Eo B- exam prep Flashcards

Question

name two characteristics for Rate of capital gain

Answer 1

 Which shows that the return on a bond is the current yield plus the rate of capital gain  Prices and returns for long-term bonds are more volatile than those for shorter-term bonds

Answer 2

states that the nominal interest rate i equals the real interest rate i r plus the expected rate of inflation: i = ir +pi e

Answer 3

provides one theory of how interest rates are determined.  Effect on demand of assets  increased wealth +  increased expected return +  increased risk –  increased liquidity +  Effects on Supply of Bonds: Expected profitability of investment opportunities + Expected inflation + Government budget deficit +

Answer 4

A business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. Using the same reasoning, in a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left. Another factor that affects wealth is the public’s propensity to save. If households save more, wealth increases and, as we have seen, the demand for bonds rises and the demand curve for bonds shifts to the right. Conversely, if people save less, wealth and the demand for bonds will fall and the demand curve shifts to the left. An increase in expected inflation shifts demand curve left, causes the supply of bonds to increase and the supply curve to shift to the right. For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence, the quantity of bonds supplied increases at any given bond price. Real cost of borrowing r=i- π. Bond prices and interest rate falls. Higher government deficits (increased spending) increase the supply of bonds and shift the supply curve to the right. On the other hand, government surpluses decrease the supply of bonds and shift the supply curve to the left

Answer 5

The conclusion is that the quantity of bonds and money supplied must equal the quantity of bonds and money demanded: B s +M s=B d+M d

Answer 6

An alternative theory of how interest rates are determined is provided by the liquidity preference framework, which analyses the supply of and demand for money. It shows that interest rates will change when the demand for money changes because of alterations in income or the price level, or when the supply of money changes.

Answer 7

Income effect Price-Level effect

Answer 8

When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their holdings of money in real terms to the former level, people will want to hold a greater nominal quantity ofmoney, so a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Answer 9

as an economy expands and income rises, wealth increases and people want to hold more money as a store of value. Second, as the economy expands and income rises, people want to carry out more transactions using money as a medium of exchange, and so they also want to hold more money. a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Answer 10

 when income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise.  when the price level increases, with the supply of money and other economic variables held constant, interest rates will rise.  When the money supply increases (everything else equal), interest rates will decline.

Answer 11

There are four possible effects on interest rates of an increase in the money supply: the liquidity effect, the income effect, the price-level effect, and the expected- inflation effect. The liquidity effect indicates that a rise in money supply growth will lead to a decline in interest rates; the other effects work in the opposite direction. The evidence seems to indicate that the income, price- level, and expected-inflation effects dominate the liquidity effect such that an increase in money supply growth leads to higher—rather than lower—interest rates.

Answer 12

 A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium  The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but also its liquidity  Interest payments on municipal bonds are exempt from federal income taxes

Answer 13

(the relationship among interest rates on bonds with the same maturity) is explained by three factors: default risk (+), liquidity (-) and the income tax (if more favourable  -) treatment of a bond’s interest payments.

Answer 14

1. Expectations theory 2. Segmented markets theory 3. Liquidity premium theory

Answer 15

i long-term bond = average of the short- term interest rates that people expect to occur over the life of the long-term bond  When the yield curve is upward-sloping, the expectations theory suggests that short- term interest rates are expected to rise in the future. In this situation, in which the long-term rate is currently higher than the short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can occur only if short-term interest rates are expected to rise. Explains 1+2

Answer 16

markets for different-maturity bonds as completely separate and segmented  The interest rate for each bond = determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities  The key assumption in the segmented markets theory is that bonds of different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity  LESS DEMAND FOR BONDS WITH A LONGER MATURITY WILL CAUSE THE PRICE TO DECREASE AND YIELDS TO INCREASE, HENCE EXPLAINING UPWARD SLOPING YIELD CURVES . Explains 3.

Answer 17

the interest rate on a long- term bond will equal an average of shortterm interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond.

Answer 18

, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors to prefer one bond maturity over another. In other words, bonds of different maturities are assumed to be substitutes but not perfect substitutes

Answer 19

assumes that investors have a preference for bonds of one maturity over another, a particular bond maturity (preferred habitat) in which they prefer to invest.  Because they prefer bonds of one maturity over another, they will be willing to buy bonds that do not have the preferred maturity (habitat) only if they earn a somewhat higher expected return  Because investors are likely to prefer the habitat of short-term bonds over that of longer-term bonds, they are willing to hold long-term bonds only if they have higher expected returns

Answer 20

- Interest rates on bonds of different maturities tend to move together over time - Yield curves usually slope upward - When short-term interest rates are low, yield curves are more likely to have a steep upward slope, whereas when short-term interest rates are high, yield curves are more likely to be inverted

Answer 21

- A steep upward slope of the yield curve means that short-term rates are expected to rise, - a mild upward slope means that short-term rates are expected to remain the same, - a flat slope means that short-term rates are expected to fall moderately, - an inverted yield curve means that short-term rates are expected to fall sharply.

Answer 22

Should all loans be allocated the same capital structure?  Corporate finance: firms with more volatile cash flows and higher asset betas (greater systematic risk) use more equity in their capital structure  it is safer → each loan category will have a hypothetical capital structure, with more risky loans allocated more equity

Answer 23

-year corporate loan, loan volume of € 1mn Operating cost: € 5,000, PD = 2%, LGD = 40%, funded via 90% deposits, 10% equity. Cost of deposits is 2%, cost of equity is 10% r= 5000/1000000 + 2%*40% + 90%*2% + 10%*10% What is the interest rate you need to charge the customer (in absence of cross-selling) to cover all costs? €5,000/€1mn + 2%·40% + (90%·2%+10%·10%) = 50bps + 80bps + 2.8% = 4.1%

Answer 24

 ex-ante: What earnings capacity to repay a loan (good quality) or not (bad quality) does a potential borrower have = adverse selection e.g., credit rationing when interest rates rise  ex-post: will counterparty change its behaviour after loan approval = moral hazard e.g., highly leveraged firm’s management uses loans for private benefits

Answer 25

- Private Production and sale of information  BUT free-rider problem - Government regulation to increase information  government intervention - Financial intermediation  more regulation/ more information - Collateral and net Worth  banks have more info / reduce risk

Answer 26

credit rating agencies can certify the quality of a firm, today companies pay to receive certification, problem is that companies might shop for ratings. - private collection of information, limited effort in addressing adverse selection

Answer 27

- when privately collected info becomes public, it can be used again and creates a positive externality, this weakens incentives to collect info  free-rider problem. Information externalities lead to under-investment in info collection.

