Banking Exam 2
"A bank that expects interest rates to increase in the future will want to hold more rate-sensitive assets and fewer rate-sensitive liabilities." Do you agree with this statement?
Agree. Rate-sensitive assets will increase in value thus holding more of them as assets, while reducing them as liabilities, will increase bank profits.
Did the existence of reserve requirements make it easier for banks to deal with bank runs? Briefly explain.
The existence of reserve requirements did not change the situation that banks faced during bank runs because banks were unable to use required reserves to cover deposit withdrawals.
Are the funds in your checking account an asset to you or a liability? Are they an asset or a liability to your bank?
The funds are an asset to you and a liability to your bank, since it is your money and the bank is obligated to pay it back to you on demand.
What are the disadvantages of defined benefit pension plans for employees? (Check all that apply.)
The implicit return to the plan may be fairly low if plan managers do not invest well. A worker could lose some pension benefits if the plan is underfunded or if the employer goes out of business. The worker has no control on how the money is invested and some plans do not adjust future payouts to keep pace with inflation.
Which of the following is not a reason why savers with small amounts to invest rarely make loans directly to individuals or firms?
The interest rate that savers would earn from making these loans is too low.
If everyone were perfectly honest, would there be a role for financial intermediaries?
Yes
Loan sales is
a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.
Standby letters of credit are
a promise by a bank to lend funds, if necessary, to the seller of commercial paper at the time that the commercial paper matures.
Off-balance-sheet activities are
activities that do not affect a bank's balance sheet because they do not change either the bank's assets or its liabilities
Trading activities are
activities that include trading in the futures, options, or swaps market.
What is a "standing repo facility"? A standing repo facility allows the Fed to engage in repos when firms cannot obtain short-term loans from other firms. This makes the problems associated with the mismatch of maturities for investment banks better , since it would provide more stability for short-term borrowing .
allows the Fed to engage in repos, better, provide more stability for short-term borrowing
A T-account is
an accounting tool used to show changes in balance sheet items.
Loan commitment is
a bank's consent to provide a borrower with a stated amount of funds during some specified time.
Financial intermediaries take advantage of economies of scale , which refers to the reduction in average cost that results from an increase in the volume of a good or a service produced.
economies of scale, reduction, an increase
The United States is said to have a dual banking system because banks
may be chartered either by state governments or by the federal government.
The FDIC stands for
the Federal Deposit Insurance Corporation.
The World Bank measures financial development by:
the total amount of credit banks and financial markets extend to households and firms as a percentage of GDP.
Who is "providing" capital to these firms?
Buyers of stocks.
Use a T-account to show the effect on Bank of America's balance sheet of your depositing $80 in currency in your checking account.
80
What is the difference between venture capital firms and private equity firms?
A private equity firm raises equity capital to acquire shares in established firms with the intention of reducing moral hazard problems. A venture capital firm is a firm that raises equity capital from investors to invest in startup firms.
All of the following are reasons why these financial foundations were important in making possible the rapid growth of the U.S. economy during the nineteenth and twentieth centuries, except:
A central bank provided direct control over all interest rates, facilitating the control and direction of the overall economy.
What is the shadow banking system?
A collection of nonbank financial institutions that channel money from savers to borrowers.
What is a credit report?
A list of your debts, payment history, and information about where you live and work.
What is systemic risk?
A risk to the entire financial system.
[Related to the Making the ConnectionLOADING...] What incentives would the partners in an investment bank have to turn it into a public corporation?
A. Going public eliminates the risk involved to the top executives, as it is not solely their money that is being risked. B. Going public provides more access to capital and leverage. C. (Answer) A and B are correct. Your answer is correct. D. Neither A, nor B is correct.
An article in the Economist magazine observes: "Insurance companies often suspect the only people who buy insurance are the ones most likely to collect." Source: "The Money Talks," Economist, December 5, 2008. What do economists call the problem being described here?
Adverse selection.
"A bank that expects interest rates to fall will want the duration of its assets to be greater than the duration of its liabilities - a positive duration gap." Do you agree with this statement?
Agree. A fall in interest rates with a positive duration gap will increase a bank's capital.
The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." Source: Marc Santora, "How to Be a Brainy Renter," New York Times, June 3, 2010. Do you agree with this statement? If so, what do landlords know that potential renters might not?
Agree; Landlords know more about the quality of the property, and hence its true value, than renters.
