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cheat sheet test 3

~How many commercial banks are there in the US? How many in other major countries? Why the difference? Government Safety Net, Restrictions on Asset
Holdings, Capital Requirements, Prompt Corrective Action, Financial Supervision, Chartering/Examination, Assessment of Risk Management, Disclosure
Requirements, Consumer Protection, Restriction on Competition
~Describe what is the first category of banking regulation mentioned - Government Safety Net: includes government guarantee of deposits (with defined limits),
ad hoc government loans, and the Fed Reserve System as lender of last resort. Federal Reserve Act of 1913 and the Banking Acts of 1933 (Glass-Steagall)
and 1935
~What historical factors led to the creation of government-provided deposit insurance in the US - During the Great Depression of 1929/1930s and before 1934
there was no government guarantees for depositors' money, so if/when a bank was expected to fail, there would be a "run" to the bank to withdraw their
money. This run could accelerate/cause a bank to fail
~ Generally speaking, what 2 actions can the FDIC take to deal with a bank that fails? Payoff method: FDIC allows bank to fail and depositors are provided their
insured deposit balances. Purchase and Assumption Method: FDIC recognizes bank by finding another bank which is willing/able to purchase the failed
~What are the asymmetric information risks (adverse selection and moral hazard) associated with the use of government-provided deposit insurance? Adverse
selection risk: that people who would take negative advantage of the government guarantee would be attracted to banking. Moral Hazard: existing bank
managements are incented to take greater risks than otherwise because they are not responsible for depositor's funds.
~What does "too big to fail" mean? When the FDIC refuses to let a bank fail because of its size, because permitting it to fail might trigger a financial crisis
(1984, Continental Illinois Bank); this policy increases the moral hazard problem
~The increasing amount of consolidation in the banking industry poses special challenges to the so-called government safety net. What are those challenges? RiegleNeal Interstate Banking and Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 permitted the
creation of much larger and more financial service conglomerates which increase the too big to fail moral hazard problem and the
government safety net might have to be extended to non-bank financial organizations
~The second category of banking regulations mentioned is "restrictions on asset holdings". What legislation addressed this issue directly and what are some examples
of restrictions on assets holdings - The Banking Act of 1933 (Glass-Steagall Act) created the FDIC which in exchange for the government's guarantee of
deposits, banks must restric what kinds of assets they can own (not permitted to own common stocks)
~A related area of banking regulations is "Capital Requirements". Describe this in terms of the forms mentioned in the text - Through the FDIC and the Federal
Reserve banks are required to have a minimum amount of equity capital which provide the normal stockholder's incentive to avoid losses. Banking Act of
1933 (aka Glass-Steagall Act) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
~Another category of banking regulations is "Financial Supervision: Chartering and Examination". What level of government charters which type of commercial
bank? National banks are chartered by the U.S. Comptroller of the Currency; state banks are chartered by the banking commissions located in each state
~Regarding "Financial Supervision: Chartering and Examination", which government agencies provide supervision and examination for national banks? For
state banks? National Banks: U.S. Comptroller of the Currency, Fed, FDIC. State Banks: state government banking regulatory agencies/bank commissions,
the FDIC, and the Fed
~Another category of regulation is called "Consumer Protection". What is this about? Consumer Protection Act of 1969 (aka Truth in Lending Act); Equal Credit
Opportunity of 1974/6; the Dodd-Frank Act of 2010 created the Bureau of Consumer Financial Protection
~How many commercial banks are there in the US? How many in other major countries? Why the difference? About 5700 bank ownership groups in US; usually
only several large banks; due to the unique economic and political history of the US, particularly the dual banking system plus the historical restrictions
on competition which used to be considered an important way to encourage the financial health of banks
~Until 1863, which level of government chartered commercial banks? State governments only from 1787-1863; after 1863 both the Federal and State
government(s) charter banks
~What were the purposes of the National Banking Act of 1863? Did it eliminate chartering of banks by state governments? The National Banking Act of 1863
created the national banks, banks chartered by the federal government office of the comptroller of the currency, to compete with if not drive state
government-chartered banks out of business (1863 was middle of civil war); it ended the controversy over which level of government would be able to
charter commercial banks (both federal gov and state govs could charter banks)
