Exam 2 Chpater 11, 15,16,17

An investment bank manages pool of assets for a pension fund. The firm has $232 million of assets under management and charges a fee of 65 basis points per year. How much revenue does this activity generate?

$1.508 million ($232 million * 0.65%)

. A recent IPO consisted of 650 million shares at an offer price of $8 per share. Given the standard 7% fee in the industry, how much did the firm pay to its investment bankers?

$364 million

. A mutual fund owns 10,500 shares of Bank of America stock and 500 IBM bonds. The fund has 4,400 shares outstanding and has $185,000 in liabilities. At the end of the day, each share of stock is worth $33 and each bond is worth $458. Calculate the funds' NAV (Net Asset Value), rounded to the nearest penny.

$88.75

Federal Reserve System

-has regulatory power over all nationally chartered banks -FRS regulates and examines bank holding companies as well as the banks themselves (Ex- Citigroup is the holding company of Citibank, a national bank) -19% of state-chartered banks have also chosen to become members of the FRS -primary advantage to FRS membership is direct access to federal funds wire transfer network for interbank borrowing and lending of reserves

Office of the Comptroller of the Currency (OCC)

-oldest U.S. bank regulatory agency, subagency of U.S. Treasury -charters national banks, examines them, approves/disproves merger applications, closes national banks

A term life insurance product pays $500,000 if the policyholder dies within one year. The insurance company charges a premium of $349. Assume that that the insurance company's goal is to break even. What is the likelihood that the policyholder dies during the next year?

0.0698%

Summary of trends

1. Decrease in the number of banks Decrease has largely been due to consolidation (mergers) and somewhat due to bank failures Consolidation driven in large part by deregulation of geographical restrictions on banking Interstate Banking, Interstate Branching, Intrastate Banking 2. Increase in the number of branches Summary: Fewer banks, but more branches 3. Greater concentration in the banking industry Dominated by larger banks, fewer smaller players

Strahan and Weston's Findings:

1. Large banks lend more to small businesses than small banks (in dollar terms) 52.3% of loans to small businesses come from "large" banks Takeaway: large banks are important to small business borrowers (from borrower point of view). 2. Small business loans are a larger portion of the loan portfolio for small banks than large banks 9.2% of loans were to small businesses for smallest banks, only 3.4% for largest banks -The reason is that small banks are essentially shut out of the lending market to large businesses Takeaway: small business loans are important to small banks (from bank point of view) 3. Consolidation among small banks seemed to increase lending to small businesses, while consolidation among medium and large banks had no negative effect. Takeaway: Summary: diversification benefits seem to outweigh the harm from centralization of decision making authority and organizational complexity.

How to shrink banks?

1. Limits on growth o Current restriction on mergers that result in one firm holding >10% of financial sector liabilities (but no limit on organic growth) 2. Force large banks to split into smaller banks o Undo prior mergers o Seems difficult to do in a free economy 3. Force large banks to sell non-banking assets o Separating commercial banking from investment banking activities will shrink traditional commercial banks (JP Morgan Chase, BoA). o But the unintended consequence will be to grow investment banks who will likely buy those assets (Goldman, Morgan Stanley)

Loans fall into four categories

1. Real estate, about 55%, includes both commercial and residential 2. Business, about 25%, also called commercial and industrial 3. Individual loans, about 15%, such as loans for auto purchases, credit cards, etc. 4. Other, about 5%, loans to emerging-market countries

After the FDIC takes over the bank, what are its options for the bank going forward?

1. close the bank and pay depositors, 2. run the bank itself, 3. find a buyer (most common)

. On the Liabilities side of commercial bank balance sheets, Borrowings is _____% of Total Assets.

10.4%

At Heritage Community Bank, how many accounts were there? What was the total amount in those accounts?

12,000 deposits, totaling > $200 million

In which year was the first mutual fund established?

1924

. A firm wants to borrow $56,000 from a bank. The funds will be returned in one year, with interest, if the project is successful (97% chance). If the project is not successful (3% chance), the bank gets nothing. Assume that the bank's goal is to breakeven. What interest rate should the bank charge?

