relatively cheaper, making it a good time to visit the Tower of London. This was also true, to a lesser extent, in the early 2000s. 19. When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American-made or foreign-made jeans? Are U.S. companies that manufacture jeans happier when the dollar is strong or when it is weak? What about an American company that is in the business of importing jeans into the United States? When the dollar increases in value, foreign goods become less expensive relative to American goods; thus, you are more likely to buy French-made jeans than Americanmade jeans. The resulting drop in demand for American-made jeans because of the strong dollar hurts American jeans manufacturers. On the other hand, the American company that imports jeans into the United States now finds that the demand for its product has risen, so it is better off when the dollar is strong. 20. While much of the Japanese government debt is held by domestic investors, some of it is also held by foreign investors. How do the fluctuations in the Japanese yen affect the value of that debt held by foreigners? As the value of the Japanese yen depreciates (decreases in value) relative to a foreign currency, one yen is equivalent to (can be exchanged for) less foreign currency. Thus, for a given debt amount, a weaker yen will yield less home currency to foreigners, so the asset will be worth less to foreign investors. Similarly, an appreciation would increase the value of the debt. ANSWERS TO APPLIED PROBLEMS 21. The following table lists the foreign exchange between euros (€) and British pounds (£) during October 2020. Which day would have been the best for converting €100 into British pounds? Which day would have been the worst? What would the difference be in pounds? Date
€/£
10/1/2020
1.086
0.92
10/2/2020
1.084
0.92
10/5/2020
1.081
0.93
10/6/2020
1.07
0.93
10/7/2020
1.051
0.95
10/8/2020
1.042
0.96
10/9/2020
1.04
0.96
10/12/2020
1.038
0.96
10/13/2020
1.037
0.96
10/14/2020
1.036
0.97
10/15/2020
1.035
0.97
10/16/2020
1.034
0.97
10/19/2020
1.033
0.97
10/20/2020
1.05
0.95
10/21/2020
1.06
0.94
10/22/2020
1.07
0.93
10/23/2020
1.086
0.92
10/26/2020
1.09
0.92
10/27/2020
1.091
0.92
10/28/2020
1.1
0.91
10/29/2020
1.12
0.89
10/30/2020
1.1
0.91
The best day would be October 19, 2020. At the rate of €1.033/pound, you would have £96.805. The worst day is October 29, 2020. At €1.12/pound, you would have £89.286. The difference in pounds is £7.519.
ANSWERS TO DATA ANALYSIS PROBLEMS 1.
Go to the St. Louis Federal Reserve FRED database and find data on the threemonth Treasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate (CPN3M), the 30-year Treasury bond rate (GS30), the 30-year fixed rate mortgage average (MORTGAGE30US), and the NBER recession indicators (USREC). For the mortgage rate indicator, set the frequency setting to ‟monthly.‖ a. In general, how do these interest rates behave during expansionary periods? Generally speaking, the interest rates fall during recessions and rise during expansionary periods. b. In general, how do the three-month interest rates compare to the 30-year rates? How do the Treasury rates compare to the respective commercial paper and mortgage rates? In nearly all instances, the 30-year rates are significantly higher than the threemonth rates. Likewise, in most cases, the 30-year mortgage rate is higher than the 30-year Treasury rate, and the three-month commercial paper rate is higher than the three-month Treasury rate. c. For the most recent available month of data, take the average of each of the three-month rates and compare it to the average of the three-month rates from January 2000. How do the averages compare? d. For the most recent available month of data, take the average of each of the 30year rates and compare it to the average of the 30-year rates from January 2000. How do the averages compare? June 2020
January 2000
Three-month rate avg.
0.17
5.53
30-year rate avg.
2.33
7.42
See the table above. For both rate averages, they have decreased significantly since January 2000.
2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 money supply (M1SL) and the 10-year Treasury bond rate (GS10). Add the two series into a single graph by using the ―Add Data Series‖ feature. Transform the M1 money supply variable into the M1 growth rate by adjusting the units for the M1 money supply to ―Percent Change from Year Ago.‖ a. In general, how have the growth rate of the M1 money supply and the 10-year Treasury bond rate behaved during recessions and during expansionary periods since the year 2000? Generally, the 10-year Treasury rate fell during the recessionary periods of 2001 and 2007–2009; during expansionary periods, there was less of a pattern, but there seems to be a long-run downward trend in the interest rate. The money growth rate increased significantly during recessionary periods; however, during expansions, there is less of a pattern; following the 2001 recession, money growth gradually declined, but after the 2007–2009 recession, money growth was relatively high and variable. b. In general, is there an obvious, stable relationship between money growth and the 10-year interest rate since the year 2000? When money growth rises, the 10-year Treasury rate appears to fall, and vice versa; however, this effect is more obvious over some periods than others. c. Compare the money growth rate and the 10-year interest rate for the most recent month available to the rates for January 2000. How do the rates compare? May M1 Money Growth 10-year Treasury rate
2020
January 2000
33.49
2.19
0.67
6.66
The money growth rate is significantly higher in May 2020 than it was in January 2000. The 10-year Treasury rate is significantly lower in May 2020 than it was in January 2000.
