econ 310 chapter 12
What changes were made to Section 13(3) of the Federal Reserve Act?
The Fed was no longer permitted to make loans to individual companies were no longer allowed.
Which of the following is a reason that the Federal reserve failed to intervene to stabilize the banking system in the early 1930s?
The fed wanted to purge speculative excess, believing that it was necessary for the price level to fall and weak banks and weak firms to fail before a recovery could begin
negotiable order of withdraw (NOW) account
looked like checks and treated like checks -were effectively interest-paying checking accounts
The consequences of losing investor confidence will most likely result in a _____ credit rating and _____ interest costs.
lower; higher
in the absence of deposit insurance, the stability of a bank depends on
the confidence of its depositors
How is being a lender of last resort connected to the too-big-to-fail policy?
-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. -The too-big-to-fail policy and the lender of last resort have to provide liquidity to banks during bank panics.
negotiable CDs
-time deposits w fixed maturity of ex. 6 months -had values of at least $100,000 so were not subject to regulation Q interest rate ceilings -could be bought and sold together so provided competition to commercial paper
pattern of response to a crisis
1) a crisis in the financial system occurs 2) the government responds to the crisis by adopting new regulations 3) financial firms respond to the new regulations 4) government regulators adapt policies as financial firms try to evade regulation
government 2 approaches to avoid bank panics
1) central bank can act as lender of last resort 2) government can insure deposits
sovereign debt crises result from either of 2 circumstances
1) chronic government budget deficits that eventually result in the interest payments required on government bonds taking up an unsustainably large fraction of government spending 2) a severe recession that increases government spending and reduces tax revenues, resulting in soaring budget deficits
several factors increased severity of downturn before great depression:
1) decrease in stock prices --> reducing household wealth and uncertainty --> less spending on durable goods 2) smoot-hawley tariff act which led foreign governments to increase tariffs in retaliation --> decrease US exports 3) decline in spending on new houses bc of slowdown of population growth due to immigration restrictions
regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost to the FDIC of bank failures in 2 ways:
1) increasing ability of the bank to remain solvent after incurring losses 2) increasing the amount the bank's owners will lose in the event of the bank's failure, thereby giving the owners greater incentive to avoid risky investments
why fed did not intervene to stabilize the banking system during the great depression:
1) no one was in charge 2) the fed was reluctant to rescue insolvent banks 3) the fed failed to understand the difference b/w nominal and real interest rate 4) the fed wanted to "purge speculative excess"
to circumvent regulation Q, banks developed 4 new financial instruments for savers:
1. negotiable certificates of deposits (CDs), 2.negotiable order of withdrawal (NOW) accounts 3. automatic transfer system (ATS) accounts 4. money market deposit accounts (MMDAs)
contagion of fear
A bank run that is fueled by fear of bank failure.
What are the two methods that governments typically use to avoid bank panics? (Check all that apply.)
A central bank can act as a lender of last resort. The government can insure deposits.
What are the two main ways in which the government can keep one bank failure from leading to a bank panic?
A central bank can act as a lender of last resort, and the government can insure deposits.
financial crisis
A situation in which serious problems in the financial system result in a significant disruption in the flow of funds from lenders to borrowers. -typically leads to economic recession as households cut back on spending
Regulation Q
Administered by fed -placed ceilings on interest rates banks could pay on time and savings deposits and prohibited banks from paying interest on demand deposits (which were then the only form of checkable deposits) -intended to maintain banks' profitability spread b/w interest rates banks received on loans and interest rates they paid on deposits -forced banks to innovate in order to survive
How does deposit insurance encourage banks to take on too much risk?
Banks can make riskier investments without worrying about deposit withdrawals because the government has insured depositors against losses.
Why was the decision by the Fed to orchestrate the purchase of Bear Stearns so controversial?
Because the Fed intervened by brokering a guaranteed deal with JP Morgan. Because, according to some economists, the action increased moral hazard in the financial system. Because Bear Stearns is an investment bank, as opposed to a commercial bank, and, as such, policymakers faced unexpected challenges.
All of the following are reasons why one bank failure might lead to many bank failures
Depositors of other banks may become concerned that their banks might also have problems. Banks will be forced to sell loans and securities to raise money to pay off depositors. Depositors have an incentive to withdraw their money from their banks to avoid losing it should their banks be forced to close.
Financial crisis typically results in a recession for all of the following reasons
Firms struggle to fund long-term investments in new factories, machinery, and equipment. The flow of funds from lenders to borrowers becomes disrupted. Firms have trouble financing day-to-day activities. Households borrow less to finance purchases of goods and services.
Why would 100% reserve requirements on checking accounts eliminate the need for FDIC insurance?
If a bank failed, it would have 100% of the deposits on hand, so there would be no possibility of anyone losing their deposits. Therefore, there would be no need for FDIC insurance
What did bank depositors have to fear in the early 1930s?
If a bank failed, then depositors would potentially lose all their money.
Why did Treasury Secretary Paulson want Bear Stearns to sell for such a low price?
In order to prevent systemic risk. To punish the firm's owners and managers for bad decisions, without letting them go bankrupt.
What is a lender of last resort?
Is an entity that seeks to stop a bank failure from turning into a bank panic by making sure solvent institutions can meet their depositors' withdrawal demands. The Federal Reserve acts as a lender of last resort. A lender of last resort is an institution that serves as an ultimate source of credit to which banks can turn during a panic.
was deflation during the early 1930s good or bad for firms
It was bad because it effectively raised interest rates.
Which of the following is true regarding the bursting of the housing bubble in the U.S. economy?
