ECON 330 Money & Banking: Test 2

If a bank needs to raise the amount of capital relative to assets, a bank manager might choose to

Shrink the size of the bank

Monetary Base Formula

MB=C+R

Which of the following are primary concerns of the bank manager?

Maintaining sufficient reserves to minimize the cost to the bank of deposit outflows.

If a bank has $10 million of checkable deposits, a required reserve ratio of 10 percent, and it holds $2 million in reserves, then it will not have enough reserves to support a deposit outflow of

$1.2 million

If the required reserve ratio is 10 percent, currency in circulation is $40 billion, checkable deposits are $80 billion, and excess reserves total $0.8 billion, then the money supply is _________

$120 billion

How can a bank meet its reserve requirement at the end of the day?

-Borrow from other banks (federal funds market) -Sell securities (treasury securities) -Borrow from the Federal Reserve (discount loan) -Reduce its loan balance (sell loans: securitization, call-in loans: bad option) -Holding excess reserves is the banks' insurance against having to get reserves elsewhere

Types of liabilities on a bank's balance sheet

-Checkable deposits (demand deposits, negotiable orders of withdrawal, money market deposit accounts) -Nontransaction deposits (savings accounts, time deposits) -Borrowings (discount loans, borrowings from other banks in the federal funds market) -Bank Capital (not actually a liability, a source of funds)

What are the FDIC's rescue methods?

-Payoff method: if a bank fails deposits are insured up to the $250,000 limit -Purchase and assumption method: reorganizes the bank usually through a merger or buyout, all deposits are insured even over the limit

What are the types of banking regulation?

-Restrictions on Asset Holdings -Capital Requirements/Restrictions -Operating Restrictions (Chartering and Examination) -Assessment of Risk Management -Disclosure Requirements -Consumer Protection -Restrictions on Competition

How do banks manage credit risk from asymmetric information?

-Screening and monitoring: credit score and background information -Specializing in loans to certain groups: lots of loans to one industry or location -Restrictive covenants: helps maintain the value of the collateral -Long-term customer relationships -Loan commitments: stand ready to loan o a corporation at a specified rate -Collateral and Compensating Balances: keep watch on your checking account -Credit rationing: lower loan amounts or higher interest rates

What is the main concern of asset management?

-Seek the highest possible returns on loans and securities -Reduce risk -Maintain adequate liquidity

Return on Equity (ROE) equation

Measures how well the shareholders or owners are doing on their equity ROE=net profit after taxes/equity captial

Types of assets on a bank's balance sheet

-Total reserves (required reserves, excess reserves) -Cash items in process of collection -Securities -Loans (commercial & industrial, real estate, consumer, loans to other banks)

How many Federal Reserve Banks are there?

12 (SD is in 9, NE in 10)

Who serves on the Federal Open Market Committee?

12 members: 7 Governors President of the New York Fed 4 other Fed presidents (rotates)

What is the length of term for the Federal Reserve Board of Governors?

14 years plus the part of another term. One term begins every two years.

When was the Federal Reserve System created?

1913

How many members are on the Federal Reserve Board of Governors?

7 members who are appointed by the President and confirmed by the Senate

Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, eight million dollars on deposit with the Federal Reserve, and one million dollars in required reserves. Given this information, we can say First National Bank has _______ million dollars in excess reserves

9

McFadden Act of 1927

A commercial banking structure with many small banks Banks could not branch across state lines and all national banks had to conform to the branching regulations in the state of their location (why wells fargo is located in sd) This allowed small banks to stay profitable because big banks couldn't branch nearby In response the industry created bank holding companies and ATMs

What is the Federal Open Market Committee?

A committee that determines monetary policy by giving directives to the open market trading desk. Meet 8 times per year

Return on Assets (ROA) equation

A measure of the profitability of a bank ROA=net profit after taxes/assets

What are the moral hazard and adverse selection problems of the FDIC?

Adverse selection happens when depositors can't tell good banks from bad. Also happens when crooks and risk-takers want to charter banks Government safety net creates moral hazard as they provide incentives for banks to take too much risk.

Overview of Chartering and Examination

All commercial banks must have a charter Banks are subject to on-site examination Banks are monitored on how well they are managing risk

Describe how the housing price bubble happened and why that was a problem.

An increase in liquidity from cash flows surging to the U.S. (large capital inflows from China and India) The development of subprime mortgage market fueled housing demand and housing prices: this increased the pool of people eligible for mortgages, raising demand for houses and raising prices

What happens to the money multiplier when the currency ratio changes? Why?

An increase in the currency ratio decreases the money multiplier because of a decrease in deposit expansion

What happens to the money multiplier when the excess reserve ratio changes? Why?

An increase in the excess reserve ratio decreases the money multiplier because banks are holding more excess reserves and not making loans

What happens to the monetary base during open market operations?

