Banking Exam 2

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"A bank that expects interest rates to increase in the future will want to hold more​ rate-sensitive assets and fewer​ rate-sensitive liabilities." Do you agree with this​ statement?

Agree.​ Rate-sensitive assets will increase in value thus holding more of them as​ assets, while reducing them as​ liabilities, will increase bank profits.

Did the existence of reserve requirements make it easier for banks to deal with bank​ runs? Briefly explain.

The existence of reserve requirements did not change the situation that banks faced during bank runs because banks were unable to use required reserves to cover deposit withdrawals.

Are the funds in your checking account an asset to you or a​ liability? Are they an asset or a liability to your​ bank?

The funds are an asset to you and a liability to your​ bank, since it is your money and the bank is obligated to pay it back to you on demand.

What are the disadvantages of defined benefit pension plans for​ employees? ​(Check all that apply​.)

The implicit return to the plan may be fairly low if plan managers do not invest well. A worker could lose some pension benefits if the plan is underfunded or if the employer goes out of business. The worker has no control on how the money is invested and some plans do not adjust future payouts to keep pace with inflation.

Which of the following is not a reason why savers with small amounts to invest rarely make loans directly to individuals or​ firms?

The interest rate that savers would earn from making these loans is too low.

If everyone were perfectly​ honest, would there be a role for financial​ intermediaries?

Yes

Loan sales is

a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.

Standby letters of credit are

a promise by a bank to lend​ funds, if​ necessary, to the seller of commercial paper at the time that the commercial paper matures.

​Off-balance-sheet activities are

activities that do not affect a​ bank's balance sheet because they do not change either the​ bank's assets or its liabilities

Trading activities are

activities that include trading in the​ futures, options, or swaps market.

What is a​ "standing repo​ facility"? A standing repo facility allows the Fed to engage in repos when firms cannot obtain​ short-term loans from other firms. This makes the problems associated with the mismatch of maturities for investment banks better ​, since it would provide more stability for short-term borrowing .

allows the Fed to engage in repos, better, provide more stability for short-term borrowing

A​ T-account is

an accounting tool used to show changes in balance sheet items.

Loan commitment is

a​ bank's consent to provide a borrower with a stated amount of funds during some specified time.

Financial intermediaries take advantage of economies of scale ​, which refers to the reduction in average cost that results from an increase in the volume of a good or a service produced.

economies of scale, reduction, an increase

The United States is said to have a dual banking system because banks

may be chartered either by state governments or by the federal government.

The FDIC stands for

the Federal Deposit Insurance Corporation.

The World Bank measures financial development​ by:

the total amount of credit banks and financial markets extend to households and firms as a percentage of GDP.

Who is​ "providing" capital to these​ firms?

Buyers of stocks.

Use a​ T-account to show the effect on Bank of​ America's balance sheet of your depositing ​$80 in currency in your checking account.

80

What is the difference between venture capital firms and private equity​ firms?

A private equity firm raises equity capital to acquire shares in established firms with the intention of reducing moral hazard problems. A venture capital firm is a firm that raises equity capital from investors to invest in startup firms.

All of the following are reasons why these financial foundations were important in making possible the rapid growth of the U.S. economy during the nineteenth and twentieth​ centuries, except:

A central bank provided direct control over all interest​ rates, facilitating the control and direction of the overall economy.

What is the shadow banking​ system?

A collection of nonbank financial institutions that channel money from savers to borrowers.

What is a credit​ report?

A list of your​ debts, payment​ history, and information about where you live and work.

What is systemic​ risk?

A risk to the entire financial system.

[Related to the Making the ConnectionLOADING...​] What incentives would the partners in an investment bank have to turn it into a public​ corporation?

A. Going public eliminates the risk involved to the top​ executives, as it is not solely their money that is being risked. B. Going public provides more access to capital and leverage. C. (Answer) A and B are correct. Your answer is correct. D. Neither​ A, nor B is correct.

