Econ 310 Chapter 12

Key Provisions of the Dodd Frank Act

-Created consumer financial protection bureau to protect consumers -established financial stability oversight council to identify and act on systematic risks to the system -ended too-big-to-fail policy, changes in Fed's operations, -required derivatives to be traded on exchanges -implemented volcker rule -required hedge funds and P.E. firms to register with the S.E.C -required firms selling MBS at commercial banks to retain at least 5% credit risk

Smoot Hawley Tariff Act (1930)

-Led to retaliatory increases in foreign tariffs-> reduced U.S. exports -Fed raised interest rates after it became concerned by rapid increases in stock prices -Bank suspensions soared during bank panics of early 1930s

Why did Treasury Secretary Paulson want Bear Stearns to sell for such a low​ price? ​(Check all that apply.​) A. Because the market and book value of Bear Stearns was low. B. In order to prevent market stability. C. To punish the​ firm's owners and managers for bad​ decisions, without letting them go bankrupt. D. In order to prevent systemic risk. Why was the decision by the Fed to orchestrate the purchase of Bear Stearns so​ controversial? ​(Check all that apply.​) A. Because the Fed intervened by brokering a guaranteed deal with Lehman Brothers. B. ​Because, according to some​ economists, the action increased moral hazard in the financial system. C. Because Bear Stearns is an investment​ bank, as opposed to a commercial​ bank, and, as​ such, policymakers faced unexpected challenges. D. Because Bear Stearns is a hedge fund. E. Because the Fed intervened by brokering a guaranteed deal with JP Morgan.

1. C-To punish the firm's owners and managers for bad decisions, without letting them go bankrupt D. In order to prevent systematic risk 2. B-Because, according to some economists, the action increased moral hazard in the financial system C-Because Bear stearns is an IB, instead of a commercial bank, so policymakers faced unexpected challenges E. Because the Fed intervened by brokering a guaranteed deal with JP Morgan

All of the following are reasons why deflation might not be good for​ consumers, except: A. it causes lower interest rates. B. it causes nominal wage cuts. C. it causes a higher burden of debt ratio. D. it causes higher interest rates. Was deflation during the early 1930s good or bad for​ firms? A. It was good because the supply of loans increased. B. It was good because it effectively lowered interest rates. C. It was bad because it effectively raised interest rates. D. It had no effect on firms.

1. A- It causes lower interest rates (deflation causes HIGHER interest rates, which is bad) 2. C- It was bad because it effectively raised interest rated

In describing the bank panic that occurred in the fall of​ 1930, Milton Friedman and Anna Schwartz​ wrote: A contagion of fear spread among​ depositors, starting from the agricultural​ areas, which had experienced the heaviest impact of bank failures in the twenties. But such contagion knows no geographical limits. What do the authors mean by a​ "contagion of​ fear"? A. The fear of bad​ weather, which causes an increase in the prices of agricultural goods. B. A bank run that is fueled by fear of bank failure. C. A recession. D. The bankruptcy of depositors. What did bank depositors have to fear in the early​ 1930s? A. Depositors had fear of a reduction of interest rates. B. If a bank​ failed, then depositors would potentially lose all their money. C. Depositors had fear of hyperinflation. D. Depositors had fear of the nationalization of commercial banks. Do depositors today face similar​ fears? A. Depositors face the same fears now as in the early 1930s. B. Because TARP insurance did not exist in the early​ 1930s, depositors today do not face similar fears. C. Because FDIC insurance did not exist in the early​ 1930s, depositors today do not face similar fears. D. It is impossible to compare problems depositors face now and those in the early 1930s. What do the authors mean that​ "such contagion knows no geographical​ limits"? A. Bank panics produce a contagion that spreads from country to country. B. Bank panics always start in agricultural area​ banks, then spread to urban area banks. C. Bank panics may start in an isolated​ area, but the fear they engender quickly spreads to banks elsewhere. D. None of the above.

1. B- A bank run that is fueled by fear of bank failure 2. B- If a bank failed, then depositors would potentially lose all of their money 3. C-Because FDIC insurance did not exist in the early 1930s, depositors today do not face similar fears 4. C-Bank panics may start in an isolated area, but the fear they engender quickly spreads to banks elsewhere

Government intervention to avoid bank panics:

1. Lender of Last Resort: central bank acting as ultimate source of credit to system (make loans to solvent banks against their good (illiquid) loans) 2. Government can insure deposits -FDIC (1933), federal govt. agency established -Note: If 100% of reserves are held, no runs, make loans and buy securities solely with own capital

The Fed did not intervene to stabilize the banking system because:

