ECON 303 EXAM 2

If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazards might occur?

Adverse selection would occur in this situation because people who would try to burn down their property to collect their insurance money would try to access this. Moral hazard would occur because people with this insurance would have less incentive to prevent a fire.

Describe the functions and history of the Fed.

After historically being hostile to centralized banking and causing the demise of two earlier central banks, North America finally came to a compromise in 1913. Congress created the Federal Reserve Act of 1913 which constructed the elaborate and unusual structure of the Federal Reserve System. The founders who designed this system designed it so that it was decentralized and had checks and balances. The Federal Reserve System is made up of the Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee. The seven Board of Governors work together to conduct monetary policy by setting reserve requirements and reviewing and determining the discount rates. The twelve Federal Reserve Banks located across America in districts that equally represent their regions are involved in monetary policy by establishing the discount rate that the Board reviews and determines, while also electing one commercial banker to serve on the Federal Advisory Council which provides input in the decision making of monetary policy. The seven Governors and five of the 12 federal bank presidents (one permanently being the NY Fed president) serve on the Federal Open Market Committee. This committee directs open market conditions and advise on reserve requirements and the discount rate.

What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

Benefit of increasing capital is that it increases the safety of the investments of the company from going bankrupt. The cost is that the return to investors/bank owners will be lower due to the increased capital.

Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the Fed?

Borrowing from the Fed involves collateral whereas a bank with higher interest rates does not involve collateral.

What are bubbles?

Bubbles occur when asset prices rise far above their fundamental values. The existence of these bubbles suggest that unexploited profit opportunities may exist and that the efficient market hypothesis is fundamentally flawed.

What are cash flows?

Cash flows are the funds that transfer in and out of a business that stockholders are residual claimants to.

A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

Compensating balances serve as collateral and increase the likelihood of the loan being paid off. Also, it is a way for banks to monitor the borrower effectively.

What is the primary tool that congress uses to exercise some control over the Fed?

Congress uses the threat to acquire greater control over the Fed's finances and budget (through legislation which would actively affect the Fed Reserve).

What is credit risk?

Credit risk is the risk arising from the possibility that a borrower might default.

What is a credit spread and why do they rise significantly during a financial crisis?

Credit spreads are the difference between interest rates on household/commercial loans and interest rates on completely safe and will be paid back loans like US Treasuries. Credit spreads rise significantly during a financial crisis so that lender's can protect themselves from credit losses.

How can a decline in real estate prices cause deleveraging and a decline in lending?

Decline in US house prices showed subprime borrowers that their mortgages were "underwater", meaning that the value of their home was less than the mortgage amount. Therefore, borrowers began to default causing millions of foreclosures. As a result, the values of mortgage-back securities lowered which lowered banks' asset values and thus lowering net worth. This all resulted in deleveraging and a decline in lending.

What is fair-value accounting?

Fair value accounting is also known as mark-to-market accounting in which during a financial crisis, assets are valued in the balance sheet at what they could sell for in the market. Fair value accounting has a major flaw during financial crises, because asset prices during that time of distress do not reflect its fundamental values.

T/F The independence of the Fed leaves it completely unaccountable for its actions.

False. Congress still can hold the Fed accountable by passing legislation limiting its power.

"Bank managers should always seek the highest return possible on their assets." Is this true or false?

False. Having high returns also means having a lot of risk, so that should be considered.

T/F The theory of bureaucratic behavior indicates that the Fed never operates in public interest.

False. Just because it works to maximize its welfare does not mean it doesn't engage in altruism while doing so.

The FHLBS gives loans to S&Ls and thus performs a function similar to the ________ for commercial banks.

Federal Reserve

In what ways can the regional FRBs influence the conduct of monetary policy?

Federal Reserve banks establish the discount rate, decide which banks can obtain discount loans, select a commercial banker to be on the Fed Advisory Committee which consults the Board and provides info to advise monetary policy, and 5 of the 12 banks' presidents reside on the FOMC which controls open market conditions.

The Dodd-Frank bill created an agency to monitor markets for asset price bubbles and the buildup of systemic risk. This agency is called the

Financial Stability Oversight Council

"Financial engineering always leads to a more efficient financial system." True, false, or uncertain?

Financial engineering does not always lead to an efficient financial system. Financial innovations created can be very complex and hard to value. Consequently, they lead to worse asymmetric problems.

What technological innovations led to the development of the subprime mortgage market?