3.09%

An auto insurance company provides the following financial information. Calculate the amount of loss adjustment expenses. Premiums written: $126 M Losses: $87 M Loss Adjustment Expenses: $?M Operating Expenses: $36 M Dividends Paid: $4 M Investment Profit: $8 M Operating Ratio: 103% A. $10.78 B. $11.74 C. $24.58 D. $7.28

A. $10.78

A mutual fund has $40 million worth of stock, $30 million worth of bonds, $2 million of debt (liabilities), and 17 million shares outstanding. Investors sell 1 million shares back to the mutual fund. The fund manager must buy back the shares and give investors cash equal to the NAV times the number of shares owned. In order to pay investors, the fund manager chooses to borrow (increasing debt) rather than sell stocks or bonds. The next day, the stocks are worth $42 million and the bonds are worth $27 million. Calculate the fund's NAV after these transactions. A. $3.94 B. $4.00 C. $3.72 D. $4.31

A. $3.94

You invest $2 million into a hedge fund that charges a 2% asset management fee (calculated based on the average value of the fund) and a performance fee of 20% of profits. The fund has a raw return of 8%. How much do you pay the fund manager (asset management fee + performance fee)? A. $73,600 B. $87,800 C. $26,500 D. $43,200

A. $73,600

Suppose that a bank makes a 30 year fixed-rate mortgage at 7.5%. The bank pays depositors 2.5% interest. Which of the following scenarios will harm the bank the most? A. All interest rates rise by 2.0 percentage points, homeowners do not refinance B. All interest rates fall by 0.5 percentage points, homeowners do not refinance C. All interest rates fall by 2.0 percentage points, homeowners refinance D. All interest rates rise by 1.0 percentage points, homeowners refinance

A. All interest rates rise by 2.0 percentage points, homeowners do not refinance

To protect the U.S. financial system from systemic risk, some have suggested shrinking large institutions. Which of the following is not one of the ways that have been proposed to shrink banks? A. Convert all investment banks to commercial banks B. Impose limits on growth, such as limits on mergers and acquisitions C. Force large banks to split into smaller banks D. Force large banks to sell non-banking assets

A. Convert all investment banks to commercial banks

Palatine Bank is a state-chartered commercial bank headquartered in South Carolina. The bank is not a member of the Federal Reserve System. Which regulators oversee this bank? I. Federal Deposit Insurance Corporation (FDIC) II. Office of the Comptroller of the Currency (OCC) III. Federal Reserve System IV. Office of the Commissioner of Banking in South Carolina (state authority) A. I. and IV. B. IV. and III. C. I. and II. D. IV. only

A. I. and IV.

. A firm wants to borrow $213,000 from a bank. The funds will be returned in one year, with interest, if the project is successful. If the project is not successful, the bank gets nothing. Assume that the bank's goal is to breakeven. Calculate the dollars of interest and the interest rate the bank should charge the firm if there is a 60% chance of success. A. The bank should charge interest of $142,000, for an interest rate of 66.7% B. The bank should charge interest of $319,500, for an interest rate of 150.0% C. The bank should charge interest of $27,690, for an interest rate of 13.0% D. The bank should charge interest of $14,217, for an interest rate of 6.7%

A. The bank should charge interest of $142,000, for an interest rate of 66.7%

. An insurance company has an operating ratio of 98%. Beginning next year, the insurance company expects to substantially increase the amount of dividends paid out. Which of the following additional changes, when combined with an increase in dividends, will result in an increase to the operating ratio? A. The company's investments become less profitable. B. The company pays out less in claims to policyholders. C. The company increases the profitability of its investments. D. The company increases efficiency at its corporate headquarters to reduce expenses.

A. The company's investments become less profitable.

Akamai Technologies issued 9 million shares of stock for the first time (IPO) at an offer price of $26. The first day closing price was $145. Which is not a potential explanation for the large increase in price from the offer to the first close? A. The firm accurately priced the offering in order to raise as much money as possible from new investors. B. The owners of the firm were not upset about leaving over $1 billion "on the table" because their personal wealth dramatically increased. C. New investors received a large reward in return for providing information to help price the firm during the book-building phase of the IPO process. D. Investment bankers may have intentionally set a low offer price in order to allocate shares of this "hot" IPO to favored clients.