If commercial banks were allowed to purchase significant amounts of stock in the companies to which they make loans, would this increase or decrease the extent of moral hazard in the financial system?
All answers are correct.
How do banks manage credit risk?
All of the above are correct.
Suppose that Lena, who has an account at SunTrust Bank, writes a check for $140 to Jose, who has an account at National City Bank. Use following the T-account for SunTrust Bank to show how it is affected after the check clears.
Assets Liabilities A) Reserves A (140) L)Checkable deposits L (140) Use following the T-account for National City Bank to show how it is affected after the check clears. Assets Liabilities A) Reserves A 140 Checkable deposits L) 140
The key accounting equation on which balance sheets are based is given by
Assets = Liabilities + Shareholders' Equity.
Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically optimal?
Asymmetric information makes information costs for external funds higher than for internal funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal.
In 2020, during the recession caused by the Covid-19 pandemic, Federal Reserve Chair Jerome Powell announced the banks would be allowed to reduce their leverage ratios. He stated that reducing banks' leverage ratios "would give us the ability to allow banks to grow their balance sheets." What is a bank's leverage ratio? How is it related to a bank's leverage?
A bank's leverage ratio is the ratio of its capital to assets . A bank's leverage is the inverse of the leverage ratio.
How do banks manage interest-rate risk?
Banks can reduce interest-rate risk by making more floating rate loans, or ARMs. Interest-rate swaps can reduce interest-rate risk exposure.
What is a credit score?
A three-digit score based off several factors related to your credit history.
As an employee of a large firm, you are given the choice between a defined benefit pension plan and a defined contribution pension plan. What are the advantages of defined benefit pension plans for employees?
A worker's retirement payout is determined by a formula so that the worker bears no direct risk.
Does a bank's capital appear on the left side of the bank's balance sheet?
Bank capital appears on the right side of the balance sheet, because it is the difference between assets and liabilities.
How do banks manage liquidity risk
Banks manage this risk by keeping some funds very liquid, such as a reverse repurchase agreement. Banks manage this risk by keeping some funds very liquid, such as in the federal funds market. Banks can increase their borrowings to cover liquidity risk.
If the article is correct about what was happening in the Chinese banking system, what problems might arise as a result?
Banks will make riskier and riskier loans over time.
In the adjacent figure, countries that are above the upward sloping line have relatively high levels of real GDP per capita for their levels of financial development and countries that are below the line have relatively low levels of real GDP per capita for their levels of financial development. Holding constant all other factors that might affect a country's rate of economic growth, would we expect future growth rates to be higher for countries above the line or for countries below the line?
Below the line because these countries have underperformed so far given the strength of their financial system.
"If a bank manager expects interest rates to fall in the future, he should increase the duration of his bank's liabilities." Do you agree with this statement?
Disagree. Higher duration of its liabilities will reduce the value of the bank's capital.
What benefits do employees receive from saving for retirement using 401(k) plans?
Employees are not taxed on their contributions to 401(k) plans, or the earnings on those investments, until they are withdrawn during retirement.
Which of the following is not an advantage automobile dealers might gain from using a finance company, rather than a bank, to finance their purchases of cars from the manufacturer and their customers' purchases of cars from the dealers?
Finance companies are more reliable during recessions than commercial banks since they raise money from long-term savers and only loan to those with high credit scores.
What is the difference between a defined contribution pension plan and a defined benefit plan?
In a defined contribution pension plan, the firm invests contributions for the employees, who own the value of the funds in the plan. In a defined benefit plan, the firm promises employees a particular dollar benefit payment based on each employee's earnings and years of service.
Developing new financial securities or investment strategies, using sophisticated mathematical models.
Financial engineering
[Related to the Apply the Concept: "FICO: Can One Number Forecast Your Financial Life—and Your Romantic Life?"] At the beginning of the Covid-19 pandemic, an article on bloomberg.com observed that: "Online personal-loan companies such as Social Finance Inc. ... are another question mark in a downturn because the default rate for alternative lenders is unknown." What does the article mean by referring to a fintech lender like Social Finance (SoFi) as an alternative lender?
Fintech lenders use alternative measures of default risk, which expands the types of borrowers they are willing to lend to.
Which of the following might explain why a country without a strong financial system would struggle to achieve high rates of economic growth?
Firms are unable to acquire funds they need to expand.
