Money & Banking chp. 9-10
How are they related ROA and ROE?
ROE is equal to ROA multiplied by the ratio of bank assets to bank capital.
The most important bank assets are:
Real estate loans and U.S. government/agency securities.
Wall Street Journal columnist Brett Arends offered the opinion that "as a rule of thumb, the more complex a [financial] product is, the worse the deal." Do you agree? Why would a more complex financial product be likely to be a worse deal for an investor than a simpler product?
Agree; When investors buy simpler products, they typically have more information and can make more informed choices about the products.
The FDIC stands for
Federal Deposit Insurance Corporation
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.
An article in the Wall Street Journal in 2016 referred to the past 35 years as open "the biggest bond bull market in history." What does the article mean by a bull market in bonds?
Investors were increasing their demand for bonds.
The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." 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.
What is the most important source of external funds to small- to medium-sized firms?
Loans from financial intermediaries.
Aaron Levie, one of the founders of the Internet file-sharing site Box, Inc. explained the difficulty the firm had in raising funds from investors:"quote...investors had a hard time investing in a company where the founders acted 40, were 19 and looked 12. They thought we'd run off to Disneyland with the funding money." What do economists call the problem Levie encountered?
Moral hazard.
An article in the Economist magazine observes: "Insurance companies often suspect the only people who buy insurance are the ones most likely to collect." What do economists call the problem being described here?
Adverse selection.
___________________ occurs when bad risks are more likely to seek/accept a financial contract than are good risks. ________________ occurs in financial markets when borrowers use borrowed funds differently than they would have used their own funds.
Adverse selection; Moral hazard
"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."
Agree. A fall in interest rates with a positive duration gap will increase a bank's capital.
"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.
The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." 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 a bank needs to acquire funds quickly to meet an unexpected deposit outflow, the bank could
borrow from another bank in the federal funds market.
Credit risk is the risk that
borrowers might default on their loans.
First National Bank Assets Liabilities Variable-rate $40 million $50 million Fixed-rate $60 million $50 million Assuming that the average duration of its assets is four years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to ________ by approximately ________ of the total original asset value.
decline; 5 percent
Loans by the Federal Reserve to banks are known as
discount loans.
The sensitivity of bank capital to market interest rates is measured by
duration analysis.
The World Bank's data tells us that countries with higher levels of financial development tend to have _________levels of real GDP per capita, which indicates they are ___________ able to provide a high standard of living for their residents.
higher; better
Banks experience interest rate risk
if changes in interest rates cause bank profits to fluctuate.
Why was TRAP created?
was created to restore the market for mortgage-backed securities and other toxic assets in order to provide relief to financial firms that had trillions of dollars worth of these assets on their balance sheets.
"Bonds are meant to be safe, dull investments." Which of the following is a risk bond investors buying bonds during a bull-market are most likely to face?
Interest-rate risk
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.
Why are U.S. government securities referred to as a bank's secondary reserves?
They are very liquid.
Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.5. If interest rates increase from 5 percent to 6 percent, the net worth of the bank falls by
$2.15 million.
Why was the FDIC established?
-The FDIC was established to ameliorate bank runs. -The FDIC was established in 1934 after a series of bank failures.
First National Bank Assets Liabilitiies Variable-rate $20 million $50 million Fixed-rate $80 million $50 million Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to decline by approximately ________ of the total original asset value.
10 percent
Which of the following is a correctly explained key feature of the financial system? (Check all that apply.) A. 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. B. Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce adverse selection. C. 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. D. The bond market is a less important source of external funds to corporations than is the stock market. This is because there is less moral hazard involved with stocks than with bonds. E. Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard. F. Trade credit is the most important external source of funds for small- to medium-sized firms. Trade credit can reduce the transaction costs of borrowing for small firms. F. Trade credit is the most important external source of funds for small- to medium-sized firms. Trade credit can reduce the transaction costs of borrowing for small firms.
A, C, D
How does the lemons problem lead many firms to borrow from banks rather than from individual investors? (Check all that apply.) A. Because potential investors have difficulty in distinguishing good borrowers from bad borrowers, they offer good borrowers terms they are reluctant to accept. B. Because banks have difficulty in distinguishing good borrowers from bad borrowers, they offer good borrowers terms they are reluctant to accept. C. Because potential investors specialize in gathering information, they are able to overcome the problem of distinguishing good borrowers from bad borrowers. D. Because banks specialize in gathering information, they are able to overcome the problem of distinguishing good borrowers from bad borrowers.
