Financial Markets and Institutions Final

Describe the underwriting function of a securities firm.

An IBF may be willing to underwrite the stock of an issuing corporation, which guarantees the price to be received by the corporation. The IBF assumes the risk that the securities could sell for a lower price than anticipated.

Which agreement creates uniform capital requirements globally?

Basel Agreement

What is the role of banks in the US?

Efficiently move capital between surplus and deficit units.

Banks are required to hold some cash as reserves because they must abide by reserve requirements enforced by the U.S. Treasury.

F

Like other market interest rates, the discount rate moves in reaction to changes in demand or supply of funds or both.

F

Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) reduced the perceived risk of savings institutions.

FIRREA prohibited investment by savings institutions into junk bonds. Second, it mandated an increase in capital requirements of savings institutions. Third, it helped to eliminate many of the troubled savings institutions.

How do economies of scale in banking relate to the issue of interstate banking?

If banks need to maximize growth to fully achieve economies of scale, they would need to grow nationwide. Interstate banking restrictions could prevent them from fully achieving economies of scale.

Why don't banks reduce the default risk of their securities?

If they reduced their default risk, they would not generate as much return.

Why are bank regulators more concerned about a large bank failure than a small bank failure?

Large bank failures can carry indirect costs, such as a change in the public's risk perception of the banking industry, which in turn could affect bank deposit runs and the risk of other banks.

How do insurance companies finance the real estate market?

Life insurance companies hold all types of mortgages as assets. Mortgages are originated by other financial institutions and then are sold to insurance companies in the secondary market. Yet, they are serviced by the originating institutions.

Explain why the moral hazard problem may have received so much attention during the credit crisis.

Moral hazard was a serious problem during the credit crisis because the government was attempting to prevent failures of banks. Yet, some critics argued that the government should not bail out banks because it could send a signal that banks can take excessive risk without worry about failure.

Explain the relative risk of the various types of securities in which a money market fund may invest.

Most money market securities exhibit some default risk, since the issuers of securities could go bankrupt. Eurodollar deposits, CDs and commercial paper are exposed to default risk. U.S. Treasury bills are free from default risk.

Describe the main provisions of the DIDMCA that relate to deregulation.

The provisions allowed deposit rates to be deregulated. In addition, all depository institutions were able to offer checking account services and provide some commercial loans.

Describe the process of borrowing from the Federal Reserve. What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve?

"Borrowing at the discount window" represents the borrowing by depository institutions from the Federal Reserve. The interest rate charged on these loans is known as the discount rate and is set by the Fed.Banks tend to prefer the federal funds market over the discount window because the Fed may monitor the bank's reasons for borrowing. The Fed's discount window is intended to accommodate banks that experience "unanticipated" shortages of funds.

What are four major sources of funds for banks? Which alternatives does a bank have if it needs temporary funds? What is the most common reason that banks issue bonds?

1.Transaction deposits 2.Savings deposits 3.Time deposits 4.Money market deposit accounts Sources of temporary funds include: 1.Federal funds market 2.Discount window3 .Repos 4.Eurodollar borrowings Banks may issue bonds to purchase fixed assets.

Obtaining funds through _______ is not a common way for banks to satisfy a temporary deficiency of funds. A. issuing bonds B. the federal funds market C. repurchase agreements D. borrowing from the Federal Reserve

A

Is the value of a money market fund or a bond fund more susceptible to increasing interest rates? Explain.

A bond fund is more susceptible to increasing interest rates because the securities contained in a bond fund have longer maturities than securities contained in a money market fund.

Describe the origination process for corporations that are about to issue new stock.

A corporation about to issue new stock contacts an IBF, which recommends the amount of stock to issue along with the suggested price and other provisions. The corporation then registers with the SEC with a registration statement.

Describe a defined-benefit pension plan. Describe a defined-contribution plan and explain why it differs from a defined-benefit plan.

A defined-benefit plan requires contributions that are dictated by the benefits that will eventually be provided. The retirement benefits are known during the time at which the employee is still working. The benefits provided by the defined-contribution plan are determined by the accumulated contributions and the return on the fund's investment performance. This plan allows a firm to know with certainty the amount of funds to contribute. The retirement benefits are not known with certainty because they are dependent on the performance of the investments that were made with the funds that were contributed.

