Eo B- exam prep

Question 1

What causes financial markets to be imperfect, and what creates a role for FI?

Answer 1

 transaction costs
 need for risk sharing
 presence of information asymmetries

Question 2

Why are FM and FI regulated?

Answer 2

• intermediaries differ by source and maturity of their funding, the level of insurance/risk, their
  regulation
• retail savers face similar information frictions in their relationship with financial institutions, and
  lack resources to monitor them: creates a role for gov
• Purpose of regulation

Question 3

definition: Purpose of regulation

Answer 3

increase and improve information, maintain sound financial system, avoid
panics, trade-off efficiency and stability

Question 4

Why are banks special?

Answer 4

• issue transaction accounts for households and firms
• run the payment system
• create and provide liquidity
• Specialized in collecting information (screen, monitor)
• Main tool for transmission of monetary policy.

Question 5

A firm or an individual can obtain funds in a financial market in two ways:

Answer 5

• to issue a debt instrument (bond or mortgage) contractual agreement of payment
• issuing equities (common stock) claims to a share in net income and assets of a company.

Question 5

what does money equal and 2 characteristics:

Answer 5

= anything generally accepted in payment for good, services, debts…
- change over time as certain assets become easier to convert into currency
- three functions: medium of exchange, unit of account, store of value

Question 6

what is the main disadvantage of owning a corporation’s equities rather than its debt

Answer 6

An equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it
pays its equity holders.

Question 7

definition- residual claimant

Answer 7

the corporation must pay all its debt holders before it pays its equity holders.

Question 8

what is the advantage of holding equities

Answer 8

is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity
holders

Question 8

name the three types of financial intermediaries:

Answer 8

1) Depository institutions (banks)
2) Contractual savings institutions
3) Investment intermediaries.

Question 9

definition-Mutual funds:

Answer 9

These financial intermediaries acquire funds by selling shares to many individuals and
use the proceeds to purchase diversified portfolios of stocks and bonds.

Question 10

name two characteristics for MUTUAL FUNDS

Answer 10

1. Lower transaction costs
2. Diversify porfolios

Question 11

definition- LOWER TRANSACTION COSTS:

Answer 11

Mutual funds allow shareholders to pool their resources so that they can take advantage of lower
transaction costs when buying large blocks o stocks or bonds

Question 12

definition-DIVERSIFY PORFOLIOS

Answer 12

Mutual funds allow shareholders to hold more diversified portfolios than they otherwise would
Money market mutual funds: These financial institutions have the characteristics of a mutual fund
but also function to some extent as a depository institution because they offer deposit-type accounts

Question 13

definition-Money market mutual funds:

Answer 13

These financial institutions have the characteristics of a mutual fund
but also function to some extent as a depository institution because they offer deposit-type accounts

Question 14

what is investment bank

Answer 14

is a different type of intermediary that helps a corporation issue securities. First it
advises the corporation on which type of securities to issue (stocks or bonds); then it helps sell
(underwrite) the securities by purchasing them from the corporation at a predetermined price and
reselling them in the market

Question 15

Financial markets are regulated for two main reasons:

Answer 15

1) To increase the information available to investors
2) To ensure the soundness of the financial system.

Question 16

what are the primary Functions of Money

Answer 16

-Medium of exchange
-Unit of account
-Store of value

Question 17

definition-Medium of exchange:

Answer 17

used to pay for goods and services. The use of money as a medium of
exchange promotes economic efficiency by minimizing the time spent in exchanging goods and
services.

Question 18

definition-Unit of account:

Answer 18

that is, it is used to measure value in the economy
We can see that using money as a unit of account reduces transaction costs in an economy by
reducing the number of prices that need to be considered. The benefits of this function of money
grow as the economy becomes more complex.

Question 19

definition-Store of value:

Answer 19

it is a repository of purchasing power over time
A store of value is used to save purchasing power from the time income is received until the time it
is spent.

