ECON 304 - 2

What are the advantages of securitization (say, from the end borrower's point of view)

- bank gets loans off books - connects borrowers to broader pool of lenders (biggest adv) - tries to solve the problem that investors/savers don't know what borrowers are going to do with the money due to info frictions - played a role in the financial crisis - reduces risk and increases liquidity for banks, and it raises the supply of loans

Give an example of a case where a financial intermediary reduces informational asymmetries by gathering information.

- bank that specializes in info gathering increases the info available to the under-informed party (screening/monitoring) - disclosure is an example (ex- of earnings)

Explain why banks prefer to keep only a fraction of deposits on hand as cash while loaning out the rest (this business model is known as fractional reserve banking).

- banks only earn a very small interest rate on the cash they keep in their reserves from the Fed - banks would therefore prefer to invest this money elsewhere, where they can receive a higher return - thus, banks are highly leveraged - must keep some of the cash in reserves for when individuals want to withdraw money

Explain the relationship between fractional reserve banking and leverage.

- banks typically keep 5% of their deposits on hand (fractional reserve - fraction of deposits on hand), therefore banks are considered to be highly leveraged (using various financial instruments to increase the potential return of an investment) - they use deposits to make finance loans questions the bank needs to ask: - how much leverage is the bank willing to risk? (how many loans is the bank willing to make?) - how much cash does the bank need to cover withdrawals? (banks don't have requirements made by the gov anymore)

Explain the Monty Haul Game.

- probability game - Monty Haul has incentives (players have incentives - not a stats problem, it's an econ problem) - you should always switch if you open door 2 and there's no car*

Consider the model of bank lending and moral hazard studied in class. Explain why the firm has less incentive to cheat when the amount of soft capital that is needed is small (i.e. μ is low).

- when looking at the equation, profits from embezzlement would then be low - when the incentive constraint is binding, the loss of productivity induced by under-investment in soft capital would imply a drop in the borrower's profits which would not be offset from the gains from cheating. therefore under such a constraint the borrower always invests in soft capital - see paper

In the model seen in class, give the conditions under which the moral hazard problem is irrelevant. Explain why these conditions make the problem irrelevant.

- when production with effort is worthwhile - entrepreneurs want to work (incentive compatible) - lend at R bar (b/c you want to work - correct rate) - moral hazard problem is irrelevant - not worth goofing off - see equation

What were the suggested financial reform methods?

1) Increased regulation of non-bank financial institutions 2) Policies to prevent institutions from becoming too big to fail 3) Rules that discourage excessive risk taking 4) New structures for regulatory agencies

How do banks reduce info asymmetry?

1) info gathering: screening borrowers - looking at assets, existing debts, profit history 2) reducing default risk: collateral and networth (capital) - banks use provisions in loan contracts to reduce default risk - reduces prob of default: borrower has a lot at stake - reduces the loss of borrowers default loan contract may also set a minimum for the borrower's net worth, also known as its capital 3) interest rates and credit rationing - pricing risk

Outline the process by which a mortgage is financed: a) the old way (bank keeps the mortgage). b) the new way (bank sells the mortgage).

a) borrower gets mortgage from bank and bank uses deposits from customers to give the borrower this mortgage in exchange for interest b) securitization method - borrower gets mortgage from bank and the bank invests that money in securities - borrowers take out loans, lenders (commercial bank/finance company) sell loans to securitizer, securitizer creates derivative securities backed by pools of loans, securities sold to financial institutions (pension fund, commercial bank, investment bank) - banks sell mortgages b/c the possibility of default makes it risky to hold them - by selling loans, the bank shifts default risk to the ultimate holders of the loans - bank still performs its basic function of reducing asymmetric information. It uses its expertise to screen borrowers, design loan covenants, and set collateral - see paper

Suppose that a bank has made bad loans and lost most of its depositors' money. a) In this case, the only equilibrium is for everyone to try to withdraw their money at once. Explain why this is the case. b) How would this affect a policy of deposit insurance.

a) bank run occurs because everyone has lost confidence in the bank and they want to withdraw all of their money ASAP b) if deposit insurance was in place then a bank run would most likely not happen b/c depositors know that they will be compensated for any of their losses

