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.