Describe a direct placement of bonds. What is an advantage of a private placement? What is a disadvantage?

A direct placement involves the sale of securities directly to a specific investor (or investors) without offering securities to the general public. This is more likely for bonds than for stocks. A direct placement can avoid underwriting fees. However, the demand for securities that are directly placed may be low, since only a fraction of the market is targeted.

Support or refute the following statement: Investors can avoid all types of risk by purchasing a mutual fund that contains only Treasury bonds.

A mutual fund containing Treasury bonds is susceptible to interest rate risk. If interest rates rise, the market value of the Treasury bonds contained in the mutual fund will decline.

What is a policy loan? When is it popular? Why?

A policy loan occurs as insurance companies lend funds to whole life policyholders based upon their cash value of the policy. They are popular during times of rising interest rates as they have a guaranteed rate of interest, so are less expensive sources of funds during these times.

Describe the ideal mutual fund for investors who wish to generate tax-free income and also maintain a low degree of interest rate risk.

A short-term municipal bond fund can avoid taxes and has a low degree of interest rate risk.

What is an adjustable-rate mortgage (ARM)? Discuss the potential advantages that such mortgages offer a savings institution.

An adjustable rate mortgage has an interest rate that is tied to some market determined rate such as the one-year T-bill rate. The ARM rates are periodically adjusted in accordance with the formula stated in the ARM contract. ARMs are advantageous for savings institutions because they are used as a strategy to reduce interest rate risk. They enable savings institutions to maintain a more stable margin between interest earnings and interest expenses. ARMs also reduce the adverse impact of rising interest rates

Explain how changing foreign currency values can affect the performance of international mutual funds.

As foreign currencies depreciate (appreciate) against the dollar, the prices of foreign stocks as measured in dollars decline (rise). Thus, depreciation (appreciation) of foreign currencies tends to decrease (increase) the net asset value of international mutual funds that are held by U.S. investors.

What is asset stripping?

Asset stripping is a form of arbitrage in which after a firm is acquired, some of its divisions are sold.

The market where banks can borrow and lend reserves is called the: A) Open market. B) Federal funds market. C) Discount window. D) Money market. E) None of the above.

B

How are banks' balance sheet decisions regulated?

Banks are required to pay a premium on deposits, and to maintain a minimum level of capital, and are restricted to a maximum loan amount to any single borrower. They cannot use borrowed or deposited funds to purchase common stock. They can only invest in bonds that are considered "investment-grade" quality.

Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank's capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain this difference?

Banks may prefer a low level of capital because they can possibly achieve a higher return to shareholders (higher earnings per share). However, regulators enforce minimum capital requirements so that a bank's capital is sufficient to absorb operating losses that could occur.Banks are more highly leveraged (less capital and more liabilities) than manufacturing companies because their future cash inflows are much more predictable. They can handle the future payments due to liabilities, because they know the future level of cash inflows.

The interest rate banks charge their most creditworthy customers is known as the _______ rate. A. federal funds B. primary credit lending C. prime D. call money

C

When a bank in need of funds for a few days sells some of its government securities to a firm with a temporary excess of funds, then buys them back shortly thereafter, this is a: A. federal funds loan. B. discount window loan. C. repurchase agreement. D. commercial paper transaction.

C

When banks need funding for just a few days, they would most likely: A. issue bonds and then call them .B. issue stock and then repurchase it. C. borrow in the federal funds market .D. issue NCDs.

C

Who regulates CUs? What are the regulators' powers? Where do credit unions obtain deposit insurance?

CUs are regulated by the National Credit Union Administration (NCUA), which has the power to grant or revoke charters. It also examines the financial condition of CUs and supervises any liquidations or mergers. Most credit unions obtain insurance from the National Credit Union Share Insurance Fund

Who are the owners of credit unions? Explain the tax status of credit unions and the reason for that status. Why are CUs typically smaller than commercial banks or savings institutions?

CUs are technically owned by the depositors. CUs are not taxed because they are non-profit institutions. CUs are small because each CU is designed to accommodate a particular group or affiliation.

Explain how credit union exposure to liquidity risk differs from that of other financial institutions. Explain why credit unions are more insulated from interest rate risk than some other financial institutions.

