Week 1: Banks, Money And The Credit Market Flashcards

Question

What does investment do and what combination increases consumption in both periods?

Answer 1

Investment is another way to move consumption to the future. Market risk plays a crucial role Combination of investing and borrowing can further increase consumption in both periods. Wealth and income determine the opportunities to engage in these activities and their interest rates

Answer 2

Balance sheet as a tool to track wealth A balance sheet summarises what the household or firm owns and what it owes to others Assets = Anything of value that is owned Liabilities = Anything of value that is owed Net worth = assets – liabilities A loan creates both an asset and a liability on your balance sheet

Answer 3

Wealth or net worth does not change when you lend or borrow A loan adds both assets and liabilities to the balance sheet: - the borrowed money (cash) is an asset - the debt is an equal liability (to be repaid)

Answer 4

A bank is a firm that makes profits by supplying credit, investing in financial markets, and managing assets for clients. Banks borrow from households (deposits), other banks, and the central bank. They offer a variety of financial services and products. Banks make profits by paying lower interest on deposits than they charge on loans.

Answer 5

- The central bank is the only bank that creates legal tender, money that must be accepted by law. cash (notes, coins) + commercial banks reserves (also called base money) - The central bank is usually owned or controlled by the government through treasury/finance ministry, ensuring alignment with national economic policy goals - Acts as the “the bank of banks” as commercial banks need to hold accounts at the central bank. - It facilitates interbank payments, liquidity management, and monetary policy implementation

Answer 6

Commercial banks create money through lending (making loans) - This is called bank money ≠ legal tender - Loans are considered a liability to the bank, not an asset - Banks earn profits by charging interest on bank money

Answer 7

Broad Money = Base Money + Bank Money The bank physically only has 20 dollars but puts 180 into ginos bank account which he pays back so the bank ends up with 200. Maximum deposit = 20/0.10 =200 Maximum credit = 200-20=180

Answer 8

By taking deposits and making loans, banks provide the economy with maturity transformation (short-term borrowing vs long-term lending): - Deposits can be withdrawn at any time - But loans are repaid after a pre-agreed time (typically years)

Answer 9

Liquidity is how quickly an asset can be turned into cash. Banks also provide liquidity transformation: Ø Deposits are liquid Ø Loans to borrowers are illiquid The above exposes two risks affecting banks: 1. Default risk: loans will not be repaid 2. Liquidity risk: an asset cannot be exchanged for cash rapidly enough to prevent a financial loss

Answer 10

Banks make money by lending more than they hold in legal tender, following central bank rules on reserves. A bank run happens when all depositors demand their money at once, and if the bank runs out of money, it may go bankrupt. Banks can also fail by making bad investments or offering loans that aren’t repaid. If a bank fails, the government may intervene with bailouts because a banking crisis can affect the entire financial system.

Answer 11

Banks make many transactions with each other daily, most of which cancel out, and settle up at the end of the day. Each bank transfers or receives the net amount of transactions. Banks need enough base money to cover these transactions. If they don’t have enough, they can borrow base money on the money market at the short-term interest rate. The demand for base money depends on transaction volumes, and the central bank controls the total supply of base money through monetary policy.

Answer 12

Policy interest rate = interest rate on base money set by the central bank Bank lending rate = average interest rate charged by commercial banks to firms and households who borrow

Answer 13

The central bank’s policy rate affects the level of spending in the economy via the interest rate The more it costs to borrow, the less household and firms will borrow to spend and invest Higher interest rate → lower level of investment/spending today

Answer 14

Bank’s costs: • Operational costs: salaries, IT infrastructure, branch rents • Cost of money: determined by policy interest rates via the money market • Interest on liabilities: paying interest on deposits and other borrowings Bank’s revenue: • Interest and repayments from loans • Financial products (structuring and sales) • Transaction fees and other fees • Investments Expected return: The return on loans, investments, and transactions, considering default risk, market fluctuations, and transaction volumes.

Answer 15

Leverage = Total assets / Net worth. Net worth (or equity) = Assets - Liabilities. It’s what’s owed to shareholders and includes shares and retained profits. For banks, net worth is a small portion of the balance sheet. A negative net worth means the bank is insolvent (liabilities exceed assets). Leverage describes a company’s reliance on debt. For banks, it’s the ratio of assets to equity (net worth). For companies, leverage is total liabilities divided by total assets.

Answer 16

The relationship between the lender and the borrower is a principal–agent problem Principal-agent = a conflict of interest between principal (lender) and agent (borrower), about some hidden action or attribute of the agent that cannot be enforced or guaranteed in a binding contract Screening & monitoring are difficult: lender cannot ensure that the borrower will use the funds in a prudent way or is going to put a lot of effort in a business project A loan is made now and has to be repaid in the future.

Answer 17

To reduce the conflict of interest between the principal (lender) and the agent (borrower): Ø Equity: the lender may require the borrower to put some of her wealth into the project 1. This creates incentive to work hard to ensure the project’s success 2. It signals that the borrower thinks that the project is of sufficient quality to succeed Ø Collateral: the borrower has to set aside assets that will be transferred to the lender if the loan is not repaid (e.g. land, house, factory, car, yacht, arts) House as collateral: In the UK, a 10% rise in value of real estate increases the number of start- up businesses by 5%

Answer 18

Those with little or no wealth cannot provide equity nor collateral (e.g. farmers in Chambar) Credit rationing = when those with less wealth find it difficult to borrow Ø Credit-constrained: borrow on unfavourable terms compared with those with more wealth (1 in 8 US families had their request for credit rejected by a financial institution) Ø Credit-excluded: are refused loans entirely (impossible to get a loan at any interest rate)

Answer 19

People with limited wealth are credit-constrained, which limits their ability to profit from the investment opportunities that are open to those with more assets Inequality increases when few people are in a position to profit by lending money to others (their wealth will grow at higher pace) Credit-rationing increases inequality: people with limited wealth do not have the same level of access to investment opportunities compared to those with more assets