Commercial Banks and Other Financial Intermediaries

Question 1

A bankers’ _______ is a type a bank draft. How it works is, a firm requests that an agent (usually a bank)) pay the owner of the draft a particular amount at a specified time.

Answer 1

Acceptance. The instrument is used normally by importers and exporters. For example, if Company A in the United States wants to buy clothing from Company B in Singapore, then instead of taking out a loan to buy 2m worth of clothes, it asks Company B to take out a banker’s acceptance for 2.05m, maturing in 30 days.
What this means is, Company B presents the bank with a draft for 2.05 million, and this draft is called a “banker’s acceptance” once the bank adds its irrevocable under taking to pay the amount of the draft to the beneficiary (Company B). In other words 2.05m plus a fee to the bank. The bank then pays the owners of the bank acceptance (Company B) after 30 days.
The whole point of a bankers’ acceptance is that is allows the buyer to defer payment. Company A may not want to pay for the clothes right now– they want to pay for them in 30 days after they’ve had a chance to sell them. Company B may not be willing to take this risk of giving $2m worth of clothes without getting payment.– what if Company A doesn’t sell the clothes and doesn’t have the money to pay? By using a bankers’ acceptance, Company B is guaranteed that they will receive the money from a big reputable bank. In essence, the bank is substituting its credit for that of Company A.

Question 2

Certificates of deposit are marketable certificates for funds deposited in a bank that promise to pay the holder the original amount deposited plus a specified _________ rate.

Answer 2

Interest. Certificates of Deposit are commonly just referred to as CDs.

Question 3

When one US bank instructs the Federal Reserve (FED) to transfer funds from its FED account to the FED account of another US bank, this type of loan is called ________>

Answer 3

Federal funds. This loan id preferable to banks that need money quickly as the funds are available immediately upon transfer. The principal (amount borrowed) is returned with interest added when the loan period expires.

Question 4

A bond is a debt security, traded on the capital market, entitling the holder to ______ payments at specific times, as well as the face value of the bond at maturity.

Answer 4

Coupon. Bonds are securities with maturity dates exceeding one year. These types of intermediate to long-term debt are traded on thee capital market. A corporate bond is similar to a bond except that it is issued by a corporation.

Question 5

The coupon payments from a _____ are a type of interest payment.

Answer 5

Bond. This is another way of describing the coupon payment.

Question 6

A Treasury Note differs from a Treasury Bond in that the former has an original maturity date between ______ and five years whereas the latter has an original maturity date exceeding five years.

Answer 6

One. Bonds in general have maturity dates exceeding one year, but Treasury Bonds have a maturity date exceeding five years.

Question 7

Corporate ____ is an equity security issued by the corporation that entitles the holder to a proportion of dividends.

Answer 7

Stock. Remember, there are two general types of securities: there are equity securities, which indicate ownership, and debt securities. Corporate stock is a type of equity security.

Question 8

A _______ is a bond with an infinite maturity date, promising to pay interest at specified periods, but not guaranteeing the payment of the face value.

Answer 8

Consol.

Question 9

The yield on a financial instrument id the rate of _____ in a security.

Answer 9

Return.

Question 10

Treasury Bills are an example of a highly ______ asset because they can be readily sold at close to their full value.

Answer 10

Liquid. Liquidity refers to the speed that as asset can be converted to cash.

Question 11

The ______ risk refers to the risk that the price of an asset will fall as interest rates rise.

Answer 11

Market. For example, as interest rates rise, bond prices tend to fall; this is market risk.

Question 12

The ______ risk describes the risk that the issuer of a financial instrument will fail to make coupon payments or pay the face value.

Answer 12

Default. Default risk ( the risk someone will default on their payment) is also known as credit risk. Obviously, instruments issued by the federal government carry a small risk, whereas those issued by small companies carry a much higher risk.

Question 13

The present value (PV) refers to the current value of an asset whereas the ______ value refers to the value at a later date assuming the asset has been earning a particular rate of return.

Answer 13

Future. Future value is often referred to as FV.

Question 14

The ______ yield is the measure of interest gained per dollar invested.

Answer 14

Current.

Question 15

The holding period yield defines the rate of return obtained over the period the ______ is actually held.

Answer 15

Security.

Question 16

______ gain is the difference between the price of an asset when sold as compared to when it was purchased.

Answer 16

Capital. Capital gain tells you what you made or lost on an asset. It can be expressed in the positive, where an asset has increased in value or in the negative, where an asset has reduced in value.

Question 17

When the bond price _____, the yield rises.