Question 20

Three characteristics for Coupon Rates and YTM

Answer 20

1) When the coupon bond = face value, the yield to maturity = the coupon rate
2) The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to
maturity rises, the price of the bond falls. As the yield to maturity falls, the price of the bond rises
3) The yield to maturity > coupon rate  bond price < face value

Question 21

definition-Current yield:

Answer 21

the yearly coupon payment divided by the price of the security

Question 22

Rate of capital gain:

Answer 22

the change in the bond’s price relative to the initial purchase price
R = ic + g
The return on a bond will NOT necessarily equal the yield to maturity on that bond. More generally,
the return on a bond held from time t to time t + 1 can be written as
R = (C+Pt+1 – Pt)/Pt

Question 23

name two characteristics for Rate of capital gain

Answer 23

 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

Question 24

what is The Fisher equation

Answer 24

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

Question 25

The supply and demand analysis for bonds:

Answer 25

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 +

Question 26

The supply and demand analysis for bonds
Examples:

Answer 26

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

Question 27

Keynes’ analysis:

Answer 27

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

Question 28

In Keynes’s liquidity preference framework:

Answer 28

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.

Question 29

Two factors cause the demand curve for money to shift: income and the price level.

Answer 29

Income effect
Price-Level effect

Question 30

definition-Price-Level effect

Answer 30

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.

Question 31

definition-Income effect:

Answer 31

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.

Question 32

Shifts in the supply of money

Answer 32

 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.

Question 33

Money and Interest Rates:

Answer 33

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.

Question 34

Ch 6 - The Risk and term Structure of Interest Rates

Answer 34

 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

Question 35

The risk structure of interest rates

Answer 35

(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.

Question 36

Three theories of the term structure of interest rates

Answer 36

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

Question 37

1. Expectations theory

Answer 37

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

Question 38

2. Segmented markets theory

Answer 38

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.

Question 39

3. Liquidity premium theory

Answer 39

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.

Question 40

The liquidity premium theory’s key assumption is that bonds of different maturities are
substitutes,

Answer 40

, 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

Question 41

Preferred habitat theory

Answer 41

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

Question 42

The liquidity premium and preferred habitat theories explain the following facts:

Answer 42

• 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

Question 43

YIELD CURVE AND EXPECTATIONS OF SHORT TERM RATES

Answer 43

• 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.

Question 44

Composition of funding:

Answer 44

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

Question 45

Composition of funding
Example: 1

Answer 45

-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%

Question 46

Ch 8 - An Economic Analysis of Financial Structure
Information Asymmetry can be:

Answer 46

 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

Question 47

 Adverse Selection
How to help solve the adverse selection problem:

Answer 47

• 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

Question 48

Remedies: Mitigating in credit markets

Answer 48

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

Question 49

Remedies: Hurdles to resolving Adverse Selection

Answer 49

• 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.

Question 50

Remedies: Addressing free-rider problem:

Answer 50

: 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

Question 51

Relationship banking definition

Answer 51

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

Question 52

what is public solutions for free-rider problem

Answer 52

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

Question 53

The lemon problem:

Answer 53

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

Question 54

The lemon problem: adverse selection

Answer 54

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.

Question 55

Moral Hazard (3)

Answer 55

• 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

Question 56

Mitigation:

Answer 56

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

Question 57

Equity contracts are:

Answer 57

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

Question 58

Tools to help solve the principal–agent problem

Answer 58

• 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)

Question 59

Tools to help solve moral hazard in debt contracts

Answer 59

• 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

Question 60

Conflicts of interest:

Answer 60

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

Question 61

Conflicts of interest:
Types of financial service activities:

Answer 61

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

Question 62

China - How could they grow so fast with weak financial development?

Answer 62

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.

Question 63

Eight basic facts about the global financial system:

Answer 63

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.

Question 64

1. Stocks are not the most important source of external financing for businesses. Explanation:

Answer 64

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

Question 65

Collateral is a prevalent feature of debt contracts for both households and businesses. Explanation:

Answer 65

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.

Question 66

Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower. one characteristic:

Answer 66

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.

Question 67

Financial institutions play an important role in the financial system

Answer 67

• 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

Question 68

Why banks exist?

