Money and Banking Ch. 11 Flashcards

What was the major controversy involving banking in its early years?

who should charter banks (the federal government or the states)

This president helped create the Bank of the United States in 1791

Alexander Hamilton

This bank was created in 1791 as America’s first attempt at a centralized banking power, intended to control the money & credit supply in the economy as a whole.

The Bank of the United States (1791)

What was the fate of The Bank of the United States (1791)?

It was pressured into elimination by states who didn’t trust the centralized power.

This bank was created in 1816 by congress as a direct result of the War of 1812. Regarded as the second attempt at central banking in the United States

Second Bank of the United States

Up until 1863, why did banks regularly fail due to fraud or lack of bank capital? (3)

1. No central bank

2. No national currency

3. Lax banking regulations

1. What was the National Bank Act of 1863?

2. What was the goal?

3. What was the result?

1. Created a new banking system of federally chartered banks (National banks)

2. To eliminate abuses of state-chartered banks by drying them out of funds.

3. Led to the dual banking system

Until 1863, banks primarily obtained funds from ____.

banknotes (currency that could be exchanged for gold)

This department of the Treasury, created in the National Bank Act of 1863, supervises national banks.

Office of the Comptroller of the Currency

What was the method by which the National banks tried to eliminate State banks?

Putting a tax on their banknotes whilst leaving the bank notes of federally chartered banknotes untaxed

Type of banking system where State-chartered banks and Federally-chartered banks operate side by side

a. Central banking system
b. National banking system
c. Dual banking system
d. Normalized banking system

C; Dual Banking System

Created in 1913 to promote a safer banking system. Required all national banks to become members (optionally for state banks), and had strict regulations issued by the Fed

Federal Reserve System (the Fed)

Created in 1933 to prevent future depositor losses as a result of the Great Depression.

Federal Deposit Insurance Corporation (FDIC)

T/F After the creation of the Federal Reserve System, which required federal banks to purchase deposit insurance, many state banks didn’t buy the insurances.

False; almost all of them did

What 3 things came about from the creation of the FDIC?

1. Required all member banks of the Federal Reserve System to purchase depositor insurance

2. imposed new regulations

3. gave non-member banks the option to buy insurance.

This act separated commerical banking activities from the securities industry by:

1. Prohibiting commercial banks from dealing in ____ ____.

2. Prohibiting investment banks from dealing in ____ ____.

3. Only allowing banks to ______________________.

Glass-Steagall Act

1. Corporate securities

2. Commercial banking

3. Purchase safe debt securities

T/F Commercial bank regulation has developed to be refined and streamlined with minimal regulatory agencies

False; Commerical banking regulation is overlapped and confusing, and there are pushes to consolidate regulation.

Financial innovation is driven by the desire to
a. earn profits
b. reduce risk
c. pursue high returns
d. All of the above

A

A system in which bank lending is replaced by lending via the securities market. On the rise whilst traditional banking is declining.

Shadow banking

A change in the financial environment will stimulate:
a. The development of new financial instruments
b. The creation of new financial institutions or services
c. The evolution of markets to adapt to new conditions
d. The search for profitable financial innovations

What’s another way of saying the correct answer?

D; Financial engineering in short

The process of researching and developing new financial products and services that will meet customer needs and also prove profitable

Financial Engineering

The three basic types of financial innovation

1. Responses to changes in Demand of financial products

2. Responses in changes to Supply of financial products

3. Avoidance of existing regulations

Between the 1950’s and 1980’s, interest rate risk fluctuated ____ (more/less). What were the two responses to Changes in Demand Conditions regarding the interest rate volitility?

Interest rate risk fluctuated more

• Adjustible rate mortgages

• Financial derivatives

A type of mortgage with an interest rate that fluctuates

Adjustible-rate mortgages

Adjustible mortgages are attractive to businesses and homeowners in what ways?

1. Business:

2. Homeowners:

1. Keeps profits high when rates rise

2. Offer a lower initial interest rate

Why were Adjustible rate mortgages and financial derivatives created?
a. To increase transaction costs
b. To reduce interest rate risk
c. To eliminate government regulation
d. To guarantee higher profits for banks

B

Instruments that have payoffs that are derived from previously issued securities; used to hedge (reduce) interest rate risk.

Financial Derivatives

The most important source of the changes in supply conditions that stimulated financial innovation is:
a. Deregulation of financial markets
b. Declines in transaction costs from economies of scale
c. The improvement in information technology
d. Increases in interest rate volatility

C

The improvement in Information technology had two effects:

1. Lowered transaction costs

2. Made it easier for firms to issue securities (from easier info collection)

Name the four Responses to Changes in Supply Conditions—Information Technology
The creation of:
1.

2.

3.

4.

1. Debit/credit cards

2. Electronic banking

3. Junk bonds

4. Commercial Paper Market

A type of bond with a lower credit rating, below Baa (or BBB), which indicates a higher risk of default.

Junk Bonds

What led to the emergence of Junk Bonds in the 1970’s?
a. The elimination of all restrictions on commercial banks, which allowed them to underwrite high-risk corporate securities
b. Advancements in information technology, which reduced information costs and made it easier to evaluate lower-rated firms
c. A prolonged decline in U.S. Treasury issuance, forcing investors to seek alternative sources of fixed-income securities
d. Rising inflation and interest rate volatility, which directly improved the creditworthiness of speculative-grade companies

B

What happened to the Commercial Paper Market after the improvements in Information Technology?

a. It became simpler and easier for investors to participate, leading to rapid growth in its popularity
b. It became heavily regulated, which restricted the use of commercial papers
c. It was phased out as corporations shifted entirely to long-term bond financing
d. It collapsed due to rising alternative invesments among corporations

A

Involves a number of financial institutions working together, bundling small and otherwise un-liquid financial assets into marketable capital market securities.