Credit unions must rely on members for future deposits. They cannot accept deposits from nonmembers and are therefore more limited than other depository institutions. This can limit their ability to resolve any liquidity problems. Their interest rate risk of CUs is limited because they do not provide long-term loans with fixed rates.

Why did banks become so large? Are they too big to fail?

Due to changes in regulations, economy and competition. Yes.

What led to the establishment of FDIC insurance?

During the 1930-1932 Depression period, there was a run on bank deposits, causing many bank failures. The establishment of FDIC insurance in 1933 was intended to prevent such bank deposit runs.

Define federal funds, the federal funds market, and the federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday?

Federal funds are loaned in the federal funds market from one bank (or other depository institution) to another at an interest rate known as the federal funds rate.The federal funds rate is not directly set by anyone but is determined by the market. The rate changes frequently in response to changing supply and demand conditions. The Fed influences the federal funds rate by adjusting the money supply.The federal funds market is active on Wednesday because depository institutions use the market to adjust their required reserve position on that day (it is the final day of the settlement period for required reserves).

Explain how pension plans provide tax benefits.

First, a portion of the income earned by the employee is contributed to the employee's pension before taxes are imposed, so taxes are deferred until money is withdrawn from the fund after retirement. Second, since the annual income to the employee after retirement is likely to be lower than the annual income earned by the employee while employed, the income provided by the pension plan may be subject to a lower tax rate.

Explain how the Financial Reform Act is intended to prevent some problems that contributed to the credit crisis.

In July 2010, the Financial Reform Act (also referred to as Wall Street Reform Act or Consumer Protection Act) was implemented. It requires that banks and other financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy, so that it can prevent another credit crisis in the future. The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the U.S. and makes regulatory recommendations to regulators that could reduce any risks to the financial system. The council can recommend methods to ensure that banks do not rely on regulatory bailouts, which may prevent situations where a large financial institution is viewed as too big to fail. The act also assigned specific regulators with the authority to determine that any particular financial institution should be liquidated. This expedites the liquidation process and can limit the losses incurred by a failing financial institution. The act calls for the creation of an orderly liquidation fund that can be used to finance the liquidation of a financial institution that is not covered by the Federal Deposit Insurance Corporation. The act mandates that commercial banks must limit their proprietary trading, whereby they pool money received from customers and use it to make investments for their clients. It also requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter

What is a best-efforts agreement?

In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation, but only promises to offer its best efforts in selling the securities. Thus, the issuing corporation bears the risk that the securities may sell for a lower price than anticipated.

How does an index fund differ from an active fund?

Index funds (passive funds) try to replicate stocks and bonds of an underlying index and they do not trade frequently. Active funds buy and sell stocks and bonds frequently to try to beat the market.

Why did Lehman Brothers experience financial problems during the credit crisis?

Lehman Brothers had much exposure to mortgage-backed securities. It had a relatively low level of cash, and its high degree of financial leverage created more pressure. For every dollar of equity, it had about $30 of debt. Furthermore, some of its debt was short-term and therefore could be cut off (not renewed) if creditors sensed that Lehman was experiencing potential financial problems.

Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds).

Liabilities 1.Transaction deposits 2.Savings deposits 3.Time deposits 4.Money market deposit accounts 5.Federal funds purchased 6.Repurchase agreements 7.Eurodollar borrowings Assets 1.Cash 2.Loans 3.Investment securities 4.Federal funds sold 5.Repurchase agreements 6.Eurodollar loans 7.Fixed assets

Discuss the liquidity risk experienced by life insurance companies and by property and casualty (PC) insurance companies.

Life insurance companies have somewhat predictable payouts over time. However, a high frequency of claims can cause the insurance companies to be illiquid. To boost liquidity, the companies could maintain some liquid assets. PC insurance companies have claims that are less predictable and need to maintain sufficient liquid assets to cover any payouts.

What are the main assets of life insurance companies? Identify the main categories. What is the main use of funds by life insurance companies?

Life insurance companies invest in government securities, corporate securities, mortgages, real estate, and policy loans. The main investment by life insurance companies is corporate bonds.

Explain the difference between load and no-load mutual funds.

Load mutual funds require a fee to help pay for marketing commissions. No-load mutual funds do not require such a fee.

