FIN 5900: Financial Institutions I

Comprehensive vocabulary flashcards covering the core economic definitions, models, and institutional details of Financial Institutions I (FIN 5900).

Direct Finance

A form of financing where borrowers issue securities directly to savers on financial markets without passing through an intermediary.

Indirect Finance

A form of financing where funds flow from savers to borrowers through financial intermediaries, such as banks.

Qualitative Asset Transformation (QAT)

The modification of the attributes of financial claims (including lot size, maturity, and risk) to match the distinct needs of savers and borrowers.

Financial Intermediaries

Financial institutions that act as middlemen channeling funds between savers with surplus funds and borrowers with financing needs.

Non-Bank Financial Institutions (NBFIs)

Financial institutions other than traditional banks that provide financial services, including pension funds, private equity firms, hedge funds, and insurance companies.

Leverage Ratio

The ratio of total assets to equity, expressed as $\frac{E + L}{E}$, indicating the degree to which a firm relies on debt relative to equity.

Market Leverage Ratio

The leverage metric defined as $\frac{\text{MCAP} + L}{\text{MCAP}}$, where $\text{MCAP}$ is market capitalization and $L$ is total liabilities.

Net Interest Income

A primary revenue source for banks, defined as total interest income minus total interest expense.

Brokerage

An intermediation service that brings together economic agents with complementary financial transaction needs, such as savers and borrowers, without transforming the claim.

Adverse Selection

A pre-contract information asymmetry problem in which higher-risk borrowers self-select into applying for loans because average market pricing is unfavorable to low-risk borrowers.

Screening

The pre-contract process of gathering, analyzing, and verifying information regarding borrower risk to address adverse selection before extending credit.

Moral Hazard

A post-contract situation where the incentives of the principal and agent diverge, leading one party to take unobservable or unverifiable actions at the other party's expense.

Information Reusability

The underlying economic driver of cost savings in brokerage, existing either cross-sectionally (across different users) or intertemporally (over time).

Lot-Size Transformation

A component of QAT in which a bank pools numerous small-denomination deposits to fund large-denomination loan demands.

Maturity Transformation

A component of QAT where a bank funds long-term, illiquid assets (such as loans) using short-term, liquid, and demandable liabilities (such as deposits).

Risk Transformation

A component of QAT where a bank issues safe, low-risk claims to depositors while investing the proceeds in risky borrower projects, supported by diversification and monitoring.

Private Credit / GDP

A standard metric developed by Levine, Loayza, and Beck (2000) used to measure the level of financial intermediary development in an economy.

Bank-Market Ratio

A structural metric defined as $\frac{\text{Total bank assets}}{\text{Stock market capitalization} + \text{Private bond market capitalization}}$, used to examine the degree of bank orientation in a financial system.

Delegated Monitoring

The delegation of monitoring activities to a single financial intermediary on behalf of multiple depositors, eliminating costly duplication of monitoring effort across households.

Fractional Reserve Banking (FRB)

A banking framework in which institutions maintain only a fraction of their total deposit liabilities as liquid reserves, deploying the remainder into illiquid loans.

Lender of Last Resort (LoLR)

A central bank facility that acts as a liquidity backstop, providing emergency liquidity to solvent but temporarily illiquid institutions during financial distress or runs.

Deposit Insurance

A public guarantee that protects depositor funds up to a specified limit, eliminating or diminishing depositors' economic incentives to initiate a bank run.

Yield to Maturity (YTM)

The internal rate of return that equates the current market price of a debt security with the present value of all its promised future cash flows: $P = \sum_{t=1}^T \frac{C}{(1 + \text{YTM})^t} + \frac{F}{(1 + \text{YTM})^T}$.

Term Structure (Yield Curve)

The schedule describing the relationship between yield to maturity and time to maturity for debt instruments possessing identical default risk profiles.

Term Premium

The yield difference observed between otherwise identical long- and short-maturity bonds (e.g., 10-year minus 1-year Treasury yields), reflecting rate expectations and duration risk.

Expectations Hypothesis

A theory postulating that in the absence of uncertainty, the yield on an $n$-period bond equals the geometric average of expected future one-period short rates: $(1 + i_0^n)^n = (1 + i_0^1)(1 + i_1^1)\cdots(1 + i_{n-1}^1)$.

Macaulay Duration

The weighted average maturity of a security's cash flows, weighted by the present value of each payment: $D = \sum_{t=1}^T t \times \hat{w}_t$, where $\hat{w}_t = \frac{w_t}{P}$ and $w_t = \frac{\text{CF}_t}{(1 + i)^t}$.