Answer 28

: Means to privately ‘solve’ part of the free-rider problem in information collection  by making private loans, banks avoid free-rider problem, collect information on borrowers Relationship banking - public solutions for free-rider problem

Answer 29

can help reduce asymmetries, make information priority, but also hold-up issue as banks build up relationships, the fact that they have private info makes it hard for firms to move to other banks

Answer 30

public credit registry, regulation and certification of info by firms and issuers of securities.

Answer 31

 adverse selection  over time the market has developed solutions, inspections, reports, quality certifications.  death spiral, market collapses.

Answer 32

sellers have more info - asymmetric information, buyer’s only willing to pay average quality, so highest quality sellers exit market, average quality drops and so on  death spiral, market collapses.

Answer 33

- An economic agent in the presence of asymmetric info has an incentive to increase their exposure to risk because they do not bear the full costs of the risk. - plays an important role in firm’s ability to get debt or equity funding - related to separation of ownership and control in a business

Answer 34

- reduce information asymmetry (banks monitor borrowers) - reduce incentives to exploit (introduce loan covenants) - regulations

Answer 35

are subject to a particular type of moral hazard called the principal– agent problem.

Answer 36

- Production of information: monitoring - Government regulation to increase information - Financial intermediation (e.g. venture capital firms) - Debt contracts (still subject to moral hazard, because a debt contract requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take on investment projects that are riskier than the lenders would like)

Answer 37

- Net worth and collateral (it makes the debt contract incentive-compatible; that is, it aligns the incentives of the borrower with those of the lender) - Monitoring and enforcement of restrictive covenants - Financial intermediation

Answer 38

a type of moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives  Conflicts of interest are especially likely to occur when a financial institution provides multiple services

Answer 39

1. underwriting and research in investment banks, 2. auditing and consulting in accounting firms, and 3. credit assessment and consulting in credit-rating agencies

Answer 40

With an extremely high savings rate, averaging around 40% over the past two decades, the country has been able to rapidly build up its capital stock and shift a massive pool of underutilized labour from the subsistence-agriculture sector into higher-productivity activities that use capital.

Answer 41

1. Stocks are not the most important source of external financing for businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses 5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well-established corporations have easy access to securities markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower.

Answer 42

Bank loans and nonbank loans and even bonds account for a larger percentage of external finance for nonfinancial businesses

Answer 43

Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well.

Answer 44

The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy.

Answer 45

- expertise in interpreting signals gives cost advantage - can use info over and over  economies of scale - by providing multiple services to customers apply one info resource to many different services  economies of scope - multiple services to same customers  broader and longer-term relationships with firms

Answer 46

Europe = Bank-based US= Market-based - Bank credit makes up 40-60% of all corporate funding in EU/JP/CA, compared to 20% in the US - Bank credit has become increasingly important in EU since WW2

Answer 47

A bank acquires funds by issuing (selling) liabilities, such as deposits, which are the sources of funds the bank uses. The funds obtained from issuing liabilities are used to purchase income-earning assets.

Answer 48

: bank accounts that allow the owner of the account to write cheques to third parties or to draw cash out of ATMs without loss of interest

Answer 49

are the primary source of bank funds (58% of bank liabilities), two basic types:  Savings accounts  Time deposits

Answer 50

Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are called discount loans

Answer 51

the final category on the liabilities side of the balance sheet is bank capital, the bank’s net worth, which equals the difference between total assets and liabilities Assets A bank uses the funds that it has acquired by issuing liabilities to purchase income-earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits.

Answer 52

deposits plus currency that is physically held by banks

Answer 53

1. Some reserves, called required reserves, are held because of reserve requirements, the regulation that for every euro of sight deposits at a bank, a certain fraction must be kept as reserves. This fraction is called the required reserve ratio. 2. Banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a cheque is written on an account.

Answer 54

1. Companies are more likely to do business with banks that hold their securities. 2. Short-term company securities are liquid, but less liquid and riskier than equivalent maturity government securities, primarily because of default risk: there is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature. Therefore the interest rate on commercial paper is normally higher than that on Treasury bills.

Answer 55

banks make their profits primarily by issuing loans. Loans are typically less liquid than other assets because they cannot be turned into cash until the loan matures. If a bank makes a one-year loan, for example, it cannot get its funds back until the loan comes due in one year. Loans also have a higher probability of default than other assets. Because of their lack of liquidity and their higher default risk, the bank earns its highest return on loans.

Answer 56

these securities can be classified into three categories: government and agency securities such as Treasury bills and short-term government bonds, commercial paper and privatesector bonds, and other securities.  Because of their high liquidity, short-term government securities are called secondary reserves

Answer 57

1. Liquidity management 2. Asset management 3. Liability management 4. Capital adequacy management

Answer 58

the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors.  To make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows – that is, when deposits are lost because depositors make withdrawals and demand payment. To eliminate a shortfall of the reserve requirement, the bank has four basic options: 1) to acquire reserves to meet a deposit outflow by borrowing them from other banks in the central bank funds market or by borrowing from corporations 2) for the bank to sell some of its securities to help cover the deposit outflow 3) to acquire reserves by borrowing from the central bank 4) a bank can acquire the reserves to meet the deposit outflow by reducing its loans by this amount and depositing the money it then receives with the central bank, thereby increasing its reserves  Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold

Answer 59

the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings 1. banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. 2. banks try to purchase securities with high returns and low risk. 3. in managing their assets, banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets (short- and long-term, government bonds and highly rated commercial bonds) and approving many types of loans to a number of customers. 4. the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. G

Answer 60

to acquire funds at low cost Before 60s majority of fund sources were sight deposits. After 60s interbank market was developed like negotiable certificates of deposits CDs which enables surplus banks to fund those in need of cash. It provides banks quickly with funds when they find attractive loan opportunities.