Chapter 2 ANSWERS TO QUESTIONS 1. If Marco buys a laptop today for €1,000, and it will be worth €2,000 next year because it enables him to work remotely as an assistant, should he take out a loan from Prestiti Di Pasquale, a small Italian loan firm, at a 90% interest rate? Marco cannot get a loan from anyone else. Will he be better or worse off for taking out this loan? Would you consider this a shark loan? Yes, Marco should take out the loan, as he will be better off as a result of doing so. His interest payment will be €900 (90% of €1,000), but as a result, he will earn an additional €100 since he is able to collect €1,000 more in terms of earnings in the first year. This would be an example of a shark loan as it involves a lender charging an extremely high interest rate (probably doing so illegally). 2. Some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense? Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly. 3. Luigi, who has just started to work as an engineer, asks his sister Maria, a finance graduate, to explain how financial markets are fundamental for him to get a new apartment. What do you think Maria’s explanation should be? Maria should explain that while Luigi earns a good salary, he has just started to work and has not saved much. Financial markets will enable him to buy a house now and pay some interest, without having to wait to save enough. In the absence of financial markets, Luigi would have to save enough money to buy the house of his dreams, but by the time he purchases it, he might be too old to enjoy the full benefits of it. 4. If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why? You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants. 5. Suppose that the government of Albania issues a euro-denominated bond in Albania (Note: the currency of Albania is the Albanian Lek.). Is this debt instrument considered to be a Eurobond? How would you answer change if the bond were issued in London? The euro-denominated bond issued in Albania and the one issued in London would be considered to be Eurobonds because the denomination differs from the local currencies. 6. Describe who issues each of the following instruments: a. Stocks Corporate organizations
b. Mortgage-backed securities Government agencies c. Corporate bonds Corporate organizations d. State and local government bonds Municipalities e. Consumer and bank commercial loans Banks and financial companies 7. What is the difference between a mortgage and a mortgage-backed security? Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans. Mortgagebacked securities are bond-like debt instruments that are backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holders of the security. In other words, when an individual takes out a mortgage, that loan is bundled with other individual mortgages to create a composite debt instrument, which is then sold to investors. 8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a railroad system. Why did this make both countries better off? The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads. 9. A significant number of European banks held large amounts of assets as mortgagebacked securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets? The international trade of mortgage-backed securities is generally beneficial in that the European banks that held the mortgages could earn a return on those holdings, while providing needed capital to U.S. financial markets to support borrowing for new home construction and other productive uses. In this sense, both European banks and U.S. borrowers should have benefitted. However, with the sharp decline in the U.S. housing market, default rates on mortgages rose sharply, and the value of the mortgage-backed securities held by European banks fell sharply. Even though the financial crisis began primarily in the United States as a housing downturn, it significantly affected European markets; Europe would have been much less affected without such internationalization of financial markets.
10. How does risk-sharing benefit both financial intermediaries and private investors? Financial intermediaries benefit by carrying risk at relatively low transaction costs. Since higher risk assets on average earn a higher return, financial intermediaries can earn a profit on a diversified portfolio of risky assets. Individual investors benefit by earning returns on a pooled collection of assets issued by financial intermediaries at lower risk. The financial intermediary lowers risk to individual investors through the pooling of assets. 11. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger? Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk-taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member. 12. One of the factors contributing to the European debt crisis of 2010-2012 was the huge amounts of debt faced by governments of countries like Greece and Portugal. What is the main difficulty in regulating governments? The main problem with governments is that they are sovereign institutions. Unlike private firms, they do not have any regulators. In addition, the size of the debt is too high for any financial institution to absorb the investor losses. 13. Why do loan sharks worry less about moral hazard in connection with their borrowers than some other lenders do? Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize their paying off the loan. Hence, borrowers from a loan shark are less likely to increase moral hazard. 14. If you are an employer, what kinds of moral hazard problems might you worry about with regard to your employees? They might not work hard enough while you are not looking or may steal or commit fraud. 15. If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard problem still exist? Yes, because even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so the problem of moral hazard still exists. 16. ―The only reason a government regulates financial markets is to ensure the soundness of the financial system.‖ Is this statement true, false, or uncertain? Explain your answer. The statement is false. The government regulates financial markets for two reasons: to increase the information available to investors and to ensure the soundness of the financial system.