An open market purchase always increases the monetary base

Overview of Restrictions on Asset Holdings

Attempts to restrict financial institutions from too much risk taking Bank regulations: promote diversification, prohibit holdings of common stock Capital requirements: minimum leverage ratio (for banks), Basel accord, regulatory arbitrage

Money Supply Formula

Money Supply=money multiplier * monetary base

What is the main concern of capital adequacy management?***

Bank capital helps prevent bank failure Measure the profitability of the bank Measure how well the shareholders are doing

What would cause a change to the excess reserve ratio?

Banks holding more excess reserves

What would cause a change to the required reserve ratio?

Banks holding more excess reserves

Which of the following statements most accurately describes the task of bank asset management?

Banks seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity.

Why were financial innovations in the mortgage market during the crisis a problem?

Banks were lending to riskier borrowers Banks were selling the MBS to gain funding for more mortgaes

Macro-prudential vs. micro-prudential

Before financial crisis, regulatory authorities engaged in micro-prudential supervision: focuses on safety of individual financial institutions after the crisis, macro-prudential supervision was clearly needed: focusing on the safety of institutions in aggregate

Pros of nationwide banking

By diversifying in multiple states, banks will reduce the overall loan risk Consumers will have increased access to their funds Nationwide banks can take more advantage of economies of scale and scope

A bank with insufficient reserves can increase its reserves by

Calling in loans

Overview of Capital Restrictions

Capital: the difference between bank assets and liabilities banks are restricted on asset types and the amount of capital they have Leverage ratio

Open market operations

Changes in the monetary base open market purchase: a purchase of government bonds by the Fed open market sale: a sale of government bonds by the Fed

What are the functions of the federal reserve banks?

Clear checks and electronic payment Issue new currency and remove damaged Manage discount loans Regulate and examine national and state banks Conduct economic research

What are the new regulations put into place after the crisis?

Consumer protection Annual stress tests Resolution authority Systemic risk regulation Volcker Rule Derivatives

Glass-Steagall Act (Banking Act of 1933)

Created the FDIC: all members of the federal reserve system are required to purchase insurance, non-members could choose to purchase insurance, most did Separates banking and securities industries: prohibited commercial banks from underwriting or dealing in securities, prohibited investment banks form performing commercial banking functions Repealed in 1999

What types of liabilities does the Fed hold?

Currency in circulation (in the hands of the public, not in a bank vault) Reserves (includes all reserves at the Fed and all vault cash in banks)

Simple Deposit Multiplier Formula

Deposit multiplier = 1/r change in deposits = 1/r * change in reserves

Bank loans from the Federal Reserve are called ________ and represent a __________ source of funds.

Discount loans; source

The regulatory system that has evolved in the United States whereby banks are regulated at the state level, the national level, or both, is known as a ________ __________ system.

Dual Banking

What is a dual banking system?

Federally chartered banks operate alongside state chartered banks

Explain why new regulation was needed.

Given the size and cost of the financial crisis, there needed to be dramatic changes

The legislation that separated investment banking from commercial banking until its repeal in 1999 is known as the _________________.

Glass-Steagall Act

What types of assets does the Fed Hold?

Government securities (U.S. Treasury securities and MBS) Discount Loans

What are the two types of central bank independence?

Instrument Independence: the central bank gets to choose how monetary policy is conducted Goal independence: the central bank gets to decide why monetary policy is conducted (goals)

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

International Banking Facilities

Cons of Nationwide banking

Large, nationwide banks may be less likely to lend to businesses in small communities The increased competition will reduce the profitability of local banks Nationwide banking may produce more large banks that are more difficult to regulate

Leverage ratio

Leverage ratio=bank capital/bank assets A well capitalized bank has a leverage ratio of >5% Restrictions are imposed for banks with LR <3%

What are the four areas of bank management?

Liquidity management, asset management, liability management, capital adequacy management

Money multiplier formula

M= m*MB Money supply = money multiplier * monetary base

What type of asymmetric information problems arose during the subprime crisis?

Moral hazard problem occurred when brokers made risky loans Borrowers had little incentive to disclose information about their ability to pay (adverse selection) Commercial and investment banks had little incentives to assess the quality of securities

What is originate-to-distribute?

Moral hazard problem when brokers made risky loans

National Bank Act of 1863

National currency: banks issued their own banknotes redeemable for gold. If a bank failed, the banknotes were worthless. Office of the Comptroller of the Currency: act established a federal bank charter system. National banks extended national banknotes (currency) that were honored at all national and state banks Dual Banking system

What is the main liability management?***

No longer need to rely on demand deposits as their main source of funds. Rely on: Certificates of Deposit and the Federal Funds market

What would cause a change to the currency ratio?

People holding more cash on hand (depositors)

Who controls the federal reserve banks?

Quazi-public The district banks are owned by the private commercial banks in the geographical area Member banks buy stock in the Fed bank Not completely run by the government, but not private (or possibly the directors)

Total reserves equation

R= RR+ER Total reserves = required reserves +excess reserves

What is gap analysis?***

Rate sensitive assets-rate sensitive liabilities=Gap Gap*interest rate change=change in profits

What are the functions of the Federal Reserve Board of Governors?