How does the money market deposit account differ from other bank sources of funds for banks?

MMDAs differ from conventional time deposits in that they do not specify a particular maturity. In addition, a limited number of checks can be written against these accounts.

How did the creation of money market deposit accounts influence the savings institution's overall cost of funds?

Money market deposit accounts (MMDAs) increased a savings institution's cost of funds, because some depositors switched their funds from savings accounts or NOW accounts to the higher yielding MMDAs.

How do money market funds differ from other types of mutual funds in terms of how they use the money invested by shareholders? Which security do money market funds invest in most often? How can a money market fund accommodate shareholders who wish to sell their shares when the amount of proceeds received from selling new shares is less than the amount needed?

Money market funds are composed of money market securities, such as Treasury bills, commercial paper, Eurodollar deposits, banker's acceptances, repurchase agreements, or CDs. Conversely, mutual funds are composed of stocks and bonds.Money market funds invest more money in commercial paper than in any other type of security. Money market funds could sell some of their security holdings in order to generate sufficient funds to cover the redemptions.

Explain why mutual funds are attractive to small investors. How can mutual funds generate returns to their shareholders?

Mutual funds enable small investors to benefit from a portfolio manager's expertise, and from diversification capabilities due to a large portfolio.Mutual funds can provide dividends or capital gain distributions to investors. In addition, investors also benefit from share price appreciation; they may be able to sell the shares at a higher price than they paid.

According to research, have mutual funds outperformed the market? Explain. Would mutual funds be attractive to some investors even if they are not expected to outperform the market? Explain.

Mutual funds have not outperformed the market, based on a risk-return comparison with the market. Mutual funds provide diversification benefits that investors could not afford to achieve on their own. Mutual funds also allow investors to rely on someone else's investment decisions rather than on their own judgment.

Aren't global and international funds the same?

No. Global funds include both foreign and U.S. funds while international does not include U.S.

Provide examples of off-balance sheet activities. Why are regulators concerned about them?

Off-balance sheet commitments occur when a bank guarantees a customer payment, through a standby letter of credit, or an interest rate swap, or foreign exchange commitments. Under some economic conditions, the bank could be exposed to too much risk. For example, if it guaranteed payments to back corporations that issued commercial paper, and those corporations fail, it will have to make the payments. Regulators are concerned about this risk.

Identify some advantages of credit unions. Identify disadvantages of credit unions that relate to their common bond requirement

Possible answers are: 1. They offer attractive rates to members, as they are non-profit and not taxed. 2. Non-interest expenses are relatively low. 3. They have a small spread between loan and share deposit rates, which benefits savers and borrowers. A disadvantage is that the common bond requirement restricts a CU from growing beyond the potential size of that particular affiliation. It also limits the CUs ability to diversify among its balance sheet accounts and also geographically.

Most securities firms experience poor profit performance after periods in which the stock market performs poorly. Given what you know about securities firms, offer some possible reasons for these reduced profits.

Profits are reduced because of (1) less stock transactions by investors, resulting in less commissions; (2) less issuances of new stock by firms (since their stock prices are so low, they do not want to sell new stock at that price), resulting in less underwriting fees; and (3) some securities firms had made major investments in some targets with their own equity. The market value of these equity positions had declined substantially.

What purpose do property and casualty (PC) insurance companies serve? Explain how the characteristics of PC insurance and life insurance differ.

Property and casualty insurance companies protect against fire, theft, liability, and other events that result in economic or noneconomic damage. PC insurance differs from life insurance in the following ways: 1.Policies often last one year or less, as opposed to long-term or permanent life insurance. 2.PC insurance encompasses a wide variety of activities, whereas life insurance is more focused. 3.Future compensation amounts paid on PC insurance is more difficult to forecast.

Why can't one bank dominate the entire US market?

Regulations prevent this from happening. One bank dominating the entire US market can be detrimental due to too much control.

What is reinsurance?

Reinsurance permits companies to write large policies by allocating a portion of the risk to other insurance companies, but they then must share the return.

Describe the liquidity and credit risk of savings institutions and discuss how each is managed.