In order for a banker to reduce adverse selection she must screen out good from bad credit risks by learning all she can about potential borrowers. Similarly, in order to minimize moral hazard, she must continually monitor borrowers to ensure that they are complying with restrictive loan covenants. Hence, it pays for the banker to be nosy. 13. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why? Compensating balances can act as collateral. They also help establish long-term customer relationships, which make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent the firm from taking on too much risk, thereby not acting in the interest of the bank. 14. You are looking to buy the stock of a commercial bank in Israel. After looking into the balance sheet and the investor relations presentations you understand that it only makes loans to the oil companies. Would you be willing to buy stock in that bank? Why or why not? While the bank might be profitable, the fact that it is exposed only to one sector means that in times of difficulties in the oil sector it might suffer huge losses. So, you should be careful about buying the stock of that bank. 15. ―Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans.‖ Is this statement true, false, or uncertain? Explain your answer. False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard. 16. Parameshwar works as a junior analyst at a local commercial bank in India. Her boss tells her he believes that interest rates will rise in the future but he is not sure if they should make more short-term loans or long-term loans. What should Parameshwar suggest? Parameshwar should suggest that the bank should make short-term loans. Then, when these loans mature, the bank will be able to make new loans at higher interest rates, which will generate more income for the bank. 17. Her boss tells Parameshwar that "Bank managers should always seek the lowest risk possible on their assets.‖ Is this statement true, false, or uncertain? Explain your answer. False. If an asset has very low risk, it also probably has a very low return. A bank manager might not want to hold such an asset because there might be assets that have a similar risk but higher returns. Therefore, a bank manager must consider risk as well as the expected return when deciding to hold an asset. 18. Describe what can be done to reduce the principal-agent problem in financial
institutions. Managers of financial institutions must set up internal controls that include the separation of people in charge of trading activities from those in charge of bookkeeping for trades. They must scrutinize risk assessment procedures and set limits to the total amount of traders' transactions and on the institution's risk exposure. ANSWERS TO APPLIED PROBLEMS 19. Develop the T-accounts of Intesa Sanpaolo and Unicredit Bank. Describe what happens when Giancarlo Pisano writes a €3,000 check on her account at Intesa Sanpaolo to pay his friend Alessandra Pavone, who in turn deposits the check in her account at Unicredit Bank. The T-accounts for the two banks are as follows: INTESA SANPAOLO Assets Reserves
Liabilities €3,000
Checkable Deposits
€3,000
UNICREDIT Bank Assets Reserves
Liabilities €3,000
Checkable Deposits
€3,000
20. What happens to reserves at Banca Mediolanum if one person withdraws €1,000 of cash and another person deposits €500 of cash? Use T-accounts to explain your answer. If these transactions take place, the reserves drop by €500. The T-account for Banca Mediolanum is as follows: Banca Mediolanum Assets Reserves
Liabilities €500
Checkable Deposits
€500
21. Angus Bank holds no excess reserves but complies with the reserve requirement. The required reserves ratio is 9%, and reserves are currently $27 million. Determine the amount of deposits, the reserve shortage created by a deposit outflow of $5 million, and the cost of the reserve shortage if Angus Bank borrows in the federal funds market (assume the federal funds rate is 0.25%). Deposits = 27/0.09 = 300. The reserve shortage is calculated as outstanding reserves after the deposit outflow, minus required reserves after the deposit outflow: 22 ‒ 295 × 0.09 = ‒ 4.55
Angus Bank has to borrow $4.55 million. Borrowing from the Fed will cost Angus Bank: 0.0025 × 4.5 = $11,250 dollars. 22. Excess reserves act as insurance against deposit outflows. Suppose that on a yearly basis Malcom Bank holds $12 million in excess reserves and $88 million in required reserves. Suppose that Malcom Bank can earn 3.5% on its loans and that the interest paid on (total) reserves is 0.2%. What would be the cost of this insurance policy? The cost of the insurance policy is the amount of foregone interest income equal to $12 × 0.035 = $0.42 million minus the interest paid on excess reserves = 12 × 0.002 = $0.02 million. Therefore, the yearly cost of holding $12 million in excess reserves is $0.40 million. 23. Victory Bank reports an EM of 25, while Batovi Bank reports an EM equal to 14. Which bank is better prepared to respond against large losses on loans? Victory Bank has 1/25 = 0.04 of equity capital as a percentage of assets, while Batovi Bank has 1/14 = 7.13. Batovi Bank is therefore better capitalized than Victory Bank and better suited to take large losses on loans. 24. Suppose you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank’s interest rate risk? The assets fall in value by $8 million (= $100 million –2% 4 years) while the liabilities fall in value by $10.8 million (= $90 million –2% 6 years). Because the liabilities fall in value by $2.8 million more than the assets do, the net worth of the bank rises by $2.8 million. The interest rate risk can be reduced by shortening the maturity of the liabilities to a duration of four years or lengthening the maturity of the assets to a duration of six years. Alternatively, you could engage in an interest rate swap, in which you swap the interest earned on your assets with the interest on another bank’s assets that have a duration of six years. 25. Thomas is a risk manager at Barclays Bank. The bank has £150 million of fixed-rate assets, £300 million of rate-sensitive assets, £250 million of fixed-rate liabilities, and £200 million of rate-sensitive liabilities. Thomas must conduct a gap analysis for the bank and show what will happen to bank profits if interest rates rise by 2 percentage points. What actions could he take to reduce the bank’s interest-rate risk? The gap is GBP 100 million (GBP 300 million of rate-sensitive assets minus £200 million of rate-sensitive liabilities). The change in bank profits from the interest rate rise is £2 million (2% £100 million); the interest-rate risk can be reduced by increasing rate-sensitive liabilities to £300 million or by reducing rate-sensitive assets to £200 million. Alternatively, he could suggest that the bank engage in an interestrate swap in which it swaps the interest on £100 million of rate-sensitive assets for the interest on another bank’s £100 million of fixed-rate assets.
ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data for all commercial banks on total liabilities (TLBACBM027SBOG), total deposits (DPSACBM027SBOG), and residual of assets less liabilities (RALACBM027SBOG). a. What is the balance sheet interpretation of the residual of assets less liabilities? b. For the most recent month of data available, use the three indicators listed above to calculate the total amount of borrowings by banks. a. The residual of assets less liabilities is bank capital. b. Since liabilities equal total deposits + borrowings + bank capital, then borrowings can be solved for. Using the data for June 2020: Borrowings = liabilities – deposits – bank capital = $18,200.4 Bil. – $15,544.6 Bil. − $1,999.4 Bil. = $656.4 Bil.
Chapter 10 ANSWERS TO QUESTIONS 1. Why are deposit insurance and other types of government safety nets important to the health of the economy? A government safety net can short-circuit runs on banks and bank panics, and overcome reluctance by depositors to put funds in the banking system. This helps to eliminate a contagion effect, in which both good and bad banks could become insolvent in the event of a bank panic. Without confidence in the banking system, such panics could result in a collapse of the financial system and severely inhibit investment and economic growth. 2. What was the main reason for the EU Bank Recovery and Resolution Directive (BRRD) introduced by the European Union for failing banks after the financial crisis? During the financial crisis of 2012, many banks were considered too big to fail and were bailed out with public funds. The EU BRRD aims to address moral hazard and permits banks to fail in an orderly manner, so that government bailouts are not needed. 3. Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer. Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of excessive risk-taking on the part of banks. It would, however, make bank failures and panics more likely, so it might not be a very good idea. 4. How could higher deposit insurance premiums for banks with riskier assets benefit the economy? The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk, because doing so would increase their deposit insurance premiums. The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are. 5. What are the costs and benefits of a too-big-to-fail policy? The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives for moral hazard by big banks that know that depositors do not have incentives to monitor the banks’ risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks. 6. Suppose that Altin has 500,000 ALL in deposits in a bank in Albania. Due to a severe shock, the bank is considered insolvent by the Albanian Deposit Insurance Agency. Which methods would he prefer the Deposit Insurance Agency to apply considering that the agency insures deposits of up to 250,000 ALL, and that it either uses the payoff method or the purchase and assumption method? What if his deposits were 200,000 ALL? If Altin has 500,000 ALL in deposits he would prefer that the deposit insurance agency use the purchase and assumption method, since he would get more of his
money back compared to the payoff method. In the second case, he would prefer the payoff method. Not only he would get all his money back, but the cost for the taxpayers would be lower. 7. The Deposit Insurance Agency is the institution in charge of deposit insurance in Albania of up to 250,000 ALL. Considering the country has weak institutions and prevalent corruption, do you think it was a good idea for the government to have founded it many years ago? Even though the country has weak institutions and a high level of corruption, the presence of the deposit insurance agency has helped to increase the trust of the public in the banking system, especially after a failed Ponzi scheme in 1997. This, along with a generally healthy banking system, has been a staple in the last two decades. 8. During the financial crisis the Irish government had to intervene and bail out a number of commercial banks by injecting capital. What could have been the government's rationale for doing this? The intervention was necessary to prevent widespread disruption to the financial markets and the real economy. 9. What special problem do off-balance-sheet activities present to bank regulators, and what have they done about it? Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Banking regulators have dealt with this problem by imposing an additional risk-based bank capital requirement that banks set aside additional bank capital for different kinds of off-balance-sheet activities. 10. What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3 Accord attempt to address these limitations? The original Basel Accord takes into account the riskiness of capital, but in practice, the risk weights can differ substantially from the actual risk the bank faces. The Basel 2 Accords were created to address this limitation; however, addressing these shortfalls greatly increased the complexity of the accord, and there was substantial delay with countries adopting and implementing the regulations. More specifically, Basel 2 did not require banks to hold adequate capital to survive financial crises. Moreover, risk weights were dependent on credit ratings, which can be unreliable, particularly in financial crises. In addition, Basel 2 implies procyclical capital requirements, whereas countercyclical capital requirements would be more prudent. Also, there is not a sufficient focus on the need for liquidity, which is necessary particularly during financial crises. Basel 3 attempts to address these shortfalls by increasing the quality and quantity of capital requirements, making capital requirements less procyclical, establishing rules on the use of credit ratings, and requiring firms to have access to more stable funding to increase liquidity. 11. The government safety net creates both an adverse selection problem and a moral hazard problem. Explain. The adverse selection problem occurs because risk-loving individuals might view the banking system as an opportunity to misuse other peoples' funds, knowing that those
