Banking and the Management of Financial Institutions

No flashcards were created as the input notes length did not warrant a flashcard generation.

What is the basic rule for a bank's balance sheet?

Assets = Liabilities + Bank Capital

What are reserves on a bank's balance sheet?

Cash banks hold in their vaults and deposits at the Federal Reserve. They are used to meet the reserve requirement (around 10% of checkable deposits).

Define 'correspondent balances'.

Deposits that banks hold at other banks, which help them settle transactions.

What are the characteristics of securities held by banks?

Include U.S. government bonds and municipal bonds. They earn interest and can be sold quickly if needed.

Why are loans important assets for banks?

They earn high returns but are less liquid and more risky.

What are checkable deposits?

Funds that customers can withdraw on demand using checks or debit cards.

What are nontransaction deposits?

Include savings deposits and time deposits (CDs), which pay interest but cannot be withdrawn immediately.

Explain 'discount loans'.

Loans obtained by banks from the Federal Reserve.

What does bank capital represent?

The owners' equity, which acts as a cushion against losses, protects depositors, and prevents insolvency.

What is 'asset transformation' as it relates to banks making a profit?

The process by which banks convert short-term, liquid liabilities (like deposits) into long-term, higher-interest assets (like loans).

Define 'spread' in the context of bank profits.

The difference between the interest earned on a bank's assets and the interest paid on its liabilities, which is the bank's main source of profit.

What is the primary goal of liquidity management?

To ensure the bank has enough cash on hand to meet withdrawals or deposit outflows.

What are four options a bank has if it experiences a shortfall in reserves due to deposit outflows?

1. Borrow from other banks in the federal funds market.

2. Sell securities.

3. Borrow from the Federal Reserve through discount loans.

4. Reduce loans by calling them in or selling them.

What is the trade-off in holding excess reserves?

Holding excess reserves provides safety (liquidity) but leads to less profit because the funds are not invested in higher-returning assets.

What are the four main strategies banks use for asset management?

1. Seek high-interest/low-default borrowers.

2. Buy securities that offer good returns but are not too risky.

3. Diversify assets across different industries and regions.

4. Balance the need for liquidity with the desire for higher returns.

How has liability management changed since the 1960s?

Before the 1960s, banks relied mainly on fixed deposits. Since the 1960s, banks use new tools like negotiable CDs, federal funds borrowing, and repurchase agreements to raise funds more flexibly and aggressively, managing both sides of their balance sheet.

Why is capital adequacy management important?

1. It helps prevent bank failure by absorbing losses.

2. It affects returns to the bank’s owners.

3. It is required by regulators to maintain financial stability.

What are the formulas for Return on Assets (ROA), Return on Equity (ROE), and Equity Multiplier (EM)?

\text{ROA} = \frac{\text{Net profit after taxes}}{\text{Total assets}}
\text{ROE} = \frac{\text{Net profit after taxes}}{\text{Bank capital}}
\text{EM} = \frac{\text{Assets}}{\text{Capital}} (These are related by: ROE = ROA \times EM)

What is credit risk?

The risk that borrowers will not repay their loans.

List five tools banks use to manage credit risk.

1. Screening and monitoring

2. Long-term relationships

3. Loan commitments

4. Collateral and compensating balances

5. Credit rationing

What is interest-rate risk?

The risk that changes in interest rates will adversely affect a bank’s profits, especially if a bank has more rate-sensitive liabilities than assets.

How do banks manage interest-rate risk?

1. Conduct gap analysis

2. Use duration analysis

3. Use derivatives (futures, options, swaps)

What are off-balance-sheet activities?

Actions that generate income for banks but do not appear directly on their balance sheets, such as loan sales, fee-based services, and trading derivatives.

What are the formulas for Required Reserves, Excess Reserves, Capital Ratio, and Equity Multiplier?

\text{Required Reserves} = \text{Reserve Ratio} \times \text{Checkable Deposits}
\text{Excess Reserves} = \text{Actual Reserves} - \text{Required Reserves}
\text{Capital Ratio} = \frac{\text{Bank Capital}}{\text{Total Assets}}
\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Bank Capital}} (Also, ROE = ROA \times \text{Equity Multiplier})

Why is the financial system heavily regulated?

Financial markets are prone to asymmetric information problems (adverse selection and moral hazard), which can lead to instability and financial crises. Regulation aims to protect depositors, maintain confidence, and prevent such crises.