A. The firm accurately priced the offering in order to raise as much money as possible from new investors.

Which Key Activity of security firms/investment banks typically occurs first in the life cycle of a firm? A. Venture Capital B. Investment Banking C. Mergers and Acquisitions D. Investing

A. Venture Capital

Key point (to connect to Financial Crisis)

As long as prices are set correctly, there is no problem. But what if we mis-judged the factors used to set prices? Then, we could see defaults on AAA rated bonds greater than the expected rate, a reduction in bond prices, and damage to institutions' and investors' portfolios.

An investment bank manages a pool of assets for university endowments. The firm has $150 million of assets under management and charges a fee of 75 basis points per year. How much revenue does this activity generate? A. $2.785 million B. $1.125 million C. $4.584 million D. $7.785 million

B. $1.125 million

Snap's IPO consisted of 230 million shares at an offer price of $17 per share. Given the standard 7% fee in the industry, how much did Snap pay to its investment bankers? A. $230.0 million B. $273.7 million C. $391.1 million D. $170.4 million

B. $273.7 million

A mutual fund owns 7,000 shares of Deere stock and 350 Kraft Foods bonds. The fund has 6,000 shares outstanding and has $90,000 in liabilities. At the end of the day, each share of stock is worth $60 and each bond is worth $550. Calculate the funds' NAV (Net Asset Value), rounded to the nearest penny. A. $92.18 B. $87.08 C. $58.78 D. $43.65

B. $87.08

A mutual fund owns 1,300 shares of Navistar and 2,100 shares of Motorola. The fund has 10,500 shares outstanding. Stock prices for Day 1 and Day 2 are given below. At the end of Day 1, investors sell 2,100 shares back to the mutual fund. The fund manager must buy back the shares and give investors cash equal to the NAV times the number of shares owned. In order to pay investors, the fund manager chooses to sell shares of Navistar at the Day 1 price. Given this transaction and the Day 2 stock prices, calculate the percentage return for investors in the fund between Day 1 and Day 2. Stock Day 1 Day 2 Navistar $154 $164 Motorola $198 $196 A. -2.812% B. 0.157% C. 1.724% D. -0.253%

B. 0.157%

Which financial institution is known for paying employees a high salary, long working days, and high stress? A. Commercial Banks B. Investment Banks C. Insurance Companies D. Mutual Funds

B. Investment Banks

In Snap's IPO, the offer price was $17 per share and the first day closing price was $24.48. Facebook's IPO offer price was $38 per share, and the first closing price was $38.23. Select the incorrect statement regarding the first day of trading in IPOs. A. Snap's stock had a larger first day return than Facebook's stock did. B. Snap's investment bankers had to provide price support during the first day of trading. C. It is typical for firms to have a positive first day return (closing price > offer price) for IPOs D. Facebook had a low first day return, likely because they raised the offer price and number of shares outstanding during their book building process.

B. Snap's investment bankers had to provide price support during the first day of trading. C. It is typical for firms to have a positive first day return (closing price > offer price) for IPOs

An insurance company manager examines the following ratios for the past three years. The company does not pay dividends. What does the manager conclude? Premiums Loss Ratio LAE Ratio Combined Ratio Operating Ratio 2014 $135 M 61% 11% 101% 99% 2015 $146 M 67% 13% 110% 107% 2016 $142 M 59% 12% 121% 119% A. The company does not do a good job managing its LAE ratio. B. The company's expenses are increasing each year. C. The investments made by the company have lost money every year. D. The company paid out more dollars to claimants in 2014 than it did in 2016.