Answer 68

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

Question 69

Chapter 10 - Banking and the Management of Financial Institutions
Liabilities

Answer 69

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.

Question 70

Chapter 10 - Banking and the Management of Financial Institution
 Checkable deposits:

Answer 70

: 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

Question 71

Chapter 10 - Banking and the Management of Financial Institutions
Non-Transaction Deposits:

Answer 71

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

Question 72

Chapter 10 - Banking and the Management of Financial Institutions
Banks’ deposits and other funding

Answer 72

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

Question 73

Chapter 10 - Banking and the Management of Financial Institutions
 Bank capital:
Assets

Answer 73

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.

Question 73

Chapter 10 - Banking and the Management of Financial Institutions
Reserves:

Answer 73

deposits plus currency that is physically held by banks

Question 73

Although reserves earn a low interest rate, banks hold them for two reasons.

Answer 73

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.

Question 74

Banks also hold commercial paper and other short-term securities of the non- financial company
sector for two reasons(2)

Answer 74

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.

Question 74

Loans:

Answer 74

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.

Question 74

Although reserves earn a low interest rate, banks hold them for two reasons.
 Securities:

Answer 74

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

Question 75

The bank manager has four primary concerns:

Answer 75

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

Question 76

The bank manager has four primary concerns:
1. Liquidity management

Answer 76

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

Question 77

The bank manager has four primary concerns:
2. Asset management

Answer 77

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

Question 78

The bank manager has four primary concerns:
3. Liability management

Answer 78

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.

Question 79

The bank manager has four primary concerns:
4. Capital adequacy management

Answer 79

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

Question 80

Return on assets (ROA),

Answer 80

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

Question 81

Credit Risk Management:
definition:

Answer 81

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:

Question 82

Credit Risk Management:(4)

Answer 82

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

Question 83

Credit Risk Management:
1. Screening:

Answer 83

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

Question 84

Credit Risk Management:
2. Specializing in Lending:

Answer 84

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.

Question 85

Credit Risk Management:
3. Monitoring and restrictive covenants:

Answer 85

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

Question 86

Credit Risk Management:
4. Credit rationing:

Answer 86

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

Question 87

Gap analysis:
two types:

Answer 87

1. Maturity bucket approach
2. Standardized gap analysis

Question 88

Gap analysis - definition

Answer 88

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

Question 89

Gap analysis:
Maturity bucket approach:

Answer 89

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

Question 90

Gap analysis:
Standardized gap analysis:

Answer 90

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

Question 91

Duration analysis:

Answer 91

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

Question 92

Types of Banks

Answer 92

› 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

Question 93

Ratio analysis: compare profitability and riskiness of banks ( C.A.M.E.L.)

Answer 93

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

Question 94

Ratio analysis: compare profitability and riskiness of banks
(C)apital adequacy

Answer 94

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

Question 95

Ratio analysis: compare profitability and riskiness of banks
(A)sset quality

Answer 95

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

Question 96

Ratio analysis: compare profitability and riskiness of banks
(M)anagement quality

Answer 96

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

Question 97

Ratio analysis: compare profitability and riskiness of banks
(E)arnings

Answer 97

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

Question 98

Ratio analysis: compare profitability and riskiness of banks
(L)iquidity

Answer 98

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

Question 99

Basel Accord  established capital requirements/buffers & regulative guidelines
Basel 1:

Answer 99

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.

Question 100

Basel Accord  established capital requirements/buffers & regulative guidelines
Basel 2:

Answer 100

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

Question 101

Basel Accord  established capital requirements/buffers & regulative guidelines
Basel 3 is to introduce three types of buffers.

Answer 101

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.

Question 102

Chapter 11 - Economic Analysis of Financial Regulation
 Types of risk banks are exposed to:

Answer 102

• 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.

Question 103

What have banks done to regulate and supervise banks?

Answer 103

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

Question 104

Bank resolution
Occurs when authorities determine that:

Answer 104

*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

Question 105

Microprudential - definition

Answer 105

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

Question 106

Macroprudential- definition

Answer 106

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

Question 107

Deposit Insurance(3)

Answer 107

• 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

Question 108

Trade-off between greater efficiency (competition) and lower financial stability (risk)

Answer 108

• 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…

Question 109

If the amount of a financial institution’s capital falls to low levels, there are two serious problems.

