money and banking Flashcards
What is a balance sheet?
A summary of what a household or firm owns (assets) and owes (liabilities), used to understand changes in wealth.
What are assets?
Assets are what you own.
What are liabilities?
Liabilities are what you owe.
What is net worth?
Net worth is the difference between assets and liabilities.
Formula: Net worth ≡ Assets − Liabilities
What is the balance sheet identity?
Assets ≡ Liabilities + Net Worth
How does borrowing affect net worth?
Borrowing does not change net worth because it creates both an asset (cash) and a liability (debt) of equal value.
Why does lending or borrowing not change your net worth?
Because a loan adds both an asset and a liability of equal value, keeping net worth unchanged.
How does consumption affect net worth?
Consumption decreases assets without changing liabilities, so net worth falls.
What happens to Julia’s net worth when she borrows 58?
Her assets and liabilities both increase by 58, so her net worth remains 0. If Julia consumes the 58 then she has no asset so net worth will be -58
What are the three types of money?
Base money, bank money, and broad money.
What is base money?
Cash and central bank reserves; it is a liability of the central bank.
What is bank money?
Bank deposits created when commercial banks give credit; it is a liability of commercial banks.
What is broad money?
The total money held by the non-bank public, equal to base money + bank money.
What is legal tender?
Money that must be accepted by law for payment, including cash and commercial bank reserves.
Where does most of our money come from?
It is created by commercial banks when they make loans.
What happens when Marco deposits $100 in a bank?
The bank gains $100 of base money as an asset and has a $100 liability to Marco.
What happens when Marco transfers $20 to Gino?
Marco’s bank’s assets and liabilities drop by $20; Gino’s bank’s assets and liabilities rise by $20.
What happens when Gino borrows $100 from his bank?
Bank creates $100 of bank money; asset = loan to Gino, liability = Gino’s deposit.
What happens when Gino pays Marco $10 in wages?
Gino’s bank transfers $10 of base money to Marco’s bank.
Why don’t banks need all legal tender to settle transactions daily?
They cancel out many transactions and only settle the net difference.
Why do banks want more deposits?
More deposits mean fewer interbank payments and more lending power.
Is the money created by banks an asset or liability?
A liability, because it must be paid on demand.
What is maturity transformation?
Banks borrow short-term (deposits) and lend long-term (loans).
What is liquidity transformation?
Turning liquid deposits into illiquid loans.
What is liquidity risk?
The risk that many depositors withdraw money at once, causing a bank run.
What is a bank run?
When many depositors withdraw funds at the same time, and the bank can’t meet the demand.
Why might governments rescue failing banks?
Because a banking crisis can collapse the financial system and economy.
What is the price of borrowing base money?
The short-term interest rate.
Why might a bank borrow base money?
To cover net daily transactions when they don’t have enough base money.
Why do banks borrow from each other?
Some banks have excess base money while others face a shortage.
What are the costs of attracting deposits for banks?
Interest payments, marketing, and maintaining branches.
What determines the interest rate in the money market?
Supply and demand for base money:
Demand: Number of transactions banks must make
Supply: Set by the central bank
How does the central bank control interest rates?
By supplying whatever base money is demanded at a chosen interest rate (the base rate).
What is the base rate also known as?
The official rate or policy rate.
Why won’t banks lend below or borrow above the base rate?
Because they can always borrow from the central bank at rate i.
What is the bank lending rate?
The average interest rate charged by commercial banks to households and firms.
What is the markup or spread in banking?
The difference between the bank lending rate and the base rate.
Can the central bank control the markup?
No, but the lending rate generally moves with the base rate.
What is the yield?
The interest rate on government bonds.
How does the lending rate affect spending?
Higher rates reduce borrowing and spending; lower rates encourage them.
Why would you not pay €100 today for a promise of €100 in a year at a 6% interest rate?
Because you could invest €100 in the bank and get €106 in a year instead.
What is the present value (PV) of €100 received in 1 year at a 6% interest rate?
PV = €100 / 1.06 = €94.34
What does the present value formula look like for t years in the future?
PV = sum up to: X / (1+𝑖)^𝑡
What happens to present value when interest rates increase?
Present value decreases, because future payments are discounted more heavily.
