Financial System Midterm 1

Balance Sheet

A financial statement that lists an entity’s assets, liabilities, and net worth at a specific point in time.

Assets

Resources owned by a company or individual that have economic value.

Liabilities

Obligations or debts owed to others.

Net Worth

The residual interest in assets after liabilities are deducted.

Underwater Households

Households whose liabilities exceed the market value of their assets.

Solvency

The ability of an entity to meet long-term financial obligations.

Liquidity

The ability to quickly convert assets into cash without significant loss in value.

Liquid Asset

An asset easily convertible into cash, such as deposits or Treasury bills.

Cash Inflow

Money received by an individual or organization.

Cash Outflow

Money paid out by an individual or organization.

Leverage

The use of borrowed funds to increase potential returns on investment.

ROE

Return on Equity, measuring profitability relative to shareholders’ equity.

ROA

Return on Assets, measuring profitability relative to total assets.

Credit Risk

The risk that a borrower will default on a loan.

Interest Rate Risk

The risk that changes in interest rates will reduce the value of financial assets.

Unsecured Loan

A loan not backed by collateral.

Non-Recourse Loan

A loan secured by collateral, where the lender can only claim the collateral if default occurs.

Collateral

An asset pledged as security for a loan.

Mortgage

A loan used to purchase real estate, with the property as collateral.

Moral Hazard

When one party takes more risk because another bears the cost of that risk.

Adverse Selection

A situation where one party has more information than another, leading to potentially poor outcomes.

Underwriting

The process of evaluating and pricing the risk of a loan or security issuance.

Initial Public Offering

The first sale of a company’s stock to the public.

Seasoned Offering

A subsequent sale of stock after a company’s IPO.

Market-Maker

A firm or individual providing liquidity by continuously buying and selling securities.

Dealer

A trader who buys and sells securities for their own account.

Broker

An agent who executes trades on behalf of clients.

Specialist

A market participant assigned to maintain fair and orderly trading in a specific stock.

Stocks

Securities representing ownership in a corporation.

Bonds

Debt instruments issued by governments or corporations promising fixed payments.

CDs

Certificates of Deposit, time deposits with fixed interest rates and maturities.

Commercial Paper

Short-term unsecured promissory notes issued by corporations.

Investment Bank

A financial institution that underwrites securities and advises on mergers and acquisitions.

Commercial Bank

A depository institution offering loans, deposits, and other financial services.

Pension Fund

A fund that collects and invests retirement savings on behalf of employees.

Hedge Fund

A pooled investment fund that uses diverse strategies to earn high returns.

Mutual Fund

An investment vehicle pooling funds from investors to buy securities.

REIT

Real Estate Investment Trust, a company that owns and operates income-generating real estate.

Government-Sponsored Enterprise

Financial services corporations created by Congress to support credit flow in specific sectors.

Over-the-Counter

A decentralized market where securities trade directly between parties without a formal exchange.

Securities and Exchange Commission

The U.S. regulatory agency overseeing securities markets and protecting investors.

Federal Deposit Insurance Corporation

The agency that insures deposits at U.S. commercial banks and savings institutions.

Defined-Benefit Plan

A pension plan guaranteeing a specified retirement benefit amount.

Defined-Contribution Plan

A retirement plan where contributions are defined, but benefits depend on investment performance.

Vesting

The process by which an employee earns the right to employer-provided benefits.

Premium

The price paid for insurance coverage.

Deductible

The amount a policyholder must pay out of pocket before insurance covers costs.

Co-Payment

A fixed amount paid by an insured person for covered services.

Creditworthiness

A borrower’s ability and willingness to repay debt.

Federal Reserve System

The central banking system of the United States.

FOMC

The Federal Open Market Committee, which sets U.S. monetary policy.

Board of Governors

The central policymaking body of the Federal Reserve System.

Federal Reserve Banks

The 12 regional banks that implement Federal Reserve policies.

Federal Funds Rate

The interest rate on overnight loans between banks of reserve balances.

Federal Funds Rate Target

The rate the Federal Reserve aims to achieve through policy tools.

Open-Market Operation

The purchase or sale of government securities by the Fed to influence reserves.

Discount Rate

The interest rate charged by the Federal Reserve for loans to commercial banks.