What would happen to a) the money supply and b) the relationship between the amount of currency in circulation and broader measures of money (like chequing account deposits) if banks decided to hold more cash (because of a lack of attractive investment opportunities, for example)?

a) money supply: would contract if people held more cash; there would be less money deposited in banks and therefore less money that the bank could lend out to others b) chequing account deposits: there would be lesser deposits/less in their reserves

What are transaction costs?

costs in time and money of exchanging goods, services, or assets - lower costs for savers/investors when firms borrow from banks (indirect financing) - reflects economies of scale: a bank lends to many firms, reducing the cost of each loan

What is deposit insurance? Explain how it can stop bank runs. Explain how it can prevent bank runs from occurring in the first place.

deposit insurance: government guarantees deposits using tax revenue - banks sometimes pay a deposit insurance fee - now my actions don't depend on you anymore and one rushes to the bank b/c they're thinking the same thing - bank runs would never happen - stops these runs for free except for the ads informing people of this insurance) - there are caps on deposit insurance (GM example)

What is a finance company?

non-bank financial institution that makes loans but does not accept deposits

What is a chartered bank?

obtained government permission on some level to do business in the banking sector

What is the name of a financing system that looks like banking?

parallel banking system/shadow banking system: - non-bank financial intermediaries that provide services similar to traditional commercial banks components include: - securitization vehicles, markets for repurchase agreements (repos), investment banks, and mortgage companies, etc - primary factor in the subprime mortgage crisis of 2007

List the pros/cons of banks.

pros: - can trade what looks like untradeable purchasing power - finance loans that would otherwise not be financed - overnight borrowing (banking) cons: - aggregate mismatch of assets and liabilities of the bank (pooling eliminates this problem for individuals) - potential for liquidity issues (if everyone wanted to withdraw all of their money)

What is a covenant?

provision in a loan contract that restricts the actions of the borrower

What is a suspension of payments?

refusal by a bank to allow withdrawals by depositors - people can calm down and then bank run may not even occur

What is an optimal contract with moral hazard?

rewarding you for doing well (bank suffers) vs. punishing you for doing bad (bank doesn't suffer - price you pay when you fail - bank makes revenue) - both are incentives to produce - reduce the need to generate info by providing better incentives (requires intermediaries)

What is a repurchase agreement (repo)?

sale of a security with a promise to buy it back at a higher price on a future date example: - suppose a bank makes a repo agreement with a pension fund - bank sells the pension fund a security, such as a Treasury bill, and agrees to buy it back later at a higher price - this deal is equivalent to a loan, because the bank receives cash temporarily - the security is collateral for the loan, and the increase in the security's price is interest

What is a mortgage-backed securities (MBSs)?

securities that entitle an owner to a share of payments on a pool of mortgage loans - MBSs are highly liquid and are considered safe because they are backed by prime mortgages

Explain how default rates on "teaser" rate mortgages (where the interest rate is low for the first two or three years) depend on the growth rate of housing prices.

sub-prime mortgage example: - interest rates looking initially appealing especially when we expect housing prices to rise - if the growth rate of housing prices fall, this means that demand is falling 1) as housing prices increase before increase in IR - default (but you really wouldn't want to) - refinance once you hit higher IR - sell the house 2) if housing prices aren't rising too much - people really won't need to default - incentives change

Suppose information gathering is costly, what sorts of problems does this cause for financial markets?

- asymmetric information if some have access to info while others don't - why doesn't EMH imply that all this info is already included in the price of bonds (suppose info is costly to gather - Grossman & Stightz paradox) Paradox: If markets are efficient and securities' prices reflect all available information and, obtaining information about securities requires resources (time, money) Then, Why do people commit resources to researching securities at all, and if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

Give an example of moral hazard, as it might occur in financial transactions.

- bank doesn't know how much effort borrowers are going to put into their projects - different incentives - may be some actions that entrepreneurs make that don't max return (jet/huge office) - entrepreneur's mindset could be: if I don't work hard, only have to payback sometimes - the person who doesn't care about the loan/IR is the one who's not going to pay you back

Outline the similarities between the behaviour of financial firms (like investment banks) leading up to the financial crisis and commercial banks.

