banks on the income statements? Why are there differences between the two groups of banks? For example, why is the net interest income higher for small banks?

Compared to large banks, small banks have proportionally higher interest income from loans and securities, explained by higher proportions of loans and securities on their balance sheets, higher interest expense (due to higher reliance on deposits), lower noninterest income because they do not provide as many fee-earning services to customers, and higher noninterest expense, with the difference mostly accounted for by a higher salaries and employee benefits expense. It does not mean that small banks pay higher salaries; rather, they have lower assets per employee than large banks. As a result, it translates into a larger salaries expense when expressed in percent of total assets.

Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?

Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient.

Explain how you believe economic activity would be affected if we did not have financial markets and institutions.

Financial markets and institutions make transactions more cost and time efficient since they specialize in transactions. Since it's more efficient, this increases economic activity so... a lack of financial markets and institutions would result in a decrease in economic activity.

What is fiscal policy? How does fiscal policy compare to monetary policy?

Fiscal policy is the control over government spending and taxes over the business cycle. Monetary policy, on the other hand, boils down to the control of money supply.

Explain the concepts of frictional unemployment, structural unemployment, and the natural rate of unemployment. How do these affect what is considered full employment?

Full employment implies that every person of working age who wants work is working. It is a desirable goal, but not necessarily a practicable one. A certain amount of unemployment in the economy is frictional unemployment—a portion of those that are unemployed are in transition between jobs. Another reason for people not working is structural unemployment, meaning that there is a mismatch between a person's skill levels and available jobs or there are jobs in one region of the country but few in another region. Policy makers tolerate a certain level of unemployment—the natural rate of unemployment—a sort of "full employment unemployment rate." However, the politically acceptable rate of unemployment varies directly with the actual rate.

The Fed decides to buy $10,000 of government bonds from Goldman Sachs. Using T-accounts show the complete transaction. Did the money supply increase or decrease? Explain.

Goldman Sachs -10,000 Gov. bonds| +10,000 Reserves at FRB| The FED +10,000 Gov. Bonds| |+10,000 Reserve Deposit of Goldman sachs The money supply increased because the banking system as a whole now has $10,000 more in reserves.

Explain why stable prices are so important to an economy.

High rates of inflation present two problems. First, it is hard to adjust to price level changes. It means that those market participants who underestimate inflation lose purchasing power. The second problem is that high inflation rates increase uncertainty regarding long-term investment decisions. To avoid these risks, many potential investors may withdraw from the financial markets altogether, causing a decline in economic activity.

Why is the concept of a liquidity trap important in the conduct of monetary policy?

If money supply is expanded so much that any extra money would be hoarded (rather than lent or invested), further injections of money have no effect on interest rate and the economy overall. Economy must be stimulated by other means.

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Why are negotiable CDs and federal funds primarily sources of funds for very large banks?

Large banks can more easily enter these parts of the money market. Transactions are very large (usually $1 million or more), and banks must be well known and of the highest credit standing.

What is the essential difference between the Keynesian and the Monetarist view of how money affects the economy?

Monetarists believe the key financial variable is the money supply. Keynesians believe the key financial variable is interest rates

Define and contrast: Monetary Base, M1, M2

Monetary Base - Currency in circulation plus financial institution reserve deposits at the Federal Reserve. The monetary base consists of all assets that can be used to satisfy legal reserve requirements. Thus, if it grows, financial institution reserves (and financial institution deposits) usually grow too. M1 - Currency + checking deposits M2 - M1 + savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, noninstitutional money market mutual funds, and small time deposits.

Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why?

Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or "capital goods" are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to "store" cash in money market securities, which are generally, safe, liquid, and short-term.

Describe some of the recent trends affecting bank income statements. For example, has net interest income increased or decreased in recent years? What about other components of the income statement?

Net interest income has remained fairly stable, while its components - gross interest income and gross interest expense - have been volatile and lately have both fallen along with the level of interest rates. Another key change in the banks' aggregate income statement has been a large increase in the provision for loan losses, PLL, beginning in 2007 (see Exhibit 13.13). PLL reduces a bank's income; it goes up and down with losses on loans and investments. The latest increase in PLL was related to the 2007-2009 financial crisis.

What do we mean by off-balance-sheet activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?

Off-balance-sheet activities are financial services which earn revenue but do not directly or immediately put assets or liabilities on the balance sheet. Examples include loan commitments, letters of credit, loan brokerage, securitization, and derivatives. These activities are important: They are a large component of the revenue of the world's largest banks, they materially affect a bank's overall risk profile and profitability, and yet they are not readily apparent in cursory examination of financial statements. Assessment of their full effect requires an analysis of notes to financial statements.

Explain how the Fed changes the money supply with an open-market purchase of Treasury securities.

Open market purchases increase total reserves in the banking system directly, immediately, and dollar-for-dollar.