An article in the Economist magazine​ observes: ​"Insurance companies often suspect the only people who buy insurance are the ones most likely to​ collect." ​Source:​ "The Money​ Talks," Economist​, December​ 5, 2008. What do economists call the problem being described​ here?

Adverse selection.

​"A bank that expects interest rates to fall will want the duration of its assets to be greater than the duration of its liabilities​ - a positive duration​ gap." Do you agree with this​ statement?

Agree. A fall in interest rates with a positive duration gap will increase a​ bank's capital.

The author of a newspaper article providing advice to renters observes that​ "landlords will always know more than you​ do." ​Source: Marc​ Santora, "How to Be a Brainy​ Renter," New York Times​, June​ 3, 2010. Do you agree with this​ statement? If​ so, what do landlords know that potential renters might​ not?

Agree; Landlords know more about the quality of the​ property, and hence its true​ value, than renters.

If commercial banks were allowed to purchase significant amounts of stock in the companies to which they make​ loans, would this increase or decrease the extent of moral hazard in the financial​ system?

All answers are correct.

How do banks manage credit​ risk?

All of the above are correct.

Suppose that​ Lena, who has an account at SunTrust​ Bank, writes a check for ​$140 to​ Jose, who has an account at National City Bank. Use following the​ T-account for SunTrust Bank to show how it is affected after the check clears.

Assets Liabilities A) Reserves A (140) L)Checkable deposits L (140) Use following the​ T-account for National City Bank to show how it is affected after the check clears. Assets Liabilities A) Reserves A 140 Checkable deposits L) 140

The key accounting equation on which balance sheets are based is given by

Assets​ = Liabilities​ + Shareholders' Equity.

Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically​ optimal?

Asymmetric information makes information costs for external funds higher than for internal​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal.

In​ 2020, during the recession caused by the​ Covid-19 pandemic, Federal Reserve Chair Jerome Powell announced the banks would be allowed to reduce their leverage ratios. He stated that reducing​ banks' leverage ratios​ "would give us the ability to allow banks to grow their balance​ sheets." What is a​ bank's leverage​ ratio? How is it related to a​ bank's leverage?

A​ bank's leverage ratio is the ratio of its capital to assets . A​ bank's leverage is the inverse of the leverage ratio.

How do banks manage​ interest-rate risk?

Banks can reduce​ interest-rate risk by making more floating rate​ loans, or ARMs. ​Interest-rate swaps can reduce​ interest-rate risk exposure.

What is a credit​ score?

A​ three-digit score based off several factors related to your credit history.

As an employee of a large​ firm, you are given the choice between a defined benefit pension plan and a defined contribution pension plan. What are the advantages of defined benefit pension plans for​ employees?

A​ worker's retirement payout is determined by a formula so that the worker bears no direct risk.

Does a​ bank's capital appear on the left side of the​ bank's balance​ sheet?

Bank capital appears on the right side of the balance​ sheet, because it is the difference between assets and liabilities.

How do banks manage liquidity​ risk

Banks manage this risk by keeping some funds very​ liquid, such as a reverse repurchase agreement. Banks manage this risk by keeping some funds very​ liquid, such as in the federal funds market. Banks can increase their borrowings to cover liquidity risk.

If the article is correct about what was happening in the Chinese banking​ system, what problems might arise as a​ result?

Banks will make riskier and riskier loans over time.

In the adjacent​ figure, countries that are above the upward sloping line have relatively high levels of real GDP per capita for their levels of financial development and countries that are below the line have relatively low levels of real GDP per capita for their levels of financial development. Holding constant all other factors that might affect a​ country's rate of economic​ growth, would we expect future growth rates to be higher for countries above the line or for countries below the​ line?

Below the line because these countries have underperformed so far given the strength of their financial system.

"If a bank manager expects interest rates to fall in the​ future, he should increase the duration of his​ bank's liabilities." Do you agree with this​ statement?

Disagree. Higher duration of its liabilities will reduce the value of the​ bank's capital.

What benefits do employees receive from saving for retirement using​ 401(k) plans?