B. The company's expenses are increasing each year.

Table 15-6 shows the combined ratio after dividends for Property Casualty insurance companies over time. Suppose that insurance companies lost money on their investments in each year from 2000 to 2013. This would imply that... A. combined ratios before dividends are generally above 103%. B. operating ratios are generally above 100% C. operating ratios are generally below 99% D. loss ratios are generally above 97%

B. operating ratios are generally above 100%

Investment banks are typically responsible for ______________ while securities firms typically are active in __________________. A. capital market activities; money market activities B. primary market activities; secondary market activities C. secondary market activities; primary market activities D. capital market activities; primary market activities

B. primary market activities; secondary market activities

Charles Schwab effects trades for customers without offering investment advice or tips. As such, it can be classified as a ___________________________. A. specialized electronic trading securities firm B. specialized discount broker C. private equity firm D. regional securities firm

B. specialized discount broker

A defining characteristic of commercial banks is... A. the high use of equity, total equity is about 89% of total assets across the industry. B. the high use of leverage, total liabilities are about 89% of total assets across the industry. C. the low use of leverage, total liabilities are about 11% of total assets across the industry. D. the high use of cash, cash is about 30% of total assets across the industry.

B. the high use of leverage, total liabilities are about 89% of total assets across the industry.

What can we learn from the asset structure of the balance sheet about the risks faced by banks?

Banks face credit risk / default risk (risk that a security issuer will default on a security)

Off-Balance-Sheet Activities Benefits, costs

Benefits to banks: earn fee income, don't have to hold reserves against off-balance-sheet-assets, remove credit risk from books, manage interest rate risk Costs to banks: involve risks that can increase chance of insolvency, reduced incentives to screen loan applicants OBS can remove some risks (credit), but increase others (insolvency)

. You invest $8,000 into an index mutual fund that has an expense ratio of 0.25%, calculated based on the average value of the fund. The fund has a raw return of 6% over the first year and 10% over the second year. What is the value of your investment after two years? A. $9,875.98 B. $10,385.87 C. $9,283.13 D. $8,812.27

C. $9,283.13

Which line of insurance accounts for the greatest percentage of premiums written? A. Homeowners Multiple Peril B. Commercial Multiple Peril C. Automobile Liability and Physical Damage D. Liability Insurance (other than auto)

C. Automobile Liability and Physical Damage

Select the correct statement regarding the balance sheets of life insurance and property casualty insurance companies. A. Life insurance companies' main assets are stock while property casualty insurance companies' main assets are bonds. B. Life insurance companies' assets include 25% cash while property casualty insurance companies' assets include 10% cash C. Both life insurance companies and property casualty insurance companies hold a large amount of bonds on their balance sheets. D. Reserves for losses are about 75% of both life insurance and property casualty insurance companies' liabilities

C. Both life insurance companies and property casualty insurance companies hold a large amount of bonds on their balance sheets.

Which type of life insurance policy has an expiration date? A. Whole B. Variable C. Endowment D. Universal

C. Endowment

The structure of the securities firm and investment banking industry includes "Commercial banks or financial services holding companies", "Specialized firms", "Large investment banks", as well as other categories. What characteristics makes Lazard a "Large investment bank"? A. Focuses on domestic rather than international business B. Focuses only on IPOs rather than giving advice on mergers and trading activities C. Focus on institutional clients and operates primarily in major cities D. Focus only on secondary market activities rather than on primary market activities

C. Focus on institutional clients and operates primarily in major cities

Select the correct statement(s) regarding commercial bank balance sheets. (Note: percentages are in terms of industry assets). I. On the Asset side, loans are about 50% II. On the Asset side, investment securities are about 10% III. On the Liabilities side, borrowings are about 35% IV. On the Liabilities side, deposits are about 75% A. I. and III. B. II. and IV. C. I. and IV. D. III. only

C. I. and IV.

You have $1 million to invest into either an index fund or a hedge fund. The index fund has an expense ratio of 0.39% (calculated based on the average value of the fund). The fund returns 7% over the next year. The hedge fund charges a 2% asset management fee (calculated based on the average value of the fund) and a performance fee of 20% of profits. Select the correct statement regarding the performance of the hedge fund and the ending values of the two investments. A. If the hedge fund earns raw returns of 8.7% or less, then the ending value of the investment in the hedge fund will be greater than that of the index fund. B. If the hedge fund earns raw returns of 9.4% or more, then the ending value of the investment in the hedge fund will be greater than that of the index fund. C. If the hedge fund earns raw returns of 10.9% or more, then the ending value of the investment in the hedge fund will be greater than that of the index fund. D. If the hedge fund earns raw returns of 12.6% or less, then the ending value of the investment in the hedge fund will be less than that of the index fund.