- both of these types of financial intermediaries were affected due to decreases in asset prices - an institution may fail because it becomes insolvent, that is, its assets fall below its liabilities and its net worth (capital) becomes negative - commercial bank can become insolvent because of loan defaults, increases in interest rates, and other events - when a bank becomes insolvent, regulators are likely to force its closure - financial firms can also become insolvent - example: hedge funds borrow money from banks to purchase risky assets - if the prices of these assets decline, a fund's net worth can become negative - when this happens, the fund is likely to default on its debts and go out of business - insolvencies can spread from one institution to many others, because financial institutions have debts to one another - banks have deposits at other banks, lend to each other in the federal funds market, and lend to hedge funds and investment banks - if one institution fails, its depositors and lenders suffer losses, and they, in turn, may become insolvent - even if a financial institution is solvent initially, it can fail because it doesn't have enough liquid assets to make payments it has promised (liquidity crisis/bank run) - causes a credit crunch to occur in both firms

Explain in words how adverse selection can destroy or unravel a market.

- can't filter out the bad borrowers - people that are more likely to not pay are the ones that want to trade with me - increase R to try to price risk but it makes things worse - drives out good borrowers disproportionately - good borrowers don't like that they're charged a very high IR when they're safe to lend to so they just leave and don't want to borrow from you - if you don't want to lend to bad borrowers, the market will then shut down

What are mortgages backed by?

- collateral - down-payment

What happens to the money supply during a bank run? Explain.

- decrease in the money supply - bank run results in a rise in the currency-deposit ratio (refers to the relationship between the amount of cash a person holds and the amount of money she maintains in readily accessible bank accounts, such as checking accounts) and thereby reduces the deposit multiplier and the money supply

Why did a crisis in subprime mortgages lead to a general shortage of credit extension?

- default rates look low (2004-2005), so lenders continue to lend to borrowers using system - bubble (credit fueled) - lots of sub-prime borrowing (wrong idea that defaults will remain low) - securitizing the loans - fall in asset prices also makes it harder for individuals and firms to borrow - lower prices decrease the value of borrowers' collateral and net worth, which worsens adverse selection and moral hazard in loan markets - result is a credit crunch, a sharp decrease in bank lending where some borrowers are cut off from loans or face higher interest rates - mortgage-backed securities were used heavily in 2008 - could borrow repeatedly in short term repo markets - borrowing $ to buy assets = leveraging (asset transformation - banking) - these people wouldn't normally lend to me, but I have the asset as collateral - when increase in people try to sell assets, that decreases the value of them (mortgage-backed securities went down in value) - tomorrow some securities are worth less - must liquidate more of my assets - lenders stop wanting to lend (shortage of credit extension)

Consider the model of bank lending and moral hazard studied in class. Explain why the optimal loan contract involves setting the payment as high as possible when the outcome of the firm's project is bad.

- don't want to give the firm more than necessary to get them to behave - gives the firms an incentive to not perform poorly - limited liability constraint - see paper

Why did the prices of all bonds fall during the financial crisis (even those not related to real estate)?

- during a bubble, people expect asset prices to rise, which causes high demand for the assets, which makes the expectations of higher prices self-fulfilling - asset prices rise far above the present value of expected income from the assets - then at some point, people begin to worry that asset prices are too high and start selling the assets, pushing prices down - falling prices shake confidence further, leading to more selling, and so on - decreases in asset prices are accompanied by failures of financial institutions

Give an example of adverse selection, as it might occur in financial transactions.

- entrepreneurs (good projects vs. bad projects) - have the option to borrow from bank or self-finance (whatever is least costly) - when the bank doesn't know whether the borrowers are risky and less likely to pay back this is where adverse selection can come into play - in order to try and drive out these bad borrowers, they increase R to try to price risk but it makes things worse - drives out good borrowers disproportionately - good borrowers don't like that they're charged a very high IR when they're safe to lend to so they just leave and don't want to borrow from you - if you don't want to lend to bad borrowers, the market will then shut down - car example and lemons - result: most owners can't sell their cars for what they're worth, and buyers can't find a decent car stocks example and lemons - result: investors realize that the stocks offered for sale are likely to be lemons. This belief pushes down stock prices. More firms stop issuing stock, so prices fall farther.

