econ 310 chapter 12

What changes were made to Section​ 13(3) of the Federal Reserve​ Act?

The Fed was no longer permitted to make loans to individual companies were no longer allowed.

Which of the following is a reason that the Federal reserve failed to intervene to stabilize the banking system in the early​ 1930s?

The fed wanted to purge speculative excess, believing that it was necessary for the price level to fall and weak banks and weak firms to fail before a recovery could begin

negotiable order of withdraw (NOW) account

looked like checks and treated like checks -were effectively interest-paying checking accounts

The consequences of losing investor confidence will most likely result in a _____ credit rating and _____ interest costs.

lower; higher

in the absence of deposit insurance, the stability of a bank depends on

the confidence of its depositors

How is being a lender of last resort connected to the​ too-big-to-fail policy?

-The​ too-big-to-fail policy and the lender of last resort strive to prevent systemic​ risk, where the failure of a few firms leads to the widespread failure of solvent banks. -The​ too-big-to-fail policy and the lender of last resort have to provide liquidity to banks during bank panics.

negotiable CDs

-time deposits w fixed maturity of ex. 6 months -had values of at least $100,000 so were not subject to regulation Q interest rate ceilings -could be bought and sold together so provided competition to commercial paper

pattern of response to a crisis

1) a crisis in the financial system occurs 2) the government responds to the crisis by adopting new regulations 3) financial firms respond to the new regulations 4) government regulators adapt policies as financial firms try to evade regulation

government 2 approaches to avoid bank panics

1) central bank can act as lender of last resort 2) government can insure deposits

sovereign debt crises result from either of 2 circumstances

1) chronic government budget deficits that eventually result in the interest payments required on government bonds taking up an unsustainably large fraction of government spending 2) a severe recession that increases government spending and reduces tax revenues, resulting in soaring budget deficits

several factors increased severity of downturn before great depression:

1) decrease in stock prices --> reducing household wealth and uncertainty --> less spending on durable goods 2) smoot-hawley tariff act which led foreign governments to increase tariffs in retaliation --> decrease US exports 3) decline in spending on new houses bc of slowdown of population growth due to immigration restrictions

regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost to the FDIC of bank failures in 2 ways:

1) increasing ability of the bank to remain solvent after incurring losses 2) increasing the amount the bank's owners will lose in the event of the bank's failure, thereby giving the owners greater incentive to avoid risky investments

why fed did not intervene to stabilize the banking system during the great depression:

1) no one was in charge 2) the fed was reluctant to rescue insolvent banks 3) the fed failed to understand the difference b/w nominal and real interest rate 4) the fed wanted to "purge speculative excess"

to circumvent regulation Q, banks developed 4 new financial instruments for savers:

1. negotiable certificates of deposits (CDs), 2.negotiable order of withdrawal (NOW) accounts 3. automatic transfer system (ATS) accounts 4. money market deposit accounts (MMDAs)

contagion of fear

A bank run that is fueled by fear of bank failure.

What are the two methods that governments typically use to avoid bank​ panics? ​(Check all that apply.​)

A central bank can act as a lender of last resort. The government can insure deposits.

What are the two main ways in which the government can keep one bank failure from leading to a bank​ panic?

A central bank can act as a lender of last​ resort, and the government can insure deposits.

financial crisis

A situation in which serious problems in the financial system result in a significant disruption in the flow of funds from lenders to borrowers. -typically leads to economic recession as households cut back on spending

Regulation Q

Administered by fed -placed ceilings on interest rates banks could pay on time and savings deposits and prohibited banks from paying interest on demand deposits (which were then the only form of checkable deposits) -intended to maintain banks' profitability spread b/w interest rates banks received on loans and interest rates they paid on deposits -forced banks to innovate in order to survive

How does deposit insurance encourage banks to take on too much​ risk?

Banks can make riskier investments without worrying about deposit withdrawals because the government has insured depositors against losses.

Why was the decision by the Fed to orchestrate the purchase of Bear Stearns so​ controversial?