Duration Gap

The mismatch between the duration of assets and the leverage-adjusted duration of liabilities, expressed as $D_A - \left(\frac{L}{A}\right)D_L$, which determines equity sensitivity to interest rate shocks.

Funding Liquidity

The capacity of a financial institution to obtain cash and settle payment obligations immediately as they fall due.

Market Liquidity

The ease and speed with which an asset can be liquidated on the secondary market without incurring a significant price discount.

Loan Commitment

A legally binding forward-market contract promising to lend funds in the future under pre-established terms, pricing, and covenants.

5 C's of Credit Analysis

A credit evaluation framework encompassing Capacity, Character, Capital, Collateral, and Conditions.

Hard Information

Quantifiable, objective, and verifiable data that can be systematically stored and transmitted across organizations, such as credit scores, financial ratios, and income statements.

Soft Information

Subjective, qualitative, and context-dependent borrower information acquired primarily through personal interaction and long-term relationships, such as managerial competence.

Risk Shifting

An agency problem where leveraged borrowers or bank equity holders exploit the call-option structure of equity by taking on excessive asset risk at the expense of creditors.

Inside Collateral

An asset financed directly by the underlying credit facility that is pledged to the lender to secure debt repayment (e.g., a home backing a mortgage loan).

Outside Collateral

Assets pledged to secure credit that are unassociated with the project financed by the loan, such as the borrower's independent personal wealth.

Sequential Service Constraint (SSC)

The 'first come, first served' contractual mechanism governing deposit accounts that pays out withdrawal requests sequentially until liquid reserves are exhausted.

Suspension of Convertibility

A contractual or regulatory commitment by a bank to freeze deposit redemptions once cumulative withdrawals reach a predetermined threshold.

Deposit Paradox

The structural reality that liquid deposits provide essential social value but generate inherent run fragility, while deposit insurance prevents runs but magnifies bank moral hazard.

Modigliani-Miller Proposition 1

The corporate finance theorem establishing that under frictionless, perfect capital markets, overall firm market value is invariant to capital structure (the debt-to-equity ratio).

Modigliani-Miller Proposition 2

The theorem showing that a firm's cost of equity rises linearly with leverage according to the relation $r_E = r_A + \frac{D}{E}(r_A - r_D)$.

Trade-off Theory of Capital Structure

The framework positing that optimal capital structure represents a balance between the tax shield benefits of debt and the expected costs of financial distress or bankruptcy.

Systemic Risk

The risk that distress at individual entities propagates, causing a severe impairment in the functioning of the entire financial system and the broader macroeconomy.

Doom Loop

A mutually reinforcing adverse feedback loop between credit losses in the financial system and contractions in real economic output and investment.

Fire Sales

Forced, rapid sales of assets in illiquid markets that depress asset prices, triggering mark-to-market losses and balance sheet deterioration across all institutions holding similar assets.

Shock Amplification

The process by which an initially modest exogenous disturbance is enlarged by internal mechanisms, such as fire sales, deleveraging spirals, or market runs.

Shock Propagation

The network transmission of financial losses and default distress from troubled institutions across counterparties to initially healthy entities.

Microprudential Regulation

Supervisory frameworks aimed at safeguarding the safety, solvency, and operational soundness of individual financial institutions considered in isolation.

Macroprudential Regulation

Regulatory and supervisory oversight focused on maintaining the stability and resilience of the financial system as an interconnected whole, mitigating systemic risks.

Risk-Weighted Assets (RWA)

The aggregate denominator in Basel capital calculations computed by weighting each asset and off-balance-sheet exposure by its designated risk weight: $\text{RWA} = \sum_i A_i \times w_i$.

Tier 1 Capital

The primary loss-absorbing core capital of a banking institution, comprising Common Equity Tier 1 (CET1) such as common shares, retained earnings, disclosed reserves, and Additional Tier 1 instruments.

Tier 2 Capital

Supplementary regulatory capital consisting of secondary loss-absorbing instruments, including general loan-loss reserves, hybrid instruments, and qualifying subordinated long-term debt.

Internal Ratings-Based (IRB) Approach

A Basel II and III framework permitting eligible banks to use internal statistical models to estimate credit risk parameters (e.g., Probability of Default) for computing RWA.

Output Floor

A finalized Basel III reform dictating that a bank's total model-derived RWAs cannot fall below $72.5\%$ of the RWAs calculated under the regulatory Standardized Approach.

Single Supervisory Mechanism (SSM)

The European banking supervisory framework wherein the European Central Bank directly supervises significant institutions, while national authorities oversee less significant institutions.

Regulatory Whac-a-Mole

The ongoing cycle whereby new prudential regulations introduce unintended opportunities for regulatory arbitrage, prompting supervisors to draft further regulatory restrictions.