Chapter 10 Homework Questions
If the housing market suddenly crashed, Universal Bank would be better off with ____________________________ accounting system.
the historical-cost
Which of the following statements regarding banking crises throughout the world is true?
Banking crises in different countries occur repeatedly.
The presence of deposit insurance increases the adverse selection problem in banking by
attracting risk-loving people into bank ownership.
The Federal Deposit Insurance Corporation Improvement Act of 1991:
required the FDIC to establish risk-based deposit insurance premiums.
Consider a failing bank. If the FDIC uses the payoff method, a deposit of $340,000 is worth
$306,000 $340,000 * 0.90 = $306,000
If the FDIC uses the purchase and assumption method, a deposit of $340,000 is worth
$340,000 = to original deposit
Before the loan commitment, the bank's risk-weighted assets are $_________ million
$48 million Reserves and T-bills are risk-free assets.
The risk-weighted assets after Oldhat's first day are $_____________ million
$55 $30 + $25
After the loan commitment, the bank's risk-weighted assets are $_________ million
$58 million Add $10 million (loan) to loans already on balance sheet.
The risk-weighted capital ratio after Oldhat's first day is _________%
21.8% risk-weighted capital ratio = value of capital divided by the value of total risk-weighted assets
(Oldhat) The leverage ratio is _________________% and the bank is ______________
8.45% Well capitalized Leverage ratio = capital/total assets To be classified as well-capitalized, bank's leverage ration must be > 5%
Consider a bank with the following balance sheet: Assets: Required reserves $8 million Excess reserves $5 million T-bills $44 million Commercial loans $48 million Liabilities: Checkable deposits $95 million Bank capital $10 million The bank makes a loan commitment for $10 million to a commercial customer. Before the commitment, the bank's capital ratio equals ___________ %.
9.52% $10 million / $105 million = 0.952 Banks capital ratio = amount of capital divided by the bank's total assets
After the commitment, the bank's capital ratio equals _________ %
9.52% The loan is not a counted transaction yet
Oldhat Financial starts its first day of operations with $10 million in capital. A total of $140 million in checkable deposits are received. The bank makes a $30 million commercial loan and another $40 million in mortgages, with the following terms: 200 standard 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for $200,000. Assume that required reserves are 88%. Assets: Required reserves: $11 million Excess reserves: $69 million Loans: $70 million Liabilities: Checkable deposits: $140 million Bank capital: $10 million Early the next day the bank invests $35 million of its excess reserves in commercial loans. Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%, implying a present value of its current mortgage holdings of $99,838 per mortgage. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat's balance sheet look like? Fill in the blanks in the actual balance sheet as it would look after the sale.
Assets: Required Reserves: $11 Excess reserves: $54 Loans: $65 Liabilities: Checkable deposits: $140 Bank capital: $-10 Excess reserves, loans, and bank capital are affected by this change. The sale of each mortgage would be recorded as: Debit: Cash: $99,838 Loss: $100,162 Credit: Mortgages: $200,000 After the bank invested $35 million of its excess reserves in commercial loans and sold its mortgages, loans equal: New Loans = Initial loans + Commercial loans − Mortgages Loans = 70 + 35 − 40 = $65 million
Oldhat Financial starts its first day of operations with $12 million in capital. A total of $130 million in checkable deposits are received. The bank makes a $25 million commercial loan and another $60 million in mortgages, with the following terms: 200 standard 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for $300,000. Assume that required reserves are 8%. Complete the bank's balance sheet provided below.
Assets: Required reserves: $10 Excess reserves: $47 Loans: $85 Liabilities: Checkable deposits: $130 Bank Capital: $12 Liabilities consist of $130 million of checkable deposits and $12 million of bank capital. Total Liabilities= Checkable Deposits + Bank Capital 130 + 12 = $142 million Since total assets must equal total liabilities, total assets = $142 million
What have bank regulators done about this problem (off-balance sheet activities), if anything?
Bank regulators have imposed an additional risk-based bank capital requirement.
Why does imposing bank capital requirements on banks help limit risk taking?
Banks have more to lose if they fail and are thus more likely to pursue less risky activities.
At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of the largest U.S. banks to accept capital injections, in exchange for nonvoting ownership stock, even though some of the banks did not need the capital and did not want to participate. What could be the rationale for doing this?
By forcing all banks to accept capital injections, it would help prevent bank runs on the weakest banks.
If casualty insurance companies provided fire insurance without any restrictions, what kind of moral hazard problem might result?
Customers would take less preventive care in avoiding fire risk with this type of insurance
Why are deposit insurance and other types of government safety nets important to the health of the economy?
Deposit insurance and other government safety nets help to eliminate a contagion effect.
Which of the following is true of a banking system with deposit insurance?
Depositors are less likely to withdraw their money in the event of a crisis.
Which of the following is not a difficulty in the regulation and supervision of banks?
Financial institutions are not required to follow the rules
Which of the following isis a feature of the Dodd-Frank Act?
Giving the federal government the ability to dissolve bank holding companies in an orderly fashion.Giving the federal government the ability to dissolve bank holding companies in an orderly fashion.
What do your previous answers tell you about the tradeoffs between the two accounting systems (historical-cost and mark-to-market)?
Historical-cost accounting often does not provide an accurate picture of a firm's capital position. Mark-to-market rules generally provide a more accurate picture of a bank's capital position.