A, D
How do banks manage credit risk? A. Banks can manage credit risk by performing credit risk analysis, requiring borrowers to put up collateral, and using credit rationing. B. Banks can manage risk by creating long-term business relationships by which the bank could acquire information about the creditor. C. Banks can manage credit risk by diversifying their assets.
A,B,C
How do banks manage liquidity risk? (Check all that apply.) A. Banks manage this risk by keeping some funds very liquid, such as a reverse repurchase agreement. B. Banks can increase their assets to cover liquidity risk. C. Banks manage this risk by keeping some funds very liquid, such as in the federal funds market. D. Banks can increase their borrowings to cover liquidity risk.
A,C,D
How do banks manage interest-rate risk? (Check all that apply.) A. Interest-rate swaps can reduce interest-rate risk exposure. B. Banks can manage interest-rate risk by keeping some funds as repurchase agreements. C. Banks can increase their borrowings to manage interest-rate risk. D. Banks can reduce interest-rate risk by making more floating rate loans, or ARMs.
A,D
All of the following help explain why this problem might be less likely with larger established firms than with small startups, except: A. Large firms do not face a principal-agent problem. B. Larger firms have established histories that lenders can reference while startups have less available information. C. Larger firms have a higher opportunity cost of running off with money inappropriately. D. Large firms have a separation of ownership from control.
A.
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.
What is the difference between a bank's return on assets (ROA) and its return on equity (ROE)?
A bank's return on assets (ROA) is the ratio of a bank's after-tax profit to the value of its assets. Return on equity (ROE) is the ratio of the value of a bank's after-tax profit to the value of its capital.
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.
What is the most important source of funds to small- to medium-sized firms?
The owners' personal funds and profits.
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.) A. The problem is adverse selection (once insured, you won't work as hard). B. 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). C. The problem is moral hazard (people who are more likely to be fired or get low raises would be more likely to buy such insurance). D. The problem is moral hazard (once insured, you won't work as hard). E. This type of insurance would be unpopular among workers.
B, D
Which from the following are off-balance-sheet activities? A. Increase in reserve requirements. B. Issuing credits. C. Trading activities. D. Standby letters of credit. E. Loan sales. F. Loan commitment.
C,D,E,F
"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.
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.
Why don't insurance companies just raise the annual premiums they charge instead of canceling policies?
Higher rates will attract riskier people to buy policies and discourage safer people.
The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." 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.
The most important bank liabilities are
Small-denomination time deposits and Checkable deposits.
The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." 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.
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.
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.
A reader wrote to an advice column in the New York Times complaining that his insurance company canceled his homeowner's policy after he had filed two claims. The advice columnist discovered that open " lot of people have shared a version of [this man's] experience ... a couple of small claims ... then nonrenewal." By canceling these people's policies, insurance companies are attempting to avoid ______________.
adverse selection
Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.
adverse selection
Loan commitment is
a bank's consent to provide a borrower with a stated amount of funds during some specified time.
If insurance companies are correct in their suspicion, it will ___________ the price of insurance.
increase
Bankers' concern regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of
liquidity management.
If a bank has ________ rate-sensitive assets than liabilities, then ________ in interest rates will increase bank profits.
more; an increase
Because _______ depositors are fully insured, they have ______ incentive to withdraw their money and cause their bank to fail. This encourages ___________by bank managers as depositors are protected _______ how the bank actually performs.
most, little, risk-taking, regardeless of
Which of the following is a bank liability?
nontransaction deposits
On a bank's balance sheet, total assets are equal to
total liabilities plus bank capital.
Banks hold excess and secondary reserves to
provide for deposit outflows.
The "lemons problem"
refers to the adverse selection problem that arises from asymmetric information.
For a bank, the ratio of after-tax profit to assets is its
return on assets.
Federal funds are
short-term loans between banks.
Bank capital is
the capital contributed by the bank's shareholders plus accumulated retained profits.
Bank capital is equal to
the difference between the value of the bank's assets and the value of its liabilities.
Required reserves are
the portion of demand deposits and NOW accounts banks must hold.
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.