C. If the hedge fund earns raw returns of 10.9% or more, then the ending value of the investment in the hedge fund will be greater than that of the index fund.

Select the correct statement regarding the predictability of losses for an insurance company. A. Insurance policies are ideal products to handle high severity, high frequency losses B. High severity, low frequency losses are easier to predict than low severity, high frequency losses. C. Low severity, high frequency losses are easier to predict than high severity, low frequency losses. D. Insurance policies are ideal products to handle low severity, low frequency losses

C. Low severity, high frequency losses are easier to predict than high severity, low frequency losses.

15. _______________ is/are one example of how commercial banks manage interest rate risk. A. Cash reserves B. Screening of applicants C. Off-balance sheet activities D. Diversification

C. Off-balance sheet activities

What does the academic literature (e.g., Carhart's 1997 paper) say about the performance of fund managers? A. The best mutual fund managers in a given year continue to outperform other managers over a long period of time. B. Hedge fund managers tend to outperform active mutual fund managers over a long period of time. C. The best mutual fund managers in a given year do not continue to outperform other managers over a long period of time. D. Passively managed funds are a good investment for non-sophisticated investors, but sophisticated investors should choose actively managed funds.

C. The best mutual fund managers in a given year do not continue to outperform other managers over a long period of time.

. Brioso, a restaurant, agrees to maintain a minimum debt service ratio of 1.35 to 1.0 in order to obtain a commercial bank loan. This is an example of ... A. collateral. B. an off-balance sheet activity. C. a covenant. D. how commercial banks manage liquidity risk.

C. a covenant.

How do insurance companies deal with the moral hazard problem? A. establish different pools of the population based on health characteristics B. utilize off-balance sheet activities C. include deductibles in insurance policies D. increase information asymmetry

C. include deductibles in insurance policies

Which of the following is not a characteristic of hedge funds? A. restricted to a set number of investors B. the fund's focus can change over time C. low ownership of fund managers D. investors cannot liquidate their holdings easily

C. low ownership of fund managers

. A financial institution earns its fees on an activity based on the "bid ask spread" between securities bought and sold. This activity can be classified as ________________. A. investing B. trading C. market making D. venture capital

C. market making

What does the term "dual banking system" refer to? A. the fact the most banks are regulated by the Federal Reserve and the Office of the Comptroller of the Currency B. legislation that forces banks to obtain both a state-level and a national charter C. the coexistence of both nationally and state-chartered banks D. the coexistence of both commercial banks and investment banks

C. the coexistence of both nationally and state-chartered banks

Suppose a bank makes a fixed rate loan at 5% and the bank pays 1% interest to depositors. Calculate Net Spread What happens if interest rates rise 2%? What happens if interest rates fall 2%?

Calculate Net Spread : (5%-1%)=4% Thus, the bank's net interest spread is 4% What happens if interest rates rise 2%? Loan still gives bank 5% (no refinancing), but bank must pay 3% on deposits. Spread is 2%. What happens if interest rates fall 2%? Borrowers refinance to 3%, bank pays 0.01% on deposits. Spread is 3%.