Answer 109

 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.

Question 110

CAMELS rating:

Answer 110

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

Question 111

CAMELS rating:
Adjustable-rate mortgages:

Answer 111

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

Question 112

CAMELS rating:
Financial Derivatives

Answer 112

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.

Question 113

Responses to changes in supply conditions: information Technology

Answer 113

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

Question 114

information Technology
Junk bonds:

Answer 114

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.

Question 115

information Technology
Commercial Paper market:

Answer 115

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.

Question 116

CH 12 - Banking Industry: Structure and Competition
The impact of deregulation can be separated into three distinct phases

Answer 116

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

Question 117

CH 12 - The impact of deregulation can be separated into three distinct phases.
-removals of quantitative barriers to growth in banking:

Answer 117

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.

Question 118

CH 12
The impact of deregulation can be separated into three distinct phases.
increase in competition:

Answer 118

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.

Question 119

CH 12-The impact of deregulation can be separated into three distinct phases.
growth of non-traditional business:

Answer 119

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

Question 120

Net interest margin (NIM):

Answer 120

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

Question 121

Shadow banking system:

Answer 121

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

Question 122

There are three basic types of financial innovation:

Answer 122

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

Question 123

Banks Loss of Competitiveness -> growth of shadow banking system

Answer 123

• 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.

Question 124

There are three basic frameworks for the banking and securities industries

Answer 124

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

Question 125

What does universal banking provide?

Answer 125

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.

Question 126

What does British-style universal banking system engage in?

Answer 126

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.

Question 127

Chapter 13
Time-inconsistency problem:

Answer 127

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

Question 128

Objectives of monetary policy:

Answer 128

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

Question 129

what is Price stability?

Answer 129

Price stability is the primary goal of most central banks

Question 130

why is high employment a worthy goal? (2)

Answer 130

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).

Question 131

what interest-rate stability is?

Answer 131

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.

Question 132

Role of CB =

Answer 132

-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

Question 133

SHOULD THE CENTRAL BANK BE INDEPENDENT?
->FOR:

Answer 133

• 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.

Question 134

SHOULD THE CENTRAL BANK BE INDEPENDENT?
->AGAINST:

Answer 134

• 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.

Question 135

Chapter 14
The ‘cast of characters’ in the money supply story is as follows:

Answer 135

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

Question 136

Central Bank Balance Sheet:
assets and liabilities(2)

Answer 136

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

Question 137

Chapter 14
Central Bank Balance
LIABILITIES -Currency in circulation and Reserves

Answer 137

 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

Question 138

Chapter 14
Central Bank Balance
ASSETS- Government securities and Loans to banks

Answer 138

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.

Question 139

What is the monetary base, and how is it calculated?

Answer 139

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.

Question 140

How does the central bank primarily influence changes in the monetary base?

Answer 140

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

Question 141

What happens to reserves when the central bank conducts an open market purchase, depending on how the seller uses the proceeds?

Answer 141

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.

Question 142

How does an open market purchase affect the monetary base, regardless of how the seller uses the proceeds?

Answer 142

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

Question 143

What is the simple deposit multiplier, and how is it calculated?

Answer 143

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.

Question 144

What does the money multiplier indicate, and how is it calculated?

Answer 144

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.

Question 145

How does an increase in the required reserve ratio affect the money supply?

Answer 145

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

Question 146

What happens to the money supply when banks increase their holdings of excess reserves?

Answer 146

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

Question 147

What are the structural weaknesses of the money multiplier model?

Answer 147

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.

Question 148

What distinguishes the monetary base from other measures of money supply, such as M1 or M2?

Answer 148

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.

Question 149

How do open market operations function as a tool for the central bank to implement monetary policy?

Answer 149

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.

Question 150

What factors determine whether an open market purchase leads to an increase in reserves, and how does this impact the money supply?

Answer 150

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.