What is Net Present Value (NPV) in investment decisions?
NPV = Present Value of profits − Cost of investment
If NPV > 0, the investment is worthwhile.
What is a bond?
A financial asset where the issuer borrows money and promises to repay over time.
What are the two main payments from a bond?
Coupons (C): Fixed periodic payments
Face value (F): Lump sum paid at maturity
What determines the price of a bond?
The discounted present value of its coupons and face value.
When does a bond’s yield equal the interest rate?
When interest rates are expected to stay constant over time.
What is known vs. unknown when it comes to bonds and interest rates?
We know the bond’s price, coupons, and face value — but we don’t know if future interest rates will stay the same.
What is arbitrage in this context?
Moving funds between bonds, deposits, and loans to take advantage of small differences in returns.
Numerical example: A bond with F = €100, yearly coupon C = €5, T = 4 years, interest rate = 3%. What’s the max price you’d pay?
€107.43
If the central bank raises the interest rate, what happens to bond prices and yields?
Bond prices fall and yields rise to match the new interest rate.
What are the main costs of a bank?
Operational costs (e.g. salaries, branches)
Interest costs (on deposits and other borrowings)
What are the revenues of a bank?
The interest and repayments from loans to customers.
What happens to the interest markup/spread if loan risk increases?
It widens, to cover higher risk of defaults.
What determines bank profitability?
The difference between cost of borrowing and return from lending, adjusted for defaults and operational costs.
How do you calculate a bank’s net worth?
Assets – Liabilities
What does it mean if a bank has negative net worth?
The bank is insolvent — it owes more than it owns.
What are the 5 main asset categories on a bank’s balance sheet?
(A1) Cash & central bank reserves
(A2) Bank’s own financial assets
(A3) Loans to other banks
(A4) Loans to households/firms
(A5) Tangible assets (buildings/equipment)
What is secured vs unsecured lending?
Secured: Backed by collateral (e.g. mortgage)
Unsecured: No collateral (e.g. credit card)
What are the 4 main liabilities on a bank’s balance sheet?
(L1) Deposits
(L2 & L3) Borrowings (secured/unsecured)
(L4) Net worth/equity (shares + retained profits)
Why do banks hold only minimum prudent reserves?
Because holding cash has an opportunity cost — it could be earning interest elsewhere.
What is equity for a bank?
Shares issued + accumulated profits not paid out as dividends.
What is the leverage ratio of a company?
For banks: Total assets / Net worth
For companies: Total liabilities / Total assets
What are current assets and liabilities?
Current assets: Cash, inventory, short-term assets
Current liabilities: Short-term debts and payments due soon
What is the typical reason households borrow?
To buy large items like cars or houses, often using collateral.
What is a principal–agent problem in lending?
The lender (principal) can’t perfectly observe the borrower’s (agent) effort or the project’s quality, creating risk and conflict of interest.
What are two ways lenders reduce the principal–agent problem?
Requiring equity from the borrower
Requiring collateral
Why does requiring equity or collateral help?
Increases borrower’s incentive to succeed
Signals confidence in the project’s quality
What is credit rationing?
When borrowers with low wealth are either
Refused loans, or
Offered loans on unfavourable terms
What does it mean to be credit-excluded?
You cannot borrow at any interest rate due to insufficient wealth/collateral.
What does it mean to be credit-constrained?
You can borrow, but only on unfavourable terms.
Why does inequality arise in credit markets?
Wealthy people can lend at favourable rates
Poorer people borrow at high rates or are excluded, limiting their opportunities
Why are banks and credit markets essential for the economy?
They allow people to move spending across time, enabling both investment and consumption smoothing, especially for those with less wealth.
why is default risk not a big problem
default risk is not a problem as it is expected and the interest rate they set such that they incorporate the risk already
what do banks do when default risk is higher then anticipated
A bank reacts by increasing interest rate spread done by either increasing loan rate or decreasing deposit rate.
how does a bank solve insolvency
The banks cannot solve this on its own. Bank cannot borrow as it adds liabilities to borrowing side
it can go to court and declare bankrupt.
or The central bank steps in and give the banks cash. The cash adds to cash and reserves so they go up.