Balance Sheet Asset Percentages

Cash assets 11.8% Investment Securities 26.7% Total loans 53.7% other assets 7.8%

Threat to loans (assets):

Competition from commercial paper, and to some extent bond markets for loans

Threat to deposits (liabilities):

Competition from money market mutual funds

Strahan and Weston's Setup:

Consolidation in banking can potentially harm lending to small businesses because: 1. Centralization of decision making authority 2. More complexity in the organization may make it more difficult to lend to small businesses However, consolidation can potentially benefit small businesses because: 1. Larger banks are more diversified- can possibly take on riskier small business loans

You graduate from Clemson and get a great job in the insurance industry. You set up a savings account that puts $480 each month into a Fidelity mutual fund. The fund's NAV is $12 for the first deposit, $8 for the second deposit, and $10 for the third deposit. The following day, the NAV is $11 and you decide to withdraw your money. What is the value of your holdings (ignore fees and transaction costs)? A. $1,738 B. $693 C. $1,320 D. $1,628

D. $1,628 The simplest way to solve this problem is to track the number of shares in the fund. After the first deposit, you own 40 fund shares ($480/$12). The next deposits give 60 and 48 fund shares. Therefore, you own 40+60+48=148 fund shares at withdrawal. 148 shares * $11 = $1,628

Professor Greene buys a term life insurance product that pays $500,000 if he dies within one year. The insurance company charges a premium of $675. Assume that that the insurance company's goal is to break even. What is the likelihood that he dies during the next year? A. 0.587% B. 0.785% C. 0.098% D. 0.135%

D. 0.135%

. Large financial institutions must produce "Living Wills", which explain how to wind down the institution in the event of a crisis. A recent review of the living wills of 8 large banks revealed: A. 3 banks were given passing grades while 5 were given failing or partially failing grades B. 7 banks were given passing grades while 1 (Goldman Sachs) was given a failing grade C. All 8 banks were given passing grades D. 4 banks were given partially failing grades while 4 banks passed

D. 4 banks were given partially failing grades while 4 banks passed

Select the incorrect statement regarding the history of mutual funds. A. The first mutual fund was established in the 1920s. B. In the year 2001, there were about 8,300 funds in existence, with about $7 billion in net assets. C. In the year 1990, there were about 3,000 funds in existence, with about $1 billion in net assets. D. Equity mutual funds become popular as an alternative to commercial bank deposits in the 1970s.

D. Equity mutual funds become popular as an alternative to commercial bank deposits in the 1970s.

39. A mutual fund owns 5,000 shares of Caterpillar, Inc. and 10,000 shares of Archer Daniels Midland. The fund has 8,500 shares outstanding. Stock prices for Day 1 and Day 2 are given below. At the end of Day 1, investors buy 700 shares of the fund at the NAV. The manager chooses to hold the new funds in cash rather than invest in stock. How will the NAV change between Day 1 and Day 2? Stock Day 1 Day 2 Caterpillar $90 $?? Archer Daniels Midland $45 $?? A. If Caterpillar's stock price decreases and Archer Daniels Midland's stock price increases, then the NAV at Day 2 will be the same as the NAV at Day 1. B. If Archer Daniels Midland's stock price increases and Caterpillar's stock price decreases, then the NAV at Day 2 will be greater than the NAV at Day 1. C. If Archer Daniels Midland's stock price increases and Caterpillar's stock price remains the same, then the NAV at Day 2 will be less than the NAV at Day 1. D. If Caterpillar's stock price increases and Archer Daniels Midland's stock price remains the same, then the NAV at Day 2 will be greater than the NAV at Day 1.

D. If Caterpillar's stock price increases and Archer Daniels Midland's stock price remains the same, then the NAV at Day 2 will be greater than the NAV at Day 1.

Bank of America's business segment Global Wealth & Investment Management (GWIM) can be described as follows: Client assets managed under advisory and/or discretion of GWIM are assets under management (AUM) and are typically held in diversified portfolios. Fees earned on long-term AUM are calculated as a percentage of total AUM. The asset management fees charged to clients are dependent on various factors, but generally range from 50 to 150 bps on their total AUM. Provides a high-touch client experience through a network of financial advisors focused on clients with over $250,000 in total investable assets. Provides tailored solutions to meet our clients' needs through a full set of investment management, brokerage, commercial banking and retirement products, and cash management. Which "Key Activity" of securities firms and investment banks does GWIM not perform? A. Trading B. Investing C. Cash Management D. Investment Banking