funds are protected. The moral hazard problem comes about because depositors will not impose discipline on the banks since their funds are protected As the banks knowthis, they will be tempted to take on more risk than they would otherwise. 12. Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management? With the advent of new financial instruments, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk, bank supervisors now are focusing more on whether the risk-management procedures in banks keep them from excessive risk-taking that might make a future bank failure more likely. 13. During the financial crisis the Irish government had to intervene and bail out a number of commercial banks by injecting capital. What could have been the government's rationale for doing this? The intervention was necessary to prevent widespread disruption to the financial markets and real economy. 14. Suppose Erste Bank holds €100 million in assets, which are composed of the following: Required reserves: €10 million Excess reserves: € 5 million Mortgage loans: €20 million Corporate bonds: €15 million Stocks: €25 million Commodities: €25 million Do you think it is a good idea for Erste Bank to hold stocks, corporate bonds, and commodities as assets? Why or why not? It is probably not a good idea. Since these assets are relatively high-risk, the bank is subject to fluctuations in the values of these assets, which can be substantial. This could result in a significant decrease in the value of its assets to the point where it can no longer cover its immediate liabilities, and would become insolvent. It is for this reason that the government places restrictions on the types and amounts of assets that financial institutions can hold. 15. Why might more competition in financial markets be a bad idea? Would restrictions on competition be a better idea? Why or why not? With more competition in financial markets, there are more firms making less profits. Thus, there is greater incentive for financial firms to take on greater risk in an effort to increase profits. Although restrictions on competition would decrease the incentive for risk by financial firms, it may not be altogether beneficial. It is likely that lower competition would result in higher fees to consumers and decreased efficiency of banking institutions.
16. In what way might consumer protection regulations negatively affect a financial intermediary’s profits? Can you think of a positive effect of such regulations on profits? Consumer protection regulations in general make sure that all relevant information is disclosed to potential borrowers (including costs and conditions of loans) and forbid discrimination against lenders. Complying with these regulations can be costly for financial intermediaries (both in terms of the disclosing of information and lost opportunities if they for example only lend to richer potential borrowers), and thereby negatively affect their profits. However, by disclosing information and not discriminating, financial intermediaries might attract more potential customers, that will now have a fair chance of getting a loan and to thoroughly understand its conditions. ANSWERS TO APPLIED PROBLEMS 17. Consider a failing bank. How much is a deposit of $290,000 worth if the FDIC uses the payoff method? The purchase and assumption method? Which method is more costly to taxpayers? If the FDIC uses the payoff method, a deposit of $290,000 is worth $261,000. If the FDIC uses the purchase and assumption method, a deposit of $290,000 is worth $290,000. The purchase and assumption method would be costlier to taxpayers. 18. Consider a bank with the following balance sheet: Assets Required reserves Excess reserves T-bills Commercial loans
Liabilities $9 million $2 million $46 million $39 million
Checkable deposits Bank capital
$90 million $6 million
The bank makes a loan commitment for $15 million to a commercial customer. Calculate the bank’s capital ratio before and after the agreement. Calculate the bank’s risk-weighted assets before and after the agreement. Before the commitment, the bank's capital ratio equals 6.25 %. After the commitment, the bank's capital ratio equals 6.25 %. Before the loan commitment, the bank's risk-weighted assets are $39 million. After the loan commitment, the bank's risk-weighted assets are $ 54 million. 19. Oldhat Financial starts its first day of operations with $11 million in capital. A total of $120 million in checkable deposits is received. The bank makes a $30 million commercial loan and another $40 million in mortgages with the following terms: 200 standard, 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for $200,000. Assume that required reserves are 8%. a. What does the bank balance sheet look like?
b. How well capitalized is the bank? c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day.