Regulate bank holding companies and international banks operating in the U.S. Serve on the Federal Open Market Committee Set the reserve requirement Review the discount rate for each district Appoint the "C" directors to each district Fed

Repeal of Glass-Steagall Act

Repealed in 1999***

Types of reserves a bank can hold***

Required reserves & Excess reserves. Both can be stored as vault cash or at a federal reserve.

Overview of Disclosure Requirements

Requirements to adhere to standard accounting principles and to disclose wide range of information The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board

Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called

Return on equity

What are thrift institutions?

Savings and loan associations: chartered by the federal government or by states, most are members of federal home loan bank system (FHLBS), Deposit insurance provided by SAIF part of FDIC, Regulated by the office of thrift supervision Mutual Banks: chartered and regulated by states, deposit insurance provided by FDIC or state insurance Credit Unions: Chartered by federal government or states, tax exempt with a common bond for members, regulated by the National Credit Union Administraton (NCUA), Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)

What type of financial innovations were in the mortgage market during the crisis?

Subprime and Alt-A mortgages: lending to riskier borrowers Mortgage-backed securities: banks would sell the MBS to gain funding for more mortgages Collateralized debt obligations: SPV buys lots of assets and created multiple payment streams (tranches) with varying degrees of risk

What is the Too-Big-To-Fail Policy?

The FDIC will bail out large banks so that no depositor or creditor suffers any losses.

Which regulatory body charters national banks?

The Office of the Comptroller of the Currency

What is the main concern of liquidity management?

The bank needs to make sure that large outflows of deposits do not deplete the required reserves of the bank.

What happens to the money multiplier when the required reserve ratio changes? Why?

The money multiplier decreases because banks are making fewer loans

Why were banks in trouble during the subprime crisis?

Their balance sheets were in trouble because of mortgage write-downs and problems making payments on CDOs.

What does the Federal Open Market Committee do?

They determine monetary policy by giving directives to the open market trading desk.

What does it mean for monetary policy when the money multiplier is less than 1.00?

This is caused when banks hold more excess reserves. While the Fed does not control the multiplier, they can change it by changing the money supply and monetary base. The fed can control the nonborrowed monetary base. They change it by holding an open market share or purchase

Why was the Federal Reserve System created?

To be a lender of last resort

What is the goal of the FDIC?

To function as a government safety net.

A bank failure is less likely to occur when

a bank has more bank capital

A debit card differs from a credit card in that

a credit card is a loan while for a debit card purchase, payment is made immediately.

Factors that cause a decline in the money multiplier include:

an increase in expected deposit outflows

The primary difference between the "payoff" and the "purchase and assumption" methods of handling failed banks is

that the FDIC is more likely to use the "purchase and assumption" method when the bank is large and deemed "too-big-to-fail"

The existence of deposit insurance can increase the likelihood that depositors will need to deposit protection, as banks with deposit insurance

are likely to take on greater risks than they otherwise would

Currency ratio formula

c=C/D currency ratio=Currency in circulation/total deposits in banking system

Thrift institutions include

credit unions

Decisions by ________ about their holdings of currency and by ________ about their holdings of excess reserves affect the money supply.

depositors; banks

Excess reserve ratio formula

e=ER/D excess reserves/deposits

The National Bank Act of 1863, and subsequent amendments to it,

established the Office of the Comptroller of the Currency and a national currency.

As a result of restrictive banking regulations, the United States

has too many banks when compared to other industrialized countries

Bank consolidation will likely result in

increased competition

Benefits of nationwide banking will likely include

increased competition and increased diversification of banks' loan portfolios

If the Fed injects reserves into the banking system and they are held as excess reserves, then the monetary base ________ and the money supply _________.

increases; remains unchanged

Money multiplier other formula

m= (1+c)/(rr+e+c) money multiplier = (1+currency ratio)/(required reserves ratio+excess reserves ratio+currency ratio)

When a member of the nonbank public withdraws currency from her bank account, then the monetary base will ________, but reserves will ________

not change; increase

How could a U.S. bank engage in international banking?

operate a foreign branch overseas operate an Edge Act corporation own part of a foreign bank overseas international banking facility in the U.S.

How could a foreign bank operate in the U.S.?

operate an agency office of the foreign bank: allowed to lend and transfer funds in the U.S. but not accept deposits from domestic residents be a subsidiary of a U.S. bank operate a branch of the foreign bank

Regular bank examinations and restrictions on asset holdings help to indirectly ________ the adverse selection problem because, given fewer opportunities to take on risk, risk-prone entrepreneurs will be ______ from entering the banking industry

reduce; discouraged

When the Federal Reserve sells a government bond in the open market to a bank,

reserves in the banking system decline

Required reserve ratio

rr=RR/D required reserved/deposits

An essential characteristic of credit unions is that

they are organized for individuals with a common bond

The too-big-to-fail policy

treats large depositors of small banks inequitably when compared to depositors of large banks

The monetary base is the sum of

vault cash, deposits at the fed, and currency in circulation