Discount Window

The facility through which banks borrow reserves from the Federal Reserve.

Real Bill Doctrine

The idea that central banks should issue money only against short-term commercial loans.

Capital Adequacy Ratio

The ratio of a bank’s capital to its risk-weighted assets, ensuring solvency.

Reserve Requirement Ratio

The minimum fraction of deposits banks must hold as reserves.

Reserve

Funds held by banks at the Federal Reserve or as vault cash.

Required Reserve

The portion of deposits that banks are legally required to hold.

Excess Reserve

Reserves held beyond the required minimum.

Monetary Base

The sum of currency in circulation and reserves held by banks.

Demand Deposit

Bank deposits withdrawable on demand, such as checking accounts.

Glass-Steagall Act of 1932

Early banking reform expanding Federal Reserve lending powers.

Glass-Steagall Act of 1933

Established FDIC and separated commercial and investment banking.

Glass-Steagall Act of 1935

Strengthened Federal Reserve powers and restructured governance.

Cease and Desist Order

A regulatory directive to stop unsafe or unlawful banking practices.

CAMELS

A system used by regulators to rate banks on Capital, Assets, Management, Earnings, Liquidity, and Sensitivity.

Explain the impact of lower asset value on the balance sheet

Lower asset values reduce total assets and may lower net worth, potentially threatening solvency.

Explain the impact of delinquency and lower asset prices on the balance sheet of banks

Loan delinquencies reduce asset quality and revenue, lowering capital and solvency.

Why does negative net worth not imply insolvency?

Insolvency occurs when liabilities exceed the realizable value of assets, but temporary losses can be offset by liquidity or future earnings.

How are leverage, ROE and ROA related?

Higher leverage amplifies both ROE and risk, linking returns on equity and assets through financial structure.

What are benefits and disadvantages of leverage?

Benefits include higher returns

What is the main difference between depository institutions and other financial institutions?

Depository institutions accept deposits and create money, while others do not.

What are the two main concerns of any financial company?

Solvency and liquidity.

Which risks correspond to specific scenarios?

Variable-rate liabilities with fixed-rate assets indicate interest rate risk

What is a liquid asset?

One easily converted into cash with minimal loss in value.

What is a demand liability, contingent liability, and dated liability?

Demand liabilities are payable on request, contingent liabilities depend on specific events, and dated liabilities have fixed repayment dates.

Under what balance sheet structure does a company face high liquidity risk?

When illiquid assets are financed with demand liabilities.

Under what structure does a financial company face high solvency risk?

When liabilities greatly exceed net worth or asset values fall significantly.

How can financial companies solve immediate liquidity problems?

Borrowing reserves, selling liquid assets, or accessing the discount window.

How can financial companies solve solvency problems?

Raising new capital or reducing liabilities.

Why do companies issue stock and bonds?

To raise funds for investment or expansion.

Why do companies issue commercial paper?

To meet short-term funding needs.

What happens when a security is issued?

The issuer receives funds, and investors obtain a claim on future payments.

What happens once a security matures?

The issuer repays the holder

How do market makers improve liquidity?

By continuously quoting buy and sell prices to facilitate trade.

What do OCC, FDIC, and SEC do?

OCC charters and supervises banks

What is Regulation Q and when was it removed?

It limited interest on deposits and was phased out in the 1980s.

Why are capital requirements imposed on banks?

To ensure stability and absorb potential losses.

Describe the organization of the Federal Reserve System

It includes the Board of Governors, 12 Reserve Banks, and the FOMC, each with distinct functions.

What was the Real Bill Doctrine and why was it abandoned?

It limited central bank lending to short-term commercial credit but was abandoned for being too restrictive.

Explain the difference between Discount Window and Open Market Operations

The discount window lends directly to banks

Why are Federal Reserve notes liabilities of the Fed?

They are obligations of the central bank to the public.

What does the central bank target and why?

The federal funds rate, to influence credit conditions and achieve macroeconomic goals.

Why doesn’t the central bank create unlimited money?

To maintain credibility, control inflation, and meet its policy mandates.

How do the Treasury and Federal Reserve coordinate policy?

The Fed manages liquidity while Treasury operations affect reserves and funding needs.