Employees are not taxed on their contributions to​ 401(k) plans, or the earnings on those​ investments, until they are withdrawn during retirement.

Which of the following is not an advantage automobile dealers might gain from using a finance​ company, rather than a​ bank, to finance their purchases of cars from the manufacturer and their​ customers' purchases of cars from the​ dealers?

Finance companies are more reliable during recessions than commercial banks since they raise money from​ long-term savers and only loan to those with high credit scores.

What is the difference between a defined contribution pension plan and a defined benefit​ plan?

In a defined contribution pension​ plan, the firm invests contributions for the​ employees, who own the value of the funds in the plan. In a defined benefit​ plan, the firm promises employees a particular dollar benefit payment based on each​ employee's earnings and years of service.

Developing new financial securities or investment​ strategies, using sophisticated mathematical models.

Financial engineering

​[Related to the Apply the​ Concept: "FICO: Can One Number Forecast Your Financial Life—and Your Romantic ​Life?"​] At the beginning of the​ Covid-19 pandemic, an article on bloomberg.com observed​ that: "Online​ personal-loan companies such as Social Finance Inc. ... are another question mark in a downturn because the default rate for alternative lenders is​ unknown." What does the article mean by referring to a fintech lender like Social Finance​ (SoFi) as an alternative​ lender?

Fintech lenders use alternative measures of default​ risk, which expands the types of borrowers they are willing to lend to.

Which of the following might explain why a country without a strong financial system would struggle to achieve high rates of economic​ growth?

Firms are unable to acquire funds they need to expand.

In describing the work of hedge​ funds, financial journalist Sebastian Mallaby has​ observed: [Research] showed that the unglamorous​ "value" stocks were underpriced relative to overhyped​ "growth" stocks. This meant that capital was being provided too expensively to​ solid, workhorse firms and too cheaply to their flashier rivals. . . . It was the function of hedge funds to correct inefficiencies like this. ​Source: Sebastian​ Mallaby, More Money Than​ God: Hedge Funds and the Making of a New Elite​, New​ York: The Penguin​ Press, 2010, pp.​ 8-9. Explain what the first two sentences in this excerpt​ mean: What is the connection between the relative prices of these two types of firms and their cost of raising​ capital?

Growth stocks had a higher​ price-to-earnings ratio than value stocks. The cost of raising new capital falls with an increase in the stock price.

What did Powell mean by allowing banks to​ "grow their balance​ sheets"? How would a lower leverage ratio allow banks to grow their balance​ sheets?

He is talking about easing capital restrictions by letting banks have more assets per dollar of capital. As asset holdings​ grow, banks' balance sheets will be growing.

How can hedge funds correct this​ inefficiency?

Hedge funds correct this inefficiency by buying value stocks and putting upward pressure on their price. B. Hedge funds correct this inefficiency by selling growth stocks and putting downward pressure on their price. C. A and B are correct. Your answer is correct. D. ( Answer) Neither​ A, nor B are correct.

In what ways is the market for rental apartments like the market for used​ cars?

In both​ markets, the owner knows more than the potential renter or buyer.

Rather than declining to renew​ policies, why​ didn't the insurance companies raise the rates they charged people in these areas for fire​ insurance?

Insurers must believe that raising rates would increase adverse selection even​ more, making any future fires very costly for the companies.

What are the key problems that investment banks can encounter in borrowing short and investing long that commercial banks​ don't?

Investment banks face counterparty risk since there are no federal guarantees like commercial banks have on​ deposits, and the repo market can be volatile.

In what ways are they​ different?

Investment institutions are different from commercial banks because they do not engage in traditional commercial banking​ activities, such as taking deposits and making loans.

If becoming a public corporation increases the risk in investment​ banking, how do publicly traded investment banks succeed in selling stock to​ investors?

Investors desire investment​ banks' stocks because of the potentially high profits of these banks due to their access to high leverage.

If the statement is​ correct, what are the implications for the market for rental​ apartments?

Landlords will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry.