1. No one was in charge (power was divided, had less independence from executive branch) 2. The Fed was reluctant to rescue insolvent banks (may encourage moral hazard) 3. Fed failed to understand difference between nominal and real interest rates (higher than expected) 4. Fed wanted to "purge speculative excess" -believed that depression was result of financial speculation, so Fed followed "liquidationist policy": allow price level to fall and weak banks/firms to fail before recovery could begin

Debt-Deflation Process

A cycle of falling asset prices and falling prices of goods/services that can increase the severity of an economic downturn -Price level fall effects: 1. Real interest rates would rise, real value of debts will increase 2. Process of falling asset prices, falling prices of g/s, and increasing bankruptcies and defaults

Regulation Q

A historical Federal Reserve regulation that set a maximum interest rate that banks could pay on deposits to limit competition for funds among banks. All interest rate ceilings on time and savings were phased out on April 1, 1986, by federal law.

Exchange Rate Crisis

A sudden and unexpected collapse in the value of a nation's currency, due to countries attempting to keep value of currency fixed by pegging it against another currency

How does deposit insurance encourage banks to take on too much​ risk? A. Banks can make riskier investments without worrying about deposit withdrawals because the government has insured depositors against losses. B. Deposit insurance encourages banks to increase investments in riskless assets. C. With deposit​ insurance, depositors have more incentive to withdraw their deposits if the managers make reckless investments. D. Banks can make riskier investments because the government has insured banks against losses on their investments.

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

Financial crisis typically results in a recession for all of the following reasons​ EXCEPT? A. The government is unwilling to intervene during a financial crisis. B. The flow of funds from lenders to borrowers becomes disrupted. C. Firms struggle to fund​ long-term investments in new​ factories, machinery, and equipment. D. Firms have trouble financing​ day-to-day activities. E. Households borrow less to finance purchases of goods and services.

A. The government is unwilling to intervene during a financial crisis

How is being a lender of last resort connected to the​ too-big-to-fail policy? ​(Check all that apply.​) A. The​ too-big-to-fail policy and the lender of last resort strive to prevent systemic​ risk, where the failure of a few firms leads to the widespread failure of solvent banks. B. The​ too-big-to-fail policy and the lender of last resort have to provide liquidity to banks during bank panics. C. The​ too-big-to-fail policy and the lender of last resort strive to promote​ "moral hazard" in the banking system. D. A lender of last resort is not connected to the​ too-big-to-fail policy.

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

What policy actions did the Treasury take during the financial​ crisis? A. The Treasury insured money market mutual fund deposits. B. The Treasury helped JPMorgan Chase acquire Bear Stearns. C. The Treasury passed​ TARP, which injected capital into the banking system. D. The Treasury began buying commercial paper issued by nonfinancial corporations.

A. The treasury insured money market mutual fund deposits

FDICIA (1991)

Act required FDIC to deal with failed banks using the method that would be least costly to the taxpayer

What role did the bank panics of the early 1930s play in explaining the severity of the Great​ Depression? A. Bank panics aggravated the effects of the Great Depression by making residential and commercial loans easier to get comma which further reduced economic activity. B. Bank panics exacerbated the effects of the Great Depression by reducing the ability for people to safely store their money comma which further reduced economic activity. C. Bank panics of the early 1930s did not play any role in explaining the severity of the Great Depression. D. Both A and B are correct.

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

A column in the Wall Street Journal notes that "every heavily indebted country weighs the cost of repaying debt against the loss of confidence and creditworthiness that default entails." . Whose confidence is the country afraid of​ losing? A. borrowers B. investors C. depositors D. the government

B. Investors The consequences of losing investor confidence will most likely result in a lower credit rating and higher interest costs

What changes were made to Section​ 13(3) of the Federal Reserve​ Act? A. The Fed was permitted to make loans designed to prevent individual companies from avoiding bankruptcy. B. The Fed was no longer permitted to make loans to individual companies were no longer allowed. C. The government was permitted to make loans to specific corporations. D. The Fed was permitted to make loans to specific corporations.

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

Feedback Loop

BAD NEWS (depositors question value)--> BANK RUN (demand instant returns of funds)--> CONTAGION (depositors demand funds from other banks)--> BANKS REACT (sell assets to reduce loans)--> THE ECONOMY (output, employment, and prices decline, causing more failures) -->

Fed Response to Housing Bubble Burst

Began aggressively driving down short term interest rates -federal govt effectively nationalized Fannie Mae and Freddie Mac -unveiled plan for congress to authorize $700 billion used to purchase mortgages and MBSs from financial firms and other investors

All of the following are reasons why one bank failure might lead to many bank​ failures, except: A. Banks will be forced to sell loans and securities to raise money to pay off depositors. B. Depositors of other banks may become concerned that their banks might also have problems. C. If multiple banks have to sell the same​ assets, the prices of those assets are likely to rise. D. Depositors have an incentive to withdraw their money from their banks to avoid losing it should their banks be forced to close.