Answer 61

the manager must decide the amount of capital the bank should maintain and then acquire the needed capital  Banks have to make decisions about the amount of capital they need to hold for three reasons. 1. bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business. 2. the amount of capital affects returns for the owners (equity holders) of the bank. 3. a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities.  A bank maintains bank capital to lessen the chance that it will become insolvent

Answer 62

A basic measure of bank profitability, the net profit after taxes per euro of assets: ROA = net profit after taxes/assets  The return on assets provides information on how efficiently a bank is being run, because it indicates how much profits are generated on average by each euro of assets Return on equity (ROE): how much the bank is earning on their equity investment; the net profit after taxes per euro of equity (bank) capital:  ROE = net profit after taxes/equity capital  Given ROA, the lower the bank capital, the higher the return for the owners of the bank

Answer 63

To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely. The attempts of financial institutions to solve these problems help explain a number of principles for managing credit risk:

Answer 64

1. Screening 2. Specializing in Lending 3. Monitoring and restrictive covenants 4. Credit rationing

Answer 65

Adverse selection in loan markets requires that lenders screen out the bad credit risks from the good ones, so that loans are profitable to them. To accomplish effective screening, lenders must collect reliable information from prospective borrowers

Answer 66

It is easier for the bank to collect information about local firms and determine their creditworthiness than to collect comparable information on firms that are farther away. Similarly, by concentrating its lending on firms in specific industries, the bank becomes more knowledgeable about these industries and is therefore better able to predict which firms will be able to make timely payments on their debt.

Answer 67

: financial institutions must write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities.

Answer 68

refusing to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate.  Credit rationing takes two forms. The first occurs when a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like.  If a bank has more rate- sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits

Answer 69

1. Maturity bucket approach 2. Standardized gap analysis

Answer 70

in which the amount of rate-sensitive liabilities is subtracted from the amount of ratesensitive assets

Answer 71

to measure the gap for several maturity subintervals, called maturity buckets, so that effects of interest-rate changes over a multi-year period can be calculated

Answer 72

accounts for the differing degrees of rate sensitivity for different ratesensitive assets and liabilities

Answer 73

examines the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates  Percent change in market value of security  percentage point change in interest rate * duration in years

Answer 74

› Retail bank: Consumer deposits, consumer loans, mortgages, small business loans › Wholesale bank (Corporate bank): Deposits/loans to large companies, governments, pension funds, etc. > Investment bank: Fee/commission generating business (asset management, M&A, proprietary trading) › Universal bank: Offer all

Answer 75

(C)apital adequacy (A)sset quality (M)anagement quality (E)arnings (L)iquidity

Answer 76

equity/assets: lower capital ratio implies riskier banks (capital to assets)

Answer 77

– impaired loans/total loans: higher ratio implies riskier banks (how many loans)

Answer 78

- (Overhead + Other operating expenses) / (Net interest income + Other operating income)cost-to-income ratio (how many costs to make €1,- of income)

Answer 79

– Net income / Equity or Net income/Assets: return on assets return on equity, the higher the more profitable

Answer 80

Cash/Total assets: how many liquid assets does the bank have, the higher the saver

Answer 81

banks that operate internationally must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets. May lead to increased risk taking and regulatory arbitrage.

Answer 82

banks to hold adequate capital to cover credit, market, and operational risk exposures. In case of non-compliance, regulators force financial institutions to engage in prompt corrective actions and to raise their capital in order to avoid penalties that could go all the way to shutting down the institutions. Financial crisis showed limitations

Answer 83

1. more capital buffers were imposed since previous buffers proved insufficient to help banks recover. 2. new liquidity buffers were introduced to enable banks to withstand the drying up of money markets during periods of liquidity crunch. 3. The drastic asset sales at artificially depressed levels during the crisis prompted the need to make banks less leveraged.

Answer 84

- Interest rate changes – interest rate risk - marketable securities lose value – market risk - non-payment by borrowers (default) – credit risk - unexpected variation in deposit withdrawals (reserve requirements aim at avoiding bank runs) – liquidity risk - Fraud by staff, crime and mistakes – operational risk - When expectation driven behaviour conflicts with previous behaviour of the bank then there can be a liquidity problem. Increases probability of bankruptcy.

Answer 85

- Global structure of institutions - Global standards, national and regional regulations - Regulation and supervision of banks is complemented by: deposit insurance schemes and resolution frameworks

Answer 86

*a bank is failing or likely to fail *there is no other supervisory or private sector intervention that can restore the institution to viability within a short time frame, and *normal insolvency proceedings would cause financial instability while having an impact on the public interest *Normal bankruptcy proceedings slow, inefficient and ineffective for financial intermediaries

Answer 87

addresses institution specific risk, through oversight or regulation to ensure the balance sheets of individuals institutions are robust to shocks.  capital & liquidity requirements, consumer protection (influence consumers), licensing and supervision, asset restrictions. Post GFC = Basel committee

Answer 88

addresses system-wide risks, through financial policies aimed at ensuring stability of the financial system as a whole, to prevent substantial disruptions in credit and vital financial services that are necessary for stable economic growth.  counter-cyclical capital buffer

Answer 89

- DI mitigates the effects of panics - financial institutions (Not retail depositors) have the info that enables them to discipline risky banks - retail DI will not raise moral hazard

Answer 90

- banks with more market power found to be on average more stable, more competition associated with greater bank fragility in countries with: lower systemic fragility, better developed stock exchanges, more effective information sharing…

Answer 91

 bank is more likely to fail because it has a smaller capital cushion if it suffers loan losses or other asset write-downs.  with less capital, a financial institution has less ‘skin in the game’ and is therefore more likely to take on excessive risks.

Answer 92

The acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk Responses to changes in Demand conditions: increased interest-rate volatility - Adjustable-rate mortgages -Financial Derivatives

Answer 93

attractive for both lender and borrower but risks of increased mortgage payments.

Answer 94

To hedge risk created futures contracts in financial instruments, which are called financial derivatives because their payoffs are linked to (i.e., derived from) previously issued securities, they could be used to hedge risk.

Answer 95

- Bank credit and debit cards - Electronic banking – ATM and ABM - Junk bonds - Commercial Paper market

Answer 96

the concept of selling new public issues of junk bonds, not for fallen angels but for companies that had not yet achieved investment-grade status.

Answer 97

improvements in information technology made it easier for investors to screen out bad from good credit risks, thus making it easier for corporations to issue debt securities. Not only did this make it simpler for corporations to issue long-term debt securities, as in the junk bond market, but it also meant they could raise funds by issuing short-term debt securities, such as commercial paper, with greater ease.

Answer 98

1. removals of quantitative barriers to growth in banking. 2. increase in competition 3. growth of non-traditional business

Answer 99

The result of phase one was the growth in bank assets and services leading to a rise in prices for its products and an increase in profits.

Answer 100

from new entrants from overseas, competition from non-bank financial institutions and even competition from non-financial institutions leading to the growth of a significant ‘shadow banking’ system. This second phase saw the banks reacting by narrowing spreads and cutting the relative cost of loans as competition bit into profits.

Answer 101

as banks fought the competition by increasing their revenue sources from off- balance-sheet activity such as financial market trading, derivatives and securitization.