Answer 17

Falls. Prices are inversely related to yield because the dollar amount of the interest paid on the bond is fixed, In other words, the amount in dollars that a bond pays in interest doesn’t change, so if the price of the bond rises, then it would take a lower interest rate (or yield) to pay the same interest. So prices increase, bond yield decreases and vice versa.

Question 18

An ______ banker is a specialist agent that obtains new security issues and sells them to investors.

Answer 18

Investment. This is one of the main jobs of an investment banker.

Question 19

Securities _____ charge clients a fee to buy and sell securities for them whereas securities dealers buy and sell securities from their own inventory of securities.

Answer 19

Brokers. This is what dealers do. They earn their commission in the difference in the bid price ( the price they’re willing to buy at) and the ask price (the price they’re willing to sell at). For instance, in the retail market, the investor will buy securities from the dealer at the ask price, and sell at the bid price.

Question 20

There are two main difficulties associated with direct arrangements between borrowers and savers, such as high search costs for bilateral loans and differences between the maturity needs of borrowers and savers, These difficulties can be overcome through financial _______.

Answer 20

Intermediation. One of the big difficulties is agreeing on a maturity date. Most savers want to lend money for short time periods, whereas borrowers usually want to borrow for longer periods. Use of financial intermediary, such as a commercial bank, can overcome this problem to meet the needs of both groups.

Question 21

The advantages of saving money with a depository institution such as a bank is that there is no market risk, transactional costs are low, the default risk is minimal due to agency backed insurance, and they offer a wide range of products.

Answer 21

Government. Remember, market risk refers to the risk that the price of an asset will fall as interest rates rise. This isn’t a risk when saving money with a bank (versus saving money in bonds); the bank is committed to returning all of your deposits whenever you ask. You also have minimal default risk, which is the rick of losing your savings due to the bank collapsing financially. Banks are insured by a government agency (usually FDIC), so you do not have to worry about the bank defaulting on your deposit.

Question 22

The drawbacks of saving in a depository institution are that there is little protection from inflation and returns in the longer term may be poorer than is a ______ investment.

Answer 22

Direct. Inflation refers to the fall of purchasing power of money over time. For example, back in 1980, 0.86 could buy you a gallon of gas, whereas it now takes 3.25 or more to buy the same amount of gas. The value of cash savings usually do not keep up with inflation. So, over time, the value of the money in the bank, sometimes even with interest payments, declines.

Question 23

Mutual funds are an attractive option for savers because they are professionally managed, highly liquid, provide rates of return comparable to direct investments, have low transactional costs and can be _________, thereby reducing risk.

Answer 23

Diversified. Diversification reduces the risk level experienced by the investor. The advantage of mutual funds over savings deposits is that the invested sum can be spread over various different types of investment, such as property and equities, thereby reducing exposure while providing better returns.

Question 24

Commercial banks are the most popular financial institutions is the US, and they mainly raise funds through savings and ______ deposits while investing in government securities and mortgages.

Answer 24

Checking. The checking account is essential for most people and used to make regular payments such as grocery and utilities bills.

Question 25

Until the late 1980’s, mutual savings and loan associations, and ______were commonly known as thrifts.

Answer 25

Credit unions. This term was coined to denote financial institutions whose mainstay was lending for residential mortgages. Nowadays, most savings institutions have failed, but credit unions still remain.

Question 26

Mutual savings and loans associations except that they are owned by the _______.

Answer 26

Depositors, The name ‘mutual’ implies that ownership lies with the savers themselves.

Question 27

Credit unions are like mutual savings banks in that they are owned by their depositors, but in addition they invest mainly in _______ loans.

Answer 27

Consumers. This is the main purpose of a credit union, with the income gained divided amongst the members in proportion to their deposits.

Question 28

Thor four types on non-depository financial institutions are insurance companies, _______ funds, mutual funds, and finance companies.

Answer 28

Pension. Pension funds collect contributions from members. Those contributions are invested on their behalf until the members reach retirement age, when they receive retirement benefit payouts.

Question 29

Insurance companies can be classified as either life insurance companies or property and _______ companies.

Answer 29

Casualty. Property and casualty companies accept premiums in exchange for coverage on property damage and financial consequences resulting from injury or death. As premiums are collected before insured losses occur, the company can invest these monies and hence act as financial intermediaries.

Question 30

_______ funds are a combination of financial instruments, called ‘shares’, wrapped in a fund managed by investment companies who charge fees for their services to shareholders.

Answer 30

Mutual. A mutual fund is nothing more than collection of stocks and/or bonds, You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.