~In which of the instructor's historical phases was there a high degree of stability and a minimum of bank failures? Phase 4: 1933-1970 (after the implementation of
the Banking Act of 1933 up to the 70s just prior to the investment banks starting to create financial products that competed with commercial banks)
~When did the US establish a (permanent) central bank and what led to its creation? What impact did this have on the US commercial banking industry (before central
bank and after) The Federal Reserve Act of 1913 created the Federal Reserve System (the Bank of the United States and Second bank of the US were
essentially temporary experiments); the financial panic of 1907 and the related damage to the banking industry and economy convinced bank lenders,
political leaders, business leaders, and the general public the US needed a central bank
~Why was the Banking Act of 1933 (G/S) passed and what did it achieve? The Glass Steagall Act was created during the Great Depression to repair the
damage done by the failure of 1/3 of all commercial banks by creating government deposit insurance with the FDIC, and by prohibiting commercial
banks from significantly owning/underwriting common stocks or otherwise engaging in investment banking activities and insurance company activities,
and by prohibiting investment banks and insurance companies from owning/operating commercial banks
~In which of the Instructors historical phases were commercial banks prohibited from engaging in the investment banking business and in which phase(s) did this
change? Phase 4: 1933-1970s, at the beginning; In phase 5: 1970s to Early 90s (late 80s) Citibank, JP Morgan, and Bank of America petitioned to gain
increasing permissions to grow their investment banking businesses; In phase 5: Late 80s to 2008, the Glass-Steagall Acts requirement of separate
ownership of commercial banking, investment banking, and insurance company businesses was repealed with the Gramm-Leach Blilely Act of 1999.
~What are the multiple regulatory agencies which regulate the commercial banking business (as revised/updated by the instructor)? National Banks: Office of the
Comptroller of the Currency, FDIC, Federal Reserve, Financial Stability Oversight Council; State Banks: state government banking commissions, FDIC,
Federal Reserve, and Financial Stability Oversight Council
~Describe the number and size of US Commercial banks from table 1. What does this say about the level of competitiveness in the banking industry? Over 5700
bank ownership groups: 544 (9.4%) control 92% of the industry's total assets and each has over $1 Billion in total assets; 5213 (90.6%) control only 8% of the
industry's assets; appears to be highly competitive
~What are the 5 major commercial banks and how significant are they? Jp Morgan Chase, Bank of America, Wells Fargo, Citibank, and US Bank; top 4 banks
control about 45% of the US banking industry's total assets; Phase 7: 2008 to present
~Why did the US have restrictions on branch banking for so long and what impact did this have on the number of banks in the US? The textbook author said the
American people did not like the idea of big banks (concentrated economic power) so we created restrictions on banks opening branches, which meant there
would evolve a large number of bank ownership groups to serve a given community/city/urban area
~With respect to the Financial Innovation section in the text: Describe the innovations for managing "interest rate volatility" Adjustable rate mortgages and
financial derivatives were financial products created to help manage increasing interest rate volatility of the 1970s and 80s.
~With respect to the Financial Innovation section in the text: Describe the innovations driven by advancements in information technology. How have junk bonds and
commercial paper impacted commercial banks market share for loans? Bank credit/debit cards, electronic banking (ATMs, internet banking), junk bonds
and commercial paper programs were created by investment banks to provide intermediate term and short term financing to businesses at both ends of the
credit rating spectrum normally served by commercial bank term loans and lines of credit (so commercial banks lost market share)
~With respect to the Financial Innovation section in the text: What is the shadow banking system (aka parallel banking system) The shadow banking system
represents a myriad of mostly unregulated, private investment and financing entities which are organized by regulated commercial banks, investment
banks, and investment companies, which use securities to finance the purchase of portfolios of smaller loans (mortgages, business loans, student
loans, credit card receivables). One segment of this system specializes in sub-prime credits (borrowers with below-average credit ratings)
~Since the 1980s, there has been a marked trend towards fewer commercial banks in the US. How many commercial banks were there between 1935-1985, how many
are there today, and what factors have led to the reduction in the number of banks? 1935-1985: about 14000 (prior to 1935 there were more than 20000);
today, about 5700; primary factor: attitude against large commercial banks changed which led to repeal of branching restrictions and restrictions on
interstate banking, so a large number of banks have been acquired or merged with other banks to achieve greater economies of scale.