D. Investment Banking

20. Consolidation among small commercial banks is controversial, however there are some potential benefits to consolidation. What is one reason that consolidation in commercial banking can benefit small business borrowers? A. larger banks centralize decision making authority B. larger banks are more complex C. small business loans are a smaller portion of the loan portfolio for large banks compared to small banks D. larger banks are more diversified

D. larger banks are more diversified

A key difference between securities firms/investment banks and most other types of financial institutions is that _____________________________________________________________. A. they tend to have more cash on their balance sheets than most other financial institutions B. they generate income from off-balance sheet activities C. they transform securities unlike other institutions such as commercial banks D. they do not transform the securities, rather they serve as brokers/middlemen

D. they do not transform the securities, rather they serve as brokers/middlemen

State authorities

Example: Office of the Commissioner of Banking (S.C.) -perform functions similar to OCC for state chartered banks

List the three regulators of Wells Fargo, a nationally chartered bank. (Abbreviations are acceptable)

FDIC, OCC, Federal Reserve

On which day of the week do bank closures typically occur?

Friday, after close of business (over the weekend)

Current plan to deal with large banks:

Living Wills

Liquidity: (circle one) Liabilities are more / less liquid than assets. Maturity: (circle one) Liabilities have shorter / longer maturity than assets.

More Shorter

Balance Sheet Characteristic: Large amount of loans as assets Name of Risk: Managing the Risk:

Name of Risk: Credit Risk / Default Risk: risk that a security issuer or borrower will default on a security or loan Managing the Risk: Diversify, Screen, Monitor, Collateral, OBS, Covenants

Balance Sheet Characteristic: Little equity Name of Risk Managing the Risk

Name of Risk: Insolvency Risk: risk that a financial institution will be unable to satisfy its debts (bankruptcy risk). Managing the Risk: Raise adequate capital

Balance Sheet Characteristic: Liabilities have shorter maturity than assets Name of Risk Managing the Risk

Name of Risk: Interest Rate Risk: risk incurred by a FI when the maturity of its assets and liabilities are mismatched and interest rates are volatile. Managing the Risk: Off-balance sheet activities

Balance Sheet Characteristic: Liabilities are more liquid than assets Name of Risk: Managing the Risk:

Name of Risk: Liquidity Risk: risk that arises when a FI's liability holders such as depositors demand cash for the financial claims they hold with the financial institution. Managing the Risk: Reserves, Investment Securities (safe, liquid)

How many regulators? Which regulators?

Nationally Chartered Banks 3 regulators: FDIC, OCC, Fed State Chartered Banks 2 or 3 regulators: FDIC, State Auth, Fed (if member)

Has any depositor every lost money on an insured deposit?

No

When the FDIC pays depositors and/or pays the salaries of bank employees, does it use tax payer money?

No. The funds come from FDIC reserves, which are collected from banks paying insurance premiums. The FDIC can use US Treasury money if needed, it is backed by the full faith and credit of the US government.

Savings and Loans (S&Ls) Crisis Pre-Crisis Crisis Post-Crisis

Pre-Crisis (1970s): over 3,000 S&Ls, holding half of all mortgages, Thrifts controlled >20% of FI assets Crisis (late 1970s/1980s): high, volatile interest rates as Fed chair Volcker was fighting inflation The crux of the problem was that S&Ls had fixed rate mortgages that were long-term and the cost of their short-term funds began to rise substantially. During the crisis, 1,248 S&Ls failed, while others committed fraud to try to survive, leading over 800 bankers to be jailed for their crimes. Post-Crisis: about 1,000 institutions, Thrift institutions control less than 5% of the assets of all FIs

Who regulates life insurance companies?

State authorities

Mortgage-backed securities How to create a MBS?

Step 1: Bank loans money to individual to buy a home (this step is repeated until there is a large pool of loans) Step 2: Loans are sold and pooled together Often a gov't agency (Fannie Mae) or investment bank pools and repackages the loans After selling the loan, the bank has cleared the credit risk from its books Step 3: Bonds are issued, with the coupon payments tied to mortgage repayments Tranches are developed to correspond to the "safest" and "riskiest" bonds The "riskiest" bonds will take the first hit if defaults occur

Four months prior to closure, what was Heritage ordered to do? Who ordered Heritage to do this?