Once housing prices started to fall, homeowners realized their mistake and began defaulting on their mortgages. Many financial assets were based on the bet that housing prices would only increase. Once housing prices started to fall, the banks that owned mortgaged-backed securities experienced losses.
"sustained run"? Why can't a bank survive a sustained run?
Simultaneous withdrawals by a bank's depositors result in the bank closing.
Why have some European countries been suffering from a sovereign debt crisis?
The 2007-2009 recession reduced tax revenues to the government. They have had chronic government budget deficits. The 2007-2009 recession led to increased government spending.
Why is the issue of whether Bear Stearns and AIG held sufficient collateral important legally?
The Fed can only make loans to firms provided that the loan being made is secured by adequate collateral.
What does Bernanke mean by "solvent under normal conditions" double quote?
The value of a bank's assets is more than the value of its liabilities, so its net worth, or capital, is positive.
pegging
The government's or central bank's attempt to tie the value of the domestic currency to the value of a foreign currency, or to gold
lender of last resort
a central bank that acts as the ultimate source of credit to the banking system, making loans to solvent banks against their good, but illiquid, loans
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
A currency crises can occur under a pegged currency when _______.
an excess supply of the domestic currency forces the central bank to use foreign reserves to purchase the domestic currency the pegged exchange rate ends up substantially above the equilibrium rate 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
basel accord
an international agreement about bank capital requirements -categories used to calculate a measure of bank's risk-adjusted assets by multiplying the dollar value of each asset by a risk-adjustment factor -tier 1 capital - shareholders equity/bank capital -tier 2 capital - bank's loan loss reserves, subordinated debt, other bank balance sheet items
What role did the bank panics of the early 1930s play in explaining the severity of the Great Depression?
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
feedback loop during a bank panic
bank runs can cause good and bad banks to fail --> costly failures bc they reduce availability of credit to households and firms. Once a panic starts, falling income, employment, and asset prices can cause more bank failures. -This feedback loop can cause a panic to continue unless the government intervenes
bank regulators determine bank's capital adequacy by calculating 2 ratios:
bank's tier 1 capital relative to its risk-adjusted assets and the bank's total capital (tier 1 + tier 2) relative to its risk-adjusted assets --> on basis of the 2 capital ratios, banks are assigned to 5 risk categories
underlying problem in contagion and bank panic
banks build their loan portfolios on the basis of private info about borrowers, information banks gather to determine which loans to make -info is private --> depositors cant review it --> little basis for assessing quality of their banks' portfolios and distinguishing solvent from insolvent banks
sovereign debt crisis
bonds issues by a government -occurs when a country has difficulty making interest or principal payments on its bonds or when investors expect a country to have this difficulty in the future -if it leads to actual default, government may for a period of time be unable to issue bonds --> rely exclusively on tax revenues to pay for government spending. -even if government avoids default it will probably have to pay much higher interest rates when it issues bonds -resulting decreases in other government spending or increases in taxes can push the economy into a recession
Sovereign debt refers to ______ issued by a government. A sovereign debt crisis occurs when there is a fear that a government ________
bonds; cannot make interest or principal payments
CAMELS rating
capital adequacy asset quality management earnings liquidity sensitivity to market risk
poor camels rating can lead to
cease-and-desist order being issues to a bank to change its behavior --> mimics way private markets approach moral hazard by inserting restrictive covenants in financial contracts
disintermediation
exit of savers and borrowers from banks to financial markets -costs banks lost revenue b/c it means they do not have savers' funds to lend
The debt-deflation process is the process of ______ that can increase the severity of an economic downturn. The debt-deflation process contributed to the severity of the Great Depression by _____ the real interest rate and the real value of debts, which ________ the burden on borrowers and led to _____ loan defaults.
falling asset prices; increasing; increased; more
Federal Deposit Insurance Corporation (FDIC)
federal government agency established by congress in 1934 to insure deposits in commercial banks -ended era of commercial bank panics in the US
What policy actions did the Treasury take during the financial crisis?
insured money market mutual fund deposits
All of the following are reasons why deflation might not be good for consumers
it causes higher interest rates it causes nominal wage cuts it causes a higher burden of debt ration
automatic transfer system (ATS) accounts
means of helping large depositors avoid interest rate ceilings -effectively pay interest on checking accounts by "sweeping" a customer's checking account balance at the end of the day into an interest-paying overnight repurchase agreement
Does a bank have to be insolvent to experience a run?
no
in "lending into continuing runs" the fed ____ additional ______ from banks in order to avoid ______ longer-term assets at a ______, further ______ investor confidence
provided; capital; selling; loss; undermining;
All of the following might be reasons why the Fed did not lend to Lehman Brothers in the days before its bankruptcy, except:
the failure of Lehman Brothers would have little impact on the economy.
contagion
the process by which a run on one bank spreads to other banks resulting in a bank panic
bank run
the process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close
debt-deflation process
the process first identified by Irving Fisher in which a cycle of falling asset prices and falling prices of goods and services can increase the severity of an economic downturn
insolvent
the situation for a bank or other firm of having a negative net worth because the firm's assets have less value than its liabilities -may be unable to meet its obligations to pay off its depositors
bank panic
the situation in which many banks simultaneously experience runs -feeds on self-fulfilling prophecy: if depositors believe that their banks are in trouble, the banks are in trouble -can lead to declines in production and employment, so can cause recession or make existing one worse.
Why did Congress with the Dodd-Frank Act decide to require large financial firms to have living wills?
to give regulators a clearer understanding of a bank's operations.