~How did US commercial banks respond to the restrictions on interstate banking which existed until 1994? Commercial banks created ways to legally circumvent
some of the interstate branching restrictions (example Texas Commerce Bancshares), and interstate restrictions by creating interstate banking agreements
between and among state governments (example of Bank of America)
~What is Bank Consolidation about? Bank consolidation means US commercial banks since the mid 1980s have been acquiring/merging with other bank
ownership groups to achieve greater economies of scale, especially with the repeal of interstate branching restrictions (and interstate branching restrictions
in many states)
~how did the instructor and textbook define a "financial crisis" a major disruption in financial markets caused by increases in adverse selection and moral
hazard problems that prevent financial markets from channeling funds to people (individuals and organizations) with productive investment opportunities,
leading to a sharp contraction in economic activity
~in the text, during "stage one: initial phase", what are the three general factors cited as contributing to a financial crisis? -credit boom and bust (sometimes driven
by financial innovations); -asset-price boom and bust (usually driven by a credit boom and bust, and leading to write downs of loans and equity investments
on balance sheets of companies and financial institutions) -increase in uncertainty in the financial markets/economy (which leads to productive project
investors cutting back their investing as well as financial intermediaries cutting back the provision of credit to them)
~in the text, during "stage two: banking crisis" what are three more general factors cited as contributing to a financial crisis? economic activity declines; major
banks fail; adverse selection and moral hazard problems worsen
~what is "stage three" in past US financial crises? "debt deflation" - a substantial unanticipated decline in price level, wherein the regular inflation rate turns
into a negative number (which causes a substantial drop in business' and consumers' net worth but without a corresponding decrease in their debt
obligations), such that productive project investors and financial intermediaries decrease their investing for a protracted period of time and the
economy's performance declines for a protracted period of time
~what does Dr. Mishkin mean about "financial innovation and liberalization" the creation of new financing and investment instruments and vehicles, which can
lead to a significant increase of new lending, and that increase can lead to a credit boom (and later bust)
~what is meant by "asset price boom and bust"? what kind of assets are referenced in the text?
when there is a credit boom in an economy, and productive project investors and financial intermediaries borrow and lend too much money in a short
period of time, the prices of the assets purchased by those productive project investors (real estate, stocks, bonds, business assets) can become
temporarily inflated above their intrinsic fundamental values, and then those inflated asset prices crash, leading to asset write-down losses
~describe the key points of the Timothy Geithner Speech of June, 2008.
the financial crisis of 2008 started in the Summer of 2007, and was contained in the financial markets industry for about a year ; financial innovations
such as lower quality mortgage. securities increased in volume driven by a credit boom; the "parallel" banking system (unregulated private
investing/financing vehicles organized and supported by regulated commercial banks) grew to be quite large relative to the regulated financial
institutions, invested in a lot of long-term lower-quality mortgage securities, used a lot of short-term sources of financing to purchase those loans, and
then there was a "run" on this system when subprime loan defaults increased.
~describe the key points of the president George W. Bush speeches of September 2008. Problems that originated in the credit markets—and first showed up in
the area of subprime mortgages—have spread throughout our financial system; This has led to an erosion of confidence that has frozen many
transactions, including loans to consumers and to businesses; Congress needs to pass legislation approving the federal government's purchase of up
to $700 billion of illiquid assets, such as troubled mortgages.
~describe the key points of the Dr. Benjamin Bernanke speech of January 2009. Since about August, 2007, the global financial system has been under
extraordinary stress—stress that decisively spilled over into the global economy more broadly; the proximate cause of the crisis was the turn of the
housing cycle in the U.S. and the associated rise in delinquencies on subprime mortgages; a credit boom which included declines in underwriting
standards and breakdowns in lending oversight by investors and credit rating agencies.