Explain 'adverse selection' in financial markets.

Occurs before a financial transaction when risky borrowers are more likely to seek loans because they have little to lose if they default, leading lenders to raise interest rates and discourage safer borrowers.

Explain 'moral hazard' in financial markets.

Occurs after a financial transaction when borrowers, having received funds, may take on greater risks because they don’t bear the full cost of failure, shifting potential losses to lenders.

What is the 'lemons problem' analogy in finance?

It illustrates adverse selection, where the inability to distinguish between good (peaches) and bad (lemons) quality (e.g., safe vs. risky borrowers) leads to only an average price being offered, driving good products/borrowers out of the market.

List four solutions to asymmetric information problems.

1. Private Production and Sale of Information (e.g., credit-rating agencies)

2. Government Regulation to Increase Information (e.g., SEC disclosure requirements)

3. Financial Intermediaries (e.g., banks' screening expertise)

4. Collateral and Net Worth Requirements

What is the most important government safety net in the U.S. financial system?

Deposit insurance, provided by the Federal Deposit Insurance Corporation (FDIC), which guarantees depositors will get their money back up to a certain limit if a bank fails.

What are the two main ways the FDIC deals with bank failures?

1. Payoff Method: Pays depositors up to the insured limit and sells the bank’s assets.

2. Purchase and Assumption Method: Arranges for a healthy bank to take over the failed bank’s assets and liabilities.

Besides deposit insurance, what other safety net exists?

The Federal Reserve's function as a 'lender of last resort', providing loans to banks temporarily short of funds.

What problems do government safety nets create?

They exacerbate moral hazard (depositors pay less attention to bank risk-taking) and adverse selection (risky individuals are drawn to own or manage banks).

What is the 'Too Big to Fail' (TBTF) problem?

The policy that large financial institutions are so important to the economy that the government will not allow them to fail, often leading to bailouts, which increases moral hazard for these institutions.

What challenges did financial consolidation bring?

It worsened the 'too big to fail' problem, extended government protection to previously unregulated activities (like insurance), and increased the complexity of oversight and the contagiousness of crises.

What are 'Restrictions on Asset Holdings' as a type of financial regulation?

Rules that limit the types of assets banks can own (e.g., no stock, loan diversification) to prevent excessive risk-taking, though they may limit profit opportunities.

Define the 'Leverage Ratio' in banking regulation.

A measure of a bank's capital relative to its total assets: \text{Leverage Ratio} = \frac{\text{Bank Capital}}{\text{Total Assets}}
U.S. banks must maintain a minimum leverage ratio of 5%.

What is the Basel III Capital Adequacy Ratio (CAR)?

An international regulatory framework requiring banks to hold a minimum CAR of 8% of their risk-weighted assets (RWA) to absorb unexpected losses.
\text{CAR} = \frac{\text{Capital}}{\text{Risk-Weighted Assets}} \times 100

What is 'Risk-Weighted Assets' (RWA) in the context of Basel III?

A bank's assets adjusted by risk percentages (e.g., reserves 0%, mortgages 50%, commercial loans 100%) to determine the required capital.

What is 'Prompt Corrective Action' in banking regulation?

Legislation (FDIC Improvement Act of 1991) that requires regulators to intervene early when a bank's capital falls too low, categorizing banks from 'well capitalized' to 'critically undercapitalized' and mandating corrective measures.

What is the CAMELS system in financial supervision?

A rating system used by regulators to evaluate existing banks based on six components:
C - Capital adequacy
A - Asset quality
M - Management
E - Earnings
L - Liquidity
S - Sensitivity to market risk

Why are 'Disclosure Requirements' important in financial regulation?

They mandate banks to publicly share financial information and follow standard accounting practices, improving market discipline by allowing investors to assess risk and reward responsibly.

List some key consumer protection laws in banking.

Truth in Lending Act (1969), Fair Credit Billing Act (1974), Equal Credit Opportunity Act (1974, 1976), and Community Reinvestment Act (1977).

How do 'Restrictions on Competition' relate to historical bank regulation?

Historically, rules like limits on branching and the Glass-Steagall Act (1933) were designed to reduce risk-taking by limiting competition, but these were later relaxed to improve efficiency, sometimes increasing systemic risk.

What challenges does 'International Financial Regulation' face?

It's difficult to enforce as large banks operate globally, leading to coordination failures that can allow crises in one country to spread worldwide.