In describing the work of hedge funds, financial journalist Sebastian Mallaby has observed: [Research] showed that the unglamorous "value" stocks were underpriced relative to overhyped "growth" stocks. This meant that capital was being provided too expensively to solid, workhorse firms and too cheaply to their flashier rivals. . . . It was the function of hedge funds to correct inefficiencies like this. Source: Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite, New York: The Penguin Press, 2010, pp. 8-9. Explain what the first two sentences in this excerpt mean: What is the connection between the relative prices of these two types of firms and their cost of raising capital?
Growth stocks had a higher price-to-earnings ratio than value stocks. The cost of raising new capital falls with an increase in the stock price.
What did Powell mean by allowing banks to "grow their balance sheets"? How would a lower leverage ratio allow banks to grow their balance sheets?
He is talking about easing capital restrictions by letting banks have more assets per dollar of capital. As asset holdings grow, banks' balance sheets will be growing.
How can hedge funds correct this inefficiency?
Hedge funds correct this inefficiency by buying value stocks and putting upward pressure on their price. B. Hedge funds correct this inefficiency by selling growth stocks and putting downward pressure on their price. C. A and B are correct. Your answer is correct. D. ( Answer) Neither A, nor B are correct.
In what ways is the market for rental apartments like the market for used cars?
In both markets, the owner knows more than the potential renter or buyer.
Rather than declining to renew policies, why didn't the insurance companies raise the rates they charged people in these areas for fire insurance?
Insurers must believe that raising rates would increase adverse selection even more, making any future fires very costly for the companies.
What are the key problems that investment banks can encounter in borrowing short and investing long that commercial banks don't?
Investment banks face counterparty risk since there are no federal guarantees like commercial banks have on deposits, and the repo market can be volatile.
In what ways are they different?
Investment institutions are different from commercial banks because they do not engage in traditional commercial banking activities, such as taking deposits and making loans.
If becoming a public corporation increases the risk in investment banking, how do publicly traded investment banks succeed in selling stock to investors?
Investors desire investment banks' stocks because of the potentially high profits of these banks due to their access to high leverage.
If the statement is correct, what are the implications for the market for rental apartments?
Landlords will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry.
[Related to the Making the Connection] An editorial in the Wall Street Journal argues that: "there's no evidence that [repealing the Glass-Steagall Act in 1999] had anything to do with the [2007-2009 financial] crisis." Source: "Glass-Steagall-Trump-Clinton Act," Wall Street Journal, July 28, 2016. What is the argument in favor of believing that repealing the Glass-Steagall Act did not play a role in the financial crisis?
Large banks that combine commercial and investment banking activity were not at the center of the financial crisis.
Which from the following are off-balance-sheet activities? (Check all that apply.)
Loan sales. Loan commitment. Standby letters of credit. Trading activities.
What is the most important source of external funds for these firms?
Loans from financial intermediaries
Which of the following is a correctly explained key feature of the financial system? (Check all that apply.)
Loans from financial intermediaries are the most important external source of funds for small- to medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms. The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard.
What is the most important method of debt financing for corporations?
The bond market.
Buying and selling securities, typically those that are not traded on exchanges, and maintaining an inventory of the securities in order to serve as an intermediary between buyers and sellers.
Market making
f we lived in a world in which everyone was perfectly honest, would the difference in the transactions costs faced by financial intermediaries when they make loans and those faced by small savers when they make loans disappear?
No; while information costs might decrease there are still significant legal and other transaction costs involved in matching savers and borrowers.
Why did nationwide banking come relatively late to the United States compared with other countries?
The U.S. system of many small, geographically limited banks was the result of political views that the power of banks should be limited by keeping them small and that the deposits banks received should be used only to fund loans in the local area.
Why do pension funds have vesting periods?
Pension funds have vesting periods in order to reduce turnover among employees who are not yet vested.
According to an article in the Wall Street Journal in late 2019, after several years of severe wildfires in some areas of California, "insurers have declined to renew the policies of 350,000 California homeowners who live in areas at high risk for wildfires, according to the California Department of Insurance." What key requirement that makes insurance possible did insurance companies believe no longer held in these areas of California?
Profitability and adverse selection. The volume of people in high-risk areas looking for insurance increased, resulting in insurance companies expecting ever-increasing payouts on policies.
Buying and selling securities and other assets for a bank's own account rather than for clients.