​[Related to the Making the​ Connection] An editorial in the Wall Street Journal argues​ that: "​there's no evidence that​ [repealing the​ Glass-Steagall Act in​ 1999] had anything to do with the​ [2007-2009 financial] crisis." ​Source: "​Glass-Steagall-Trump-Clinton ​Act," Wall Street Journal​, July​ 28, 2016. What is the argument in favor of believing that repealing the​ Glass-Steagall Act did not play a role in the financial​ crisis?

Large banks that combine commercial and investment banking activity were not at the center of the financial crisis.

Which from the following are​ off-balance-sheet activities? ​(Check all that​ apply.)

Loan sales. Loan commitment. Standby letters of credit. Trading activities.

What is the most important source of external funds for these​ firms?

Loans from financial intermediaries

Which of the following is a correctly explained key feature of the financial​ system? ​(Check all that​ apply.)

Loans from financial intermediaries are the most important external source of funds for​ small- to​ medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms. The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard.

What is the most important method of debt financing for​ corporations?

The bond market.

Buying and selling​ securities, typically those that are not traded on​ exchanges, and maintaining an inventory of the securities in order to serve as an intermediary between buyers and sellers.

Market making

f we lived in a world in which everyone was perfectly​ honest, would the difference in the transactions costs faced by financial intermediaries when they make loans and those faced by small savers when they make loans​ disappear?

No; while information costs might decrease there are still significant legal and other transaction costs involved in matching savers and borrowers.

Why did nationwide banking come relatively late to the United States compared with other​ countries?

The U.S. system of many​ small, geographically limited banks was the result of political views that the power of banks should be limited by keeping them small and that the deposits banks received should be used only to fund loans in the local area.

Why do pension funds have vesting​ periods?

Pension funds have vesting periods in order to reduce turnover among employees who are not yet vested.

According to an article in the Wall Street Journal in late​ 2019, after several years of severe wildfires in some areas of​ California, "insurers have declined to renew the policies of​ 350,000 California homeowners who live in areas at high risk for​ wildfires, according to the California Department of​ Insurance." What key requirement that makes insurance possible did insurance companies believe no longer held in these areas of​ California?

Profitability and adverse selection. The volume of people in​ high-risk areas looking for insurance​ increased, resulting in insurance companies expecting​ ever-increasing payouts on policies.

Buying and selling securities and other assets for a​ bank's own account rather than for clients.

Proprietary trading

ReviewHomework:Homework: Chapter 11 Question 12, End of Chapter 3.7 HW Score: 90.74%, 16.33 of 18 points Points: 0.67 of 1 Close In​ 2020, an article in the New York Times observed​ that: "For​ years, the​ country's public pension plans have faced a yawning gap between what they owe and what they can pay. . . . Public pensions are the time bomb of government finance. Now the coronavirus pandemic has it ticking​ faster." In what sense are public pension plans a​ "time bomb" for government​ finance?

Public pension plans require fixed payments to retirees regardless of the state of the economy.

Suppose that the value of a​ bank's assets is ​$44 billion and the value of its liabilities is ​$35 billion. If the bank has ROA=2​%, then what is its​ ROE?

ROE=9.789.78​% ROE=ROA*B. A/BC

The most important bank assets are

Real estate loans and U.S.​ government/agency securities.

How have the types of loans banks make changed over​ time?

Real estate loans have become a much higher percentage of total loans since​ 1973, while commercial loans have declined.

The most important bank liabilities are

Small-denomination time deposits and Checkable deposits.

Why would the​ Covid-19 pandemic have made the problems facing public pension plans​ worse?

Taxes collected by state and local governments​ declined, causing pension funds to be even more underfunded.

Why was it​ established?

The FDIC was established to ameliorate bank runs. B. The FDIC was established in 1913 together with Fed C. The FDIC was established in 1934 after a series of bank failures. D. ( Answer )A and C are correct.