Answer 102

this measure is the interest earnings from assets less interest costs of funds, all divided by earnings assets, which contains the average spread

Answer 103

in which bank lending has been replaced by lending via the securities market

Answer 104

responses to changes in demand conditions, responses to changes in supply conditions, and avoidance of existing regulations.

Answer 105

- The loss of cost advantages on the liabilities side of the balance sheet for banks, - hit by a decline in income advantages on the assets side from the financial innovations – junk bonds, securitization and the rise of the commercial paper market. - The resulting loss of income advantages for banks relative to these innovations has resulted in a loss of market share and has led to the growth of the shadow banking system, which has made use of these innovations to enable borrowers to bypass the traditional banking system.

Answer 106

1. universal banking 2. British-style universal banking system 3. The third framework features some legal separation of the banking and other financial services industries

Answer 107

universal banking provides no separation at all between the banking and securities industries. In a universal banking system, commercial banks provide a full range of banking, securities, real estate and insurance services, all within a single legal entity. Banks are allowed to own sizeable equity shares in commercial firms, and often they do.

Answer 108

British-style universal banking system, engages in securities underwriting, but it differs from the German-style universal bank in three ways: separate legal subsidiaries are more common, bank equity holdings of commercial firms are less common, and combinations of banking and insurance firms are less common.

Answer 109

in which monetary policy conducted on a discretionary, day- by-day basis leads to poor long-run outcomes

Answer 110

1. Price stability 2. High employment 3. economic growth 4. stability of financial markets 5. Interest-rate stability 6. Stability in foreign exchange markets

Answer 111

Price stability is the primary goal of most central banks

Answer 112

High employment is a worthy goal for two main reasons: (1) the alternative situation – high unemployment – causes much human misery, and (2) when unemployment is high, the economy has both idle workers and idle resources (closed factories and unused equipment), resulting in a loss of output (lower GDP).

Answer 113

Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. The stability of financial markets is also fostered by interest-rate stability, because fluctuations in interest rates create great uncertainty for financial institutions. An increase in interest rates produces large capital losses on long-term bonds and mortgages, losses that can cause the failure of the financial institutions holding them.

Answer 114

-supervise and regulate (Basel III) - LOLR - monetary policy (inflation, economic growth)  through many channels (interest rates) IS-LM curve  expansionary money policy (decrease r), expansionary fiscal policy (increase G)  if negative shock = increase money supply (decrease interest rates) = encourage inv  if overheating = decrease money supply (increase interest rates) = decrease investment In Europe, the ECB is responsible for monetary policy (Goal is price stability in the medium run)  Inflation below, but close to 2%  Unlike ECB, the Fed has a dual mandate: Price stability and maximum employment

Answer 115

- subjecting the central banks to more political pressures would impart an inflationary bias to monetary policy. - politicians may be short-sighted because they are driven by the need to win their next election. - the political process in democratic societies could lead to a political business cycle, in which just before an election, expansionary policies are pursued to lower unemployment and interest rates. After the election, the bad effects of these policies – high inflation and high interest rates – cause problems, requiring contractionary policies that politicians hope the public will forget before the next election. - Government pressure on the central bank to ‘help out’ could lead to more inflation in the economy. - An independent central bank is better able to resist this pressure from the government. - The control of monetary policy is too important to leave to politicians, a group that has repeatedly demonstrated a lack of expertise at making hard decisions on issues of great economic importance, such as reducing the budget deficit or reforming the banking system. - inflation performance is found to be the best for countries with the most independent central banks.

Answer 116

- it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. In view of the danger that an independent central bank will not be accountable, delegation of power to an independent institution requires guaranteeing its accountability - Another argument against central bank independence is that an independent central bank has not always used its freedom successfully. - central banks are not immune from political pressures and that independence may encourage them to pursue a course of narrow self-interest rather than the public interest. In particular, the theory of bureaucratic behaviour argues that an important factor affecting central banks’ behaviour is their attempt to increase their power and prestige.

Answer 117

1) The central bank 2) Banks (depository institutions) 3) Depositors

Answer 118

Assets: -Government securities -Loans to banks Liabilities: -Currency in circulation -Reserves

Answer 119

 Currency in circulation is the amount of currency in the hands of the public. Currency held by depository institutions is also a liability of the central bank but is counted as part of the reserves.  Reserves: consist of deposits at the central bank plus currency that is physically held by banks (called vault cash because it is stored in bank vaults) Reserves are assets for the banks but liabilities for the central bank, because the banks can demand payment on them at any time and the central bank is required to satisfy its obligation by paying notes. An increase in reserves leads to an increase in the level of deposits and hence in the money supply

Answer 120

Changes in the asset items lead to changes in reserves, the monetary base, and consequently to changes in the money supply.  Government securities: this category of assets covers the central bank’s holdings of securities issued by the government  An increase in government bonds held by the central bank leads to an increase in the money supply  Loans to banks: the loans they have taken out are referred to as borrowings from the central bank or, alternatively, as borrowed reserves. These loans appear as a liability on banks’ balance sheets.

Answer 121

The monetary base (MB) is the sum of currency in circulation (C) and total reserves in the banking system (R), expressed as MB = C + R.

Answer 122

The central bank primarily influences changes in the monetary base through open market operations, which involve buying or selling bonds.

Answer 123

If the seller keeps the proceeds as currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves increase.

Answer 124

An open market purchase always increases the monetary base by the amount of the purchase.

Answer 125

The simple deposit multiplier is the multiple increase in deposits generated from an increase in the banking system's reserves, calculated as ΔD = 1/r * ΔR, where ΔD is the change in total chequable deposits, r is the required reserve ratio, and ΔR is the change in reserves.

Answer 126

The money multiplier indicates how much the money supply changes for a given change in the monetary base. It is calculated as (1+c)/(r+e+c), where c is the currency ratio, r is the required reserves ratio, and e is the excess reserves ratio.

Answer 127

An increase in the required reserve ratio decreases the money supply by reducing the multiple deposit expansion, as the money multiplier becomes smaller.

Answer 128

When banks increase their holdings of excess reserves, multiple deposit creation stops, causing a contraction of the money multiplier and the money supply.

Answer 129

The structural weaknesses include its reliance on stable currency and reserve ratios, which fluctuate in response to economic, financial, and institutional changes. Additionally, the model assumes that bank lending is constrained by reserves, which may not always hold true.