a. Assets
Liabilities
Required Reserves Excess
$10 million $51
Reserves Loans
million
Checkable Deposits Bank Capital
$120 million $11 million
$70 b. The leverage million ratio is 8.40 %, and the bank is well capitalized. c. The risk-weighed assets after Oldhat's first day are $50 million; the risk-weighted capital ratio after Oldhat's first day is 22.00 %. 20. Early the next day, the bank invests $35 million of its excess reserves in commercial loans. Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%, implying a present value of Oldhat’s current mortgage holdings of $99,838 per mortgage. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat’s balance sheet look like? How do these events affect its capital position? The actual balance sheet is: Assets Required Reserves Excess Reserves Loans
$10 million $49 million $55 million
Liabilities Checkable Deposits Bank Capital
$125 million −$11 million
Now, the true state of the bank’s position is realized; bank capital is now negative, so the bank is in a dire capital position.
21. To avoid insolvency, regulators decide to provide the bank with $27 million in bank capital. Assume that bad news about mortgages is featured in the local newspaper, causing a bank run. As a result, $40 million in deposits is withdrawn. Show the effects of the capital injection and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank? If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further runs on the bank, how much of an additional capital injection is required to reach a 10% capital ratio? The effect of the capital injection and bank run are shown in the balance sheet below: Assets
Liabilities
Required Reserves
$ 8 million
Checkable Deposits
Excess Reserves Loans
$26 million
Bank Capital
$100 million $ 9 million
$75 million
The bank now has a 9/109 = 8.3% capital ratio; it is again well capitalized. With the run on the bank, checkable deposits fall to $100 million. In order to have a bank capital ratio of 10%, it must be the case that 0.10 = BC/(100 + BC ), where BC represents the required level of bank capital. Solving for BC yields a level of bank capital needed of $11.1 million. Thus, the regulators would need to inject an additional $2.1 million to reach a 10% capital ratio. ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the number of commercial banks in the United States in each of the following categories: average assets less than $100 million (US100NUM), average assets between $100 million and $300 million (US13NUM), average assets between $300 million and $1 billion (US31NUM), average assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15 billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories, as a percentage of the total number of banks, for the most recent quarter of data available and for 1990:Q1. What has happened to the proportion of very large banks? What has happened to the proportion of very small banks? What does this say about the ―too-big-to-fail‖ problem and moral hazard? In 1990:Q1, there were 25 ‟very large‖ banks, and 9,529 ‟very small‖ banks, representing 0.2% and 76.5% of total commercial banks in the United States, respectively. For the most recent quarter of 2020:Q1, there were 95 ‟very large‖ banks, and 1,000 ‟very small‖ banks, representing 2.1% and 22.5% of total commercial banks in the United States, respectively. Thus, the proportion of very large banks in the banking system has increased substantially over this period while very small banks have shrunk dramatically; because of the proportional increase in these very large banks, the ―Too Big to Fail‖ problem has steadily worsened over this time. This implies that government safety nets, along with the increase in the number of very large banks, can increase moral hazard in the banking system.
2. Go to the St. Louis Federal Reserve FRED database and find data on the residual of assets less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks (TLAACBM027SBOG). Download the data from January 1990 through the most recent month available into a spreadsheet. For each monthly observation, calculate the bank leverage ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in commercial banks over time? See the graph below. In January 1990, the leverage ratio was 6.5%, and in the most recent month of June 2020, the leverage ratio was 9.9%. There are three distinct periods in the data. The first from 1990 to the end of 1995 indicates a gradually increasing leverage ratio. At the beginning of 1996, there was a significant dropoff in bank capital, thus the ratio declines to a much lower level at some point below 4%. Beginning in 2009, as a result of the Global Financial Crisis a number of financial regulations were put into place to raise bank capital and hence the leverage ratio, thus the sharp increase. Overall, the increase in the leverage ratio from 1990 to now indicates that, holding everything else constant, moral hazard in the banking system should be lower now than in 1990.
