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chp12 Flashcards

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1
Q

what are financial frictions?

A

when there’s a disruption to efficient capital allocations

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2
Q

what type of information is involved with financial frictions?

A

assymetric information

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3
Q

assymetric information

A

adverse selection and moral hazard

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4
Q

why is it unclear if loans will be paid back?

A

banks don’t know if they are loaning money to a high or low risk person

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5
Q

what do banks do if they can’t decide whether a person is high or low risk to give a loan to?

A

not loan out any funds at all

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6
Q

if banks don’t give out loans (because they’re being cautious) what will happen?

A

inefficient number of loans being made, affecting general levels of
consumption for items such as houses and cars. This is an example of a financial friction.

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7
Q

banks don’t give out loans to be cautious. Less loans mean consumption of things are affected. what is this an example of?

A

financial friction

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8
Q

financial crisis

A

when economic activity suffers from an information problem

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9
Q

what does a financial crisis cause?

A

tremendous financial frictions

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10
Q

name the 3 stages involved in a financial crisis (IBD)

A

initial phase
banking crisis
debt inflation

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11
Q

What do we observe in the initial phase of a financial crisis? (Mr. A)

A

more uncertainty
reduction in the balance sheets of banks
asset-price decline.

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12
Q

what is a result of the initial phase of a financial crisis?

A

causes asymmetric information

leads to banking stage 2: crisis

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13
Q

what do we observe in the banking crisis stage of a financial crisis (W GF)

A

worsened asymmetric information.
general fall in economic activity (output or consumption)
fallout amongst banking institutions

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14
Q

What is a result of the banking crisis stage of a financial crisis?

A

leads to 3rd stage: debt inflation

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15
Q

what do we observe in the debt inflation stage of a financial crisis?

A

unexpected decline (negative shock) in price level (think about the opposite of inflation).

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16
Q

what is a result of the debt inflation stage of a financial crisis?

A

even worse asymmetric information and falls to economic activity occur.

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17
Q

what can we find from monetary policy for a financial crisis?

A

the Federal Reserve attempt to counteract the effects of financial crisis to reach a “steady-state” again.

18
Q

what does the Federal Reserve try to do during a financial crisis?

A

counteract effects to reach a “steady- state”

19
Q

(initial phase) define financial innovation

A

creating new forms of loans and financial products in an economy

20
Q

(initial phase) define financial liberalisation

A

reducing and removing restrictions on banking institutions

21
Q

explain financial innovation

A

banks offer loans with a new alternative collateral such as Calvin Klein hoodies. Josh now may be able to take out loans
by using hoodies as a guarantee for the loan in case of default.

22
Q

explain financial liberalisation

A

If before a bank was only allowed to lend 80% of its total funds and now can instead lend up to 100%, then this reflects a change in the required reserves requirement. This gives
greater flexibility to banks to issue loans. This is a form of financial liberalization.

23
Q

what is credit boom a possible side-effect of?

A

financial liberalisation

24
Q

(initial phase) define credit boom

A

possible side-effect of financial liberalization in which banks choose to make many loans in comparison to a period before the removal of restrictions

25
Q

(initial phase) define deleveraging

A

a condition by which banks reduce the number of loans made to individuals or the amount of loans

26
Q

(initial phase) define asset price bubble

A

an asset’s price exceeds that of its fundamental value

27
Q

what does deleveraging tend to follow?

A

a credit boom, as banks have lent out most of its funds or capital

28
Q

why is it hard to say if asset price bubble actually exist or not?

A

only easy to see them after a decline happens or there’s a crash in value

29
Q

give an exmaple of asset-price bubble

A

people paying £4mil for a home that has a fundamental value of £3mil

30
Q

(banking crisis and debt inflation) define fire sale

A

bank chooses to quickly sell its assets in order to increase its funds or capital

31
Q

(banking crisis and debt inflation) define debt inflation

A

price-level decreases (the opposite of inflation) leads to a decline in the value or net worth of firms

32
Q

example of debt inflation

A

If the products a firm sells are suddenly priced or valued at a lesser amount, then the overall worth of the firm decreases.

For example, if General Motors produces cars that previously retailed for $20,000 and deflation leads to their retailing at $18,000, then it may be the case that General Motors suddenly declines in worth as a firm.

33
Q

(banking crisis and debt inflation) define haircut

A

situation where required collateral exceeds the amount of a loan

34
Q

example of a haircut situation

A

Josh has a 2-door convertible sports car (worth $45,000) and just decided to buy a second car (priced at $30,000) for day-to-day use.

When Josh goes to the local bank to take out a loan for the car, the bank requires that Alan use the full worth of the sports car as collateral to take out a loan to buy the second car. The bank is exercising a haircut because the value of the collateral sports car exceeds that of the
new car.

35
Q

(banking crisis and debt inflation) define financial derivative

A

a financial instrument which is tied in payoff to a previously issued security

36
Q

(banking crisis and debt inflation) what is Troubled Asset Relief Program (TRAP)

A

federal government enabled the U.S.
Treasury to purchase subprime mortgage assets from struggling banking institutions

37
Q

what was TRAP made in response to?

A

07/08 financial crisis

38
Q

(banking crisis and debt inflation) define stress test

A

a test performed on a financial institution or bank to inspect potential losses and necessary capital to survive in periods of financial friction or crisis

39
Q

why are stress tests implemented? what do they reduce?

A

stop potentially problematic activity of banks in issuing loans.

40
Q

describe example of a stress test

(what is a bank doing, what will the stress test check)

A

if a bank is loaning too much or is making loans to individuals with certain credit ratings, a stress test will check to see if the bank could continue to operate if suddenly a crisis occurred.

41
Q

what’s the ultimate goal of the stress test

A

to help banks to recognise when they are acting haphazardly and curb this behaviour

Psychology (20 decks)

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