Financial engineering led to the creation of subprime mortgages.

What role does weak financial regulation and supervision play in causing a financial crisis?

Financial institutions will take on excessive risk if market discipline is weakened by the existence of a government safety net.

How do banks deal with transaction costs?

Financial intermediaries can substantially reduce transaction costs because their large size. The size of these intermediaries allow them to take advantage of economies of scale, the reduction in transaction costs per dollar of transactions as the size of these transactions increases.

What role did the shadow banking system play in the 07-09 financial crisis?

Shadow banking system funds are not regulated like traditional banks. This light regulation allowed them to take on excessively more risk than other firms. These financial instruments flowed through the system and played a part in the creation of the housing bubble. When credit markets began tightening, these funds decreased significantly and there was further reduced access to needed credit.

Why is the originate-to-distribute business model subject to principal-agent problem?

This model is subject to agency problems because originators did not have investors' best interest at heart. They just wanted to collect their money and pass the risk onto the next person. Furthermore, originators had incentives like encouraging borrowers to take on more than they could afford and had not incentives to make sure the ultimate holders would be paid off in the end by these borrowers that they didn't evaluate the creditworthiness of.

Mutual savings banks are owned by

depositors

The McFadden Act of 1927

effectively prohibited states from branching across state lines.

Through correspondent banking, large banks provide services to small banks, including

foreign exchange transactions

Agency problems in the subprime mortgage market included all of the following EXCEPT

homeowners could refinance their houses with larger loans when their homes appreciated in value.

A firm issuing credit cards earns income from

loans it makes to credit card holders and payments made by stores on credit card purchases (a percentage of the purchase price).

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals times the change in the interest rate is called

maturity bucket approach to gap analysis

Dodd-Frank addressed many of the issues that led to the financial crisis. Which of the following was NOT addressed by Dodd-Frank regulations?

privately owned, government-sponsored enterprises (GSEs) such as Fannie mae and Freddie Mac

Increased uncertainty resulting from the global financial crisis ________ the required return on investment in equity.

raised

Banks acquire the funds that they use to purchase income-earning assets from such sources as

savings accounts

If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can

sell $3million of its securities

The legislation that overturned the prohibition on interstate banking is

the Riegle-Neal Act

Under the Gramm-Leach-Bliley Act the oversight of the securities activities of bank holding companies belongs to

the SEC

Reasons for holding Eurodollars include

the fact that dollars are widely used to conduct international transactions.

The spectacular growth in international banking can be explained by

the rapid growth in international trade.

Which of the following is NOT part of the shadow banking system?

the transformer (originator->servicer->bundler->distributor)

In September 2008, the Reserve Primary Fund, a money market mutual fund, found itself in the situation know as "breaking the buck." This means that

they could no longer afford to redeem shares at par value $1.

Banks develop statistical models to calculate their maximum loss over a given time period. This approach is known as the

value-at-risk model

The three approaches to limiting the Too Big To Fail problem are:

1. Breaking up the large, systemic institutions A benefit of this would be that the government wouldn't have to bail out these firms if they failed because regulations imposing restrictions or specifying a max limit of assets would be in place. However, if there are synergies available that provide financial services at a lower cost or might help manage risk better, then breaking up might actually decrease efficiency rather than increase. 2. Higher Capital Requirements Higher capital requirements would reduce the amount of risk the large firms take on because they would have more to lose. These requirements would be countercyclical which is beneficial since these larger firms tend to take on more risk during booms but that wouldn't occur with these requirements. 3. Leave it to Dodd Frank One view is that Dodd Frank is effectively eliminating the TBTF problem by making it harder for the Fed to bail out large firms, impose restrictions on SIFIs, and through the Volcker Rule. However, some have doubts on if this bill truly removes the problem.

What is a bank panic?

A bank panic is the simultaneous failure of multiple banks, as during a financial crisis, where depositors fear for the safety of their deposits because of lack of information about the quality of a bank's portfolio, so they withdraw their deposits to the point that the banks fail.

What is a credit spread?

A credit spread is the difference between interest rates of a residential/commercial loan and the interest rates of a completely safe loans. When financial frictions rise, most lenders engage in increasing interest rates to protect themselves, which results in a rise in the credit spread.

How does deterioration in balance sheets of financial institutions and simultaneous failures of these institutions cause an increase in adverse selection and moral hazard problems?