Economist Richard Sylla of New York University has argued that in the​ 1790s, Secretary of the Treasury Alexander Hamilton "established the financial foundations that would make the United States the most successful emerging market in the nineteenth​ century, and the economic colossus of the next that some would call the​ 'American ​century.'" ​Source: Richard​ Sylla, "Financial ​Foundations: Public​ Credit, the National​ Bank, and Securities ​Markets," in Douglas A. Irwin and Richard​ Sylla, eds., Founding​ Choices: American Economic Policy in the 1790s​, ​Chicago: University of Chicago​ Press, 2011, p. 86. Sylla would focus on all of the following "financial foundations" of the United​ States, except:

The issuance of currency.

In what ways is it​ different?

The landlord is not selling the​ apartment, merely renting​ it, while the buyer of a used car makes an irreversible deal.

Consider the possibility of income insurance. With income​ insurance, if a person loses his job or​ doesn't get as big a raise as​ anticipated, he would be compensated under his insurance coverage. Why​ don't insurance companies offer income insurance of this​ type? ​(Check all that​ apply.)

The problem is adverse selection​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). The problem is moral hazard​ (once insured, you​ won't work as​ hard).

Which of the following reasons might explain why repealing the​ Glass-Steagall Act may have been a bad​ idea?

The repeal of​ Glass-Steagall increased the risk to the financial system.

What are the advantages of defined contribution pension plans for​ employees?

The return may be​ higher, and the worker often has some control over how the money is invested.

Do vesting periods have any advantages to employees relative to a system where new hires are eligible to participate in a pension plan right​ away?

Vesting periods do not have any advantages to employees relative to a system where new hires are eligible to participate in a pension plan right away.

In what ways does the shadow banking system differ from the commercial banking​ system?

The shadow banking​ system, unlike the commercial banking​ system, does not offer traditional banking services such as taking in deposits. B. The shadow banking system invests in more risky assets and tends to be highly leveraged than commercial banks. C. The commercial banking​ system, unlike the shadow banking​ system, is heavily regulated by the government. D. (answer) All of the above are correct.

In what ways are investment institutions similar to commercial​ banks?

They both borrow short and lend long.

What choices do state and local governments face in attempting to diffuse this financial time​ bomb? ​(Check all that apply.​)

They could increase taxes in an effort to help afford payments on the pension plans. They could cut government spending to help afford the pension payments.

What is the most important source of funds for small to​ medium-sized firms?

The​ owners' personal funds and profits

What are the disadvantages of defined contribution pension plan for​ employees?

The​ worker's retirement payout depends on the performance of the invested​ monies, so it is riskier.

Why​ don't these firms rely on external funds to the same extent as large firms​ do

Transactions costs and information costs are much higher for smaller firms.

An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit.

Underwriting

If insurance companies are correct in their​ suspicion, it will increase the price of insurance.

increase

Decades​ ago, many bank records were written by hand in ledgers. At the​ time, banks achieved little economies of scale as the amount of labor required to maintain such records was the same for every​ transaction, regardless of the size of the bank. The shift to keeping all records on computers has increased the opportunities to achieve economies of scale by replacing labor costs with technology costs.

little, the same, regardless, increased, labor, technology

An article in the Wall Street Journal discussed the fact that the Chinese government often intervenes to keep banks that make many bad loans from failing. The result was​ "moral hazard, or​ risk-taking based on the belief that someone else will pick up the tab if things go​ wrong." Do you agree with the​ article's definition of moral hazard in this​ context? This is an example of moral hazard because the article mentions that the government often intervenes to bail out banks making bad​ loans, therefore, banks are taking risks knowing they will not bear the entire burden when loans fail

is an example, taking risks knowing they will not bear the entire burden when loans fail

Why would the article state that it is unknown whether a fintech lender like SoFi will face a higher or lower default rate during a recession than would a bank or other conventional​ lender? Are there reasons to expect that the default rate might be​ higher? The impact of a recession on fintech lenders like SoFi is unknown since​ ________. Fintech lenders may experience higher default rates than traditional lenders because they​ ________.

it is a new industry without data on how they fair in​ recessions; are more likely to lend to individuals with little or no credit history