If the country went into a recession, would you expect banks to increase or decrease its holdings of excess reserves? Explain.

Recessions are characterized by declines in economic activity. Demand for loans falls during such times while deposits levels tend to remain fairly stable. As a result, banks tend to make less loans and hold more excess reserves.

Assume a depository institution holds vault cash of $3 million and reserve deposits at the Fed of $25 million, and has borrowed $2 million from the Fed's discount window. If that institution holds $300 million in transactions deposits and is subject to a 3 percent reserve requirement on the first $50 million of those deposits and to a reserve requirement of 10 percent on all transactions deposits over $50 million, what are its required reserves? What are its excess reserves?

Reserves total $28 million: vault cash of $3 million and deposits at the Fed of $25 million. Required reserves amount to $26.5 million (3% of the first $50 million of deposits plus 10% of the remaining $250 million), leaving $1.5 million in excess reserves. However, $2 million is due to the Fed at the Window, leaving the bank in a -$.5 million "net borrowed reserve" position.

Why are deposits a more important source of funds for small banks than for large banks? Why are deposits considered a more stable source of funds for small banks than for large banks?

Small banks are usually retail oriented and have a greater proportion of individual accounts. Large banks have proportionally more business accounts, whose balances fluctuate more.

Explain why the Board of Governors of the Federal Reserve System is considered so powerful. What are its major powers and which is the most important?

The 7 members of the Board make up a majority of the 12-member FOMC, which sets monetary policy (the Fed's most important power). The Board also promulgates all the financial system regulations listed in Exhibit 2.4, enacts the policies and procedures by which the Federal Reserve System is internally governed, and appoints 3 of the 9 directors of each Federal Reserve Bank. Governors, though appointed by the President and confirmed by the Senate, have a 14-year nonrenewable term of office and may thus discharge their duties with considerable political independence.

Explain why the FOMC is the key policy group within the Fed.

The Federal Open Market Committee, comprising the 7 Governors, the president of the New York Fed, and 4 of the remaining 11 presidents of Federal Reserve Banks, sets monetary policy

Give the reasons that banks select the bank holding company form of organization. Why would a bank holding company seek to convert to a financial holding company?

The bank holding company structure circumvents state and federal restrictions on geographic expansion and services. Holding companies also offer tax-sheltering opportunities not available with a single bank charter. Under the Financial Services Modernization Act of 1999 a bank holding company can apply to the Fed as a "financial" holding company. With the Fed's approval, a financial holding company may own insurance or investment banking subsidiaries as well as other financial holding companies.

In your opinion, what were the three most important factors that caused the 2008 financial crisis?

The first of the most important factors was the U.S. housing price bubble that burst. When many mortgages made during the housing price run-up started defaulting, it caused deterioration in the balance sheets of financial institutions that held these mortgages or mortgage-backed securities. It was the second major factor contributing to the crisis. The third major factor was the bankruptcy of the investment bank Lehman Brothers in September 2008.

What would happen to the monetary base if the U.S. Treasury collected $4 billion in taxes, which it deposited in its account at the Fed, and the Fed bought $2.5 billion in government securities? Do you know now why the Fed and Treasury try to coordinate their operations in order to have minimal effects on the financial markets?

The first transaction would lower bank reserves and increase Treasury deposits at the Fed by $4 billion. The second transaction would restore $2.5 billion in bank reserves. The net reduction of $1.5 billion in reserves would put upward pressure on the Fed Funds rate. The Treasury will probably spend its deposits down quickly, increasing bank reserves by the total of the clearing checks. The Fed may then have to sell government securities to return reserves to their intended level.

What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?

The goals of the Federal Reserve Act of 1913 were to create: (1) a reliable mechanism for adjusting the money supply to the needs of the economy; (2) a lender of last resort that could furnish liquidity to banks in times of financial crisis; (3) an efficient payment system for clearing and collecting checks at face value throughout the country; and (4) a more vigorous bank supervision system to reduce the risk of bank failures.

What are some of the potential conflicts between goals of monetary policy? Explain.

The goals often perceived in conflict are full employment and stable prices, at least in the short run. The conflict revolves around the perception that, as employment increases, so does inflation.

What are the important differences between investments and loans in a bank portfolio of assets?

The investment securities permitted to banks are highly liquid, highly marketable, and relatively low-risk. Loans are personalized contracts, lower in marketability unless participated or securitized, and higher in risk unless exceptionally well-secured.

If the Fed bought $3.5 billion in government securities and the public withdrew $2.0 billion from their transactions deposits in the form of cash, by how much would the monetary base change? By how much would financial institutions' reserves change? By how much would financial institutions' required reserves change if all proceeds from bond sales and all withdrawals from transactions accounts were deposited in or taken from accounts subject to a 10 percent reserve requirement? By how much would depository institutions' net excess reserves change?