Securitization

Four step process of Securitization performed between institutions

___ → ___ → ___ → ___

Loan origination → Servicing → Bundling → Distribution

Securtization played an especially prominent role in the development of what market?
a. Corporate bond market
b. Commercial paper market
c. Treasury securities market
d. Subprime mortgage market

D

Mortgages made to borrowers with less-than-stellar credit records

Subprime mortgages

How is Securitization related to the shadow banking system?

It’s the fundamental building block

What impact did advances in computer technology have on the subprime mortgage market?
a. It made processing mortgage applications faster, but had little effect on lending practices.
b. It made evaluating credit risk easier, resulting in an explosion in subprime mortgage lending.
c. It made approving loans simpler, but discouraged lenders from issuing risky mortgages.
d. It made tracking payments more efficient, but slowed the growth of mortgage-backed securities.

B

Avoidance of Existing Regulations suggests that when the economic environment changes such that regulatory constraints are so burdensome that large profits can be made by avoiding them:

a. firms are likely to stop innovating entirely.
b. innovation shifts exclusively toward improving existing products.
c. firms focus on reducing costs rather than creating new products.
d. loophole mining and innovation are more likely to occur.

D

The two sets of regulations that have seriously restricted the ability of banks to make profits are:

reserve requirements and restrictions on interest paid on deposits

How has reserve requirements and restrictions on interest paid on deposits limited the ability of banks to make profits?
1. Reserve requirements:
2. Restrictions on Interest paid on Deposits:

1. Create an opportunity cost (“tax” on deposits) of holding them

2. Led to disintermediation

A reduction in the flow of funds into the banking system that causes the amount of financial intermediation to decline.

Disintermediation

How do Money Market Mutual Funds allow banks to avoid existing regulations?

a. They let banks bypass deposit rate ceilings by offering investment alternatives to traditional deposits.
b. They reduce banks’ required reserve ratios with the Federal Reserve.
c. They eliminate the need for banks to pay insurance premiums to the FDIC.
d. They allow banks to ignore capital adequacy requirements.

A

What two financial innovations allowed banks to avoid restrictions on interest payments and reserve requirements?

Money Market Mutual Funds and Sweep accounts

An arrangement whereby any balances above a certain amount in a corporation’s checking account at the end of the business day are automatically invested in overnight repos that pay interest

a. Money market mutual fund
b. Sweep account
c. Certificate of deposit
d. Commercial paper

B

Commercial banks as a source of funds for nonfinancial borrowers has _____.

Shrunk dramatically

List two main factors that contributed to the decline in banks’ cost (liabilities) advantages in aquiring funds

1. Inflation messed things up = Infation increased → interest increased → disintermediation

2. Cheap deposits dried up = Old reliable “free” money (checking accounts) mattered less

List two ways information technology contributed to the decline in banks’ income (assets) advantages on uses of funds.

1. Less lending = Decreased need for short term lending

2. More rivals = Competition got cheaper

How have banks responded to financial innovation and the decline of traditional banking? (2)

1. Expanding into new and riskier areas of lending (commercial real estate loans)

2. Pursuing off-balance-sheet activities (non-interest income)

A decline in profitability usually results in an ______ and a ______.

exit from the industry, shrinkage of market share

What are the main factors that have led to the decline of traditional banking worldwide?
A. Deregulation, financial innovation, and competition from securities and international markets
B. Increased government regulation and bank mergers
C. High inflation and rising unemployment
D. Expansion of local small businesses

A

Which of the following is an example of how traditional banks have lost business internationally?
A. Banks exclusively controlling all depositors’ money
B. Government-imposed loan limits
C. Firms using foreign and offshore capital markets like the Eurobond market
D. Restricting technology use in banks

C

The ten largest commercial banks in the U.S. together hold under ___% of the total assets in the banking industry
a. 80%
b. 70%
c. 50%
d. 30%

B

Which act was designed to put national banks and state banks on equal footing by restricting branching across state lines?

McFadden Act of 1927

The McFadden Act of 1927 was motivated by:
a. A desire to modernize banking technology
b. Encouraging banks to merge across states
c. The need to protect foreign investors
d. A natural hatred of large banks

D

Branching restrictions have promoted the development of two financial innovations:

Bank Holding Companies and Automated Teller Machines

a corporation that owns several different companies

Bank Holding Companies

How did Automated Teller Machines allow banks to get around restrictive branching regulations?

Automated Teller Machines are owned by someone else and thus technically not subject to branching restrictions.

How did banks use “Holding Companies” to get around restrictive branching regulations?

They own multiple banks, controlling them without expanding
(sidenote: 90% of commercial banks are owned by holding companies!)

Currency in circulation that cannot be redeemed for gold

Fiat money

Bank failures have contributed to the decline in the number of banks. Another major reason is the

A. existence of securitization.

B. history of branching restrictions.

C. creation of financial derivatives.

D. prevalence of bank consolidation.

Banks could gain the benefits of ____ because they would now be able to make loans in different states rather than focus in just one.

D; diversification

The large number of commercial banks in the United States reflects the past:

a. lack of competition
b. presence of vigorous competition
c. high interest rate
d. innovation in financial instruments

A