Question 31

Finance companies do not offer deposits, but instead specialize in making loans to _______ individuals and businesses.

Answer 31

High-risk. This is the mainstay business of finance companies. They offer such loans to persons and companies that would normally be rejected by commercial banks.

Question 32

Consumer finance companies make loans to individuals, business finance companies make loans to businesses, and sales finance companies make loans to consumers to _______ goods.

Answer 32

Buy specific. For example, the GM Acceptance Corporation was set up specifically to give loans to people buying GM vehicles.

Question 33

Business finance companies purchase the accounts receivable of a company at a discount, thereby allowing the business to gain immediate funds in a process called _______.

Answer 33

Factoring. The accounts receivable of a company refers to whatever outstanding debts the company is waiting to collect on (i.e. money owed to the company by customers or other businesses). Companies sometimes sell their outstanding debts to business finance companies at a discount because they need money right now, and the business finance companies make money by collecting the full value of those outstanding balances.

Question 34

Mutual funds may be open-ended, which means they can be ______ by the shareholders at any time, or closed-ended, so that only a limited number of shares are issued and they can only be sold to other investors.

Answer 34

Repurchased. Most mutual funds are open-ended, which means that the find sells am many shares as investors want. The fund grows as more money comes in. When investors sell, the number of outstanding shares drops. Occasionally, open-ended finds are closed to new investors when they become too large and difficult to manage.
Conversely, a closed-ended fund raises money only once, offers fixed number of shares, and these shares are traded on exchanges.

Question 35

Money market funds are mutual funds that invest in ______ liquid investments such as Treasury Bills and other short term money market instruments, whereas equity and bond funds invest in less liquid instruments such as bonds and equities.

Answer 35

Highly. Money-market funds (MMF) are a special type of mutual fund. They invest in short term (e.g., 30 day) securities from companies or governments that are highly liquid and low risk. The goal of MMFs are to minimize risk– they try to preserve principle while yielding a modest return. Essentially, the companies try to make these feel like a high-yield bank account.

Question 36

The US government regulates depository financial institutions in order to maintain depository institution liquidity, ensure bank solvency, to promote efficient banking, and ________.

Answer 36

Consumers. Regulation will ensure that depository regulations meet certain requirements, thereby reducing the risk of the bank becoming insolvent.

Question 37

Savings and Loan Associations experienced financial stress in the 1970s and 1980s due to the sharp increase in _______.

Answer 37

Interest rates. These associations face short maturity of deposit liabilities but long maturity of mortgage assets. the government regulated the rate of interest these associations could pay to their customers. Hence, when market interest rates rose above the deposit rate, customers withdrew their deposits and invested in other more profitable instruments. This meant that the associations had fewer funds to lend out.

Question 38

The process of customers withdrawing their savings to invest in better performing financial instruments due to interest rate regulation resulted in ________ Within the financial system.

Answer 38

Disintermediation. This term developed because even when market interest rates returned to more favorable levels, customers did not necessarily return their savings to depository institutions, but instead continued to invest directly in alternative financial instruments. Therefore, the middleman- the savings association- has been removed.

Question 39

To counter the problems faced by depository institutions caused by disintermediation, the government introduced the Depository Institutions _______ Control Act of 1980 (DIDMCA) which phased out, over a 6 year period, the interest rate ceiling they were subjected to and allowed them to offer interest-bearing checking accounts.

Answer 39

Deregulation and Monetary.

Question 40

The DIDMCA was swiftly followed by the Garn-St. ________ which allowed savings associations to complete better with commercial banks by permitting money market deposit accounts.

Answer 40

Germain Act. This allowed savings associations to offer the same rates on deposits as commercial banks.

Question 41

Upon formation, banks must obtain a charter from the _______ of Currency to qualify as national banks or from a state agency to qualify as a state bank.

Answer 41

Comptroller. Banks chartered by the Comptroller of Currency are subjected to federal regulations and yearly surprise inspections by the comptroller’s examiners. State banks are subjected to the regulations within that state.

Question 42

FED bank examinations were to ensure compliance with regulations, determine whether appropriate management was in place, and to prevent _______.

Answer 42

Fraud. These regulations pertained to capital adequacy, earnings and liquidity.

Question 43

It is compulsory for national banks, though not for ______ banks, to become members of the Federal Reserve System.

Answer 43

State. Banks who are members of the FED are called ‘member banks’. Some of the regulations at the FED are stricter that at state level and that may operate as a disincentive for state banks to join.