Answer 130

The monetary base, also known as high-powered money, comprises currency in circulation (C) and total reserves in the banking system (R). Unlike measures like M1 or M2, which include broader forms of money like demand deposits, the monetary base represents the most liquid forms of money directly controlled by the central bank.

Answer 131

Open market operations involve the buying or selling of government securities by the central bank in the open market. When the central bank purchases securities, it injects money into the banking system, increasing reserves and the monetary base. Conversely, when it sells securities, it reduces reserves and the monetary base. This process influences interest rates and overall economic activity.

Answer 132

Whether an open market purchase increases reserves depends on whether the seller of the bonds keeps the proceeds in currency or deposits. If the proceeds are kept as deposits, reserves increase, expanding the money supply. However, if the proceeds are kept as currency, reserves remain unchanged, but the monetary base still increases by the amount of the purchase.

Answer 133

The simple deposit multiplier represents the multiple increase in deposits resulting from an initial increase in reserves. It is calculated as the reciprocal of the required reserve ratio. For example, if the required reserve ratio is 10%, the simple deposit multiplier would be 1/0.10 = 10. This means that an increase of $100 in reserves could potentially lead to a $1000 increase in deposits.

Answer 134

1. open market operations, which affect the quantity of reserves and the monetary base; 2. changes in borrowed reserves, which affect the monetary base; 3. changes in reserve requirements, which affect the money multiplier.

Answer 135

1) occur at the initiative of the central bank, which has complete control over their volume 2) flexible and precise; they can be used to any extent. No matter how small a change in reserves or the monetary base is desired, 3) easily reversed. If a mistake is made in conducting an open market operation, the central bank can immediately reverse it. 4) implemented quickly; they involve no administrative delays.

Answer 136

- The main function of reserve requirements is to stabilize the demand for reserves by creating a structural liquidity shortage of the banking sector. This makes it easier for the central bank to control the interest rates. - A rise in reserve requirements also increases the demand for reserves and raises the overnight market rate. - One of the disadvantages of using reserve requirements to control the money supply and interest rates is that raising the requirements can cause immediate liquidity problems for banks where reserve requirements are binding. Moreover, continually fluctuating reserve requirements would also create more uncertainty for banks and make their liquidity management more difficult.

Answer 137

- The most important advantage of lending facilities is that the central bank can use it to perform its role of lender of last resort in preventing and coping with financial and bank panics. - Although the central bank’s role as the lender of last resort has the benefit of preventing bank and financial panics, it does have a cost. If a bank expects that the central bank will provide it with lending when it gets into trouble, it will be willing to take on more risk knowing that the central bank will come to the rescue. The central bank’s lender-of-last- resort role has thus created a moral hazard problem. - The moral hazard problem is most severe for large banks, which may believe that the central bank views them as ‘too big to fail’; that is, they will always receive central bank loans when they are in trouble because their failure would be likely to precipitate a bank panic.

Answer 138

The quantity of reserves demanded by banks consists of required reserves and excess reserves. Excess reserves act as insurance against deposit outflows, providing stability to banks during periods of uncertainty. However, holding excess reserves incurs an opportunity cost, represented by the difference between the interest rate that could have been earned through lending and the interest rate offered by the central bank in its deposit facility.

Answer 139

Lending to banks is facilitated through the national central banks' standing lending facility, known as the marginal lending facility. Banks can borrow overnight loans against eligible collateral at the marginal lending rate, set at 100 basis points above the target financing rate. Conversely, the deposit facility offers banks a fixed interest rate set 100 basis points below the target financing rate. These facilities establish upper and lower bounds for overnight market interest rates, ensuring stability in the financial system.

Answer 140

The supply of reserves comprises non-borrowed reserves supplied by the central bank's open market operations and borrowed reserves obtained through loans from the central bank. The interest rate charged on borrowed reserves influences banks' borrowing decisions. Changes in the supply of reserves, particularly through open market operations, affect short-term interest rates and the overall money supply

Answer 141

Open market operations are the primary tool for implementing monetary policy. Purchases of securities expand reserves and the monetary base, leading to lower short-term interest rates and an increase in the money supply. Conversely, sales of securities reduce reserves and the monetary base, resulting in higher interest rates and a decrease in the money supply.

Answer 142

Quantitative easing involves expanding the supply of reserves beyond what is needed to maintain the policy rate target. This approach allows central banks to exert greater control over the quantity of reserves rather than focusing solely on interest rates. By adjusting the supply of reserves, central banks can influence economic conditions and address liquidity concerns in financial markets.

Answer 143

Open market operations offer several advantages, including being initiated by the central bank, which has complete control over their volume. They are flexible and precise, allowing for adjustments of any desired magnitude. Additionally, open market operations can be quickly reversed if necessary, without administrative delays, making them a highly effective tool for implementing monetary policy.

Answer 144

The central bank acts as the lender of last resort to prevent and address financial panics, providing liquidity support to banks in times of crisis. However, this role can create moral hazard, as banks may take on excessive risk, expecting the central bank to bail them out if they encounter difficulties. Large banks, in particular, may perceive themselves as "too big to fail," exacerbating moral hazard concerns.

Answer 145

Reserve requirements help stabilize the demand for reserves, facilitating central bank control over interest rates. However, increasing reserve requirements can create immediate liquidity problems for banks and increase uncertainty in the banking sector. Continual fluctuations in reserve requirements could further complicate liquidity management for banks, potentially impacting financial stability.

Answer 146

(i) timing evidence, which looks at whether the movements in one variable typically occur before those in another; (ii) statistical evidence, which performs formal statistical tests on the correlation of the movements of one variable with another; and (iii) historical evidence, which examines specific past episodes to see whether movements in one variable appear to cause those in another

Answer 147

The main advantage of reduced-form evidence is that it imposes no restrictions on the way monetary policy affects the economy. This allows for a potentially better understanding of the full effect of changes in monetary policy on economic output.

Answer 148

Reduced-form evidence might be more effective because it does not require knowing all the monetary transmission mechanisms. It allows for the observation of whether movements in economic output (Y) correlate highly with movements in the money supply (M).

Answer 149

The most notable objection is that reduced-form evidence may misleadingly suggest that changes in the money supply (M) cause changes in economic output (Y) when this is not necessarily the case.

Answer 150

The principle highlighted is "correlation does not necessarily imply causation," meaning that just because two variables move together, it does not mean that one causes the other.

Answer 151

Expansionary monetary policy leads to a fall in real interest rates.

Answer 152

A decrease in real interest rates lowers the cost of capital, which leads to a rise in investment spending. This increase in investment spending raises aggregate demand and ultimately results in a rise in aggregate output.