What is the problem with deposit insurance?

- exacerbates the problem of moral hazard - without insurance, depositors worry that banks may fail, giving them an incentive to monitor banks - before depositing money, prudent people will investigate a bank's safety (check balance sheets and income statements to be sure that insolvency risk is low) - insurance eliminates depositors' incentives to monitor banks - depositors know they will be compensated if banks fail, so they don't care much if bankers take risks or embezzle their money - moral hazard and the absence of monitoring can end up hurting taxpayers - now there are limits on insurance - bankers have incentives to misuse insured deposits now - have incentives to use deposits in ways that benefit themselves but hurt depositors - the misuse of deposits takes two basic forms: excessive risk taking and looting - if the projects succeed, the interest income produces high profits for the bank's owners - if the projects fail, the borrowers default and the bank may become insolvent

Outline the main functions of banks.

- financial intermediary that takes deposits and makes loans - help reduce trading frictions through pooling and diversification; monitoring and screening (MH/AS problems); writing and enforcing contacts; securitization - banking is leverage lending (banks make loans with borrowed money (deposits) - banking involves asset transformation (properties of assets and liabilities of a bank aren't the same) - can get your money out when you need to - allows for gains from trade

Consider an alternative to a bank and explain (hedge fund example).

- form a syndicate of lenders - hire a manager to manage the money to make all the loans and decisions on behalf of syndicate (pooling, monitor/screen/write and enforce contracts) - pay a middleman a salary - logistically feasible (hedge funds, mutual funds) - no leveraging and lending here (so not like banking) - no asset transformation going on (can't get your money out when you need to) - hedge fund model requires that my deposits have the same properties as the assets the fund buys - large pool of short term savings - purchasing power that people aren't using right now but might like to soon (high demand for liquid and safe assets)

In the adverse selection model seen in class, explain why the demand for loans from "good" borrowers is more sensitive to the interest rate than the demand for loans from "bad" borrowers. How is this related to the adverse selection problem?

- if bank tries to increase R to try to price risk because of the bad borrowers in the pool, it makes things worse - drives out good borrowers disproportionately - good borrowers don't like that they're charged a very high IR when they're safe to lend to so they just leave and don't want to borrow from you - if you don't want to lend to bad borrowers, the market will then shut down - look at graph/equations

What is the relationship between cheap mortgage financing and house prices.

- if house prices are expected to rise and there is cheap mortgage financing, more people will want to buy houses knowing that the return will be higher in the future and more people will be able to do so (sub)prime mortgages - more and more people will continue to buy houses if these expectations of rising housing prices remain - but as soon as the bubble bursts and there is no longer a demand for houses, the prices of these houses fall and people start defaulting on their loans - other financial institutions that held securities backed by subprime mortgages suffered billions of dollars of losses - rising house prices made it easier for home owners to cope with high mortgage payments - someone short on cash could take out a second mortgage; the higher value of her home gave her more collateral to borrow against - or could sell the house for more than paid for it, pay off the mortgage, and earn a capital gain - investment bankers saw the profits being made on subprime mortgages and wanted to get in on the action - they securitized these mortgages and held onto a large share of the MBS - securitization provided more funds for subprime loans and in turn, more subprime lending increased the demand for housing and fueled the rise in house prices - result: subprime mortgages grew from almost zero in the early 1990s to 14 percent of outstanding mortgages in 2007

In the adverse selection model seen in class, explain why it is important that the borrower pays nothing to the lender in the case where the project fails?

- if project fails, can discharge debts to banks via bankruptcy but you can't do that if self-financing - only have to pay back the bank if project succeeds - look at graph/equations

Explain how moral hazard problems make things worse for borrowers.

- increases the interest rate because banks want to price risk if there are borrowers with bad incentives present in pool - now more of an incentive to shirk b/c effort is costly

Consider a pool of borrowers characterized by adverse selection. Explain why borrowers in this market cannot normally raise money on financial markets. Explain how securitization could enable this pool of borrowers to access financial markets. How is the adverse selection problem alleviated?