Why does the existence of deposit insurance increase the likelihood that depositors will need deposit protection?
Insured banks tend to pursue greater risks than they otherwise would
Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer.
It is not a good idea. Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of excessive risk taking on the part of banks. It would, however, make bank failures and panics more likely.
Which agency has regulatory responsibility when a bank operates in many different countries?
It is not always clear
Give one example each of moral hazard and adverse selection in private insurance arrangements.
Leaving your car unlocked with the keys in it is an example of moral hazard, while a person with poor health seeking health insurance is an example of adverse selection
The collapse of the Bank of Credit and Commerce International, BCCI, showed the difficulty of international banking regulation. BCCI operated in more than 70 countries and was supervised by the small country of:
Luxembourg
_________________ requires financial firms to value assets at what they would sell for in the market.
Mark-to-market accounting
Suppose Universal Bank holds $100 million in assets, which are composed of the following: Required Reserves: $10 million Excess Reserves:$5 million Mortgage Loans: $20 million Corporate Bonds: $15 million Stocks: $25 million Commodities:$25 million Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and commodities as assets?
No, as these types of assets are relatively high risk, and there is a threat of insolvency.
Would restrictions on competition be better?
No, restrictions would decrease the efficiency of banking institutions.
If a bank becomes insolvent and the FDIC reorganizes the bank by finding a willing merger partner, the FDIC resolved this insolvency problem through the
Purchase and assumption method
How does the Basel 3 Accord attempt to address the shortfalls of the Basel and Basel 2 Accords?
Raising capital requirements in good times and lowering them in bad times.Raising capital requirements in good times and lowering them in bad times. Establishing new rules on the use of credit ratings Requiring firms to have access to more stable funding to increase liquidity.Requiring firms to have access to more stable funding to increase liquidity.
What bank regulation is not designed to reduce moral hazard problems created by deposit insurance?
Regulation-Q.
The Dodd-Frank Act created a Financial Stability Oversight Council that designates which financial firms are systematically important and so received the official designation of __________
SIFI (Systematically Important Financial Institutions)
Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management?
Since capital requirements do not effectively indicate whether banks are taking on too much risk, risk management allows supervisors to focus more on risk-taking procedures and thus may prevent insolvency in the future.
What are the costs and benefits of a too-big-to-fail policy?
The benefit is that it makes bank panics less likely; however, the cost is that it increases the incentive for moral hazard by big banks
Which of the following is a main provision of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989?
The establishment of the Resolution Trust Corporation to manage and resolve insolvent thrifts.
Which method (payoff method or purchase and assumption method) is more costly to taxpayers?
The purchase and assumption method
Why might more competition in financial markets be bad?
There would be greater incentive for financial firms to take on greater risk.
What special problem do off-balance-sheet activities present to bank regulators?
These activities do not appear on bank balance sheets and thus cannot be handled with bank capital requirements.
Do disclosure requirements help limit excessive risk taking by banks?
Yes. Disclosure requirements better enable depositors to evaluate and monitor financial institutions and thus act as a deterrent to excessive risk taking.
If the price of commodities suddenly increased sharply, Universal Bank would be ____________________ accounting system.
a mark-to-market
In order to limit the moral hazard incentives for banks to engage in the excessively risky behavior encouraged by deposit insurance,
a strong, institutional environment must be in place
Many countries agreed to the requirements of the financial treaty known as the Basel Accord because they wanted to standardize
bank capital requirements across international boundaries.
A main provision of the Competitive Equality in Banking Act (CEBA) of 1987 included:
directing the Federal Home Loan Bank Board to continue to pursue regulatory forbearance.
Most banking crises around the world started with
financial liberalization or innovation
The bank is now:
in a dire capital position (in the negatives)
Regulators impose capital requirements on banks because a low capital-to-asset ratio dramatically
increases a bank's moral hazard
The "too big to fail" policy of the FDIC increases the moral hazard incentives for _________ banks
large
Savings and loans grew rapidly in the latter half of the twentieth century because of the following except
large investment subsidies provided by the federal government to new savings and loans associations.
The Depository Institutions Deregulation and Monetary Control Act of 1980:
led to the creation of NOW accounts nationwide.
With deposit insurance, ____________________ information regarding banks will be collected by the depositors.
less
A bank's capital-to-asset ratio is also known as its
leverage ratio
If the FDIC considers an insolvent bank to be "too big to fail", it will resolve the insolvency through the
purchase and assumption method, which guarantees all deposits.
Banking laws in the first half of 1900's were passed to
reduce bank competition and reduced efficiency in banking.
Bank chartering reduces adverse selection problems by:
screening proposals for new institutions to prevent undesirable people from running the institution.
A significant part of the cost of the savings and loan bailout was ultimately passed onto the
taxpayers
Agreements such as ________ are attempts to standardize international banking regulations.
the Basel Accord
With lack of solid information about financial conditions, the failure of one bank can lead to runs on other banks. This is known as:
the contagion effect
A major flaw of the mark-to-market accounting is that
the price of an asset sold at a time of financial distress or a bubble does not reflect its fundamental value.
It is ___________ for the taxpayer if the FDIC resolves an insolvent institution by the "payoff method"
usually cheaper
How could higher deposit insurance premiums for banks with riskier assets benefit the economy?
Risk-based premiums would help mitigate the moral hazard problem; however, it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are