Stop risky lending, raise cash FDIC and State of Illinois

Shadow banking:

activities of nonbank firms that perform banking services Example: Money market mutual funds

Regional or Superregional banks

are those that engage in a complete array of wholesale commercial banking activities.

Dual banking system

coexistence of both nationally and state-chartered banks. Banks can choose to seek a national charter or state charter About 70% of assets are in national banks 19% of institutions are chartered as national banks. Nationally chartered banks tend to be more heavily regulated than state chartered banks

When did money market mutual funds become popular as an alternative to commercial bank deposits? (which decade)

in the 1970s

Similarities of commercial banks and shadow banks:

intermediates the flow of funds between net savers and net borrowers

Wholesale banking

is commercial-oriented banking, such as providing commercial and industrial loans funded with purchased funds.

Retail banking

is consumer-oriented, such as providing residential and consumer loans and accepting smaller deposits.

A firm wants to borrow $50,000 from a bank. The funds will be returned in one year, with interest, if the project is successful. The probability of success is "p". If the project is not successful, the bank gets nothing. Assume that the bank's goal is to breakeven. That is, the bank needs to earn $50,000 in expectation from issuing the loan. Then, the bank's problem is to charge the correct amount of interest, $X, to breakeven. Calculate the dollars of interest and the interest rate the bank should charge the firm under the following scenarios:

p = 99% p = 95% p = 90% p = 99% r = 1.01% $X = $505.05 p = 95% r = 5.26% $X= $2,631.58 p = 90% r = 11.11% $X = $5,555.56 First, list the possible outcomes: 1. The firm is "successful" and the $50,000 plus $X in interest is paid to the bank. This occurs with probability (p). 2. The firm "fails" and the bank gets nothing. This occurs with probability (1-p). Second, set up the bank's problem. Expected payoff = p*($50,000 + $X) + (1-p)*(0) This number must equal $50,000 Note: from the formula -> $50,000 = p*($50,000 + $X) 1 / p = ($50,000 + $X) / $50,000 = 1 + r Relate back to TVM As p increases, success is more likely, and r decreases Third, given p, solve for $X. If p=95%, then the bank's expected payoff is $526.32 and the rate is 5.26%

Money center banks

rely heavily on nondeposit or borrowed sources of funds.

Community banks

specialize in retail or consumer banking

E*Trade is a platform for customers to trade without the use of a broker. It is classified as a ________ ____________________ securities firm.

specialized electronic trading

Balance Sheet Liabities and Equit Percentages

total deposits 76.1% borrowings 10.4% other 2.2% total Liabilities 88.7% of assets total equity 11.3% of assets

off-balance-sheet-asset (liability):

when an event occurs, this item moves onto the asset (liability) side of the balance sheet or income (an expense) is realized on the income statement Examples: derivative transactions (futures, forwards, options, swaps), issuing guarantees such as letters of credit, and other fee-related activities.

Banks are subject to "stress tests"

which analyze bank solvency for a wide range of economic conditions -Worst case: unemployment=12.1%, stock market decline=50%, housing prices drop=20% -Depending on the results of the stress tests, banks may need to raise more equity capital.

Differences between commercial banks and shadow banks:

· credit intermediation is performed by multiple shadow banks (rather than just a single commercial bank) · shadow banks face much less regulation than commercial banks shadow banks can offer services for lower costs, and can offer credit where banks cannot

Benefits to having large banks:

· from Strahan and Weston Article · lower costs for borrowers · convenience

Costs to having large banks:

· systemic risk (Financial Crisis) o 4 of top 10 banks (40%) needed help or failed, while only 6% of small banks failed · moral hazard of "too big to fail" o may take on more risk, since bailout is likely · increased lobbying power · poor customer service, relative to smaller banks · loss of jobs from consolidation