Answer 153

Investment spending (I) includes residential housing investment and consumer durable expenditure, which refers to spending by consumers on durable items such as automobiles and refrigerators.

Answer 154

The interest-rate transmission mechanism emphasizes the real interest rate (rather than the nominal interest rate) as the rate that affects consumer and business decisions.

Answer 155

The real long-term interest rate is viewed as having the major impact on spending.

Answer 156

Lower real short-term interest rates, as long as they persist, lead to a fall in the real long-term interest rate. These lower real interest rates then result in rises in business fixed investment, residential housing investment, inventory investment, and consumer durable expenditure, all of which contribute to an increase in aggregate output.

Answer 157

The two basic categories of other transmission mechanisms are those operating through asset prices other than interest rates and those operating through asymmetric information effects on credit markets (the credit view).

Answer 158

Foreign exchange rates and the prices of equities (stocks) receive substantial attention as channels for monetary policy effects.

Answer 159

Domestic real interest rates fall as a result of expansionary monetary policy.

Answer 160

Falling domestic real interest rates make domestic assets less attractive relative to assets denominated in foreign currencies.

Answer 161

When domestic real interest rates decrease, the domestic currency depreciates.

Answer 162

A depreciated domestic currency makes domestic goods cheaper than foreign goods.

Answer 163

The depreciation of the domestic currency causes a rise in net exports (NX).

Answer 164

The schematic for the monetary transmission mechanism through the exchange rate channel is: Expansionary monetary policy leads to a fall in real interest rates (ir) The fall in real interest rates leads to a depreciation of the domestic currency (E) The depreciation of the domestic currency leads to a rise in net exports (NX) The rise in net exports leads to an increase in aggregate output (Y)

Answer 165

An increase in net exports leads to a rise in aggregate output (Y).

Answer 166

During an expansionary monetary policy, the public finds that it has more money than it wants and gets rid of it through spending, including in the stock market.

Answer 167

An increase in stock prices leads to a higher q (the Tobin's q ratio), which in turn leads to higher investment spending (I).

Answer 168

The schematic representation is: Expansionary monetary policy -> Stock prices (P_s) increase -> q increases -> Investment spending (I) increases -> Aggregate output (Y) increases.

Answer 169

An increase in stock prices raises the value of financial wealth, which increases the lifetime resources of consumers, leading to a rise in consumption.

Answer 170

The schematic representation is: Expansionary monetary policy -> Stock prices (P_s) increase -> Wealth increases -> Consumption increases -> Aggregate output (Y) increases.

Answer 171

The two types of monetary transmission channels are those that operate through effects on bank lending and those that operate through effects on firms’ and households’ balance sheets.

Answer 172

Expansionary monetary policy increases bank reserves and bank deposits, which increases the quantity of bank loans available. This increase in loans leads to a rise in investment (and possibly consumer) spending.

Answer 173

The schematic representation is: Expansionary monetary policy -> Bank deposits increase -> Bank loans increase -> Investment spending (I) increases -> Aggregate output (Y) increases.

Answer 174

The credit view suggests that monetary policy will have a greater effect on expenditure by smaller firms, which are more dependent on bank loans, than on larger firms, which can obtain funds directly through stock and bond markets.

Answer 175

1. evidence on the behaviour of firms supports the view that credit market imperfections of the type crucial to the operation of credit channels do affect firms’ employment and spending decisions. 2. there is evidence that small firms (which are more likely to be credit-constrained) are hurt more by tight monetary policy than large firms, which are unlikely to be credit- constrained. 3. the asymmetric information view of credit market imperfections at the core of the credit channel analysis is a theoretical construct that has proved useful in explaining many other important phenomena

Answer 176

1) Easing or the tightening of monetary policy does NOT always result in a fall or a rise in short-term nominal interest rates 2) Other asset prices besides those on short-term debt instruments are important elements in various monetary policy transmission mechanisms 3) Monetary policy can be highly effective in reviving a weak economy even if short- term interest rates are already near zero 4) Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal for monetary policy

Answer 177

Lower net worth means that lenders have less collateral for their loans, increasing their potential losses from adverse selection. This leads to decreased lending to finance investment spending.

Answer 178

A decline in net worth increases the moral hazard problem because owners have a lower equity stake in their firms, giving them more incentive to engage in risky investment projects.

Answer 179

Expansionary monetary policy, which raises stock prices, increases the net worth of firms. This decreases adverse selection and moral hazard problems, leading to higher lending, investment spending, and aggregate demand.

Answer 180

The schematic representation is: Expansionary monetary policy -> Stock prices (P_s) increase -> Firm’s net worth increases -> Adverse selection decreases -> Moral hazard decreases -> Lending increases -> Investment spending (I) increases -> Aggregate output (Y) increases.

Answer 181

Expansionary monetary policy lowers nominal interest rates, which raises firms' cash flow, increasing their liquidity. This makes it easier for lenders to assess the firm's ability to pay its bills, reducing adverse selection and moral hazard problems, and leading to increased lending and economic activity.

Answer 182

Lower interest rates reduce the adverse selection problem by increasing the proportion of less risk-prone borrowers, making lenders more willing to lend.

Answer 183

An unanticipated rise in the price level lowers the value of firms’ liabilities in real terms, decreasing the burden of the debt while maintaining the real value of the firms' assets, raising their real net worth.

Answer 184

An increase in the value of households' financial assets reduces the likelihood of financial distress, making consumers more secure financially. This increases consumer-durable and housing expenditure.

Answer 185

The schematic representation is: Expansionary monetary policy -> Stock prices (P_s) increase -> Value of households’ financial assets increases -> Likelihood of financial distress decreases -> Consumer-durable and housing expenditure increases -> Aggregate output (Y) increases.

Answer 186

Banks can game a risk-based capital regulation through the following mechanism: Risk mapping for probability of default determines the capital requirement, with a higher risk leading to a higher capital requirement. Banks underreport the riskiness of loans to appear less risky, which leads to holding risky loans while maintaining low capital requirements. This behavior is most prevalent in firms with a low probability of default that need more capital.

Answer 187

Deposit insurance is likely to never be correctly priced due to the following reasons: It cannot prevent moral hazard; riskier loan takers are attracted by deposit insurance, but banks cannot distinguish these 'lemons.' The insurance price is based on the average probability of default, making it relatively cheaper for riskier banks. Safer banks are incentivized to make riskier investments to cover the relatively higher insurance costs, seeking more profitable but riskier returns.