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Chapter 11 ANSWERS TO QUESTIONS 1. Do you think that before the National Bank Act of 1863 the prevailing conditions in the banking industry fostered or hindered trade across states in the United States? Two important conditions hindered trade across states before 1863: there was no national currency, and banknotes issued by state banks could become worthless any day. Given these two conditions, individuals interested in conducting their business across states had to use mostly gold as a mean of payment, with all the inconveniences attached to that particular type of money. 2. Why does the United States operate under a dual banking system? Throughout most of the history of banking in the United States, there has been a fear of centralized banking power. As a result, all banks had been chartered locally by each state. Due to lax regulation by some states, banks regularly failed due to lack of sufficient capital or fraud. To stabilize the banking system, the federal government introduced the National Banking Act of 1863, which created a system of federally chartered banks that were subject to greater regulation and scrutiny. Since federally chartered banks were less prone to failure, they increased in number over the years. However, the skepticism of centralized power in the banking system still allowed state banks to operate effectively. And although there have been attempts over the years to force all banks to be federally chartered, due to more uniformity in the chartering process, the distinctions between state and federally chartered banks have diminished, and so the two standards are still in operation today. 3. In light of the recent financial crisis of 2007–2009, do you think that the firewall created by the Glass-Steagall Act of 1933 between commercial banking and the securities industry proved to be a good thing or not? Answers will vary. In general, one could say that the Glass-Steagall Act was a good choice in term of separating a risky industry (the securities industry) from traditional commercial banking. In this sense, the Act of 1933 proved to be a good thing, since the banking industry did not experience many crises during its life (it was repealed in 1999). One could also argue that this Act put U.S. banks at a disadvantage against its foreign competitors in terms of lost opportunities to make profits. 4. Which regulatory agency has the primary responsibility for supervising the following categories of commercial banks? a. National banks b. Bank holding companies c. Nonfederal Reserve member state banks d. Federal Reserve member state banks e. Federally chartered savings and loan associations f. Federally chartered credit unions a. Office of the Comptroller of the Currency
b. The Federal Reserve c. State banking authorities and the FDIC d. The Federal Reserve e. Federal Housing Finance Agency f. National Credit Union Administration. 5. How does the emergence of interest rate risk help explain financial innovation? Large fluctuations in interest rates during the 1970s and 1980s led to a need for financial products that could help reduce risk related to unexpected interest rate fluctuations. Two examples of this type of innovation are adjustable-rate mortgages and financial derivatives, both developed during the 1970s. 6. Why did new technology make it harder to enforce limitations on bank branching? Several banks frequently share new technologies such as electronic banking facilities, so these facilities are not classified as branches. Thus, they can be used by banks to escape limitations on offering services in other states and, in effect, to escape limitations from restrictions on branching. 7. ―The invention of the computer is the major factor behind the decline of the banking industry.‖ Is this statement true, false, or uncertain? Explain your answer. Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting information, both of which have made other financial institutions more competitive with banks and have allowed corporations to bypass banks and borrow directly from securities markets. Therefore, computers were an important factor in the decline of the banking system. However, another source of the decline in the banking industry was the loss of cost advantages for the banks in acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as the rise in inflation and its interaction with regulations, which produced disintermediation. 8. ―If inflation had not risen in the 1960s and 1970s, the banking industry might be healthier today.‖ Is this statement true, false, or uncertain? Explain your answer. True. Higher inflation helped raise interest rates, which caused the disintermediation process to occur and helped create money market mutual funds. As a result, banks lost cost advantages on the liabilities side of their balance sheets, leading to a less healthy banking industry. However, improved information technology would still have eroded the banks’ income advantages on the assets side of their balance sheet, so the decline in the banking industry would still have occurred. 9. How do sweep accounts and money market mutual funds allow banks to avoid reserve requirements? With a sweep account, any account funds left at the end of the business day are technically transferred to another account, which is invested in overnight securities. Since they are no longer classified as checkable deposits, the funds are not subject to reserve requirements. Money market mutual funds are set up such that deposits are used to invest in short-term money market securities. And although money market
mutual fund accounts have check writing functions like checkable deposits, they are also not subject to reserve requirements. 10. Securitization changes the systemic (system-wide) risks in the regulated and unregulated ―shadow‖ banking system. What is securitization? Does it pose a problem for effective banking systems? Securitization, like a mortgage-back security (MBS), refers to the process of bundling illiquid financial assets into marketable capital market securities. Securitization is one of the main reasons why shadow banking systems are created—where typical lending is substituted by lending via the securities market; the system invests in long-term loans like auto loans and mortgages, and finances them by issuing short-term commercial papers or repos. It does pose a problem, because on the one hand, shadow banking seems to be very profitable, performing the same functions as regular banks, and usually has lower transaction costs and fewer regulatory restrictions. On the other hand, its lack of regulations imply that it does not benefit from the same safety net as traditional banks do. For example, players in the shadow banking system will not be able to borrow from the Fed’s discount window as they are not federally insured. The role of securitization and shadow banking in the 2007-2009 financial crises is an example of how it affects effective banking systems. 11. Why is loophole mining so prevalent in the banking industry in the United States? Since the banking sector is so heavily regulated, there is a strong incentive for banks to find ways to skirt regulations that restrict their ability to earn profits. Through loophole mining, banks can create new financial products that allow them to operate within existing regulations, but make (or increase) profits that were stifled due to regulation. 