Savings institutions experience liquidity risk since they commonly use short-term liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce their assets in order to increase liquidity. Since mortgages represent their primary asset, they are the main reason for default risk. Insurance is available for the many types of mortgages issued. In addition, savings institutions perform credit analysis and geographically diversity their mortgage loans to guard against default risk.

Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions.

Savings institutions obtain a large portion of their funds from savings deposits, more so than large commercial banks. While savings institutions can offer NOW accounts, they cannot offer the traditional demand deposits. Savings institutions concentrate on mortgages as their main use of funds. This differs from commercial banks, which concentrate on commercial loans and some consumer loans. Commercial banks offer a relatively small amount of mortgage loans compared to savings institutions. The major sources of funds for savings institutions are as follows: 1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts; 2. Borrowed funds, which come from either their district Federal Home Loan Bank for an extended length of time, the Federal Reserve discount window for very short-term loans, through repurchase agreements, and in the federal funds market; 3. Capital obtained by issuing stock and retaining earnings. The main uses of funds for savings institutions are: 1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to accommodate withdrawal requests of depositors; 2. Mortgages where the real estate represented serves as collateral to guard against default risk; 3. Mortgage-backed securities issued by other savings institutions that were in need of funds; 4. Investment securities like Treasury securities and corporate bonds that provide savings institutions with liquidity; 5. Consumer and commercial loans where consumer loans are typically for home improvements and education; the Garn-St Germain Act of 1982 allowed them to use up to 10 percent of their assets for commercial loans; 6. Other uses include providing temporary financing to other institutions through repurchase agreements, and the federal funds market.

Discuss the entrance of savings institutions into consumer and commercial lending. What are the potential risks and rewards of this strategy? Discuss the conflict between diversification and specialization of savings institutions.

Savings institutions that diversify their business may become less reliant on mortgage lending and therefore may be able to stabilize their earnings. However, by diversifying, they forgo their specialization in their area of expertise. There is a cost to learning other businesses, such as commercial lending. Yet, the costs may be worthwhile in the long run, as diversification of services may be a necessary goal for survival. Regulatory restrictions have been loosened, allowing savings institutions to offer commercial loans and consumer loans (although they still concentrate on mortgage lending). The potential risk to savings institutions that now provide such loans is that they improperly assess creditworthiness due to inexperience. However, if they can properly perform the credit evaluation and other procedures such as loan documentation, they may reduce their risk.

Why do securities firms typically have some inside information that could affect future stock prices of other firms?

Securities firm sare often aware of which firms are targets to other acquiring firms. They may even identify what they believe to be undervalued targets for their clients. Also, when a firm plans to acquire a target, it may ask a securities firm to facilitate the financing and other tasks of the acquisition. The stock prices of target firms typically rise substantially prior to an acquisition.

Explain the process of proprietary trading by securitiesfirms.How was it affected by the Volcker Rule?

Securities firms can engage in proprietary trading, in which they use their own funds to make investments for their own account. They may invest in equity securities, bonds and other debt securities, or even in derivative securities. Their proprietary trading has often supplemented their income from other operations, but their investments expose them to risk, and have resulted in major losses in some cases. The Financial Reform Act contained a provision (referred to as the Volcker rule) that restricts the proprietary trading by commercial banks and securities firms that have become BHCs. The Volcker Rule restricts many short-term speculative investments, which formerly were an important part of financial institutions' proprietary trading. As a result, the amount of proprietary trading has declined.

How do securities firms facilitate leveraged buyouts? Why are securities firms that are more capable of raising funds in the capital markets preferred by corporations that need advice on proposed acquisitions?

Securities firms facilitate leveraged buyouts by: (1) assessing the appropriate market value of the firm, (2) arranging financing, and (3) offering additional advice when needed. Many acquisitions require outside financing. A securities firm that has more ability to raise funds can enhance the chances of a successful acquisition for the potential acquiring firm.

Explain why securities firms have used a high level of financial leverage in the past. Explain how the leverage affects their expected return and their risk.

Securities firms use a high level of financial leverage because it can enhance their return on equity. For a given return on assets, the return on equity will be magnified if a higher level of financial leverage is used. However, a negative return on equity will convert into a more pronounced loss (as a percent of equity) if a higher level of financial leverage is used.

Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset? Explain.