Answer 188

Shocks to the net worth of economic agents can trigger business cycle fluctuations through the following mechanism: Due to limited liability, lenders will need to monitor borrowers who cannot repay, incurring agency costs. Entrepreneurs with less collateral have stronger incentives to take risks. Lending contracts are adjusted to account for borrower wealth, with greater wealth reducing the risk and monitoring cost, thus increasing lending. Agency costs decline with increased borrower wealth, influencing the lending dynamics and overall economic activity.

Answer 189

The stages leading up to a financial crisis are: Build up: Financial innovation and risk materialization. Financial crisis: The necessity of a clean-up process. Debt deflation: A spiral due to lack of consumer demand.

Answer 190

The financial crisis can be seen as both supply-driven and demand-driven: Supply-driven: Subprime credit and ensuing defaults were key drivers. Demand-driven: Homebuyers and lenders entered the housing market as prices were rising, and borrowers defaulted when prices dropped. Expectations of continually rising housing prices also played a role.

Answer 191

The structural problems that needed to be addressed post-FC included: >Incentive problems: -Originate-to-distribute model created a principal-agent problem, as originators did not bear the risk and were not responsible for monitoring. -Compensation structures and bonuses incentivized risky behavior. -Adverse selection due to an understanding of incentives at banks. -Homeowners' walk-away options due to limited liability, with full recourse in Europe. -Banks offloaded risk to investors. -Credit rating agencies earned more if they gave high ratings. >Information problems: -Tranching created complexity and lack of transparency about risk. -Weak supervision, including of insurance companies like AIG.

Answer 192

The timeline of events leading up to the financial crisis includes: Financial innovation in mortgages led to credit growth, pushing housing prices up and making collateral more valuable. Lending standards became laxer, not accounting for housing price risk. Housing prices began to fall, default rates on subprime mortgages rose, and the MBS markets collapsed. The failure to appropriately assess risk and global interconnectedness led to a contagion effect without adequate supervision or regulation.

Answer 193

The financial crisis led to a sovereign debt crisis through: Bank bailouts resulting in a large increase in debt-to-GDP ratios. Low labor mobility and restricted fiscal policy roles counteracted business cycle movements. A single currency made interest rates converge throughout the EU, reducing lending rates and raising credit in southern EU countries. The spillover of default risk without mechanisms to handle potential exits. Creation of new institutions like the single supervisory mechanism and single resolution mechanism to address these issues.

Answer 194

The useful implications for central banks' conduct of monetary policy include: Easing or tightening of monetary policy does not always result in a fall or rise in short-term nominal interest rates. Other asset prices besides those on short-term debt instruments are crucial elements in various monetary policy transmission mechanisms. Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are near zero. Avoiding unanticipated fluctuations in the price level is crucial, providing a rationale for price stability as the primary long-term goal for monetary policy.

Answer 195

The interest rate channel operates as follows: Real interest rate decreases. The cost of capital decreases. Firms invest more and households consume more. Aggregate demand increases.

Answer 196

The exchange rate channel works by: Real interest rates decrease. The domestic currency depreciates. Net exports increase. Aggregate demand increases.

Answer 197

The wealth channel operates as follows: Real interest rate decreases. Asset prices increase. Wealth increases. Investment and consumption increase. Aggregate demand increases.

Answer 198

The bank lending channel functions through the following steps: The central bank buys bonds. Banks have more excess reserves. Bank deposits increase, enhancing lending capacity. Consumers use loans to invest and consume more. Aggregate demand increases.

Answer 199

The balance sheet channel works as follows: Real interest rates decrease. Asset prices increase. Firms' net worth increases. Asymmetric information decreases. Lending increases. Investment and consumption increase. Aggregate demand increases.

Answer 200

The cash flow channel operates by: Nominal interest rates decrease. Cash flows from assets increase. Adverse selection and moral hazard problems decrease. Lending increases. Investment increases. Aggregate demand increases.

Answer 201

The unanticipated price level channel works as follows: An unanticipated rise in the price level lowers the value of firms' liabilities in real terms. Firms' net worth increases. Adverse selection and moral hazard problems decrease. Lending increases. Investment increases. Aggregate demand increases.

Answer 202

The household liquidity effects function through: A rise in stock prices. The net worth of households increases. Financial distress decreases. Consumption of consumer-durables increases. Aggregate demand increases.

Answer 203

Statement b) is true. U.S. is a market-based economy where bank loans are less important relative to other types of funding. Thus, the ratio is smaller in market-based economies like the U.S. than in bank- based economies like Germany.

Answer 204

Statement a) is true. Although bank credit has become relatively less important in advanced economies, it has risen relative to the size of GDP, especially in Europe

Answer 205

d) Central banks typically lower interest rates, the government runs a fiscal deficit, and common financial sector interventions are recapitalizations of and liquidity support for banks.

Answer 206

The interest rate can be calculated as follows: Interest rate =Operating costs/Loan volume+(Loss given default×Probability of default)+(Equity funding× Cost of equity)+(Deposit funding×Cost of deposits) =70,000/10,000,000+1%×100%+10%×10%+90%×0%= 0.70%+1%+1% =2.70%

Answer 207

Requiring collateral would reduce the loss given default (LGD) because, if default occurred, the bank would still have the collateral to mitigate the loss. This would reduce the overall interest rate that needs to be charged since the risk is lower with collateral.

Answer 208

If the bank could make the same loan to multiple corporations, the operational costs (in percentage terms) would decrease, leading to lower loan rates.

Answer 209

Loan-to-deposit ratio (LDR): This ratio assesses a bank's liquidity by comparing total loans to total deposits. A high LDR indicates potential liquidity issues, suggesting that the bank might struggle to cover unforeseen fund requirements, thus predicting the occurrence of crises. Non-core funding ratio: Core funding is the most stable source of funding. A high reliance on non-core funding indicates volatile and unreliable funding, which can predict financial crises. Capital ratios: Although capital ratios help determine the speed of recovery from a crisis, they do not predict the occurrence of crises. High capital ratios indicate a bank's ability to absorb losses and recover faster.

Answer 210

Safe Project: Success: Probability = 80%, Payoff = €120,000 - €100,000(1 + i) Fail: Probability = 20%, Payoff = €40,000 - €40,000 Risky Project: Success: Probability = 50%, Payoff = €150,000 - €100,000(1 + i) Fail: Probability = 50%, Payoff = €0

Answer 211

Safe Entrepreneurs: Interest Rate (r) = 15% Safe entrepreneurs would borrow because their profit (0.8 * (€120,000 - €100,000(1 + 0.15))) = €4,000, which is greater than 0. Risky Entrepreneurs: Interest Rate (r) = 100% Risky entrepreneurs would not borrow because their profit (0.5 * (€150,000 - €100,000(1 + 1))) = -€25,000, which is less than 0.