- info asymmetries prevent borrowers from accessing global savings (Norwegian pension funds)/raising money on financial markets - create info insensitive securities out of info sensitive loans - connects small borrowers and big lenders - pools loans together (some diversification) - orders claims on incoming money - selling rights to revenue generated by loans - sell the first 10% of incoming revenue - not risky at all - don't have to know whether the loans are going to default or not because the chance of them all defaulting is low and either way you are entitled to the first 10% for ex of incoming revenue

Explain the role of informational frictions in the financial crisis.

- informational frictions allow bubbles to persist and in the presence of informational frictions, non-fundamental news can lead to large price corrections or crashes

Explain why the statistical models used to price the riskiness of subprime lending performed so poorly.

- initially appealing because of low interest rate for those with little income/assets - until 2006 default rates look low (historical evidence available suggested that the securities were safe), so lenders continue to lend to borrows using system - bubble (credit fueled) - lots of subprime borrowing (wrong idea that interest rates will remain low) - but when the interest rate jumped suddenly, no one could afford to pay the interest on their loans, forcing them to default - this system may only work for some (med students)

Why doesn't this info gathering usually happen?

- it takes time and effort to learn about firms (quit job to do this - costly) - many securities are held by small savers, who lack sufficient incentives to incur these costs - savers' group example and free-riders

What are short-term lending markets?

- market where one can borrow and lend money for very short periods of time - structured as repo (market) - collateralized loan - sale and agreement to re-purchase tomorrow - I own ir today and you get it back tomorrow - if bankrupt we would need to figure out which creditors get which assets but don't have to go trough this process in this case - don't have to write out complicated contracts every time

What were the two things going on in the housing market?

- more securitization (cheaper credit) - global savings increased (size of markets grew) this led to cheaper borrowing, resulting in housing prices rising and more people buying houses (bubble)

Is MH more severe in bond markets or stock markets?

- more severe in stock markets because in bond markets, the holder of bonds doesn't care if firm's managers waste money on salaries and parties, as long as the firm makes the promised payments on its bonds - but MH arises when firms issue bonds with significant default risk - managers may increase this risk by misusing funds, so savers are wary of buying the bonds

Consider the simple model of bank lending studied in class. Explain the optimal investment choice when there is no asymmetry in information.

- overall increase in investment - banks price risk by raising interest rates for bad borrowers - banks set interest at market rate for the good borrowers - see paper

What is the Stock Price Reaction to the Challenger Crash paper about? (EMH)

- provide clinical evidence on market efficiency by studying stock price movements around the explosion of the Space Shuttle Challenger - motivated by the continuing debate on whether the market quickly and accurately processes information - study an event in which investor panic could easily lead to initial overreaction, and because the government investigation of the cause of the crash took five months, one might expect a delayed stock market reaction to the crash - findings: the market pinpointed the guilty party within minutes, and while there was some "excess volatility" associated with trading in the non-culpable firms, this provided little or no profit to traders with inside information

What are sub-prime mortgages?

- risky mortgages - lending to those are likely to not have a job/income/assets - high chance of default - low IR for first 2/3 years then high rate for next 25 years - incentive to re-finance this mortgage at this point (get out of it and just pay a penalty) - this system may work for some (med students) note: they looked too small to wipe out the financial system

What type of asset can be used as collateral in a repo market?

- safe - liquid (want the money tomorrow - bond for ex, not an expensive painting) - equally understood by both sides (simple T-bills or extremely complicated) mortgage-backed securities fulfill the above criteria b/c they are extremely complicated and you'll have a hard time sticking me with junk assets if you don't even understand the terms - these were used heavily in 2008

What could have caused the financial crisis?

- subprime crisis - securitization - bank runs

Suppose that the output produced by a good project is high, the outside value of the bank's funds (e.g.: in the bond market) is low, and there are very few bad borrowers in the loan pool. Evaluate the following claim: "most good borrowers will be able to get a loan."