A deterioration of financial institution's balance sheets results in banks deleveraging, selling off assets and restricting credit. Their net worth becomes negative and they may become unable to pay off depositors/creditors, causing some banks to go out of business. The uncertainty of the banking system's health may lead to run on banks and could cause a full fledge panic further resulting in deleveraging.

What is an automated teller machine?

A financial innovation created to effectively bypass branching restrictions. This machine allows depositors to conveniently make transactions in locations other than a bank's branch. Another company owns this machine while the bank receives a fee for each transaction.

The presidents of each of the district FRBs are currently not required to undergo a formal political appointment/approval process. Do you think this is appropriate?

A formal process of approval can be lengthy which could leave FRBs without leadership, possibly creating more problems than it solves.

What is a T-account?

A t-account is a simplified balance sheet, with lines that form a T, that lists only the changes that occur in balance sheet items starting from some initial balance sheet position.

What is Adaptive Expectations?

Adaptive Expectations is a theory about expectations that expectations of a variable are based on the weighted average of past data about that variable. This theory is considered faulty because people use more info than just past data of a variable to form their expectations of it. It is also the view that expectations change relatively slowly over time in response to new information

How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

An increase in uncertainty after a major firm's failure can cause a contagion of bank failures and panic, causing banks to become insolvent. With fewer banks operating, there is less or no information about credit worthiness of borrowers making adverse selection and moral hazard problems increase.

How does an unanticipated decline in the price level cause a drop in lending?

An unanticipated decline in price level leads to debt deflation. Debt deflation causes a decline in a borrower's net worth because the value of the borrower's liabilities increase while the value of assets does not change. Lower net worth leads to an increase in adverse selection and moral hazard problems resulting in a decline in long-term lending.

What causes bank panics to occur?

Asymmetric information causes bank panics. With the deterioration of bank balance sheets and tougher business conditions, banks go into insolvency. Because of the lack of information about the quality of a bank's portfolio and the fear of the safety of their deposits, depositors withdraw their deposits to the point that the banks fail. The contagion can spread further if the runs led to fire sales which decreases a bank's asset value, resulting in decline of net worth which can lead to further bank failure and a full fledge panic.

How does the concept of asymmetric information help to define a financial crisis?

Asymmetric information problems caused a disruption in the channeling of funds to households and firms that have productive investment opportunities.

Should the Fed Reserve be subject to periodic auditing of its policies, procedures, and finances?

Auditing the Fed could hold it more accountable but it would make it less independent.

What are off balance sheet activities?

Bank activities that involve the trading of financial instruments, the generation of income from fees, and loans sales, all of which affect bank profits but are not on balance sheets.

The modern commercial banking system began in America when the

Bank of North America was chartered in Philadelphia in 1782.

How do banks deal with the financial system?

Banks are actively involved in the financial system through indirect finance. They are the financial intermediaries that channel the flow of funds between lenders and borrowers. They use the lender-savers' funds to make loans to borrowers, which is ideal economic activity in a nation.

Why do bank panics worsen asymmetric problems in credit markets?

Banks help lessen asymmetric info problems so when bank panics occur, asymmetric problems are left unsolved and it worsens in credit markets.

How do banks deal with moral hazard?

Banks write provisions into contracts that restrict borrowers from engaging in risky activities. By monitoring borrowers to see if they are following the restrictive covenant, banks can make sure that borrowers are not taking on risk at their expense. Also, banks create long-term relationships with customers so that customers will want to borrow from them in the future and they are less likely to pursue risky activities with this in mind. Furthermore, banks use compensating balances as a way of ensuring that a loan is paid off, reducing moral hazard. Lastly, credit rationing, refusing to make a loan altogether or giving a loan amount that is less than wanted, will decrease the amount of moral hazard.

Why is it unlikely that the policy recommendation put forth by the chair of the BOG would ever be voted down?

Because all seven governors make up the majority of the FOMC so it has majority of the votes.

Why might eliminating the Fed's independence lead to a more pronounced political business cycle?

Because eliminating its independence could make it more short-sighted and subject to political influence. Thus when political gains could be achieved by expansionary policy before an election the Fed may be influenced to do so.

Why was the Federal Reserve System set up with twelve regional Federal Reserve Banks rather than one central bank like other countries?

Because historically Americans were hostile towards centralized banking systems, the founders of this Federal Reserve System set up twelve regional FRBs to make sure it was decentralized and all regions had adequate representation in the deliberation of monetary policy.

