Fin 320

Current maximum deposit amount at a bank (per individual/entity) covered by FDIC insurance

$250,000

Insolvency

(bank failure) bank's net worth is < 0 (Assets-Liab < 0)

Liquidity

- bank has cash it needs to pay those who want to withdraw funds

Advantages and disadvantages of lender of last resort

1. Adv: (In US this is the FED) you want solvent banks to be protected. Fed lends to solvent banks that are temporarily illiquid (i.e. need cash to meet depositor withdrawal demand) 2. Dis: Problems with Lender of Last Resort - Hard to tell if bank is solvent during crisis because it is hard to value assets. Hard to know if bank is solvent. Fed may give benefit of doubt in crisis.

Simplified version of Fed's balance sheet

1. Assets: US gov't securities, discount loans, MBS's - Discount loans to banks 2. Liabilities: currency in circulation, reserves, deposits (owned by banks - held at fed)

Definition of bank capital. What is its purpose?

1. Bank Capital (net worth) = assets - liabilities 2. Serves as cushion against temporary drops in value of assets (acts as insurance against insolvency)

Why are some financial institutions "too big to fail?" Why is this a problem? Is moral hazard a bigger problem for small or for big banks? (3 Reasons)

1. Because if they did fail, they would cause a financial crisis 2. Systematic risk (market risk - day to day fluctuation) 3. Moral hazard is a bigger problem for smaller banks - more risk, less regulation

What are "Living Wills" and what do they accomplish? Which one of the 7 key provisions of Dodd-Frank do they address? What problems do regulators have with the living wills provided by banks? (Article "Regulators Fault Banks' 'Living Wills.'")

1. Big institutions in distress have to close w/o messing with economy 2. Addresses provision 4********

How can the Fed create reserves or remove reserves to control the monetary base?

1. Buy or sell bonds which raise or lower reserves

What doesn't a central bank do?

1. Control securities markets 2. Control government budget

Will an increase in bank minimum capital requirements increase or decrease moral hazard problems?

1. Decrease (decrease in wanting to take more risk) 2. More capital = will lower ROE (assets to capital ratio will be lower therefore lowering ROE)

How was the response by regulators to the Financial Crisis of 2008-2009 different from their response to the thrift crisis?

1. Did not increase investment powers 2. Regulators increased required capital held for banks

Open Market Operations

1. Fed buys/sells securities to influence bank reserve amount and short term interest rates 3. - Fed sets a target for Federal Funds rate, rate at which banks make very short-term loans to each other.

Thrift crisis of 1980s —What happened and what did regulators do wrong? (Article titled "The Cost of Buying Time.")

1. Fed raised rates in late 1970s to slow growth of economy a. Mortgage loan value and capital decreased b. Regulators gave thrift more investment powers and raised maximum insured by FDIC 2. Bubble burst when thrift asset value decreased with defaulting loans ii. - Late 1970s US had very high inflation and the Fed raised interest rates to slow economy and reduce inflation. iii. January 1980 yield on 3-month Treasury bills was 6.49%. Treasury bill rates peaked at 16.3% in May 1981. Went back to single digits in 1982. iv. Thrift (savings association=savings loan) has to pay more to issue deposits; profits went down, negative gap. v. What regulators did wrong: 1. 1- Capital Forbearance - didn't insist thrifts raise more capital. Actually reduced thrifts capital requirements. 2. 2- Gave thrifts new investment powers. Let them buy corporate bonds, make consumer loans and construction loans. 3. 3- Raised FDIC max insured limit from $40,000 to $100,000. Moral hazard went up. vi. Thrifts got bigger- brought in lots of deposits and made riskier loans. Most of these thrifts were in Southwest. Real estate bubble burst in SW. vii. Prices for real estate were way higher than fundamental value. viii. Value of thrift went down because of defaults on loans, many thrifts failed. Cost taxpayers $200 billion.

