(Done) Day 4: Banking/Finance

Question 1

What’s spread?

Answer 1

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

Question 2

What’s a balance sheet?

Answer 2

keeps track of bank’s money flow: Assets, liabilities, equity

Question 3

What’re the assets?

Answer 3

1. low cash
2. mostly loans (money they lend out)
3. bank’s own bank accounts elsewhere
4. investments (treasury bonds, securities-tradable financial assets)
5. reserves (incl. Federal reserve reqs.)

Question 4

What’s a liquid asset?

Answer 4

Asset that’s easily be converted into cash on short notice/cheaply

Question 5

What’s an illiquid asset?

Answer 5

An illiquid asset is one that can’t be turned into cash quickly or without losing substantial value.

Question 6

What’re assets and liabilities?

Answer 6

what you own or owe

Question 7

What’re the liabilities?

Answer 7

1. obligations: deposits, lending

2. loss-bearing capital: equity

Question 8

What’re obligations and loss-bearing capital in liabilities?

Answer 8

1. obligations: money you have to return

2. loss-bearing capital: money you use to cover losses

Question 9

What’s equity?

Answer 9

value of a bank, aka capital/net worth/profits

- it’s loss-bearing capital, capital you can lose w/out becoming insolvent

Question 10

What’s the accounting equation?

Answer 10

Assets - Liabilities = equity

Question 11

Why do banks want lower equity and leverage ratio?

Answer 11

1. The lower the equity, the higher the profit-per-dollar invested.
2. less of the bank’s money at risk
3. split profits among fewer ppl, so more profits for all involved

Question 12

What’s the reserve requirement?

Answer 12

Fed Mandates that banks keep a certain minimum percentage of their deposits in a special account/on reserve w/ the central bank

Question 13

What’s the capital requirement?

Answer 13

Fed Mandates that the equity of a bank be at least a certain fraction of the bank’s total assets

Question 14

Transfer of payments (between banks and customers) should be:

Answer 14

1. Instantaneous
2. irreversible
3. Cheap
4. Without need for extra liquidity
5. Without counter-party risk: don’t depend on the stability of other banks (your deposit is gone).

Question 15

what’s counter-party risk?

Answer 15

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.

Question 16

Why are banks useful to society? (4)

Answer 16

1. provide payment services
2. asset transformation
3. manage risk
4. monitor debtors

Question 17

What’s asset transformation?

Answer 17

the transformation of bank liabilities (deposits) into bank assets (loans) to generate revenue

Question 18

What’s size transformation?

Answer 18

consolidate deposits and package them into larger-sized loans

Question 19

What’s risk/quality transformation?

Answer 19

diversification: diversifying lending portfolio (who they lend out to), so they spread out the risk of defaults

Question 20

What’s duration/maturity transformation?

Answer 20

they collect short-term deposits (aka on-demand deposits) to offer long-term loans/borrowings

Question 21

What’s liquidity transformation?

Answer 21

uses short-term debts like deposits to finance long-term investments like loans.

Question 22

What’re the types of asset transformation?

Answer 22

1. size
2. risk/quality
3. duration/maturity
4. liquidity

Question 23

What’re the types of bank risk?

Answer 23

1. credit risk
2. liquidity risk
3. interest rate risk

Question 24

What’s credit risk?

Answer 24

Risk that a borrower will default on a loan

Question 25

What’s liquidity risk?

Answer 25

Risk that too many depositors want their deposit back on-demand at the same time, and not enough cash on hand to cover it.

Question 26

What’s interest rate risk?

Answer 26

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.

Question 27

IMPORTANT

Why are banks illiquid?

Answer 27

1. 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
2. Banks have enough assets to cover all of customers’ deposit needs, but the loans they lend out are tied up long-term

Question 28

What’s the insolvency issue?

Answer 28

1. A bank is insolvent when assets are not enough to cover its liabilities.
2. 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

Question 29

What’s the liquidity issue for banks?

Answer 29

1. 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.
2. cash flow problem

Question 30

What’s systemic risk?

Answer 30

Because financial firms are financially interdependent via loans, etc. problems in a few financial institutions can create problems in many others.

Question 31

What’s Self-fulfilling prophecy?

Answer 31

how economic expectations can cause the occurrence of events.
- leads to bank runs

Question 32

What’s a bank run?

Answer 32

1. Self-fulfilling prophecy
2. 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
3. this leads to the bank’s insolvency.

Question 33

how to solve bank run?

Answer 33

liquidize assets

1. sell investments at discount
2. call back loans

Question 34

What’s bank panic?

Answer 34

When everyone collectively runs to their own bank for their deposits

Question 35

What’s a Gov’t-sanctioned Bank holiday?

Answer 35

gov’t prevents bank runs by closing the banks for a few days and wait until bank panic subsides

Question 36

What’s the MAIN way to solve illiquidity?

Answer 36

Have the bank lend from the CENTRAL bank!

Question 37

Ways to solve illiquidity?

Answer 37

1. lend from central bank and provide some assets as collateral
2. use up equity
3. sell assets
4. call back loans

Question 38

at aggregate level what does an increase in GDP mean?

Answer 38

increase in added value, leads to more aggregate income, leading to more consumption

Question 39

What does lending from central bank do?

Answer 39

Lending solves your liquidity issue, but NOT your insolvency issue because money’s still missing

Question 40

What’s FDIC and why are they important?

Answer 40

insure bank deposits which prevents bank runs and insolvency of healthy banks

Question 41

What’s regulatory capture?

Answer 41

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.

Question 42

What leverage ratio do we use?

Answer 42

the capital-asset ratio: equity/assets

Question 43

What does the capital-asset ratio tell us?

Answer 43

tells us what percentage of assets you can afford to lose before becoming insolvent/bankrupt (can’t cover deposits with just equity)