Why has non-interest income been growing as a sort of operating income?

Because off-balance-sheet activities that generate fees have become important to a bank's business.

In the 60's-70's, the Fed Reserve System lost member banks at a rapid rate. How can the theory of bureaucratic behavior explain the Fed's campaign for legislation to require all commercial banks to become members? Was it successful?

Because the Fed was losing power and authority, it pursued legislation to require banks to become members and to widen its jurisdiction of reserve requirements thereby giving its power and prestige back and maximizing its welfare. This is directly related to the theory of bureaucratic behavior.

Why did the Bank of England have a low degree of independence up until 97?

Because the chancellor determined interest rates not the Central bank.

Why is being nosy a desirable trait for banker?

Being nosy is a desirable trait for banks because they need to be nosy to make accurate assumptions on whether someone is a bad credit risk or not.

Why are deposit insurance and other types of government safety nets important to the health of the economy?

Deposit insurance and safety nets help reduce the possibility of bank panics and bank runs.

Do you think that eliminating or limiting the amount of deposit insurance would be a good idea?

Deposit insurance has benefits and drawbacks. Limiting the amount of deposit insurance is needed because there are both moral hazard and adverse selection concerns.

Which entities in the Fed Reserve System control the discount rate? Reserve Requirements? Open market operations?

Discount rate- "Established" by FRBs, "reviewed and determined" by Board of Governors Reserve Requirements- Board of Governors Open market conditions- FOMC

Typically, the economy recovers fairly quickly from a recession. Why did this NOT happen in the United States during the Great Depression?

During this time, there was a 25% decline in price level which led to a debt deflation. The loss of net worth increased adverse selection and moral hazard in the credit markets. This increased and lengthened the economic contraction. Due to the incessant panic, falling of stocks, failure of banks, and overall decline in the economy, the Great Depression eventually spread worldwide. Foreign companies' sales declined in the U.S. due to the lack of demand.

What is the efficient market hypothesis?

Efficient market hypothesis is application of the theory of rational expectations to the market. This hypothesis states that current security prices reflect all available information, because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities in order for a market to be efficient does not mean that all market participants have to be well informed. It also implies that stock prices generally follow a random walk.

If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? why or why not? What options are available that will enable you to provide the funds your customer needs?

Even if the bank has no excess funds, there are other ways to obtain the funds like borrowing from other banks and corporations.

What do you think prevented the 07-09 crisis from becoming a depression?

Government interventions to prop up the financial markets prevented the crisis from becoming a depression.

________ within the U.S. can make loans to foreigners but cannot make loans to domestic residents.

IBF's, International Banking Facilities

Why does imposing bank capital requirements on banks help limit risk taking?

If a bank is required to hold more capital then it will take on less risky assets because it has more to lose.

If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?

If a bank needs to raise capital, it can issue equity (common stock), reduce dividends (increase retained earnings), or keep capital at the same level by decreasing assets and then reduce securities.

How do banks deal with financial crises?

If a crisis does not lead to debt deflation, then public and/or private authorities shut down insolvent firms and liquidate them. From there, uncertainty will decline, the stock market will recover, and balance sheets improve thus leading to the elimination of financial frictions which makes the crisis go away. However, it is ultimately up to the creators of financial regulation to successfully deal with financial crises because they are the ones who can set requirements to deal with financial frictions caused by asymmetric information and financial innovations.

Why is it a good idea from macroprudential policies to require countercyclical capital requirements?

If countercyclical capital requirements were enforced, this would result in more capital during a boom, which would reduce lending, and less capital during a bust, which would encourage lending resulting in economic growth.

At the height of the global financial crisis in 2008, the US Treasury forced nine of the largest US banks to accept capital injections in exchange for non-voting ownership stock, even though some of the banks did not need the capital and did not want to participate. What could be the Treasury's rational for doing this?

If the banks that didn't need or want the capital injections didn't take them, then only the weakest ones would've received the needed capital to avoid insolvency. If that would've happened, bank runs would've occurred at these banks which would have resulted in a contagion effect through the entire financial system. These banks accepting the unwanted capital helped avoid an adverse signal to depositor/creditors at the weaker banks.

Which of the following has NOT resulted from more active liability management on the part of banks?

Increased bank holdings of cash items (because they are assets)

Why do equity holders care more about ROE than about ROA?

Investors care more about the return on their investments rather than how efficiently the bank is being run.

Why is it important for the regional FRB presidents to attend the FOMC meetings, even if they are nonvoting members?