In early​ 2020, 72 months was the most popular loan​ term, with many borrowers taking out​ 84-month loans. What are the implications of long loan terms for the likelihood that a borrower will default on a​ loan? Why would auto finance companies have been willing to make such long​ loans? Why would people be willing to borrow for such a long​ term? The longer the car​ loan, the more likely the borrower will​ default, since longer loans result in more interest payments on the loan and a higher final payout for the car. Finance companies are willing to make such long loans because they are able to sell more cars. People who are willing to borrow for such long terms are likely to have low incomes and poor credit and value the low monthly payments that come with the longer term.

more, more interest payments on the loan and a higher, they are able to sell more cars, low incomes and poor credit

In August​ 2020, during the​ Covid-19 pandemic, an article in the Wall Street Journal discussed rising default rates on automobile​ loans: "According to the New York​ Fed, 5.1% of car loan balances were 90 or more days delinquent in the first quarter​ [of 2020], only slightly below the peak of​ 5.3% in the ​[2007-​2009] financial​ crisis." The article noted​ that: "Auto lending soared in the past decade because low interest rates and longer loan terms reduced monthly​ payments." Rising loan defaults would pose problems for auto finance companies and other firms that originate automobile loans and for investors who had bought​ asset-backed securities​ (ABS) that were made up of securitized auto loans. What is an auto finance​ company? Auto finance companies are​ ________.

nonbank financial intermediaries that raise money through sales of commercial paper and other securities and use the funds to make car loans available

What is the difference between retail and wholesale​ funding? Using deposits to finance investments is called retail funding. Another source of funds is​ short-term borrowing primarily from other financial firms. This type of financing is called wholesale funding. Investment banks rely on wholesale funding of their investments as opposed to the retail funding that Commercial banks rely on.

retail, wholesale, Investment, Commercial

In July​ 2010, Congress was considering having the federal government set up a​ "lending fund" for small banks. The U.S. Treasury would lend the funds to banks. The more of the funds the banks loaned to small​ businesses, the lower the interest rate the Treasury would charge the banks on the loans. Congressman Walt Minnick of Idaho was asked to comment on whether the bill would be helpful to small businesses. Here is part of his​ response: ​"The bank​ that's struggling to write down their commercial real estate assets is having to take a hit to​ capital, and this provides replacement capital on​ very, very favorable terms. So it deals with the left side of the balance​ sheet..." Source​: Robb​ Mandelbaum, "Can Government Help Small​ Businesses?" New York Times​, July​ 29, 2010. Would a loan from the Treasury be counted as part of a​ bank's capital?

​No, a loan from the treasury would not be counted as bank capital.

​[Related to the Apply the​ Concept: "Did Moral Hazard Derail Investment ​Banking?"​] In a letter to the​ firm's shareholders, Jamie​ Dimon, the chair and CEO of JP Morgan​ Chase, observed:​ "There is one financial commandment that cannot be​ violated: Do not borrow short to invest long—particularly against​ illiquid, long-term​ assets." Do commercial banks borrow short term and invest the funds long​ term?

​Yes, commercial banks borrow by taking in​ short-term deposits and invest by making​ long-term loans.

Just before the​ Covid-19 pandemic began to significantly affect the Chinese​ economy, two articles in the Wall Street Journal noted problems in the Chinese banking system. One article noted that large​ "Chinese banks also prefer to make safe loans to​ large, state-owned companies instead of helping the kind of​ small, private companies that are truly in​ need." Another article noted that smaller Chinese banks were having difficulty attracting deposits and were also experiencing rising levels of debt defaults. Are these problems likely to matter for the future growth of the Chinese​ economy?

​Yes, small private businesses provide a lot of the​ jobs, innovation, and capital accumulation needed for a country to grow​ long-term. Only lending to large​ state-owned firms will limit growth.

Do investment banks borrow short term and invest the funds long​ term?

​Yes, they borrow short term by issuing commercial paper and invest long term by buying​ mortgage-backed securities.


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