Question 151

Can you explain the concept of the simple deposit multiplier and provide an example of its application?

Answer 151

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.

Question 152

Chapter 15
Three policy tools that central banks can use to manipulate the money supply and interest rates:

Answer 152

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.

Question 153

Advantages of Open market operations:

Answer 153

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.

Question 154

Reserve requirements(3):

Answer 154

• 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.

Question 155

Lender of last resort vs. moral hazard(3):

Answer 155

• 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.

Question 156

What factors determine the quantity of reserves demanded by banks, and how do these factors affect the banking system’s stability?

Answer 156

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.

Question 157

How does lending to banks occur, and what are the key features of the marginal lending facility and the deposit facility?

Answer 157

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.

Question 158

Can you explain the components of the supply of reserves and how changes in these components impact the money market?

Answer 158

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

Question 159

What role do open market operations play in monetary policy, and how do they influence interest rates and the money supply?

Answer 159

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.

Question 160

Could you explain the concept of quantitative easing and its implications for monetary policy?

Answer 160

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.

Question 161

What are the advantages of open market operations compared to other monetary policy tools?

Answer 161

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.

Question 162

How does the concept of the lender of last resort relate to moral hazard in the banking system?

Answer 162

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.

Question 163

What is the function of reserve requirements in monetary policy, and what are some potential drawbacks of using reserve requirements to control the money supply?

Answer 163

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.

Question 164

Reduced-form evidence can be broken down into three categories:

Answer 164

(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

Question 165

What is the main advantage of reduced-form evidence over structural model evidence in the context of monetary policy?

Answer 165

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.

Question 166

Why might reduced-form evidence be more effective in identifying the full effect of monetary policy changes?

Answer 166

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).

Question 167

What is the most notable objection to using reduced-form evidence in analyzing monetary policy?

Answer 167

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.

Question 168

What important statistical principle is highlighted as a potential issue with reduced-form evidence?

Answer 168

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.

Question 169

What effect does expansionary monetary policy have on real interest rates?

Answer 169

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

Question 170

How does a decrease in real interest rates influence investment spending and aggregate output?

Answer 170

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.

Question 171

What types of expenditures are included under investment spending (I) in the context of the interest rate channel?

Answer 171

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.

Question 172

What is emphasized as the rate that affects consumer and business decisions in the interest-rate transmission mechanism?

Answer 172

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.

Question 173

Which interest rate is considered to have a major impact on spending, according to the interest-rate transmission mechanism?

Answer 173

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

Question 174

How do lower real short-term interest rates affect real long-term interest rates and investment?

Answer 174

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.

Question 175

Besides interest rates, what are the two basic categories of other transmission mechanisms for monetary policy effects?

Answer 175

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).

Question 176

Which two asset prices, in addition to bond prices, receive substantial attention as channels for monetary policy effects?

Answer 176

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

Question 177

What happens to domestic real interest rates as a result of expansionary monetary policy?

Answer 177

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

Question 178

How do falling domestic real interest rates affect the attractiveness of domestic assets compared to foreign currency-denominated assets?

Answer 178

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

Question 179

What is the impact on the domestic currency when domestic real interest rates decrease?

Answer 179

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

Question 180

How does a depreciated domestic currency influence the price of domestic goods compared to foreign goods?

Answer 180

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

Question 181

What effect does the depreciation of the domestic currency have on net exports (NX)?

Answer 181

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

Question 182

What is the schematic for the monetary transmission mechanism that operates through the exchange rate channel?

Answer 182

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)

Question 183

What is the ultimate effect on aggregate output (Y) due to an increase in net exports?

Answer 183

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

Question 184

What happens to the public’s money holdings during an expansionary monetary policy in the context of the asset price channel?

Answer 184

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.

Question 185

How does an increase in stock prices (P_s) affect investment spending (I) according to the asset price channel?

Answer 185

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

Question 186

What is the schematic representation of the monetary transmission mechanism through the asset price channel?

Answer 186

The schematic representation is:

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

Question 187

How does an increase in stock prices influence financial wealth and consumption in the context of the wealth channel?