How will these new rules affect JP Morgan and the banking industry as a whole? (Article "New Rules May Affect Every Corner of JP Morgan.") 6 Reasons

1. Have to put up more collateral that could have been used to make loans 2. More capital requirements 3. Pressure banks earnings well into the future 4. Buying and selling of derivatives onto clearinghouses forcing banks to put up collateral against each trade 5. Banks required to hold more capital in reserves to cover potential trading loses 6. Bank would have to be careful about separating its money from the money it manages for clients in private equity bc of rule to limit amount of banks can invest in such funds

Will Basel III (compared to Basel II) increase or decrease the amount of Tier 1 capital banks must hold? What will be the likely impact on the real economy in the short & long run? (Article titled "Super Model.")

1. Increase 2. Short run, hurts the economy. Long run, helps the economy by staying out of a financial crisis

How does an increase or decrease in risk-adjusted assets affect a bank's minimum capital requirement?

1. Increase in risk-adjusted assets raises minimum capital requirements 2. Decrease in risk-adjusted assets lowers minimum capital requirements

If required reserve ratio decreases, will it increase or decrease the multiplier effect? If required reserve ratio increases, will it increase or decrease the multiplier effect?

1. Increase multiplier (required reserve ratio decrease) 2. Decrease multiplier (required reserve ratio increases)

Why is the Fed relatively independent of political influence?

1. Makes 'irreversible' decisions 2. Controls own budget, securities, giving rest to Treasury B of G has 14-year terms; president has 4-year term

What does central bank do as government's bank?

1. Manages finances of government; print money

Micro-prudential versus Macro-prudential regulation. Definition of systematic risk

1. Micro- limits risk within particular financial institution 2. Macro- limits systematic risk a. Systematic risk- risk towards the entire market

What are risk-adjusted assets? How do they relate to the riskiness of a bank's assets? What assets have a zero risk weighting in the computation of risk-adjusted assets?

1. Minimum capital required based on percentage of assets - Measure of a banks risk-adjusted assets = dollar value of each asset x risk adjustment factor 2. More risk has a higher weight 3. Bonds issued by industrialized countries, cash/reserves - Higher a banks capital ratio, the lowers its leverage and better able it is to weather short-term losses - Tier 1 Capital of at least 4% of risk-adjusted assets - Total Capital (Tier 1 + Tier 2) of at least 8% of risk-adjusted assets. - Tier 1 Capital of at least 3% of total assets. (FYI, European banks did not have this limitation on leverage under Basel I and II.) These are minimum requirements. To be well-capitalized a bank would have capital in excess of these amounts. Note that since some of the minimum capital requirements are as percent of risk-adjusted assets, the riskier the bank's assets, the more capital they are required to hold.

Two ways for FDIC to resolve a bank failure and implications for deposits over the FDIC-insured limit.

1. Payoff: close bank and pay depositors up to max and sell all bank assets 2. Purchase/Assumption: find willing bank to take over failing bank; all deposit amounts are restored (rather keep them open)

How does deposit insurance lead to moral hazard? How will changes in the maximum deposit amount insured by the FDIC affect moral hazard?

1. People act differently once insured - Moral hazard: is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. 2. They take more risk with an increased insured amount

What is the Volcker Rule and why is it necessary? What are the short-run costs and the long-term benefits of the Rule? (Article "The Costs of Good Intentions.")

1. Prohibits most proprietary trading by banks and limits bank investments in hedge funds and PE 2. Short run: costlier; Long run: better for economy

What does central bank do as banker's bank?

1. Provide loans during financial crises; lender of last resort

Margin-What is it and why is it necessary?

1. Put up money showing "skin in the game" - To reduce default risk, the exchange requires both the buyer and seller to place an initial deposit called a margin requirement into a margin account (CBOT 0requires deposits minimum of $1,100 x 100 notes instead of $1,000 x 100 notes ($110,000 face value vs. $100,000)

Role of Federal Open Market Committee (FOMC)

1. Set monetary policy 2. Fed's policy framework, objectives, with dual mandate

Role of Board of Governors

1. Set reserve requirements and discount rates 2. Determine activities of bank's holdings and approve mergers 3. Supervise/regulate reserve banks 4. Analyze financial/economic conditions and publish data 5. Regulate/supervise banks and SIFIs Hold 7 of 12 seats on FOMC Serve for 14 years

Why do big banks have higher minimum capital requirements than smaller banks? How can big banks reduce this capital surcharge? (Article titled "Fed Approves Capital Restraints for Biggest U.S. Banks.")