Question 44

It is mandatory for member banks to join the FDIC, which stands for Federal Deposit _______ Corporation, but state banks may choose whether to join or not.

Answer 44

Insurance.

Question 45

The FDIC _______ banks deposits to prevent panics that may cause bank runs, which lead to many banking failures in the 1930’s.

Answer 45

Insures. This occurs when a panic is generated about the stability of a bank. The depositors panic and all rush to withdraw their money, resulting in a banking collapse.

Question 46

The amount of federal deposit insurance coverage per deposit account is $___,000.

Answer 46

100. This is the amount mandated in the Depository Institutions Deregulation and Monetary Control act of 1980 (DIDMCA).

Question 47

The government supports four agencies to encourage home ownership in the US, and these were the Federal _______ Banks (FHLBs), Federal National Mortgage Association (Fannie Mae), the Government Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation.

Answer 47

Home Loan. The Federal Home Loan Mortgage Corporation is called Freddie Mac.

Question 48

Ginnie Mae, Fannie Mae, and Freddie Mac make the mortgage market more liquid by buying mortgages from lenders, and then replacing them as _______ mortgage-backed securities.

Answer 48

Tradable. An example is needed to explain this answer. John wants to buy a house, and he gets a loan from Wells Fargo bank. The amount of loans the bank can offer is limited as a function of its asset base. So Wells Fargo sells its rights to John’s repayment of capital and interest to Fannie Mae. Now it has turned that loan into cash and the bank can lend more. This makes the market more liquid.

Question 49

The FDIC Improvement Act of 1991 made ______ insurance premiums compulsory, so that the premium amount payable was determined by the extent of the institutions’ capitalization.

Answer 49

Risk-based. Previously, premiums were level and charged regardless of the degree of risk posed by and institution. Using the new risk-based system, the amount of premium paid depended on the amount of capitalization of an institution. The greater the capitalization, the lower to risk and premiums. The lower the capitalization, the higher the risk and premiums.

Question 50

Commercial banks are _______ organizations that 1) offer multiple products and services in markets where inputs and outputs are uncertain 2) experience short and long-term votality of assets and liabilities.

Answer 50

Oligopolistic. The value of assets such as loans and liabilities like deposits accounts are variable, or constantly changing, in the short term and long term; hence, it is volatile.

Question 51

Bank holding companies were formed in order for commercial banks to avoid the business activity _______ placed by the FED.

Answer 51

Restrictions. A bank-holding company is a corporation that owns or manages one or more banks by the FED. These activities include tax planning services, investment advisement, and data processing. Most banks are actually a bank-holding corporation.

Question 52

Two main restrictions national banks are subjected to on bank loans and investments are that they cannot lend more than ___% of their equity to one agent, and can only make limited loans to directors and officers.

Answer 52

15. This is the limit applied by the FED.

Question 53

The two main types of costs that are incurred by commercial banks are the costs in attracting funds to the bank and costs incurred from _____ and services.

Answer 53

Operations. This would include promotional expenses with attracting potential clients to deposit funds with the bank and the cost of borrowing funds. The costs of operations and management would include management of investments and deposits, rental of premises, and hiring staff.

Question 54

When the bank market structures are in perfect competition then consumers should be paying and receiving interest rates that are just sufficient to cover those costs, so that the bank is just making a ______ profit.

Answer 54

Normal. This means that the equitable owners of the bank are receiving returns which are just enough to compensate them for their holdings and not any more.

Question 55

The DIDMCA gave the FED the authority to place ______ requirements on depository institutions offering transaction deposits.

Answer 55

Reserve. In order to combat the problems of insufficient cash reserves (and the inability to pay depositors) that were faces before the creation of the Federal Reserve System, banks now have to set aside a certain amount of cash in “reserve”. The reserve balance that banks must maintain is typically a percentage of their total interest-bearing and non-interest-bearing checking account deposits (currently 3% to 10%). In other words, the amount of a bank’s required reserves will fluctuate depending on their account totals. The reserve is very important because it helps to ensure that the bank will always be able to give you your money when you ask for it. This percentage of required reserves directly affects how much money the banks can “create” in their local economies through loans and investments. It is this connection between the required reserve amount and the amount of money a bank can lend that allows the Fed to influence the economy. If the reserve requirement is raised, then banks have less money to loan and this will have a restraining effect on the money supply. If the reserve requirement is lowered, then the banks will have more money to loan. These reserves can be haled as “cash on hand,” as deposit account at regional Reserve Banks, or both.

Question 56

The _____ calculates the reserve requirements by using the required reserve ratio.

