(Done) Day 4: Banking/Finance Flashcards
What’s spread?
Spread is the net profits banks make: interest you charge for the money you lend out - interest you pay your customers for keeping their money in the bank
What’s a balance sheet?
keeps track of bank’s money flow: Assets, liabilities, equity
What’re the assets?
- low cash
- mostly loans (money they lend out)
- bank’s own bank accounts elsewhere
- investments (treasury bonds, securities-tradable financial assets)
- reserves (incl. Federal reserve reqs.)
What’s a liquid asset?
Asset that’s easily be converted into cash on short notice/cheaply
What’s an illiquid asset?
An illiquid asset is one that can’t be turned into cash quickly or without losing substantial value.
What’re assets and liabilities?
what you own or owe
What’re the liabilities?
- obligations: deposits, lending
2. loss-bearing capital: equity
What’re obligations and loss-bearing capital in liabilities?
- obligations: money you have to return
2. loss-bearing capital: money you use to cover losses
What’s equity?
value of a bank, aka capital/net worth/profits
- it’s loss-bearing capital, capital you can lose w/out becoming insolvent
What’s the accounting equation?
Assets - Liabilities = equity
Why do banks want lower equity and leverage ratio?
- The lower the equity, the higher the profit-per-dollar invested.
- less of the bank’s money at risk
- split profits among fewer ppl, so more profits for all involved
What’s the reserve requirement?
Fed Mandates that banks keep a certain minimum percentage of their deposits in a special account/on reserve w/ the central bank
What’s the capital requirement?
Fed Mandates that the equity of a bank be at least a certain fraction of the bank’s total assets
Transfer of payments (between banks and customers) should be:
- Instantaneous
- irreversible
- Cheap
- Without need for extra liquidity
- Without counter-party risk: don’t depend on the stability of other banks (your deposit is gone).
what’s counter-party risk?
Counterparty risk is the probability that the other party in a transaction may not fulfill its part of the deal and may default on the contractual obligations.
Why are banks useful to society? (4)
- provide payment services
- asset transformation
- manage risk
- monitor debtors
What’s asset transformation?
the transformation of bank liabilities (deposits) into bank assets (loans) to generate revenue
What’s size transformation?
consolidate deposits and package them into larger-sized loans
What’s risk/quality transformation?
diversification: diversifying lending portfolio (who they lend out to), so they spread out the risk of defaults
What’s duration/maturity transformation?
they collect short-term deposits (aka on-demand deposits) to offer long-term loans/borrowings
What’s liquidity transformation?
uses short-term debts like deposits to finance long-term investments like loans.
What’re the types of asset transformation?
- size
- risk/quality
- duration/maturity
- liquidity
What’re the types of bank risk?
- credit risk
- liquidity risk
- interest rate risk
What’s credit risk?
Risk that a borrower will default on a loan
What’s liquidity risk?
Risk that too many depositors want their deposit back on-demand at the same time, and not enough cash on hand to cover it.
What’s interest rate risk?
Risk that changing interest rates cause investment losses. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline.
IMPORTANT
Why are banks illiquid?
- They only keep a fraction of the deposited cash on hand for customer deposits, because they’re lending out the majority of deposits via loans to make profits on interest
- Banks have enough assets to cover all of customers’ deposit needs, but the loans they lend out are tied up long-term
What’s the insolvency issue?
- A bank is insolvent when assets are not enough to cover its liabilities.
- not just a cash flow problem: where cash flow in is less than cash flow out. even if you could sell all your assets, and withdraw all loans, still not enough to meet liabilities/deposits
What’s the liquidity issue for banks?
- When a solvent business that has enough total assets in the long run, does not have the liquid assets (cash, other liquid assets) necessary to meet its short-term obligations.
- cash flow problem
What’s systemic risk?
Because financial firms are financially interdependent via loans, etc. problems in a few financial institutions can create problems in many others.
What’s Self-fulfilling prophecy?
how economic expectations can cause the occurrence of events.
- leads to bank runs
What’s a bank run?
- Self-fulfilling prophecy
- If enough people believe a bank is insolvent and all rush to withdraw their deposits, they’ll simultaneously empty out all the deposits on hand and cause the bank to sell their assets at a discount
- this leads to the bank’s insolvency.
how to solve bank run?
liquidize assets
- sell investments at discount
- call back loans
What’s bank panic?
When everyone collectively runs to their own bank for their deposits
What’s a Gov’t-sanctioned Bank holiday?
gov’t prevents bank runs by closing the banks for a few days and wait until bank panic subsides
What’s the MAIN way to solve illiquidity?
Have the bank lend from the CENTRAL bank!
Ways to solve illiquidity?
- lend from central bank and provide some assets as collateral
- use up equity
- sell assets
- call back loans
at aggregate level what does an increase in GDP mean?
increase in added value, leads to more aggregate income, leading to more consumption
What does lending from central bank do?
Lending solves your liquidity issue, but NOT your insolvency issue because money’s still missing
What’s FDIC and why are they important?
insure bank deposits which prevents bank runs and insolvency of healthy banks
What’s regulatory capture?
Regulators start thinking like the firms they regulate (bc they work with those firms and their employees closely), prompting regulators to advance the goals and interests of those industries.
What leverage ratio do we use?
the capital-asset ratio: equity/assets
What does the capital-asset ratio tell us?
tells us what percentage of assets you can afford to lose before becoming insolvent/bankrupt (can’t cover deposits with just equity)