1. They have a larger systematic risk 2. Have to get rid of assets

What is main component of Tier 1 Capital and Common Equity Tier 1 Capital?

1. Tier 1 Capital (LEAST RISKY) (bank capital: shareholder's equity + equity reserves) = common stock + surplus + retained earnings + perpetual pref. stock 2. Common Equity Tier 1 Capital (A measurement of a bank's core equity capital compared with its total risk-weighted assets) = common stock + surplus + retained earnings - Measures the firms assets in terms of risk - Stricter capital requirement norms

Two reasons for government regulation of banks

1. To help avoid a financial crisis 2. Consumer protection

Can the Fed control the size of its balance sheet?

1. Yes - When Fed buys a million dollar bond, it is an asset of the Fed and it adds one million reserves - only composition of assets change Assets decrease by one million dollar bond, and also simultaneously increases its reserves by 1 Million -No change in liabilities

Primary reason countries create their own central banks

1. the primary goal of central banks is to provide their countries' currencies with price stability by controlling inflation.

Advantages and disadvantages of Deposit Insurance

Advantage of FDIC insurance is that it helps financial stability. With FDIC insurance there are no longer bank runs, contagion, etc. Meaning if one bank fails, people do not pull their deposits out of other banks. As long as they are below the FDIC max insurance limit, they know their money is safe. - Disadvantage is moral hazard. People/banks act differently because they have insurance/safety net. You don't investigate your bank's balance sheet for risky behavior before choosing to bank there because FDIC protects you. The bank is able borrow lots of money cheaply (via deposits) because FDIC insurance is available.

Notional principal

Agreed amount of principal, called this because it is just used as the basis for calculation, its not borrowed, lent, or exchanged

Interest rate swaps

Agreement between two counterparts to exchange periodic interest rate payments over some future period, based on agreed amount of principal.

What are interest rate futures? What kind of interest rate futures did we use in our example of bank hedging with futures?

An interest rate future is a financial derivative (a futures contract) with an interest-bearing instrument as the underlying asset. It is a particular type of interest rate derivative. Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures.

Why does Fed want low and stable inflation rather than zero inflation?

At zero inflation it can tip into deflation (price levels declining)

Negative Duration GAP decrease in market rates=

Bank Capital Decreases

Positive Duration GAP + increase in market rates=

Bank Capital Decreases

Negative Duration GAP increase in market rates=

Bank Capital Increases

Positive Duration GAP + decrease in market rates=

Bank Capital Increases

How does lender of last resort lead to moral hazard?

Bank takes more risk because they can get Federal loan

Why is it important to have a lender of last resort?

Can help banks that are illiquid pay out their debts

Bank supervision- CAMELS ratings?

Capital adequacy, asset quality, management, earnings, liquidity, Sensitivity to market risk, each factor receive a rating between 1 and 5, 1 is the best rating, banks rated four and higher are problem banks

What bank liabilities are variable-rate?

Checking/money market deposits or 3 month certificates of deposit

Seven key provisions of Dodd-Frank

Created the Consumer Financial Protection Bureau, created the Financial Stability oversight council, designates institutions as systematically important financial institutions, gives new authority to FDIC to seize, break up, and liquidate financial mega firms if failure under normal bankruptcy procedures would destabilize the economic system (i.e. systematic risk)

If banks decide to hold more of their assets in the form of excess reserves, will it increase or decrease the multiplier effect?

Decrease

Definition and main purpose of Derivatives

Derivatives are an asset that derives its economic value from an underlying asset, such as a stock or bond. They are used to transfer risk.

What does duration analysis measure?

Difference between the average duration of the bank's assets and the average duration of the bank's liabilities. Measure sensitivity of bank capital to changes in market interest rates.

