Quiz 2 Memorization of Facts Flashcards
8 Facts About How Firms Obtain Finance
1) Stocks are not that important
2) Debt is not that important, but more than stocks
3) Indirect finance is more important that Direct finance
4) Banks are an important source of external finance
5) Financial System is heavily regulated
6) Only big, established firms have access to security markets to raise funds
7) Collateral is important
8) Debt contracts are complicated and often restrict borrower behavior
Liquidity Management Techniques
Unanticipated withdrawals: A. Excess Reserves B. Borrow i, another bank at Federal Funds Rate ii, Borrow from Federal Reserve @ discount window C. Sell Assets D. Call in Loans
Asset Management Techniques
A. find people who are willing to pay IR with low probability of default
B. buy low, sell high on securities (banks often create securities)
C. Diversify to lower risk
D. Balance the need for liquidity vs returns
• gov’t bonds/ securities on book
Liabilities Management
- deposits take care of themselves
- manage borrowing (ie negotiable CD)
Capital (Adequacy) Management
- ROA, ROE
- max limit set by government for Equity Multiplier (Leverage Ratio, A/K)
- must have 10% assets in capital
- Basal III regulation
Credit Risk
1) Screening
2) Monitor
3) Debt Contracts
- long term relationships wanted
4) Collateral
5) Credit Rationing
Tools to Help Solve Adverse Selection Problems
- Private production and sale of information
- Gov’t regulation to increase information
- Financial intermediation
- intermediaries become experts in sorting out good credit risks from bad ones
- make private loans, over-come free rider problem - Collateral and Net Worth
Tools to Help Solve Principal Agent Problem
- Production of information : Monitoring (ie Audits)
- Financial Intermediation
- Gov’t regulation (forced to conform to audit principals)
- Debt Contracts
Tools to Help Solve Moral Hazard in Debt Contracts
- Net Worth and Collateral
- Monitoring , Enforce Restrictive Covenants
- Financial Intermediation
Type of Conflict of Interest
i. Underwriting and Research in Investment Banking (research company, then sell IPOs)
ii. Auditing and Consulting in Accounting Firms
iii. Credit Assessment and Consulting in Credit- Rating Agencies
iv. Universal Banking
Approaches to Remedying Conflict of Interest
- Leave it to the market
- investors want unbiased information - regulate for transparency
- mandatory disclosure (cannot reveal too much) - Supervisory Oversight
- regulate without reveal to competitors - Separation of Functions
- problem: decrease economies of scale - Socialization of Information Production
- gov’t funded agencies -> relevant info
Efficient Market Hypothesis Implications
- if there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well
- forecast errors of expectations will, on average, be 0
- prices of securities in financial markets fully reflect all available information
• expected rate of return = > equilibrium return
• expected rate of return = optimal forecast of return
Bank’s Liabilities
- Checkable Deposits
- Non transaction Deposits (savings accounts, CD)
- Borrowings
- Bank Capital
Bank’s Assets
- Reserves
- Cash Items in Process of Collection
- Deposits at other banks
- Securities
- Loans
Managing Interest Rate Risk
- Gap and Duration Analysis • Gap Analysis • Maturity Bucket Approach • Standardized Gap Analysis • Duration Analysis