The open-market purchase would increase the reserve component of the monetary base by $3.5 billion. The public's withdrawals represent a $2 billion "cash drain". The net effect on the monetary base ultimately depends on whether and to what extent the affected institutions replenish the cash. Assuming they replenish the $2 billion in cash by converting sufficient reserves into Federal Reserve Notes, the purchase of currency would be a "wash" and the monetary base would increase by $3.5 billion, the amount of the purchase of government securities. The affected institutions would initially allocate $350 million to required reserves, and immediately start trying to lend or invest $3.15 billion of excess reserves.

Why are direct financing transactions more costly or inconvenient than intermediated transactions?

The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale.

What is the primary goal of a commercial bank? Why may this goal be translated into maximizing the firm's stock share price?

The primary goal of a bank is *profit maximization*. Stock prices provide continual monitoring of how well management is doing on behalf of stockholders, and reflect shareholder's expectations about the firm's future performance. For firms not widely traded, this type of continuous review is not available.

What is the prime rate? Why do some banks make loans below the prime rate?

The prime rate is a base loan rate traditionally associated with the most creditworthy commercial borrowers. Large well-known firms with excellent credit ratings and access to the commercial paper market can often borrow below the posted prime rate, if the bank wants their business badly enough.

Why is the financial system so highly regulated?

The regulation is needed to protect consumers from abuses by unscrupulous financial firms and to ensure economic stability. People should have confidence in the financial system for it to function well, and a well-functioning financial system is critical for ensuring the flow of funds and, in turn, economic growth.

What are the six goals the Fed is required by government legislation to achieve? Which two goals are the most important? Why?

The six goals of the Fed are: price stability, full employment, economic growth, interest rate stability, stability of the financial system, and stability of foreign exchange markets. The most important goals are high employment and stable prices.

Explain the fed funds rate (and its importance) and the talk about the market for the fed funds rate.

The targeting of the fed funds rate is the key monetary policy tool of the fed. Banks borrow and lend reserves with one another in the fed funds market and impacting this market will have a marked impact on reserves in the banking system. While the fed funds market is an interbank market and the fed funds rate is the by product of the supply of and demand for reserves in the fed funds market, the Federal Reserve can impact the fed funds interest rate by changing the supply of reserves in the market. If the fed buys (sells) T-bills, the supply or reserves increases (decreases) and the fed funds rate falls (rises).

Northwest National Bank received new demand deposits (DD) of $1,650,000. The current reserve requirement is 6 percent. The bank has $80,000 in vault cash and $110,000 at the Federal Reserve that are not yet invested. How much in excess reserves does the bank have available to make new loans?

Total reserves = $80,000 + $110,000 = $190,000 Required reserves = $1,650,000*0.06 = $99,000 Excess reserves = $190,000 - $99,000 = $91,000

Give the reasons banks hold Treasury securities and municipal bonds in their investment portfolios.

Treasuries are held as secondary reserves. They are short-term (low price risk), highly marketable, and have low default risk. Munis are owned by banks primarily for their tax advantage.

What are the advantages and disadvantages of using credit scoring to evaluate a loan application?

While conventional credit analysis could take days, credit scoring takes only seconds. Thus lenders can provide instant credit for many loan products. Another advantage is that a person's credit score is based on objective criteria, which minimizes potential discrimination. The disadvantage of scoring is that it is impersonal and does not allow for special circumstances. Critics of credit scoring also argue that the secretiveness behind scoring models makes it difficult for potential borrowers to improve their score. For example, consumers who consolidate debt may actually hurt their rating because credit-scoring models may interpret the behavior as an effort to manipulate their credit rating.

Does it make sense that the typical household is a surplus spending unit (SSU) while the typical business firm is a deficit spending unit (DSU)? Explain.

Yes, households are mainly in surplus because they're typically always saving in the form of retirement. Businesses are typically in deficit because they must borrow money to fund an idea or operation, and they usually invest more in real assets than they receive in current operating cash flow.

Given your answers to Question 7, what, if anything, would you expect to happen to: a. housing investment b. plant and equipment investment c. intended inventory investment d. government expenditures e. consumption f. exports g. imports Why?

a. increase b. increase c. increase d. increase e. increase f. increase g. decrease As market interest rates decline, loans become readily available, money supplies expand, the public's liquid asset holdings increase, and the market value of financial assets rises. In addition, disintermediation pressures may diminish. As a result of the decline in interest rate, increase in liquidity, and increase in credit availability more expenditures will be undertaken in all segments of the economy.

What effects are decreases in reserve requirements likely to have on: a. bank reserves b. federal funds rates c. bank lending d. Treasury bill rates e. the bank prime rate? Explain your answers.

a. none b. reduce them c. increase it d. reduce them e. reduce it Reductions in reserve requirements will provide depository institutions with additional excess reserves. As they lend or invest these excess reserves to earn an interest return, Fed Funds rates and other short-term rates will fall, stimulating demand for loanable funds.