Answer 187

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

Question 188

What is the schematic representation of the monetary transmission mechanism through the wealth channel?

Answer 188

The schematic representation is:

Expansionary monetary policy -> Stock prices (P_s) increase -> Wealth increases -> Consumption increases -> Aggregate output (Y) increases.

Question 189

According to the credit view, what are the two types of monetary transmission channels that arise due to information problems in credit markets?

Answer 189

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.

Question 190

How does expansionary monetary policy affect bank loans and investment spending through the bank-lending channel?

Answer 190

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.

Question 191

What is the schematic representation of the monetary transmission mechanism through the bank-lending channel?

Answer 191

The schematic representation is:

Expansionary monetary policy -> Bank deposits increase -> Bank loans increase -> Investment spending (I) increases -> Aggregate output (Y) increases.

Question 192

How does the credit view suggest monetary policy affects smaller firms compared to larger firms?

Answer 192

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.

Question 193

There are three reasons to believe that credit channels are important monetary transmission
mechanisms. (3)

Answer 193

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

Question 194

What useful implications for central banks’ conduct of monetary policy can we draw?(4)

Answer 194

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

Question 195

How does lower net worth affect the lending behavior of lenders?

Answer 195

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.

Question 196

What effect does a decline in net worth have on the moral hazard problem?

Answer 196

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.

Question 197

How does expansionary monetary policy affect the net worth of firms and lending?

Answer 197

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.

Question 198

What is the schematic representation of the balance-sheet channel of monetary transmission?

Answer 198

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.

Question 199

How does expansionary monetary policy improve firms’ balance sheets through nominal interest rates?

Answer 199

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.

Question 200

How do lower interest rates affect the adverse selection problem?

Answer 200

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

Question 201

What happens to firms’ liabilities in real terms when there is an unanticipated rise in the price level due to monetary expansion?

Answer 201

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.

Question 202

How does an increase in the value of households’ financial assets affect consumer-durable and housing expenditure?

Answer 202

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.

Question 203

What is the schematic representation of the transmission mechanism through consumer cash flow?

Answer 203

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.

Question 204

Explain the mechanism by which banks can game a risk-based capital regulation.

Answer 204

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.

Question 205

Explain why deposit insurance is likely to never be correctly priced.

Answer 205

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.

Question 206

How can shocks to the net worth of economic agents trigger business cycle fluctuations?

Answer 206

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.

Question 207

What are the stages leading up to a financial crisis (FC)?

Answer 207

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.

Question 208

Was the financial crisis supply-driven or demand-driven? Explain.

Answer 208

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.

Question 209

What were the structural problems that needed to be addressed post-FC?

Answer 209

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.

Question 210

Describe the timeline of events leading up to the financial crisis.

Answer 210

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.

Question 211

How did the financial crisis lead to a sovereign debt crisis?

Answer 211

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.

Question 212

What useful implications for central banks’ conduct of monetary policy can be drawn from the financial crisis?

Answer 212

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.

Question 213

What is the mechanism of the interest rate channel in monetary policy transmission?

Answer 213

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.

Question 214

How does the exchange rate channel influence aggregate demand?

Answer 214

The exchange rate channel works by:

Real interest rates decrease.
The domestic currency depreciates.
Net exports increase.
Aggregate demand increases.

Question 215

Explain the wealth channel according to Tobin’s Q theory.

Answer 215

The wealth channel operates as follows:

Real interest rate decreases.
Asset prices increase.
Wealth increases.
Investment and consumption increase.
Aggregate demand increases.

Question 216

Describe the bank lending channel in the context of monetary policy.

Answer 216

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.

Question 217

What is the balance sheet channel and how does it affect aggregate demand?

Answer 217

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.

Question 218

How does the cash flow channel contribute to increasing aggregate demand?

Answer 218

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.

Question 219

Explain the unanticipated price level channel in monetary transmission.

Answer 219

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.

Question 220

What are the household liquidity effects on aggregate demand?

Answer 220

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.

Question 221

Which of these two countries is the U.S. and which one is Germany?
a) Country A=U.S., Country B=Germany
b) Country A=Germany, Country B=U.S.