Does the Dodd-Frank Act make the financial system safer?

Dodd Frank makes systems safer, not simpler

What is the price of a futures contract on the settlement date?

Equals the price of the underlying asset (today)

Who is the lender of last resort in the U.S.?

Federal Reserve

What is exchanged in an interest-rate swap?

Fixed interest rate for payments on a floating interest rate

What bank assets are not variable-rate?

Fixed-rate assets: 10 year T-bill, 30 year fixed mortgage

What bank liabilities are not variable-rate?

Fixed-rate liabilities: long term bonds, Long maturity Certificates of deposit

What does Gap analysis measure?

Gap analysis looks at the gap between cash flows from assets and cash flows from liabilities. It tells you how a change in interest rates will affect bank profits

What is the purpose of the Dodd-Frank Act?

Government response to Financial crisis of 2008. Act is a road map.

Is it easy or hard for lender of last resort to determine solvency of a bank in the midst of a financial crisis?

Harder because they cannot get an accurate value of assets

Why do banks get the most regulation?

Have the most systematic risk (market risk - day to day fluctuation) towards the economy (our only way of accessing payment system is through banks*)

What kind of financial institution is likely to be designated as a Systematically-Important Financial Institution (SIFI)?

If material financial distress at company could pose a threat to US financial stability (BofA)

In what situation should the lender of last resort make a loan to a bank?

If the bank is illiquid, not insolvent

If banks decide to hold less of their assets in the form of excess reserves, will it increase or decrease the multiplier effect?

Increase

What is interest rate risk and why is it important that banks manage it?

Interest rate risk is the effect of a change in market interest rates on a banks profit or capital. Risk is caused by a mismatch of maturity of bank assets and bank liabilities. Banks manage this by making adjustable rate loans that better match interest rate sensitivity of the banks liabilities. Banks need to manage it because if they didn't they would be able to make fewer loans, failure to identify and quantify risk exposure could lead to insolvency, losses in excess of bank capital.

Have regulators decided how to apply all the provisions of the Dodd-Frank Act?

It has been a back and forth between regulators and financial institutions to decide how all of these provisions will be applied. At this point most, but not all, of the regulations are in place.

What are these loans from the lender of last resort called?

Loans are called discounted borrowing loans (secured discounted loans to alleviate pressure in reserve markets)

Long interest rate futures and short interest rate futures positions: What are they and how do their values change with the price and yield of the underlying asset?

Long position- in interest rate futures contract represents a party that will buy an interest bearing financial instrument on some future date at a prearranged price. They benefit if the price of the underlying financial instrument increases, or if the interest rate on the underlying financial instrument decreases. Short position- in interest rate futures contract represents a party that will deliver (sell) an interest-bearing financial instrument to a buyer on some future date at a predetermined price, they benefit if the price of the underlying financial instrument decreases, also benefit if the interest rate on the underlying financial instrument increases.

What is the Gap?

Looks at the difference (or gap) between the dollar value of the banks variable rate assets and the dollar value of its variable rate liabilities. (variable rate assets - variable rate liabilities)

Is the Gap of a typical bank positive or negative? Why?

Negative gap because main source of funds are short term deposits (liabilities) and their main use of funds are long term loans.

Three traditional Fed monetary policy tools

Open Market Operations, Discount rate, Reserve requirements

Is the Duration Gap of a typical bank positive or negative? Why?

Positive because most bank's main use of funds is long-term loans - their assets (mainly loans and securities) have longer duration than their liabilities (deposits)

Negative GAP + increase in market rates=

Profits Decrease

Positive GAP + decrease in market rates=

Profits Decrease

Negative GAP + increase in market rates=

Profits Increase

Positive GAP + increase in market rates=

Profits Increase

Will a bank with variable-rate liabilities and fixed-rate assets hedge by being long (buying) or short (selling) Eurodollar futures?

