Financial Institutions 1

Question 1

8 key facts

Answer 1

1. Stocks not main external financing for firms
2. Issuing marketable debt and equity is not a primary finance source
3. Indirect finance more important direct finance
4. Financial intermediaries (banks) are most important external finance
5. Financial system is heavily regulated.
6. Only large corps have access to security markets for funding.
7. Collateral is common in debt contracts
8. Debt contracts place substantial restrictive covenants on borrowers.

Question 2

Financial intermediaries characteristics to reduce costs (2)

Answer 2

Economies of scale

Expertise

Question 3

Explain The Lemons problem (adverse selection)

Answer 3

If quality cannot be assessed, buyer will pay average quality price MAX

Sellers of good quality get underpaid so don’t sell.

Buyer does not buy as only bad quality items supplied in the market.

Question 4

How to solve adverse selection (4)

Answer 4

Private production and sale of information
Eval: free rider problem - people can follow leads so no one buys!

Gov regulation forcing info provision

Make borrowers put up collateral, or devote substantial resources (net worth)

Question 5

What theories are in moral hazard (2)

Answer 5

Principle agent problem - agent has more info than the principle, so acts in own self interest.

Separation of ownership and control
(Managers pursue own benefits opposed to overall profitability of firm)

Question 6

Tools to solve principle agent problem (4)

Answer 6

Monitor
Eval: free rider problem and costly

Gov regulation to increase information (transparency)

Financial intermediation

Debt contracts

Question 7

Tools to solve moral hazard in debt contracts (3)

(Solve problem of borrowers engaging in greater risk if loaning from bank, since entitled to all profits)

Answer 7

Put up net worth and collateral.

Monitoring and enforcement of restrictive covenants (discourage undesirable behaviour)

Financial intermediation

Question 8

Issue with securing collateral:

(Hint: esp in developing countries)

Answer 8

Tyranny of collateral
Hard to make ownership of land legal (expensive, timely)

Therefore securing land as collateral is hard.

Question 9

In bank panics where deposit insurance is needed (protect depositors by insuring the banks survive) , the FDIC uses 2 types of insurance:

B) Government can be used as a safety net for banks: what is this known as?

Answer 9

Payoff method - FDIC pays off insured deposits of the failed bank.
Purchase and assumption method - FDIC finds a bank willing to assume the assets and liabilities of the failed bank. (More costly, but better for depositors as shown in example)

B) Lender of last resort

Question 10

Drawbacks of lender of last resort (2)

Answer 10

Moral hazard
Adverse selection

Question 11

Moral hazard from government safety net (2)

Answer 11

Depositors do not impose discipline of marketplace

Financial institutions have incentive to take on greater risk (if know they will getting bailed out by gov)

Question 12

Adverse selection in government safety net (2)

Answer 12

Risk lovers find banking attractive

Depositors have little reason to monitor financial institutions (no need to do extra checks since know government will keep banks alive, not very efficient)

Question 13

Why do/can larger financial organisations challenge regulation (want less regulation)

Answer 13

“Too big to fail” problem,

Challenging regulation extends their safety net for more risk taking (and have bargaining power cos they are big so will get bailed)

Question 14

So…

2 ways to restrict banks from excessive risk taking and avoid moral hazard issue from lender of last resort

Answer 14

Bank regulations

Capital requirements

Question 15

1st way to restrict excessive risk taking:

Bank regulations - 2 methods

Answer 15

Promote diversification

Prohibit holdings of common stock

Question 16

2nd way to prevent excessive risk taking:

Capital requirements - 2 methods

Answer 16

Minimum leverage ratio for banks

Basel accord: risk based capital requirements

Question 17

Minimum Leverage ratio - formula and what requirement?

Answer 17

Capital/assets

Must exceed 5%. Below means increased restrictions

Question 18

If capital level too low (below requirement) this is bad…

FDIC intervene EARLY to prevent capital falling too low: how? (2)

Answer 18

Chartering (screening to prevent adverse selection)

Examinations

Question 19

Suppose that Altin has 500,000 ALL(the Albanian
currency) in deposits in a bank in Albania. Due to a
severe shock, the bank is considered insolvent by
the Albanian Deposit Insurance Agency.

Question 20

Historical development of Benin system

Answer 20

Bank of NA chartered

1863 National bank act creates system of federally charted banks

Federal reserve system in 1913

Question 21

Who insures state banks that are not FED members

Answer 21

FDIC

Question 22

State banking authorities

Answer 22

State banks without FDIC insurance.

Question 23

Financial engineering

Answer 23

Changing financial environment to stimulate larger profits

Question 24

How did they financially engineer (innovate) following high interest rate volatility?

Answer 24

Created adjustable rate mortgage e.g low initial interest rates to attract buyers.

Financial derivatives e.g interest rate swaps! - to hedge interest rate risk.

Question 25

How did they financially engineer following improvements in technology?

Answer 25

credit and debit cards

Electronic banking

Junk bonds

Commercial paper markets

Question 26

Online banking has increased.

Banks responses to the decline of traditional banking (since most move to online) (2)

Answer 26

New and riskier areas of lending e.g real estate loans

Off-balance sheet activities (non-interest income)

Question 27

Bank consolidation/nationwide banking

Benefits (3) and costs (2)

Answer 27

Increased competition drives inefficient banks out

E.O.S and scope

Lower probability of bank failure since diversified portfolios

Costs:
Less lending to small banks

Banks expanding into new area may take increased risks and fail

Question 28

Thrift industry - what does this entail

Answer 28

Other financial institutions that parallel to commercial banks

Question 29

Thrift industry institutions (3)

Answer 29

Saving and loan associations (chartered by gov)
Mutual savings banks (half charted by gov)
Credit unions (chartered by gov and tax exempt)

Question 30

Bank balance sheet assets vs liabilities (5,4)

Answer 30

Assets: Reserves cash dick sucking lips
Reserves
Cash items
Deposits at other banks
Securities
Loans

Liabilities: Chinks be non bad
Checkable deposits
Non transaction deposits
Borrowings
Bank capital

Question 31

Reasons for the decline in traditional banking (2)

Answer 31

Fall in cost advantages in acquiring funds (people borrowing money from the banks)

Fall in income advantages in using funds

Question 32

1st reason for traditional banking decline:

Fall in cost advantages in acquiring funds (2 parts, knowing 1st is fine)

Answer 32

Rising inflation caused higher interest rates, increasing cost of borrowing (thus declining traditional banking)

Low cost funds declined in importance

Question 33

2nd reason for traditional banking decline:

Fall in income advantages in banks acquiring funds (2 parts, knowing 1st is fine)

Answer 33

Tech reduced transaction costs, so more competition from other financial institutions (online ones!)

Info tech reduces need for bank lending.

Question 34

Payoff method vs purchase & assumption method

That deposit insurance agency’s choose between

Answer 34

Payoff method
- insurance agency pays off insurees directly e.g if you were insured 250k, they pay you 250k direct

Purchase & assumption method
- healthy bank/s acquire some of the assets and liabilities, so if have 500K and insured up to 250K, can be paid 250k and also whatever amount healthy bank takes over