Answer 221

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.

Question 222

On average, in both the US and Europe, the banking sector has become somewhat less important
relative to other sources of private sector funding. But how has the ratio of bank loans to GDP
developed in the US and Europe over the past 50 years?
a) It has risen in both
b) It has fallen in both
c) It has risen in Europe, but fallen in the U.S.
d) It has fallen in Europe, but risen in the U.S

Answer 222

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

Question 223

Which statement best describes the typical policy pattern during and immediately following a financial crisis in developed economies?

Answer 223

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.

Question 224

What interest rate should a bank charge on a 1-year corporate loan to earn its cost of equity given the following conditions: Loan volume of €10 million, operating cost of €70,000, PD = 1%, LGD = 100%, 90% deposit funding, and 10% equity funding with cost of equity at 10%?

Answer 224

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%

Question 225

In the above loan scenario, how does requiring collateral worth €2 million affect the calculation?

Answer 225

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.

Question 226

How would the interest rate change if the bank could make the same loan to multiple corporations?

Answer 226

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

Question 227

How do loan-to-deposit ratios, capital ratios, and non-core funding ratios predict financial crises? Base your answer on the paper by Jorda et al. (2017).

Answer 227

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.

Question 228

Draw or explain the probability tree for both safe and risky projects where each project needs a loan of €100,000.

Answer 228

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

Question 229

If a bank can distinguish between safe and risky entrepreneurs, what interest rates would it charge each to achieve an expected profit of 0? Would the entrepreneurs apply for the loan at these rates?

Answer 229

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.

Question 230

f a bank cannot distinguish between safe and risky entrepreneurs, what interest rate will it charge knowing that half of the entrepreneurs are risky and half are safe? Will any entrepreneurs apply for a loan, and what are the bank’s profits?

Answer 230

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.

Question 231

Explain one solution for adverse selection problems.

Answer 231

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.

Question 232

How can quantitative easing affect the real economy? Focus on at least two channels.

Answer 232

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.

Question 233

How does a business cycle expansion affect the demand and supply of corporate bonds?

Answer 233

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.

Question 234

True/False: For a given return on assets, the lower a bank’s capital ratio, the higher the return on equity for the bank’s owners. Explain your answer.

Answer 234

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.

Question 235

True/False: If a bank has €100,000 of checkable deposits, a required reserve ratio of 20%, and holds €40,000 in reserves, the maximum deposit outflow it can sustain without altering its balance sheet is €25,000. Explain your answer.

Answer 235

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.

Question 236

How does the introduction of collateral affect the expected loss (EL) in the loan pricing model?

Answer 236

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.

Question 237

What are the three distinct phases of deregulation in the banking industry?

Answer 237

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.

Question 238

Define Net Interest Margin (NIM) and explain its significance.

Answer 238

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.

Question 239

What is the shadow banking system and how does it function?

Answer 239

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.

Question 240

Identify and describe the three basic types of financial innovation.

Answer 240

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.

Question 241

What are financial derivatives, and how are their payoffs determined?

Answer 241

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.

Question 242

Explain the two effects of information technology on financial institutions.

Answer 242

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.

Question 243

What are economies of scope, and how has information technology influenced them in the banking industry?

Answer 243

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.

Question 244

Discuss the two main consequences of consolidation in the banking industry.

Answer 244

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.

Question 245

Why have banks lost competitiveness leading to the growth of the shadow banking system?

Answer 245

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.

Question 246

Describe the three basic frameworks for the banking and securities industries.

Answer 246

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.

Question 247

What is the time-inconsistency problem in monetary policy?

Answer 247

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.

Question 248

List and explain the primary objectives of monetary policy.

Answer 248

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.

Question 249

Compare hierarchical mandates and dual mandates in the context of central banks.

Answer 249

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.

Question 250

What are the main entities in the organizational structure of the Eurosystem?

Answer 250

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).

Question 251

What are the roles of a central bank?

Answer 251

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.

Question 252

Explain the IS-LM model’s view on expansionary monetary and fiscal policies.

Answer 252

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