C. If multiple banks have to sell the same assets, the prices of those assets are likely to rise (Prices will fall)

Which of the following is a reason that the Federal reserve failed to intervene to stabilize the banking system in the early​ 1930s? A. Power within the Federal Reserve was much more unified than today comma making it more difficult for the Fed to act. B. The Fed wanted to purge speculative excess comma believing that it was necessary for the price level to rise and weak banks and weak firms to fail before a recovery could begin. C. The Fed failed to understand that with deflation comma low nominal interest rates did not imply low real interest rates. D. The Fed was reluctant to rescue insolvent banks comma believing that doing so would discourage risky behavior by bank managers left parenthesis the moral hazard problem right parenthesis .

C. the Fed failed to understand that with deflation, low nominal interest rates did not imply low real interest rates

Why did Congress with the​ Dodd-Frank Act decide to require large financial firms to have living​ wills? A. to plan how large losses would be covered by the government. B. to plan how large losses would be covered by FDIC. C. to give regulators a clearer understanding of a​ bank's operations. D. to ensure that banks were too big to fail.

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

Pattern for crises

CRISIS OCCURS -> REGULATION ENACTED-> FINANCIAL SYSTEM RESPONDS --> REGULATORS RESPOND

Capital Requirements (CAMELS)

Capital Adequacy Asset Quality Management Earnings Liquidity Sensitivity to Market Risk

A currency crises can occur under a pegged currency when​ _______. A. an excess supply of the domestic currency forces the central bank to use foreign reserves to purchase the domestic currency B. the central bank is forced to raise interest rates in order to attract foreign investors to buy domestic​ bonds, thereby raising the demand for the domestic currency C. the pegged exchange rate ends up substantially above the equilibrium rate D. All of the above

D. All of the above

Why have some European countries been suffering from a sovereign debt​ crisis? A. The 2007-2009 recession reduced tax revenues to the government. B. They have had chronic government budget deficits. C. The 2007-2009 recession led to increased government spending. D. All of the above

D. All of the above

Dodd Frank Act (2010)

Expanded the Fed's regulatory authority over nondepository financial institutions: Intended to end the too-big-to-fail policy, allows the Fed, FDIC, and treasury to seize and "wind down" large financial firms

Lehman Brothers

In 2008, this large Wall Street investment bank declared bankruptcy after Fed and Treasury decline to help, which led to a panic in the financial industry

Volcker Rule

Limited banks' ability to trade for own account

Financial Crises

Major disruptions in the flow of funds from lenders to borrowers -Typically leads to an economic recession as households and firms face difficulty in borrowing money (most involved in the commercial banking system)

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

No

Disintermediation

Occurred when banks did not have savers' funds to loan, and when banks ended up with only low quality borrowers as firms sold a substantial fraction of their commercial paper to money market mutual funds -The exit of savers and borrowers from bans to financial markets

Contagion

Process by which a run on one bank spreads to other banks--> leads to bank panic -If multiple banks have to sell same assets, leads to price declines, push banks to insolvency

Bear Stearns

Saved with aid of the Fed and acquired by J.P. Morgan in 2008, increased moral hazard

Bank Panic

Situation in which many banks simultaneously experience runs (feeds on self fulfilling perception)

Bank run

The process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close -in the absence of deposit insurance, stability of bank depends on confidence of its depositors

Maturity Mismatch

What banks have when they borrow short term from depositors and lend long term to households and firms -Banks face a liquidity risk because they may be unable to meet their depositors' withdrawals

Money Market Deposit Accounts (MMDAs)

a federally insured savings account, offered by banks and other depository institutions, that competes with money market mutual funds, high yield

Too-big-to-fail policy

a policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system -may pose systematic risk -had unlimited deposit insurance, more moral hazard

Basel Accord

an international agreement about bank capital requirements, assets grouped into categories based on degree of risk ($ val x risk-adjusted factor)

Higher uncertainty leads to (increases/decreases) in spending

decreases

Sovereign Debt

refers to bonds issued by a government, crisis occurs when a country has difficulty making principle/interest payments on bonds, if government defaults and is unable to issue bonds, depends on tax revenues to pay, can lead to a recession

Sovereign Debt Crisis

results from chronic government budget deficits and interest payments taking up an unsustainably large portion of government spending, and sever recession that increases govt spending and reduces tax revenues

Insolvent

the situation for a bank or other firm whose assets have less value than its liabilities, so its net worth is negative (may be unable to meet obligations)