Short Eurodollar futures (think price will fall) 2. (Perfect hedge - one that eliminates all risk in a position or portfolio - buying flood insurance because your house is prone to flooding) - If a bank has variable-rate liabilities and fixed-rate assets, it's profits decline if interest rates go up. That is because its interest expense (the interest it pays on deposits) goes up, but its interest income (the interest it gets paid on loans) stays the same. So to hedge this risk, a bank would have to enter into a futures position that benefits from a rise in interest rates. (This way bank makes a profit on its futures position if rates increase.) This would be a short position in an interest rate future. Since LIBOR is a good proxy for the rate paid on bank deposits, the example in the handout has bank taking a short position in Eurodollar futures.

Why do we need regulation to set minimum amount of bank capital?

So that banks will have skin in the game

Futures contracts

Standardized contracts to buy or sell a specified amount of a commodity or financial asset on a specific future date at a predetermined price. This increases liquidity since the contract is standardized. Trade on exchanges, buyer or seller of futures is trading with the exchange as the counterpart. Reduces information costs. No payments are made initially between buyers and sellers when the contract is agreed to.

Tradeoffs- Can the Central Bank always achieve all these goals at the same time?

The fed is not always able to achieve its dual mandate, sometimes low inflation and maximum employment cant happen at the same time.

What happens to the price of a futures contract if the price of the underlying asset goes up or down?

The financial futures price moves with the market price of the underlying financial instrument

Yield to Maturity of a coupon bond

The interest rate at which the present value of a bond's payments equals its price today. If yield is higher than coupon its a premium, if yield is lower than coupon its a discount.

Multiplier effect of changes in reserves on the amount of loans and deposits in the banking system

The multiplier effect describes how an increase in one economic activity leads to a much greater increase in economic output. In the banking system, money that gets deposited multiplies as it filters through the economy, going from depositor to borrower multiple times. For any change in bank reserves, the money supply will ultimately change by a multiple of that amount

Futures contract Settlement date/delivery date

The prearranged future date for the exchange is called the settlement date or the delivery date. On the settlement date of the futures contract, the price of the futures contract must equal the price of the underlying asset.

How ECB is similar to the Fed

They have an executive board (=board of governors),national central banks (=12 reserve banks), and governing council (=FOMC)

How ECB is different from the Fed

They have many different countries on one currency (the Euro), they have a different policy objective from the fed. The ECB primary objective is defined as inflation closest but not less than 2%

Systematic Risk

Threats to the financial system as a whole

Goals of Monetary Policy

To advance our economic well being

Proprietary Trading

Trading in the bank's own account intended to make profits in the market

What bank assets are variable-rate?

Variable rate bank assets are assets with interest rates that can soon change (i.e. short term gov securities, 3 month treasury bill, adjustable rate loan) its variable rate because it will soon mature and money can be used to buy a security at current market interest rates.

Illiquidity

bank does not have cash it needs to pay those who want to withdraw funds

Solvency

bank's net worth is > 0 (Assets-Liab > 0)

Monetary base

currency in circulation+ reserves in banking. The fed controls monetary base by buying and selling securities=> open market operations. Fed controls the size of its balance sheet

Positive Duration gap

duration of banks assets is greater than duration of the banks liabilities (increase in market interest rates = reduce the value of banks assets more than the value of its liabilities - will decrease banks capital)

Negative Duration gap

duration of liabilities is greater than duration of assets

How will a bank with variable-rate liabilities and fixed-rate assets hedge with an interest-rate swap? Will they be a fixed-rate payer or a floating-rate payer?

fixed rate - To hedge a negative gap, the bank pays a fixed rate of interest out of the income from its fixed-rate assets, and it receives a variable rate of interest which covers its interest expense on variable-rate deposits.

Underlying asset

is the financial instrument (stocks, futures, commodity, currency, index) on which a derivatives price is based

What is Fed's Policy Framework (i.e. What is its dual mandate?)

maximum employment and stable prices (low inflation, 2% not 0%

Excess reserves

total reserves - required reserves Lend out excess as loans

Role of 12 Reserve Banks

• formulating and executing monetary policy, • supervising and regulating depository institutions, • providing an elastic currency, • assisting the federal government's financing operations, and • serving as the banker for the U.S. government.