Because the Fed intervened by brokering a guaranteed deal with JP Morgan. ​Because, according to some​ economists, the action increased moral hazard in the financial system. Because Bear Stearns is an investment​ bank, as opposed to a commercial​ bank, and, as​ such, policymakers faced unexpected challenges.

All of the following are reasons why one bank failure might lead to many bank​ failures

Depositors of other banks may become concerned that their banks might also have problems. Banks will be forced to sell loans and securities to raise money to pay off depositors. Depositors have an incentive to withdraw their money from their banks to avoid losing it should their banks be forced to close.

Financial crisis typically results in a recession for all of the following reasons​

Firms struggle to fund​ long-term investments in new​ factories, machinery, and equipment. The flow of funds from lenders to borrowers becomes disrupted. Firms have trouble financing​ day-to-day activities. Households borrow less to finance purchases of goods and services.

Why would​ 100% reserve requirements on checking accounts eliminate the need for FDIC​ insurance?

If a bank​ failed, it would have​ 100% of the deposits on​ hand, so there would be no possibility of anyone losing their deposits.​ Therefore, there would be no need for FDIC insurance

What did bank depositors have to fear in the early​ 1930s?

If a bank​ failed, then depositors would potentially lose all their money.

Why did Treasury Secretary Paulson want Bear Stearns to sell for such a low​ price?

In order to prevent systemic risk. To punish the​ firm's owners and managers for bad​ decisions, without letting them go bankrupt.

What is a lender of last​ resort?

Is an entity that seeks to stop a bank failure from turning into a bank panic by making sure solvent institutions can meet their​ depositors' withdrawal demands. The Federal Reserve acts as a lender of last resort. A lender of last resort is an institution that serves as an ultimate source of credit to which banks can turn during a panic.

was deflation during the early 1930s good or bad for firms

It was bad because it effectively raised interest rates.

Which of the following is true regarding the bursting of the housing bubble in the U.S.​ economy?

Once housing prices started to​ fall, homeowners realized their mistake and began defaulting on their mortgages. Many financial assets were based on the bet that housing prices would only increase. Once housing prices started to​ fall, the banks that owned​ mortgaged-backed securities experienced losses.

"sustained run"? Why​ can't a bank survive a sustained​ run?

Simultaneous withdrawals by a​ bank's depositors result in the bank closing.

Why have some European countries been suffering from a sovereign debt​ crisis?

The 2007-2009 recession reduced tax revenues to the government. They have had chronic government budget deficits. The 2007-2009 recession led to increased government spending.

Why is the issue of whether Bear Stearns and AIG held sufficient collateral important​ legally?

The Fed can only make loans to firms provided that the loan being made is secured by adequate collateral.

What does Bernanke mean by "solvent under normal conditions" double quote​?

The value of a​ bank's assets is more than the value of its​ liabilities, so its net​ worth, or​ capital, is positive.

pegging

The​ government's or central​ bank's attempt to tie the value of the domestic currency to the value of a foreign​ currency, or to​ gold

lender of last resort

a central bank that acts as the ultimate source of credit to the banking system, making loans to solvent banks against their good, but illiquid, loans

too-big-to-fail policy

a policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system

A currency crises can occur under a pegged currency when​ _______.

an excess supply of the domestic currency forces the central bank to use foreign reserves to purchase the domestic currency the pegged exchange rate ends up substantially above the equilibrium rate the central bank is forced to raise interest rates in order to attract foreign investors to buy domestic​ bonds, thereby raising the demand for the domestic currency

basel accord

an international agreement about bank capital requirements -categories used to calculate a measure of bank's risk-adjusted assets by multiplying the dollar value of each asset by a risk-adjustment factor -tier 1 capital - shareholders equity/bank capital -tier 2 capital - bank's loan loss reserves, subordinated debt, other bank balance sheet items

What role did the bank panics of the early 1930s play in explaining the severity of the Great​ Depression?