It is important for all members to show up because even though only 5 can vote, the other 7 can voice input on the decisions of monetary policy.

Should the Fed Reserve redraw its district boundaries, similar to the manner in which congressional districts are periodically realigned? Why or why not?

It would make sense for the Fed to redraw its district boundaries but that would result in the government having to rewrite the Fed Reserve Act of 1913 which would create more opportunities for political interests to interfere with monetary policy.

U.S. banks have most of their branches in

Latin America, the Far East, the Caribbean, and London

What is liquidity management?

Liquidity management is the decisions made by a bank in order to maintain enough liquid assets to meet its obligations to depositors.

Despite the important role played by the Board of Governors in setting monetary policy, seats to serve on the Board can sometimes be empty for several years. How might this happen?

Most Board of Governors don't complete their full term because their salaries are lower than compared to the private sector or at universities.

"Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is the statement true, false, or uncertain?

No this is not true. It is beneficial for banks to specialize in lending to local firms or firms in specific industries because it makes it easier for the banks to collect information/monitor customer's creditworthiness which reduces the common adverse selection problem with lending. It is not diversifying but it is decreasing risk, adverse selection risk in particular.

Do you think that the 14yr, nonrenewable terms for governors effectively insulate the board of Governors from political pressure?

No, in order to gain additional power to regulate the financial system, the Board needs Congress/President to pass favorable legislation.

If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow stock as a result of a deposit outflow, would you be willing to buy stock in that bank?

No, the bank must be holding a lot of excess reserves which do not earn interest. This is not a good investment because profits will probably be low.

How did the global financial crisis promote a sovereign debt crisis in Europe?

Several countries were hit very hard by the contraction in economic activity which reduced tax revenues at the same time that government bailouts of failed financial institutions required additional government outlays. The surge in budget deficits led to fears that governments would default on their debt. The result was a surge of interest rates that went out of control. It started in Greece and spread to Ireland, Portugal, Spain, and Italy.

What are dividends?

Periodic payments (usually every quarter) to stock holders. These payments come from the net earnings of a corporation.

What types of bank regulations are design to reduce moral hazard? Will they completely eliminate them?

Regulations that restrict banks from holding riskier assets and regulations requiring a certain amount of capital both decrease moral hazard. These will not completely eliminate the problem because banks hide holdings or overstate capital amounts.

Rank the following bank assets from most to least liquid: Commercial loans Securities Reserves Physical Capital

Reserves, securities, loans, physical capital

Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?

Rising concern in financial institutions' balance sheets, caused lenders to require more collateral (called haircuts). The rising defaults on mortgages caused higher haircuts. To afford these haircuts in order to borrow, the banks did fire sales which leads to decrease in in value further increasing haircuts. So ultimately lending contracted due to the massive deleveraging.

What issues does the Dodd-Frank bill address?

Stricter consumer protection laws, resolution authority over large financial institutions, systemic risk regulation, Volcker Rule, and higher requirements on firms dealing in derivatives

What is the dual banking system?

This banking system, created by the Fed in 1913 to create a safer banking system, is where federally chartered banks and state chartered banks work side by side.

Which is more independent, the Fed or ECB?

The ECB is more independent because its charter cannot be changed by legislation.

Essay on efficient market hypothesis

The Efficient Market Hypothesis is the application of the Theory of Rational Expectations to financial markets. The Efficient Market Hypothesis is an investment theory states that current security prices will reflect and incorporate all available information at the time. Prices only respond to new information and they do so immediately. With that being said, under this hypothesis it is said that following investment adviser's advice, following hot tips, or any other form of analysis will not benefit a person because there is no way to beat the market or have an edge over another investor. According to EMH, the only way to outperform is by purchasing riskier assets. Furthermore, this theory states that not all market participants have to be knowledgeable as long as some are so that unexploited profit opportunities are quickly eliminated. Additionally, it implies that all stock prices follow a random walk, therefore they are unpredictable. However it is believed that the Efficient Market Hypothesis is faulty because if it were entirely true, the housing bubble and crisis would not have occurred. Also, with the growth of advanced technology, it is hard to monitor if all investors receive the same information at the same time in modern society.

In what way does the Fed Reserve have a high degree of instrument independence?

The Fed can choose any method it wants in order to achieve a given set of policy objectives.

How does the Fed control money supply and financial institutions like commercial banks?