- supply of loans is fixed at R bar - as long as return is R bar, banks will lend out as many loans - some people borrow and some self-finance business ventures - if Y>R bar then these entrepreneurs have a project that is worth lending to - look at graph/equations

What happened as a result of the scarcity of lenders during the financial crisis?

- the Fed used large, expansionary, open-market operations - purchases of government bonds - to increase bank reserves and push the funds rate back down

Consider the model of bank lending and moral hazard studied in class. Explain why the firm's starting net worth affects the level of investment when there are moral hazard problems in financial markets.

- the greater the firm's starting net worth, the less likely the firm will be to shirk - as net worth increases, capital increases - lower net worth (collateral value) worsens the problem of moral hazard because the firm has not much to lose and shifts toward riskier investment - when borrower makes down-payment/pledges collateral (capital maybe), this makes failing more expensive (firm is gambling its own money) - reduces MH problems as firm doesn't have that much of an incentive to be lazy now - see paper

Consider the model of bank lending and moral hazard studied in class. Write out and explain the firm's incentive constraint.

- the incentive compatibility constraint guarantees that the manager prefers exerting effort rather than consuming private benefits - firms prefer to buy c, produce and payoff loan to taking the money, not buy c and produce poor output increasing pb (i.e punishment for poor performance) - this entices borrowers to try harder to produce - decreasing pg only satisfies this constraint because rewarding borrowers when they do well gives them the incentive to produce but doesn't help lender to max profits - see paper

Consider the model of bank lending and moral hazard studied in class. Write out and explain the limited liability constraint.

- the max the lender can get when firm fails is the revenue of the firm - how big of a punishment a lender can put on a borrower for poor performance - reward vs. punishment (incentive is the same) - see paper

Explain how the "first come first serve" constraint contributes to bank runs (what would happen if the bank could agree to give all depositors an equal proportion of their deposits back, regardless of when they showed up).

- then people would not be panicking anymore - they would go home - there would be no bank run - the reason for this run is because people think they have to get there first in order to be more likely to get their money

Explain the asset transformation role of banks.

- transforming assets into securities - banks sell liabilities with one set of characteristics and use the proceeds to acquire assets with a different set of characteristics - for example, a bank will accept a savings deposit from one customer and use the proceeds to make a mortgage loan to another customer - bank hopes to profit by charging a higher interest rate on its assets than it must pay on its liabilities - can get your money out when you need to - deposits put in are liquid

Consider the model of bank lending and moral hazard studied in class. Explain why the firm has less incentive to cheat when expected future profits (V, in the model) are higher.

- when borrower makes down-payment/pledges collateral (capital maybe), this makes failing more expensive (firm is gambling its own money) - reduces MH problems as firm doesn't have that much of an incentive to be lazy/cheat now adverse selection: - bad borrowers don't like loans with big down-payments and high collateral requirements (self-select) - don't have to worry about info asymmetry as much - see paper

In the model seen in class, explain what the implications of the moral hazard problem are in the case where this problem matters.

- when entrepreneurs don't want to work at R bar - bank doesn't offer R bar - bank needs to compensate for bad loans (Rm = R bar/P) - bank protects itself with shirking w/higher rates to compensate for risk (Rm > R bar/P) - market functions here but price is higher - entrepreneurs don't like effort; value in shirking (market prices this behaviour) - see paper

In the model seen in class, explain the source of the moral hazard problem.

- when lenders and borrowers have different incentives - bank doesn't know how risky entrepreneur's project is going to be

What can financial intermediaries do to help reduce the problems associated with adverse selection and moral hazard?