Securities provide a bank with liquidity, because they can often be sold easily in the secondary market. In addition, many securities purchased by banks have low risk. Therefore, the securities can be used to minimize liquidity risk and default risk.The optimal allocation of funds is dependent on a bank's degree of risk aversion and anticipated economic conditions. There is no formula to determine the optimal allocation. Banks must weigh the higher potential return from some uses of funds against the lower return and lower risk of other uses of funds.

Like mutual funds, commercial banks and stock-owned savings institutions sell shares; yet, proceeds received by mutual funds are used in a different way. Explain.

Shares issued by commercial banks and savings institutions are used to obtain capital, which may be used to finance their fixed assets such as land and buildings. Shares issued by mutual funds are used to obtain funds, which are invested in the mutual fund portfolio.

What were some of the more obvious reasons for the SI crisis?

Some obvious reasons are: (1) rising interest rates in the late 1980s, which reduced the spread between interest earned on loans and interest paid on deposits; (2) fraud by managers or executives of some S&Ls; and (3) illiquidity, resulting from withdrawals by depositors.

What are the biggest sources and uses of funds for commercial banks?

Sources: deposits Units: loans

Explain the general difference between the portfolio composition of private pension funds and public pension funds.

State and local government pension funds tend to concentrate more on credit market instruments and less on corporate stock.

What are the alternative forms of ownership of a savings institution?

Stock savings institutions are owned by shareholders, and mutual savings institutions are owned by depositors.

A certificate of deposit (or retail CD) requires a specified minimum amount of funds to be deposited for a specified period of time.

T

A commercial bank's risk may rise as it increases its financing of leveraged buyouts (LBOs).

T

Although commercial banks have historically focused on commercial lending, they have begun to diversify their services by creating new subsidiaries in recent years.

T

How do whole life and term insurance differ from the perspective of insurance companies? From the perspective of the policyholders?

Term insurance provides insurance only over a specified term; it is not permanent like whole life insurance. Term insurance does not build a cash value, so it is not a savings mechanism. Also, term insurance is less expensive than whole life insurance.

Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations, and how it changed the competitive landscape among financial institutions.

The Financial Services Modernization Act of 1999 allowed banks to merge with other financial service firms such as insurance companies and securities firms. Banks can now offer a more diversified product line as a result of merging with securities firms and insurance companies. They can serve as a one-stop shop. Financial institutions can now expand into other services that were previously off limits. Consequently, there is more competition among financial institutions for each type of financial service.

Briefly describe the Glass-Steagall Act, and then explain how the related regulations have changed since it was enacted.

The Glass-Steagall Act (1933) separated banking and securities activities, in response to problems during the Great Depression when banks (1) sold poor-quality securities to their trust accounts, and (2) used inside information on loan activities to make decisions on securities to purchase or sell. The regulations have changed to allow banks to offer securities activities. Yet, there are still regulations that prevent the bank's use of inside information from the banking business for making investment decisions in its securities business.

What is the NAIC and what is its purpose?

The NAIC is the National Association of Insurance Commissioners. It facilitates cooperation among the various state agencies when an insurance issue is of national concern. It is involved in common reporting issues to maintain uniformity and participates in legislative discussions.

What is the main purpose of the Pension Benefit Guarantee Corporation (PBGC)?

The PBGC provides insurance on pension plans. If a pension plan is terminated, the PBGC takes control as the fund manager.

Explain the role of the SEC, FINRA, and the stock exchanges in regulating the securities industry.

The SEC regulates the issuance of securities and specifies disclosure rules for the issuers. The New York Stock Exchange (NYSE) and the Nasdaq market are regulated by the Financial Industry Regulatory Authority (FINRA), which monitors trading patterns and behavior by market makers and floor traders. FINRA also has enforcement divisions that investigate possible violations and can take disciplinary action. It can take legal action as well and sometimes works with the SEC to correct cases of market trading abuse.

What is the purpose of the SIPC?

The SIPC offers insurance on cash and securities deposited at brokerage firms.

Why was the Federal Reserve concerned about systemic risk due to the financial problems of Bear Stearns?