The Fed controls money supply through Open market operations. It does this by the purchase and sale of securities (which occurs at the New York Federal Reserve Bank). Purchasing securities increases the money supply and selling securities decreases the money supply. The Fed controls commercial banks by setting reserve requirements and discount rates.

If the Fed has a specific mandate from congress to "achieve maximum employment and low, stable prices", then how does the Fed have goal independence?

The Fed is free to interpret exactly what Congress's objectives mean.

The Fed is the most independent of all US govt agencies. What is the main difference between it and the other agencies that explains its greater independence?

The Fed is not subject to the appropriations process (auditing).

What is the FOMC?

The Federal Open Market Committee is made up of the 7 Board of Governors and 5 presidents from the Federal Reserve Banks, one permanently being the president of the New York Fed. This committee directs open market conditions and also advises the Board in reserve requirements and the Federal Reserve Banks in establishing the discount rate.

What is a credit default swap?

This is a type of excessively risky financial derivative that provides payments to holders of bonds if they default, resulting in large fees for companies who write them.

Why is the NY Fed Reserve always a voting member of the FOMC?

The NY Fed is so important because it contains many of the largest commercial banks in the US, whose soundness/health is important to the financial system's health, making the NY Fed the supervisor of these. Also, the NY Fed houses the open market desk, where bonds are purchased and sold, and the foreign exchange market, which conducts foreign exchange interventions on behalf of the Fed Reserve System & Treasury. Also, this FRB is a member of the Bank of International Settlements, giving them a special role in international interaction. Lastly, it holds $100 billion of the world's gold and its president is only permanent voting member.

The FOMC promotes secrecy by not releasing the minutes of FOMC meetings to congress. Describe the arguments for and against this policy.

The argument for not releasing the minutes is that it keeps congress off its back, allowing it to pursue policy thats less subject to political pressures (like expansionary policy and political business cycles). The argument for releasing is believed that it would hold the Fed more accountable.

If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE?

The bank needs to lower its capital in order to raise its return. They can either buy back stock, pay out higher dividends (which would reduce retained earnings), or keep bank capital constant by increasing assets by acquiring funds and then purchasing new securities.

What are the costs and benefits of a too-big-to-fail policy?

The benefit of a TBTF policy is that it repays large, uninsured creditors of the largest banks so that no depositor/creditor incurs a loss, even if they technically aren't entitled to this. The problem is that this increases moral hazard for the big banks and financial institutions that are extended this safety net. It makes the banks feel as though they won't suffer if they take on more risk and depositors/creditors don't feel the need to monitor as much. These two things increase the likelihood of a financial crisis.

How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?

The bursting of an asset-price bubble is when the value of an asset realigns with its real fundamental value causing the lender's value/net worth to decline. This increases the asymmetric information problem and leads to deterioration of the lender's balance sheet. The lender would then have to deleverage, which leads to less lending and contraction of economic activity.

Why were consumer protection provisions included in the Dodd Frank Bill, a bill designed to strengthen the financial system?

The consumer protection part of Dodd Frank was added because authorities needed to examine and enforce regulations on firms with a lot of assets who engage in issuing residential mortgages or to low-income people. Also, legislation required lenders to verify borrowers' income, credit history, and job status. This will help strengthen the financial system by ensuring firms and borrowers do not take advantage of each other.

What is the discount rate?

The cost associated with a discount loan is the interest rate that must be paid to the Fed, called the discount rate.

Why is it important for the US govt to have resolution authority?

The govt needs resolution authority because if a large, systemic insitution is failing, the govt needs to be able to properly wind it down so the entire financial system doesnt fail.

How could higher deposit insurance premiums for banks with riskier assets benefit the economy?

The higher a deposit insurance premium, the less likely a bank will take on more riskier assets, so there will be less moral hazard in the economy. However, this is hard to monitor because only the bank making the loan knows how risky it is.

If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?

The higher the capital is, the lower the return will be.

Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?

The overnight loan market makes it possible for a bank to not have reserves. If a deposit outflow occurs, a bank can borrow in the overnight market without having to keep reserves.

How is the president of the US able to exert influence over the Federal Reserve?

The president can influence congress whom has control of legislation of the Fed. Also since governors often don't finish their terms, the president can appoint new governors of their choice.

How does the process of financial innovation impact the effectiveness of macroprudential regulation?