1) information gathering - increase the info available to the under-informed party (screening/monitoring) - intermediaries may specialize in info gathering 2) contracts - can write more complicated contracts to reduce the problems associated with asymmetric info - covenants: restriction on behaviour to reduce risk (athlete contracts - no skydiving on off-season - restrict the risk to also make insurance cheaper - often require that borrowers provide info to the lender - doesn't always eliminate the problem (bball player who stays up late and performs badly on the court next day - can't bring this to court/write contract about it) - other kinds of contracts can provide incentives to offset info problems (optimal contract under MH - see paper) - makes failing more expensive - don't have much incentive to be lazy b/c you have a lot at stake (down-payment) 3) regulation - disclosure: requires firms to publish info about their activities to prospects (earnings, annual report summarizing operations over the past year, firm's finances (revenues, costs, assets, debts) - helps savers determine value of the firm's securities - possibility of lies about this but lender can't do anything about it unless the government was involved - increases total information flows - insider trading rules: certain insiders are restricted from trading securities of their own companies - reduces total info flows - want to reduce asymmetric info (takes info away from those who know more to balance out symmetry) 4) securitization - create info insensitive securities out of info sensitive loans - info asymmetries prevent borrowers from accessing global savings (Norwegian pension funds) - pools loans together (some diversification) - orders claims on incoming money - selling rights to revenue generated by loans - sell the first 10% of incoming revenue - not risky at all - connects small borrowers and big lenders

What resources can one use to mitigate asymmetric info?

1) investment banks - reduce the problem of adverse selection in primary securities markets, especially by underwriting initial public offerings of stock - they assuage fears that shares in a company are lemons by researching the company and providing information to buyers of the stock. - they build reputations that lead people to trust their assessments of companies - investment banks earn high fees because most companies need their help to issue securities 2) rating agencies - they research companies and rate the default risk on their bonds - savers learn which bonds are safe and which are lemons, and interest rates adjust accordingly - safe firms can issue bonds at low cost

What can the financial sector or you do w/ these funds?

1) just hold them as cash or pay someone to store them 2) could use them to make loans problem: - may want to use this purchasing power soon (need loans to be liquid/safe - not attractive to borrowers) - borrowers want things they can take risks with but lenders want things to be safe - can't trade either directly or via hedge fund model - banks transform safe and liquid saving into illiquid and risky loans - requires leveraged lending (i.e bank owns the loans and only finances them with your money) - takes advantage of pooling (new deposits, interest payments, principal repayments, withdrawals)

How can one improve bank/liquidity runs?

1) suspension of convertibility - limit on ability to withdraw deposits a) if panic is irrational then gives people time to calm down (tell people to relax and come back next week) 2) deposit insurance - government guarantees deposits using tax revenue - banks sometimes pay a deposit insurance fee - now my actions don't depend on you anymore and one rushes to the bank b/c they're thinking the same thing - bank runs would never happen - stops these runs for free except for the ads informing people of this insurance) - there are caps on deposit insurance (GM example) 3) lender of last resort - central bank can just create liquidity and lend it to troubled banks (print money)

How can info gathering help mitigate the problem of asymmetric info?

AS: - savers get more information and examine firms' past earnings and financial condition - learn the details of firms' projects and estimate the chances of success - find out which managers have reputations for skill and honesty - research can help savers determine which firms' securities are valuable and which are lemons MH: - gather information about firms' uses of funds - before buying securities, savers should make firms promise to undertake safe projects and not to waste money - they should visit the firms' offices frequently to check that the promises are kept

Evaluate the following claim: "Insider trading regulations reduce the amount of information contained in market prices, and therefore reduce market efficiency."

False. It does not reduce market efficiency - it helps to solve the problem of asymmetric information so borrowers all have access to the same info - insider trading rules: certain insiders are restricted from trading securities of their own companies - reduces total info flows - want to reduce asymmetric info (takes info away from those who know more to balance out symmetry)

Consider the following scenario: i) in equilibrium, lenders would be willing to make loans if all the borrowers were known to be of the good type, and ii) in equilibrium, lenders would be willing to make loans if all the borrowers were known to be of the bad type. What are the possible equilibrium outcomes if the types are a) not know to either the lenders or borrowers, and b) known to the borrowers but not the lenders? Explain.

Case 2: nobody can distinguish between types - having uncertainty doesn't matter - graph remains the same Case 3: only borrowers know their type - R bar increases - d curve for good borrowers goes inward - end result is that bank can't lend to anyone - too difficult to price risk without driving out good ones - look at graph/equations

Consider a lending market characterized by uncertainty including adverse selection. Can a lender solve the informational problem by raising the interest rate charged on loans to accurately reflect the risk pool of the borrowers? Explain.