Proprietary trading
ReviewHomework:Homework: Chapter 11 Question 12, End of Chapter 3.7 HW Score: 90.74%, 16.33 of 18 points Points: 0.67 of 1 Close In 2020, an article in the New York Times observed that: "For years, the country's public pension plans have faced a yawning gap between what they owe and what they can pay. . . . Public pensions are the time bomb of government finance. Now the coronavirus pandemic has it ticking faster." In what sense are public pension plans a "time bomb" for government finance?
Public pension plans require fixed payments to retirees regardless of the state of the economy.
Suppose that the value of a bank's assets is $44 billion and the value of its liabilities is $35 billion. If the bank has ROA=2%, then what is its ROE?
ROE=9.789.78% ROE=ROA*B. A/BC
The most important bank assets are
Real estate loans and U.S. government/agency securities.
How have the types of loans banks make changed over time?
Real estate loans have become a much higher percentage of total loans since 1973, while commercial loans have declined.
The most important bank liabilities are
Small-denomination time deposits and Checkable deposits.
Why would the Covid-19 pandemic have made the problems facing public pension plans worse?
Taxes collected by state and local governments declined, causing pension funds to be even more underfunded.
Why was it established?
The FDIC was established to ameliorate bank runs. B. The FDIC was established in 1913 together with Fed C. The FDIC was established in 1934 after a series of bank failures. D. ( Answer )A and C are correct.
Economist Richard Sylla of New York University has argued that in the 1790s, Secretary of the Treasury Alexander Hamilton "established the financial foundations that would make the United States the most successful emerging market in the nineteenth century, and the economic colossus of the next that some would call the 'American century.'" Source: Richard Sylla, "Financial Foundations: Public Credit, the National Bank, and Securities Markets," in Douglas A. Irwin and Richard Sylla, eds., Founding Choices: American Economic Policy in the 1790s, Chicago: University of Chicago Press, 2011, p. 86. Sylla would focus on all of the following "financial foundations" of the United States, except:
The issuance of currency.
In what ways is it different?
The landlord is not selling the apartment, merely renting it, while the buyer of a used car makes an irreversible deal.
Consider the possibility of income insurance. With income insurance, if a person loses his job or doesn't get as big a raise as anticipated, he would be compensated under his insurance coverage. Why don't insurance companies offer income insurance of this type? (Check all that apply.)
The problem is adverse selection (people who are more likely to be fired or get low raises would be more likely to buy such insurance). The problem is moral hazard (once insured, you won't work as hard).
Which of the following reasons might explain why repealing the Glass-Steagall Act may have been a bad idea?
The repeal of Glass-Steagall increased the risk to the financial system.
What are the advantages of defined contribution pension plans for employees?
The return may be higher, and the worker often has some control over how the money is invested.
Do vesting periods have any advantages to employees relative to a system where new hires are eligible to participate in a pension plan right away?
Vesting periods do not have any advantages to employees relative to a system where new hires are eligible to participate in a pension plan right away.
In what ways does the shadow banking system differ from the commercial banking system?
The shadow banking system, unlike the commercial banking system, does not offer traditional banking services such as taking in deposits. B. The shadow banking system invests in more risky assets and tends to be highly leveraged than commercial banks. C. The commercial banking system, unlike the shadow banking system, is heavily regulated by the government. D. (answer) All of the above are correct.
In what ways are investment institutions similar to commercial banks?
They both borrow short and lend long.
What choices do state and local governments face in attempting to diffuse this financial time bomb? (Check all that apply.)
They could increase taxes in an effort to help afford payments on the pension plans. They could cut government spending to help afford the pension payments.
What is the most important source of funds for small to medium-sized firms?
The owners' personal funds and profits
What are the disadvantages of defined contribution pension plan for employees?
The worker's retirement payout depends on the performance of the invested monies, so it is riskier.
Why don't these firms rely on external funds to the same extent as large firms do
Transactions costs and information costs are much higher for smaller firms.
An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit.