The process of financial innovation is generally good for the economy because it creates new instruments that are intended to increase system efficiency. However, these instruments typically are risky and often mismanaged which disrupts the financial system and results in asset-price bubbles. Because these instruments are profitable innovations, people follow the path to them, putting regulators one step behind. Ultimately, it usually isn't until after a disruption by these innovations that regulators are able to understand the structure and risk associated with these instruments enough to create proper regulations. Therefore the innovations impact the effectiveness.

What is financial supervision?

The supervision of financial institutions and their operations. There is micro-prudential supervision that was exercised prior to the financial crisis of 07-09, and there is macro-prudential supervision which is exercised now.

How do banks deal with Adverse selection?

There are several ways banks deal with adverse selection. One way is that banks screen and monitor in order to determine good credit risks from bad ones. Secondly, banks specialize in lending. By specializing in lending to local firms or particular industries, they are able to more easily collect information and stay knowledgeable about the borrowers and decrease the likelihood of adverse selection. Also, banks strive to create long-term relationships in order to better manage their risk and decrease the likelihood of risky borrowers by benefitting them too. Banks who require collateral, or compensating balances, also decrease adverse selection by using this account to monitor the borrower more closely and it also increases the likelihood of a loan being paid off. Lastly, credit rationing is a safe way to decrease adverse selection because it eliminates the likelihood of adverse selection all together by not allowing the borrower to borrow at all.

What are financial derivatives?

These are financial instruments that were created to hedge investors/financial institutions from interest-rate risk. They are contracts in which payoffs are linked to previously issued securities.

How do banks deal with asymmetric information?

To deal with asymmetric information, banks must engage in two information-producing activities: screening and monitoring. Screening occurs in both consumer and business loans. Screening is gaining information about personal finances and can even lead to personal questions about family, job status, and children or in the sense of a business loan, company finances, sales figures, plans, etc. All of this information evaluates how good of a credit risk one is which helps eliminate the asymmetric information problem that is present in the banking system.

What is the too-big-to-fail problem?

Too-big-to-fail refers to the problem that regulators are reluctant to close down large financial institutions because doing so might create a financial crisis.

T/F The Federal Reserve System resembles the US constitution in that it was designed with many checks and balances.

True. They did this by setting up a decentralized system with 12 banks spread throughout the country that were quasi-public and overseen by directors from the private sector of each district who would represent the views of that district and be in close contact with their FRB president.

Describe two similarities and two differences between the US's experiences between the Great Depression and the 2007-2009 financial crisis.

Two similarities are that it had global impacts and affected worldwide markets and they both caused skyrocketing unemployment. Two differences is that the Great Depression was caused by a Stock market crash whereas 07-09 crisis was caused by mismanagement of financial innovations like mortgage-backed securities and CDO's; also, they faced different results. The 07-09 crisis did not lead to a depression because of government intervention whereas the 1930 crisis led to a depression.

T/F The independence of the Fed means that it takes the long-view and not the short-view.

Uncertain, The Fed's independence may help them think long term but it can still be influenced by political pressure.

How did a decline in housing prices help trigger the subprime financial crisis in 2007?

When housing prices rose far above their fundamental values, the asset-price bubble bursted. The decline in the housing prices revealed to borrowers that their mortgages were much higher than the actual value of their homes. So they defaulted causing millions of foreclosures reducing the values of mortgage-backed securities and CDOs that banks held as assets, which then decreased their net worth forcing them into insolvency/creating haircuts which also lowered their values causing fire sales which lead to insolvency.

Why is the Twelfth Fed Reserve district (San Fran) so much geographically larger than the Second district (NY)?

When the Fed Reserve Act of 1913 set up these districts, it was set up to reflect roughly equal populations and economic interest at the time. The West Coast was so sparsely populated compared to the East Coast so that is why San Fran's district is so large compared to New York.

How can financial innovation lead to financial crises?

With these new financial innovations often come managers who don't know how to manage risk, leading to overly risky lending. In addition, regulators do not know how to properly regulate these complicated innovations. When these eventually go sour, it leads to deterioration of balance sheets and reduction in lending, both contracting economic activity.

If you are a banker and you expect interest rates to rise in the future, would you prefer short term or long term loans?

You would prefer short term loans.

If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economists would say that expectation formation is

adaptive

The primary reason for the recent reduction in the number of banks is

bank consolidation (mergers and acquisitions)

Credit cards date back to

before World War 2

Banks earn profits from off-balance sheet loan sales

by selling existing loans for more than the original loan amount