12. Why have banks been losing cost advantages in acquiring funds in recent years? The rise in inflation and the resulting higher interest rates on alternatives to checkable deposits meant that banks had a big shrinkage in this low-cost way of raising funds. The innovation of money market mutual funds also meant that the banks lost checking account business. The abolishment of Regulation Q and the appearance of NOW accounts did help decrease disintermediation, but raised the cost of funds for American banks, which now had to pay higher interest rates on checkable and other deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their cost of funds relative to American banks. 13. Why have banks been losing income advantages on their assets in recent years? The growth of the commercial paper market and the development of the junk bond market meant that corporations were now able to issue securities rather than borrow from banks, thus eroding the competitive advantage of banks on the lending side. Securitization has enabled other financial institutions to originate loans, again taking away some of the banks’ loan business. 14. According to Reuters, the People’s Bank of China has been using targeted increases in banks’ reserve requirement ratios (RRR) in recent months. Explain
why central banks impose reserve requirements for commercial banks. Why do commercial banks try to avoid this requirement? Increasing reserve requirement ratios (RRR) is one of the main tools employed by the People’s Bank of China to keep inflation at bay and prevent asset price bubbles. Usually, central banks impose reserve requirements on commercial banks to control money supply—banks need to hold a certain amount of reserves at the central bank (or other regulatory bodies) from their deposits. Holding reserves at central banks impose opportunity costs for these banks—they could have instead offered this fraction as loans and made a profit. In certain countries, the central bank pays interests on the reserves (for example, the United States of America started doing so after 2008), which increases income taxes. Thus, banks look to financial innovations to avoid reserve requirements and, hence, avoid paying higher income taxes. 15. Why are the number of traditional banking systems in industrialized and developed countries declining? Answers may vary as students will be able to provide various examples for different countries. However, there are some common issues—expansion of securities market and shadow banking. Deregulation and information technologies have increased the availability of information about the securities market, so instead of just giving out loans and borrowing at the commercial bank, institutions and bodies may prefer to buy or sell securities. This tendency is more apparent in less developed countries that have weak securities markets. This is due to advanced technologies in those countries, which lets them trade in developed financial markets. 16. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did not have restrictions on setting up branches in other states. Why, then, are credit unions typically smaller than the other depository institutions? Credit unions are small because they only have members who share a common employer or are associated with a particular organization. 17. Why has the number of bank holding companies dramatically increased? Because becoming a bank holding company allows a bank to: (a) circumvent branching restrictions since it can own a controlling interest in several banks even if branching is not permitted, and (b) engage in other activities related to banking that can be highly profitable. 18. Given the role of the loan originator in the securitization process of a mortgage loan described in the text, do you think the loan originator will be worried about the ability of a household to meet its monthly mortgage payments? Given that the loan originator or mortgage broker is mostly worried about getting the household to accept the terms of the mortgage loan, so that the servicer can sell it to the bundler, then it is easy to see that he or she is not very worried about the financial constraints of this family. The loan originator is mostly worried about getting its fee, since he or she will not suffer any consequences if the household cannot repay its loan. This was one of the major problems at the origin of the global financial crisis of 2007–2009.
19. How did competitive forces lead to the repeal of the Glass-Steagall Act’s separation of the banking and securities industries? Brokerage firms began to engage in the traditional banking business of issuing deposit instruments, while foreign bank activities in the United States further eroded the competitive position of U.S. banks. This led to the Federal Reserve’s allowing bank holding companies to enter the underwriting business through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999 was passed to repeal Glass-Steagall. 20. What has been the likely effect of the Gramm-Leach-Bliley Act on financial consolidation? The Gramm-Leach-Bliley Act opened the door to consolidation, not only in terms of the number of banking institutions, but also across financial service activities. Banking institutions have thus become larger and increasingly complex organizations, engaging in the full gamut of financial services activities. 21. What factors explain the rapid growth of international banking? There are three main factors that have contributed to rapid growth in international banking: The growth in international trade and expansion of multinational corporations; the increased profitability of global investment banking; and the expansion of dollar-denominated deposits abroad (Eurodollars). 22. What incentives have regulatory agencies created to encourage international banking? Why have they done this? International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it will create more banking jobs in the United States. 23. How could the approval of international banking facilities (IBFs) by the Fed in 1981 have reduced employment in the banking industry in Europe? IBFs encourage American and foreign banks to do more banking business in the United States, thus shifting employment from Europe to the United States. 24. If the bank at which you keep your checking account is owned by foreigners, should you worry that your deposits are less safe than if the bank were owned by Americans? No, because the foreign-owned bank is subject to the same regulations as the American-owned bank. 25. Implementing a structural separation of commercial banking and investment banking activities is a way to reduce systemic risks when a potential bank failure threatens an entire economic system. Do you think separating banking service industries from other financial service industries is a good idea? Explain your argument. Answers will vary. Encourage students to do some research using the Internet or other resources regarding different systems. You could refer to the separation proposal