Underwriting
If insurance companies are correct in their suspicion, it will increase the price of insurance.
increase
Decades ago, many bank records were written by hand in ledgers. At the time, banks achieved little economies of scale as the amount of labor required to maintain such records was the same for every transaction, regardless of the size of the bank. The shift to keeping all records on computers has increased the opportunities to achieve economies of scale by replacing labor costs with technology costs.
little, the same, regardless, increased, labor, technology
An article in the Wall Street Journal discussed the fact that the Chinese government often intervenes to keep banks that make many bad loans from failing. The result was "moral hazard, or risk-taking based on the belief that someone else will pick up the tab if things go wrong." Do you agree with the article's definition of moral hazard in this context? This is an example of moral hazard because the article mentions that the government often intervenes to bail out banks making bad loans, therefore, banks are taking risks knowing they will not bear the entire burden when loans fail
is an example, taking risks knowing they will not bear the entire burden when loans fail
Why would the article state that it is unknown whether a fintech lender like SoFi will face a higher or lower default rate during a recession than would a bank or other conventional lender? Are there reasons to expect that the default rate might be higher? The impact of a recession on fintech lenders like SoFi is unknown since ________. Fintech lenders may experience higher default rates than traditional lenders because they ________.
it is a new industry without data on how they fair in recessions; are more likely to lend to individuals with little or no credit history
In early 2020, 72 months was the most popular loan term, with many borrowers taking out 84-month loans. What are the implications of long loan terms for the likelihood that a borrower will default on a loan? Why would auto finance companies have been willing to make such long loans? Why would people be willing to borrow for such a long term? The longer the car loan, the more likely the borrower will default, since longer loans result in more interest payments on the loan and a higher final payout for the car. Finance companies are willing to make such long loans because they are able to sell more cars. People who are willing to borrow for such long terms are likely to have low incomes and poor credit and value the low monthly payments that come with the longer term.
more, more interest payments on the loan and a higher, they are able to sell more cars, low incomes and poor credit
In August 2020, during the Covid-19 pandemic, an article in the Wall Street Journal discussed rising default rates on automobile loans: "According to the New York Fed, 5.1% of car loan balances were 90 or more days delinquent in the first quarter [of 2020], only slightly below the peak of 5.3% in the [2007-2009] financial crisis." The article noted that: "Auto lending soared in the past decade because low interest rates and longer loan terms reduced monthly payments." Rising loan defaults would pose problems for auto finance companies and other firms that originate automobile loans and for investors who had bought asset-backed securities (ABS) that were made up of securitized auto loans. What is an auto finance company? Auto finance companies are ________.
nonbank financial intermediaries that raise money through sales of commercial paper and other securities and use the funds to make car loans available
What is the difference between retail and wholesale funding? Using deposits to finance investments is called retail funding. Another source of funds is short-term borrowing primarily from other financial firms. This type of financing is called wholesale funding. Investment banks rely on wholesale funding of their investments as opposed to the retail funding that Commercial banks rely on.
retail, wholesale, Investment, Commercial
In July 2010, Congress was considering having the federal government set up a "lending fund" for small banks. The U.S. Treasury would lend the funds to banks. The more of the funds the banks loaned to small businesses, the lower the interest rate the Treasury would charge the banks on the loans. Congressman Walt Minnick of Idaho was asked to comment on whether the bill would be helpful to small businesses. Here is part of his response: "The bank that's struggling to write down their commercial real estate assets is having to take a hit to capital, and this provides replacement capital on very, very favorable terms. So it deals with the left side of the balance sheet..." Source: Robb Mandelbaum, "Can Government Help Small Businesses?" New York Times, July 29, 2010. Would a loan from the Treasury be counted as part of a bank's capital?
No, a loan from the treasury would not be counted as bank capital.
[Related to the Apply the Concept: "Did Moral Hazard Derail Investment Banking?"] In a letter to the firm's shareholders, Jamie Dimon, the chair and CEO of JP Morgan Chase, observed: "There is one financial commandment that cannot be violated: Do not borrow short to invest long—particularly against illiquid, long-term assets." Do commercial banks borrow short term and invest the funds long term?
Yes, commercial banks borrow by taking in short-term deposits and invest by making long-term loans.
Just before the Covid-19 pandemic began to significantly affect the Chinese economy, two articles in the Wall Street Journal noted problems in the Chinese banking system. One article noted that large "Chinese banks also prefer to make safe loans to large, state-owned companies instead of helping the kind of small, private companies that are truly in need." Another article noted that smaller Chinese banks were having difficulty attracting deposits and were also experiencing rising levels of debt defaults. Are these problems likely to matter for the future growth of the Chinese economy?
Yes, small private businesses provide a lot of the jobs, innovation, and capital accumulation needed for a country to grow long-term. Only lending to large state-owned firms will limit growth.
Do investment banks borrow short term and invest the funds long term?
Yes, they borrow short term by issuing commercial paper and invest long term by buying mortgage-backed securities.