The failure of Bear Stearns could have spread adverse effects throughout financial markets. Since Bear Stearns was a major provider of clearing operations for many types of financial transactions, its failure might have frozen or delayed many financial transactions, which could have resulted in a liquidity crisis for many individuals and firms that were to receive cash as a result of the transactions. Bear Stearns also served as a counterparty to various types of financial agreements. If Bear had defaulted on all of its counterparty positions, this could have caused problems for the financial institutions on the other side of those agreements, which could have created chaos in financial markets.

Explain the use of the federal funds market in facilitating bank operations.

The federal funds market is used by depository institutions that experience a temporary shortage of funds and desire to borrow from other depository institutions. It is also used by institutions that have excess funds and desire to lend those funds out.

How can the financial problems of one large bank affect the market's risk evaluation of other large banks?

The financial problems of one large bank can cause the public to change its risk perception about the banking industry in general. Consequently, the risk of other banks is perceived to be higher than before.

Describe the main source of funds for credit unions. Why might the average cost of funds to credit unions be relatively stable even when market interest rates are volatile?

The main sources of funds are (1) share deposits, with no specified maturity, and (2) share certificates, which specify a particular interest rate and maturity. The proportion of funds obtained through regular share deposits at CUs is relatively large. The rates offered on these accounts have remained somewhat stable while rates on share certificates move with the market. This allows CUs to obtain much of their funds at a relatively low and stable cost

Explain why diversification across different types of mutual funds is highly recommended.

The performance of each type of mutual fund is influenced by a particular economic factor. Thus, diversifying within one specific type of mutual fund creates significant exposure to that factor. The stock market movements influence stock fund performance, interest rate movements influence bond fund performance, and exchange rates and foreign market movements influence international funds. Diversification across stock funds, bond funds, and international funds limits the exposure to any single economic factor.

What do hedge funds, venture capital and private equity firms have in common?

They are all complex, have high risk, and have to be accredited investor by the government.

What's the difference between the NIM and ROA?

They are both profitability measures. NIM measures profitability that is generally earned by interest business. ROA looks at net profit compared to their assets.

How do banks profit through off-balance sheet activities?

They generate fee income

How do insurance companies manage credit risk and liquidity risk?

To deal with default risk, life insurance companies typically invest in securities with high ratings and then diversify among security issuers. To reduce liquidity risk, they diversify the age distribution of customers.

Explain why securities firms from the United States have expanded into foreign markets.

U.S. securities have expanded overseas because: (1) their international presence allows them to place securities in various markets, (2) they can better assess potential international mergers for corporations, and (3) they can advise on foreign securities that their institutional investors should purchase.

Identify the characteristics of universal life insurance.

Universal life insurance specifies a time period over which the policy exists. It builds a cash value that interest is earned on until the policyholder uses those funds. Universal life insurance allows flexibility on the size and timing of premiums.

How do venture capital and private equity firms differ?

Venture capital invests in startups while private equity firms invest in mature/older firms.

Explain the "moral hazard" problem as it relates to deposit insurance

While deposit insurance helps to prevent bank deposit runs, it encourages banks to take more risk. Thus, the risky banks are subsidized by the more conservative banks. This situation reflects the moral hazard problem. Risk-based insurance premiums have alleviated this problem.

Explain how the credit crisis encouraged some securities firms to convert to a bank holding company (BHC) structure.Why might the expected return on equity be lower for securities firms that convert to a bank holding company structure?

While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. Also, the bank holding company structure results in a higher required capital and greater degree of regulatory oversight by the Federal Reserve. The securities firms may be viewed as safer because of their conversion to bank holding companies, and this may also allow for easier access to funding.

Explain how the conversion of securities firms to a bank holding company (BHC) structure might reduce their risk.

While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. The bank holding company structure allows the securities firms to also offer commercial banking services, including federally insured deposits. It also results in a greater degree of regulatory oversight by the Federal Reserve, including stringent capital requirements.

How is whole life insurance serve as a form of savings to policyholders?

Whole life insurance is permanent as it protects the policyholder until death or as long as premiums are promptly paid. It is a form of savings as it builds a cash value the policyholder is entitled to even if the policy is canceled.

How might reintroducing the Glass-Steagall Act make banks safer today?

a) make banks smaller b) allow regulators to have greater control over just banking operations rather than having to oversee the entire bank holding company structure

Why did regulators lift the ban on interstate banking?

there are easier ways to communicate and work with banks all over the US than there was in the past and it is more efficient