No. (when only borrowers know their type) - as R increases the pool of good borrowers drop out quicker - can't lend to anyone in the end - look at graph/equations

Consider a lending market characterized by uncertainty but no adverse selection. Can a lender solve the informational problem by raising the interest rate charged on loans to accurately reflect the risk pool of the borrowers? Explain.

Yes. - having uncertainty doesn't matter - look at graph/equations

What would happen to a) the money supply and b) the relationship between the amount of currency in circulation and broader measures of money (like chequing account deposits) if households decided to hold less cash (because of the advent of debit cards, for example)?

a) money supply: would expand if people held less cash; there would be more money deposited in banks and therefore more money that the bank could lend out to others (money multiplier - deposits create loans, loans create deposits) b) chequing account deposits: there would be higher deposits and the bank would now have more in their reserves which they would then use to lend out excess reserves - no change in money in economy unless CB increases supply - less money circulating in the economy

Explain the concepts of adverse selection and moral hazard. Explain what it means to say that these are frictions in financial markets.

adverse selection (hidden type): - people with bad prospects want to trade more than the good types - sellers of securities know more about their value than the buyers - borrowers know more about prospects of repayment than lenders - prior to trade - more serious moral hazard (hidden action): - incentives of the borrower and lender are different - there may be some actions that entrepreneurs make that don't max return (jet/huge office) - bank doesn't know how risky the project is - after trade - insurance and recklessness nature example these frictions influence trade of purchasing power in financial markets

Briefly explain what a bank run is.

bank run: - tends to happen when there are existing concerns about the soundness of a bank or the banking sector (bank crisis) - everyone wants to take their money out and the bank does not have all that cash on hand - liquidity runs and solvency problems go hand in hand - look at distribution (chances people withdraw X% of their money)

What is a bank run and bank panic?

bank run: sudden, large withdrawals by depositors who lose confidence in a bank bank panic: simultaneous runs at many individual banks (people lose confidence in the whole banking system)

What is a lender of last resort?

central bank's role as emergency lender to financial institutions - it helps a solvent institution facing a liquidity crisis - the loan prevents the institution from failing and is repaid with interest - ultimately, there is no cost to the central bank, the government, or taxpayers

Explain the channels by which a crisis in the financial sector spilled over into the real economy (part of the economy that is concerned with actually producing goods and services).

channels (applying it to the subprime crisis): - tightening of liquidity constraint: likely to explain at least half of the actual drop in stock prices for firms that were liquidity constrained to start with - reduced consumer demand and confidence on non-financial firms - falling housing prices reduced people's wealth, leading to lower consumption - consumption and investment were also dampened by uncertainty about the economy, partly reflecting the signs of trouble in the financial system

There are two possible equilibrium outcomes in the bank run model we saw in class. Briefly describe each outcome. Explain why each is an equilibrium.

equilibrium 1: insurance/banking - everyone keeps to his "slot" - type 1s withdraw in period 1, type 2s wait until period 2 - type 1 is in eqm - type 2 is in eqm when r2>r1 (as long as all other type 2s wait as well - if they all wait the bank is solvent and won't run out of money) equilibrium 2: bank run - everyone withdraws deposits in period 1 - type 1 and 2 is in eqm - suppose I'm type 2: if all the other type 2s rush to the bank in period 1, the bank is insolvent and then anyone who wants in period 2 gets 0 - one of these eqm are not more true than the other - theoretically: both eqm are equally valid - practically: bank run requires more coordination

What is a commercial bank?

institution that accepts checking and savings deposits and lends to individuals and firms

What is insolvency?

liabilities exceed assets, producing negative net worth

What is a liquidity risk, credit risk, interest rate risk, market risk and economic risk?

liquidity risk: risk that withdrawals from a bank will exceed its liquid assets credit/default risk: risk that loans will not be repaid interest rate risk: instability in bank profits caused by fluctuations in short-term interest rates market risk: risk arising from fluctuations in asset prices economic risk: risk arising from fluctuations in the economy's aggregate output

What is a discount loan?

loan from the Federal Reserve to a bank

What is a principal-agent problem?

moral hazard that arises when the action of one party (the agent) affects another party (the principal) that does not observe the action