Chapter 17

Question 1

shadow banking

Answer 1

composed of a wide variety of types of financial firms: investment banks (lehman brothers), hedge funds (LTCM), and money market funds

• vulnerable to bank runs bc they perform maturity transformations
• banks do not accept deposits

Question 2

maturity transformations

Answer 2

the transformation of short-term liabilities into long-term assets

ex: convert deposits into bank loans that earn interest

Question 3

trade off between rate of return and liquidity

Answer 3

banks allow people to to have ready access to their funds (liquidity) even while those funds are being used to make loans for productive purposes

-without banks, this would be hard

Question 4

what depository banks do:

Answer 4

• accpet the savings of individuals, promising to return them on demand
• but put most of those funds to work by taking advantage of the fact that not everyone will want access to those funds at the same time
• **borrow on a short term basis from depositors and lend on a long term basis to others ***

Question 5

shadow bank

Answer 5

nondepository financial institution that engages in maturity transformation

• lenders to shawdow banks benefit from liquidity (their loans get reapid often overnight) and higher return compared to other ways of investing thier funds
• become popular because there were not as many regulations for shadow banks (like reserve requirements)

Question 6

How a shadow bank can fail

Answer 6

if lenders suddenly decide one day that its no longer safe to lend the shadow bank money, the bank can no longer fun its operations. Unless it can sell assets immediately to raise cash, it will quickly fail

Question 7

banking crisis

Answer 7

occurs when a large part of the depository banking sector or the shadow banking sector fails or threatens to fail

-rare (unlike bank failures)

Question 8

explanations for bank crises:

Answer 8

• asset bubble
• financial contagion

Question 9

asset bubble

Answer 9

in an asset bubble, the price of an asset is pushed to an unreasonably high level due to expectations of further price gains

ex: housing
- when bubble bursts, prices fall –> this undermines the confidence in financial institutions which can lead to financial contagion

Question 10

financial contagion

Answer 10

a vicous downward spiral among depository banks or shadow banks: each bank’s failure worsens fears and increases the likelihood that another bank will fail

• rises from the logic of bank runs
• shadow banking sector is especially prone because its unregulated

Question 11

financial panic

Answer 11

a sudden and widespread disruption of the financial markets that occurs when people suddenly lose faith in the liquidity of financial institutions and markets

-almost always involves a banking crisis

Question 12

severe banking crises almost always lead to disruptions in the _______ markets

Answer 12

stock and bonds

-lead to cycle of deleveraging

Question 13

in more advanced countries, banking crises almost always occur as a consequence of _____

Answer 13

an asset bubble

-typically in real estate

Question 14

since 2008, what banking sectors in the US have grown/shrank

Answer 14

• depository banking sector has grown
• shadow banking shrank

Question 15

severe banking crisis

Answer 15

a crisis in which a large fraction of the banking system either fails outright or suffers a major loss of confidence and must be bailed out by the government

• lead to deep recessions followed by slow recoveries
• followed by a 7% rise in unemployment

Question 16

Three main reasons that a banking crisis leads to recession:

Answer 16

1. credit crunch
2. debt overhang
3. loss of monetary policy effectiveness

Question 17

credit crunch

Answer 17

potential borrowers either can’t get credit at all or must pay very high interest rates

-unable to borrow or unwilling to pay high rates, businesses and consumers cut back on spending, pushing the economy into recession

Question 18

debt overhang

Answer 18

occurs when a vicious circle of deleveraging leaves a borrower with high debt but diminished assets

• lowers value of assets and undermines banks solvency
• or debt overhand for consumers and their lower priced houses that they can’t pay off
• leads to a fall in spending and a recession as consumers and businesses cut back

Question 19

loss of monetary policy effectiveness

Answer 19

usually monetary policy is used to fight the negative demand shocks caused by a fall in consumer investment spending …but can’t

Question 20

central banks and government take three main kinds of action in an effort to limit the fallout from banking crises:

Answer 20

1. they act as a lender of last resort
2. they offer gaurentees to depositors and others with claims on banks
3. an extreme crisis, a central bank will step in and provide financing to private credit markets

Question 21

lender of last resort

Answer 21

an institution, usually a country’s central bank, that provides funds to financial institutions when they are unable to borrow from the private credit markets

• the central bank can provide cash to a bank that is facing a run by depositors but is fundamentally solvent, so the bank doesnt have to sell assets
• lifeline – works to prevent a loss of confidence in the banks solvency

Question 22

government gaurentees

Answer 22

• gov can step in a guarentee a banks liabilities if people believe the bank is insolvent and will fail
• governments that take on banks risks often take ownership of the banks they are rescuing — almost always temporary

Question 23

provider of direct financing

Answer 23

• lending to shadow banks
• buying commercial paper
• buying debt
• the fed provided credit to keep the economy afloat

Question 24

aftershocks of 2008 financial crisis for Europe

Answer 24

• fears of bad pulic debts
• greece
• spain –> investors were worried about the solvency of spanish government and a possible default, driving up interest rates

Question 25

stimulus fans claims:

Answer 25

• continuing poor performance of economies - high unemployment, low inflation
• expansionary fiscal policy

Question 26

austerity appeals:

Answer 26

• common source of all problems are gov. debts
• cuts in gov spending would improve investor confidence and keep interest rates on gove debt low

Question 27

repo

Answer 27

very short term loans

(overnight)

Question 28

what made the shadow banking sector vulnerable:

Answer 28

1. repo
2. being outside the londer-of-last resort system
3. lack of regulation

Question 29

Four main elements of the Dodd Frank bill (wall street consumer protection act)

Answer 29

1. consumer protection
2. derivatives regulation
3. regulation of shadow banks
4. resolution authority over nonbank financial institutions that face bankrupcy

Question 30

consumer protection

Answer 30

• borrowers accpeted offers they didnt understand
• new law protects borrowers

Question 31

derivatives regulation

Answer 31

derivatives have to be bought and sold in open, transparent markets

Question 32

regulation on shadow banks

Answer 32

can designate financial institutions as “systematically important” aka they could start a crisis –which will be subject to regulation

Question 33

resolution authority

Answer 33

empower govs to seize control of financial institutions that require a bailout