bank panics exacerbated the effects of the great depression by reducing the ability for people to safely store their money, which further reduced economic activity

feedback loop during a bank panic

bank runs can cause good and bad banks to fail --> costly failures bc they reduce availability of credit to households and firms. Once a panic starts, falling income, employment, and asset prices can cause more bank failures. -This feedback loop can cause a panic to continue unless the government intervenes

bank regulators determine bank's capital adequacy by calculating 2 ratios:

bank's tier 1 capital relative to its risk-adjusted assets and the bank's total capital (tier 1 + tier 2) relative to its risk-adjusted assets --> on basis of the 2 capital ratios, banks are assigned to 5 risk categories

underlying problem in contagion and bank panic

banks build their loan portfolios on the basis of private info about borrowers, information banks gather to determine which loans to make -info is private --> depositors cant review it --> little basis for assessing quality of their banks' portfolios and distinguishing solvent from insolvent banks

sovereign debt crisis

bonds issues by a government -occurs when a country has difficulty making interest or principal payments on its bonds or when investors expect a country to have this difficulty in the future -if it leads to actual default, government may for a period of time be unable to issue bonds --> rely exclusively on tax revenues to pay for government spending. -even if government avoids default it will probably have to pay much higher interest rates when it issues bonds -resulting decreases in other government spending or increases in taxes can push the economy into a recession

Sovereign debt refers to ______ issued by a government. A sovereign debt crisis occurs when there is a fear that a government ________

bonds; cannot make interest or principal payments

CAMELS rating

capital adequacy asset quality management earnings liquidity sensitivity to market risk

poor camels rating can lead to

cease-and-desist order being issues to a bank to change its behavior --> mimics way private markets approach moral hazard by inserting restrictive covenants in financial contracts

disintermediation

exit of savers and borrowers from banks to financial markets -costs banks lost revenue b/c it means they do not have savers' funds to lend

The​ debt-deflation process is the process of ______ that can increase the severity of an economic downturn. The​ debt-deflation process contributed to the severity of the Great Depression by _____ the real interest rate and the real value of​ debts, which ________ the burden on borrowers and led to _____ loan defaults.

falling asset prices; increasing; increased; more

Federal Deposit Insurance Corporation (FDIC)

federal government agency established by congress in 1934 to insure deposits in commercial banks -ended era of commercial bank panics in the US

What policy actions did the Treasury take during the financial​ crisis?

insured money market mutual fund deposits

All of the following are reasons why deflation might not be good for​ consumers

it causes higher interest rates it causes nominal wage cuts it causes a higher burden of debt ration

automatic transfer system (ATS) accounts

means of helping large depositors avoid interest rate ceilings -effectively pay interest on checking accounts by "sweeping" a customer's checking account balance at the end of the day into an interest-paying overnight repurchase agreement

Does a bank have to be insolvent to experience a​ run?

no

in "lending into continuing runs" the fed ____ additional ______ from banks in order to avoid ______ longer-term assets at a ______, further ______ investor confidence

provided; capital; selling; loss; undermining;

All of the following might be reasons why the Fed did not lend to Lehman Brothers in the days before its​ bankruptcy, except:

the failure of Lehman Brothers would have little impact on the economy.

contagion

the process by which a run on one bank spreads to other banks resulting in a bank panic

bank run

the process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close

debt-deflation process

the process first identified by Irving Fisher in which a cycle of falling asset prices and falling prices of goods and services can increase the severity of an economic downturn

insolvent

the situation for a bank or other firm of having a negative net worth because the firm's assets have less value than its liabilities -may be unable to meet its obligations to pay off its depositors

bank panic

the situation in which many banks simultaneously experience runs -feeds on self-fulfilling prophecy: if depositors believe that their banks are in trouble, the banks are in trouble -can lead to declines in production and employment, so can cause recession or make existing one worse.

Why did Congress with the​ Dodd-Frank Act decide to require large financial firms to have living​ wills?

to give regulators a clearer understanding of a​ bank's operations.