Ch 12 Money and Banking

Why would holding more capital limit how much a financial firm can borrow and reduce the​ firm's profitability?

- It decreases the amount of funds available to invest in​ riskier, potentially​ higher-yielding assets.

A house price bubble

- occurs when house prices move beyond their fundamental values.

All of the following are reasons why one bank failure might lead to many bank​ failures, except:

- If multiple banks have to sell the same​ assets, the prices of those assets are likely to rise.

Which of the following could be a negative implication if "the maturity of the debt is less than the maturity of the assets it funds"?

- If the debt is not renewed, or rolled over, the asset side of the balance sheet becomes unsustainable.

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.

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.

Why should a recession connected with a financial crisis be more severe than a recession that did not involve a financial​ crisis?

- A recession that includes a financial crisis is generally more complex and has more severe consequences, such as decreasing asset prices and lending, which affects the economy for a longer time period than a traditional recession.

What does it mean to say that bank lending is "information sensitive"?

- Banks acquire information to decide if borrowers are creditworthy.

Why would bank lending being "information sensitive" make it difficult to replace with nonbank forms of credit?

- Banks have economies of scale or some other advantage in evaluating the riskiness of loans.

Why might a fund's dumping its position cause prices to be destabilized? Prices of what?

- Because such large positions are being sold, it decreases the prices of assets the fund holds.

What does he mean by a "sustained run"? why can't a bank by itself survive a sustained run?

- By​ "sustained run," Bernanke means a bank run that lasts for a significant period of time. A bank cannot by itself survive a sustained run because it does not have enough reserves to match the deposit withdrawals and its assets are long term and not easily liquidated.

Why would a fund's trade moving against it cause it to burn through its capital?

- Hedge funds are highly leveraged, and a marginal is generally required for their trades. - Capital serves as margin, so capital is used as a cushion between losses.

Does Greenspan's analysis proved insight into why the Fed during his tenure may have been reluctant to take action against asset bubbles?

- If Greenspan believes that most bubbles burst without severe economic consequences, then, yes, it would explain the Fed's action.

All of the following are reasons why one bank failure might lead to many bank failures, except:

- If multiple banks have to sell the same assets, the prices of those assets are likely to rise.

Was deflation during the early 1930s good or bad for firms?

- It was bad for firms that were borrowers because it effectively raised interest rates.

How did the Federal Reserve rescue Bear Stearns? The Federal Reserve arranged a buyout of Bear Stearns by

- JP Morgan Chase

What is the connection between a fund's being highly leveraged and its having a "thin cushion of capital"?

- Leverage magnifies a trading position, reducing the ratio of capital to assets. This magnifies both gains and losses and reduces the capital "cushion" for losses.

What does "liquidate" mean in this context?

- Liquidate means to let prices fall to their equilibrium level.

Why would long-term interest rates have a closer connection to house prices than overnight interest rates?

- Mortgage companies generally markup mortgages 2-3% above the 10-year Treasury bond yield.

Prices fall when a country experiences deflation, so isn't deflation good for consumers?

- No borrowers would be hurt by the higher real interest rates and higher real value of debts that deflation causes.

Does a bank have to be insolvent to experience a run?

- No, bank runs are caused by bank panics, which can occur whether a bank is insolvent or not.

In the context of the early​ 1930s, were low nominal interest rates a good indicator that policy was​ easy?

- No. Because of deflation, real rates were high

How did the emergence of shadow banking increase the risk to the financial system?

- Nonbank financial institutions are not required to maintain the equivalent of reserve requirements even though, like traditional banks, they borrow short and lend long. - In the event of a nonbank financial institution run, there is no equivalent of the FDIC.

What does a fund's "dumping its position" mean?

- Selling before a margin call. - Selling before capital runs out.

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 is lender of last resort?

- 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. - 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.

What does Bernanke mean by "solvent under normal conditions"?

- The value of a bank's assets is more than the value of its liabilities, so its net worth, or capital is positive.

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.

Why would it matter to Greenspan whether low long-term interest rates were more responsible for the housing bubble than low short-term interest rates?

- To lessen the Federal Reserve's responsibility under Greenspan's watch as Chairman for causing, at least partially, the housing bubble with low interest rates.

Does Bernanke's observation help to explain the role bank panics played in the severity of the Great Depression?

- When thousands of banks failed, it became difficult for their customers to obtain credit, thus exacerbating the severity of the Great Depression. - Yes, Bernanke's observation helps to explain the role bank panics played in the severity of the Great Depression.

Can these views help to explain the actions by the Fed during the early years of the Great Depression?

- Yes, to an extent, because the Federal Reserve was acting on the predominant economic model of the​ time, which said that the economy will​ self-adjust and any attempt to intervene will either do nothing or create negative consequences.

What does it mean to say that Fed policy is​ "easy"? An​ "easy" Fed policy suggests

- an increasing money supply and falling interest rates.

The "fragility" of commercial banking means that _____.

- banks borrow short to lend long and are relatively illiquid on any given day

Why did Bear Stearns almost fail?

- because Bear liquidated assets in order to pay back short-term loans - because lenders declined to renew Bear's short-term loans - because lenders lost faith in Bear's ability to pay back short-term loans

All of the following are reasons why the​ Dodd-Frank Act required SIFIs to hold more​ capital, except:

- because the FDIC was prohibited from intervening when SIFIs experienced economic distress.

What does Greenspan mean by "debt leverage"?

- borrowing and purchasing assets with borrowed funds

If nominal interest rates remain unchanged during a period of deflation, then when inflation rates are _____, the real interest rate in the economy will ____.

- decreasing; increase

The debt-deflation process is the process of _____ than can increase the severity of an economic downturn.

- falling asset prices

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 prices of goods and services - increasing; increased; more

What does a hedge fund's trades "moving against it" means? "Moving against it" means that

- if a hedge fund bets one way and the price moves another away, it has to exit the position fast.

What does Greenspan mean that "the added risk had not been compensated by higher capital"? In order to compensate for the risk, Greenspan believes that nonbank financial institutions should have voluntarily.

- increased their capital

In "lending into continuing runs" the Fed _____ additional _____ banks in order to avoid _____ long-term assets at a _____, further _____ investor confidence.

- provided; liquidity for; selling; loss; undermining

Does this process provide any insight into why the Federal Reserve rescued Bear Stearns? A debt-deflation process

- pushes down the price of those assets which other investment banks​ hold, thus worsening their balance​ sheets, which in turn can accelerate bankruptcies. - would occur if Bear Stearns goes bankrupt and has the sell its assets.

Nonbanks forms of credit

- refer to credit from providers other than banks.

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 is when _____.

- the failure of one bank causes runs on other banks. If multiple banks experience bank runs, the result is a bank panic.

What is a​ SIFI?

A firm whose failure would potentially cause a financial crisis.