Answer 212

The bank would charge a weighted average interest rate: 0.5 × 100 % + 0.5 × 15 % = 57.5 % 0.5×100%+0.5×15%=57.5% Safe Entrepreneurs: Profit < 0, so they would not apply for the loan. Risky Entrepreneurs: Profit > 0, so they would apply for the loan. The bank's profits would be negative because safe entrepreneurs would not apply, and the expected return from risky entrepreneurs would not cover the loans' risk.

Answer 213

Collateral can reduce adverse selection by ensuring that borrowers have a stake in the loan contract. Risky firms are less likely to enter a loan contract requiring collateral, thus reducing the overall risk.

Answer 214

Depreciation of local currency: QE increases money supply, leading to currency depreciation. This makes exports more competitive, boosting the real economy. Reducing long-term interest rates: QE increases demand for government bonds, lowering their yields and other long-term interest rates. This stimulates investment by making borrowing cheaper for long-term projects, positively affecting the real economy.

Answer 215

During a business cycle expansion, interest rates decrease, and investment is stimulated. This increases the demand for corporate bonds as investors seek higher returns, and the supply of bonds as firms raise funds for investment.

Answer 216

True. A lower capital ratio indicates higher leverage, which amplifies the return on equity (ROE) given the same return on assets (ROA). The formula for ROE is ROE = ROA * Leverage.

Answer 217

True. After a €25,000 outflow, the bank’s deposits would be €75,000, requiring reserves of 20% * €75,000 = €15,000, which matches the remaining reserves of €15,000.

Answer 218

The introduction of collateral affects the Loss Given Default (LGD). Since collateral reduces the amount the bank loses in case of a borrower default, the expected loss (EL) is reduced. The expected loss is calculated as: Expected Loss (EL)=PD×LGD With collateral reducing the LGD, the overall expected loss decreases, which can lead to a lower interest rate on the loan.

Answer 219

Removal of quantitative barriers to growth: This phase resulted in the growth of bank assets and services, leading to a rise in prices for its products and an increase in profits. Increase in competition: This phase involved competition from overseas entrants, non-bank financial institutions, and non-financial institutions, leading to a significant growth in the shadow banking system. Banks responded by narrowing spreads and cutting the relative cost of loans, which affected their profits. Growth of non-traditional business: In response to competition, banks increased their revenue sources from off-balance-sheet activities such as financial market trading, derivatives, and securitization.

Answer 220

Net Interest Margin (NIM) is a measure that represents the difference between the interest earnings from assets and the interest costs of funds, divided by earning assets. It reflects the average spread and is significant because it indicates the profitability of a bank's lending activities.

Answer 221

The shadow banking system refers to a financial system in which traditional bank lending is replaced by lending via the securities market. This system operates outside the traditional banking regulations and channels, allowing borrowers to bypass the conventional banking system.

Answer 222

Responses to changes in demand conditions: Innovations that arise to meet new or changing customer needs. Responses to changes in supply conditions: Innovations that result from advancements in technology or efficiency improvements. Avoidance of existing regulations: Innovations designed to circumvent regulatory constraints and reduce compliance costs.

Answer 223

Financial derivatives are financial instruments such as futures contracts whose payoffs are linked to (derived from) previously issued securities. Their value depends on the performance of the underlying assets.

Answer 224

Lowered cost of processing transactions: Information technology has made it cheaper for financial institutions to process financial transactions, enabling them to create new financial products and services for the public. Easier information acquisition: It has become easier for investors to acquire information, making it simpler for firms to issue securities and for investors to make informed decisions.

Answer 225

Economies of scope refer to the synergies between different lines of business that allow firms to reduce costs by offering a variety of products and services. Information technology has enhanced these synergies, leading to consolidation in the banking industry, enabling financial institutions to become larger and offer a broader range of products and services.

Answer 226

Encroachment of financial intermediaries: Different types of financial intermediaries are increasingly encroaching on each other's territory, making them more similar. Development of large, complex banking organizations (LCBOs): Consolidation has led to the formation of large, complex banking organizations as named by the Federal Reserve in the US.

Answer 227

Banks have lost competitiveness due to: Loss of cost advantages on liabilities: Banks have faced higher costs on the liabilities side of their balance sheets. Decline in income advantages on assets: Financial innovations such as junk bonds, securitization, and the commercial paper market have eroded banks' income advantages. These factors have reduced banks' market share and led to the growth of the shadow banking system, which utilizes these financial innovations.

Answer 228

Universal banking: No separation between banking and securities industries. Commercial banks provide a full range of banking, securities, real estate, and insurance services within a single legal entity. Banks can own significant equity shares in commercial firms. British-style universal banking: Similar to universal banking but differs in three ways: separate legal subsidiaries are more common, bank equity holdings of commercial firms are less common, and combinations of banking and insurance firms are less common. Partial separation: Some legal separation exists between banking and other financial services industries.

Answer 229

The time-inconsistency problem arises when monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes. Policymakers may prioritize short-term gains over long-term stability, resulting in suboptimal economic performance.

Answer 230

Price stability: Maintaining stable prices to avoid inflation or deflation. High employment: Achieving low unemployment to prevent human misery and make full use of economic resources. Economic growth: Ensuring sustainable growth of the economy. Stability of financial markets: Preventing financial market disruptions to maintain economic stability. Interest-rate stability: Reducing fluctuations in interest rates to create economic certainty and facilitate planning. Stability in foreign exchange markets: Managing the value of the domestic currency relative to foreign currencies to support international trade and control inflation.

Answer 231

Hierarchical mandates: Central banks prioritize price stability first, and then pursue other goals once price stability is achieved. Dual mandates: Central banks aim to achieve two co-equal objectives: price stability and maximum employment.

Answer 232

The Eurosystem includes three main entities: National central banks: Similar to the Federal Reserve banks. Executive Board: Comparable to the Board of Governors. Governing Council: The de facto decision-making body, similar to the Federal Open Market Committee (FOMC).

Answer 233

Supervise and regulate: Implementing regulations such as Basel III. Lender of Last Resort (LOLR): Providing liquidity to banks during financial distress. Conduct monetary policy: Managing inflation and promoting economic growth through various channels, such as adjusting interest rates.

Answer 234

Expansionary monetary policy: Decreasing interest rates (r) to encourage investment and stimulate economic activity. Expansionary fiscal policy: Increasing government spending (G)