Answer 56

FED. This is a fraction of the amount of transaction deposit balances that the FED requires. Currently, the FED requires a reserve ratio of 10%. So, for every 10 transaction deposit, the bank must maintain 1 on deposit with the FED reserve bank or in its vault.

Question 57

The implication of the required reserve rule for banks is that a bank can _____ or buy securities only if it has excess reserves.

Answer 57

Lend. This is the amount of reserve that exceeds the minimum mandated FED requirements.

Question 58

Banks do not normally hold very much excess reserves because they do not ______ income.

Answer 58

Bear. Reserve money is like cash sitting in your pocket– the FED reserve bank does not pay interest on deposits and vault cash similarly does not earn any interest, so the banks aren’t making any money on their reserves. Therefore, it makes sense that they’re not going to want to hold a lot of excess reserves.

Question 59

To provide liquidity, banks hold primary reserves, which consist of vault cash, funds deposited with the FED, and other deposit accounts, as well as ______ reserves which are liquid securities such as Treasury Bills.

Answer 59

Secondary. The primary reserves consist of vault cash and cash held on deposit at the Federal Reserve district bank under no formal regulatory requirements. The important distinction is that primary reserves are cash; secondary reserves are securities.

Question 60

Banks maximize their profits when marginal ______ (MR) equals to marginal cost.

Answer 60

Revenue. If you've ever studied micro or macro economics, this should sound familiar to you; one of the fundamental rules id that profit is maximized when marginal cost equals marginal revenue. 
Marginal cost (MC) for a bank is how much additional money it costs the bank to obtain an additional dollar of deposits to lend. The MC for a bank consists of 3 components: marginal deposit interest expense, marginal resource costs, and marginal loan resource costs.

Question 61

The MR for a bank is the additional revenue earned on the last additional dollar of _____.

Answer 61

Loans. As you can see, Marginal refers to the cost or revenue for on additional unit. For example, in a car factory, Marginal Cost might be how much it costs to produce one more car; Marginal Revenue would be how much additional money they would make from producing that additional car. Obviously, if an additional unit would cost you more to produce than it could be sold for, then it wouldn’t make any sense to make that extra unit. The bank’s primary revenue source is loans, and hence this is the primary factor in determining its MR. It costs banks money to advertise and get customers to deposit their money with the bank, but a profitable bank will make up for that cost through interest from loaning out those deposits.

Question 62

The MR is equal to the market _____ interest rate.

Answer 62

Loan. This is because, for a given bank, the MR is equal to the interest rate earned on the next dollar loaned. This is the position regardless of the number of loans given by the bank.

Question 63

The banks selected portfolio must reflect the risk of insolvency, interest rate risk, default risk, maturity ______ of assets and liabilities as well as the impact of poor customer relations on their business.

Answer 63

Mismatch. There’s a variety of different risks and factors a bank must take into account when selecting its portfolio.
Customer satisfaction is a key factor in portfolio decisions. Banks have to consider customer satisfaction in the long term. Therefore, refusing a good customer a loan is not good for business.
Banks may keep excess reserves to rid out interest rate fluctuations or if they are risk averse. Default risk is critical and banks may choose to limit business loans, for example, if there is a high risk of default, or failure to pay in this area.

Question 64

When a bank does not meet all the funds requests of a customer applying for a loan, then the bank is engaged in credit _____.

Answer 64

Rationing. For example, if a customer tries to borrow 2 mil and the bank is only willing to lend him 1 mil, the bank is rationing credit. This is how the bank might meet some of the needs of the customer to maintain good relations, while reducing the default risk (without completely turning down the customer).

Question 65

A bank may require a customer maintain a compensating balance in a deposit account in exchange for agreeing to offer them a loan at a particular _______ of interest.

Answer 65

Rate. The compensating balance is the amount of money a bank requires a customer to maintain in a non-interest bearing account in exchange for offering them a loan. This is a non-price way of dealing with customer requests that is indirectly beneficial to the bank–it reduces the bank’s risk exposure.

Question 66

In order to avoid ______ mismatches of assets and liabilities, a bank may offer a(n) adjustable rate mortgage.

Answer 66

Maturity. This means that the rate rises or falls in accordance with the market interest rate.

Question 67

_______ is known as tax haven and center of banking activity because banks are not allowed to reveal deposit information to the authorities except in specific criminal cases.

Answer 67

Switzerland. This is law in Switzerland where an banker who breaches the depositor’s secret can be imprisoned for up to six months and fined 50,000 Swiss francs.