Chapter 10-12 Test

Question 1

1. What is meant by a “dual banking system”?

Answer 1

Dual banking system is the system of banking in which state banks and national banks are chartered and supervised at different levels.

Question 2

a. What three federal agencies regulate commercial banks?

Answer 2

The comptroller of the currency, Federal depository insurance Corporation (FDIC), and the Federal Reserve

Question 3

Who do they regulate

Answer 3

o The office of the comptroller of the Currency- national banks
o Federal Reserve – state banks that our members of the federal reserve system
o FDIC – insured nonmember state banks

Question 4

1. What is the leverage ratio?

Answer 4

(Amount of banks capital)/

(Bank’s total Assets)

Question 5

What leverage ratio must a bank have to be considered “well-capitalized”?

Answer 5

+5%

Question 6

What if the leverage ratio falls below 3%?

Answer 6

Triggers increased regulatory restrictions on the bank

Question 7

What if the leverage ratio falls below 2%?

Answer 7

Must be forced to shut down

Question 8

1. What is the Basel Accord? How is it related to capital requirements?

Answer 8

It is a risk based capital requirement, which requires banks to hold capital at least 8% of their risk weighted capital requirements

Question 9

What are the 4 categories of the basel accord?

Answer 9

• Zero weight includes items that have no default risk: reserves and T-Bills
• 20% weight includes claims on a bank
• 50% included municipal bonds and residential mortgages
• 100% includes loans to consumers and corporations

Question 10

What is the key justification for deposit insurance?

Answer 10

• Avoiding banks panics where people are unsure of the condition of the bank and run to pull money out.

Question 11

1. What are the key problems of the present federal deposit insurance system?

Answer 11

• Moral hazard people feel that if they are insured they can take on more risk knowing that they won’t lose

Question 12

1. What is meant by the too big to fail policy?

Answer 12

Some banks are so large that if they fail it will cripple the whole economy. So the government will bail them out to prevent the damage on the economy

Question 13

1. What are the problems associated with too big to fail?

Answer 13

• Moral hazard again not worried about taking on too much risk because if they go down the tax payers will have to bail them out.

Question 14

1. What are the various ways in which the government provides a safety net for the banking industry?

Answer 14

• Deposit insurance (FDIC) to avoid bank panic
• lending through the central bank to troubled institution (lender of last resort)
• Governments can take over a bank

Question 15

1. What are some of the possible drawbacks to this safety net? For example, what does “Too Big to Fail” mean?

Answer 15

• Moral hazard biggest problem as people know they will not suffer loses they don’t need to worry about if the company is taking on too much risk
• Adverse selection problem arises too as people who are risk taking would love to get into it if they know they won’t suffer loses.

Question 16

What are the two primary ways that the FDIC uses to handle a failed bank? How do they differ from each other?

Answer 16

• First method is the Payoff method in which they pay off everything they insure and pay back 90 to the dollar for other deposits
• Second method is the purchase and assumption method in which the FDIC finds a willing merger partner who takes over all of the failed banks liabilities. Sweeten the deal for partnering bank by providing it with subsidized loans or by buying some of the weaker loans.

Question 17

1. What are the major provisions of the Dodd-Frank Act?

Answer 17

• Created Consumer Financial Protection Bureau to regulate mortgages and other financial products
• Required routine derivatives to be cleared through central clearinghouses and exchanges
• Required annual bank stress tests
• Limits Federal Reserve lending to individual firms
• Authorized government takeovers of financial holding companies
• Created Financial Stability Oversight Council to regulate systemically important financial institutions
• Banned banks from proprietary trading and from owning large percentages of hedge funds

Question 18

What do we mean by the term “financial crisis

Answer 18

• It occurs when information flows in financial markets experience particularly large disruption, with the result that financial friction increase sharply and financial markets stop functioning

Question 19

What is the possible sequence for the three stages identified by Mishkin

Answer 19

• Initial Phase: credit boom or bust, asset price boom and bust, and increase in uncertainty
• Banking Crisis: banks go out of business because they are unable to pay off depositors and other cerditors
• Debt Deflation: causes liabilities to increase and value of assets to decrease causing a decrease in net worth

Question 20

Why is a debt deflation so bad?

Answer 20

• This decline in real net worth of borrowers caused by a sharp drop in the price level creates an increase in adverse selection and moral hazard problems for lenders. This leads to lending and economic activity to decline for a long time.

Question 21

Why didn’t the financial crisis in 2007-2009 become worse like the great Depression?

Answer 21

• Federal reserve took actions involving both monetary policy to stimulate the economy and liquidity provisions to support orderly functioning of financial markets.
• Gov’t engaged in massive bailouts including TARP that allowed the treasury to spend 700 million to purchase subprime mortgages assets from troubled financial institutions.

Question 22

What does it mean when a mortgage is “underwater”?

Answer 22

Occurs when the value of your house was well below the amount of the mortgage. This gave struggling home owner strong incentive to walk away from their mortgages.

Question 23

Mishkin identifies three central factors behind the cause of the 2007-2009 crisis. Identify and explain how each contributed to causing the crisis.

Answer 23

• Financial innovation in the mortgage markets
o Technology helped securitize subprime mortgages which caused the explosion of subprime mortgage backed securities. Also led to the creation of collateralized debt obligations or CDO’s
• Agency problems in the mortgage markets
o Mortgage broker didn’t make a stronger effort to see if borrow could pay off loan, since they planned to sell off the loans quickly and could still make a fee (agent-principle problem), led to more adverse selection in risk takers made risky deals in hope for big payoffs.
• Asymmetric information and credit-rating agencies
o Conflict of interest for credit rating agencies who charged large fees to advise on how to structure product they themselves were rating. Therefore, they didn’t have sufficient incentives to make sure their ratings were correct. This resulted in wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized.

Question 24

Based on the article “Brewing Bubbles: Mortgage Practices Intensify Housing Booms”, Nakamura argues that there are two factors in mortgage making that have pro-cyclical effects on the housing market. Identify those factors and explain how each contributes to intensifying a housing boom.

Answer 24

• Pro-cyclical in that it makes the booms bigger and recessions worse
• First factor was that People were more likely to buy the house because they believed the value of the house was going to continue to rise so as price was increasing demand wasn’t shifting left to compensate
• Also this increase led to banks offering more loans because they thought if people defaulted that they would have a house that is also more valuable in return for collateral
• Since houses were selling all over this helped banks find the true values of the houses and were able to get prices that matched the houses making the banks loan a little safer.

Question 25

What is meant by “disintermediation”?

Answer 25

• A reduction in the flow of funds into the banking system that causes the amount of financial intermediation to decline.