~What are "subprime mortgages" and in what sense were these products of financial innovation in the U.S.? Long-term, amortizing loans made to finance
residential real estate, made to borrowers with relatively low credit ratings; innovations in information technology make it easier to measure more
precisely consumer credit risks as well as to securitize subprime mortgage loans with structured investment vehicles.
~What are "securitization", "structured credit products" and "structured investment vehicles" (aka "special purpose vehicles")? "Securitization" means the process
of selling marketable debt securities by a structured investment vehicle to raise funds to enable that vehicle to purchase pools/portfolios of smaller
loans; "structured credit product" is a complicated debt security which is supported by the cash flows from a designated tranche of loans from larger
pools/portfolios of loans; "structured investment vehicle" is a private, unregulated investment/financing entity which employs a very small amount of
equity capital (e.g., 3% of total assets) and a large amount
of debt (including a large amount of short-term debt) to finance the purchase of pools/portfolios of loans.
~what are "mortgage backed securities" and "collateralized debt obligations" Debt instruments issued by a financing/investment entity which collateralizes its
debt securities by a pool of assets (such as mortgage loans) owned by the financing/investment entity. One key idea: the credit rating for the debt securities
issued could be higher than the credit ratings of the individual loans held.
~What is the "originate and distribute" business model and what role did this have in the Subprime Financial Crisis of 2007-2008? An investment/financing process
where one entity (e.g., a mortgage broker) earns a commission to originate and sell a loan to another investing entity, which may also earn
commissions to package and sell a pool of loans to other investing entities, which may issue debt securities to own bigger pools/portfolios of loans
through private unregulated entities, such that the credit evaluation and credit monitoring process may deteriorate/fail; this process increased beyond
reason the volume/amount of subprime mortgage loans.
~When did the early stages of the Subprime Financial Crisis of 2007-2008 initially emerge in the financial markets and what were they? The TED spread, the
difference between interest rate on the 3-month LIBOR (i.e., Eurodollar) interest rate and the 3-month U.S. Treasury Bill (normally about 25 basis points)
began increasing and spiking dramatically in July/August 2007 (indicating a growing lack of confidence between banks to loan each other money, and hence,
a type of disruption in the credit markets began to intensify).
~At the end of 2013, Table 4 in Chapter 2 indicates total assets for all financial intermediaries (excluding certain government-sponsored enterprises) was about $51.9
trillion. Table 1 in Chapter 13 provides the relative percentage shares for each type of financial intermediary. What part of this total is comprised of nonbank financial
intermediaries? 68.3% or about $35.4 trillion.
~How many different kinds of insurance companies (different from insurance "policies") are mentioned in the textbook? Do health insurance companies operate more
like life insurance companies or property and casualty insurance companies? Two: Life Insurance and Property and Casualty Insurance companies; Property
and Casualty, because a large proportion of insurance premiums are paid out in claims.
~In what kinds of assets do Life Insurance companies invest and why? What about Property and Casualty Insurance companies (and why is this different from life
insurance companies)? Life: Long-term debt and equity instruments; P&C: more shorter-term, more liquid debt instruments, and more income tax exempt
securities (because Property and Casualty
~With regard to insurance companies: what is meant by "the competitive threat from the banking industry" and is this something regulators or the government in
general would approve? In recent years regulators have permitted commercial banks more freedom to invest in insurance companies/products, which
increases competition for insurance companies (yes).
~As described by the textbook, what is one way insurance companies have responded to the competitive threat from banks? Insurance companies have developed
financial derivatives trading capabilities to compete with commercial banks (e.g., credit default swaps and credit insurance derivatives).
~What was the "AIG Blowup", and what is one of the most important implications? AIG is one of the largest insurance companies in the world, and at one
time had a very large financial products business segment which was heavily involved in the credit default swap business, and a large portion of these
were to insure subprime mortgage-related debt
instruments; AIG did not have sufficient equity capital to cover its losses on these and had to
receive a bailout from the federal government; because there was no U.S. federal government regulator to oversee the insurance industry, this created
some additional problems, so the Dodd-Frank Wall Street Reform Act of 2010 created mechanisms to enable federal government oversight for larger,
systemically important insurance companies.
~What is meant in insurance management by "screening", "risk-based premiums" and "restrictive provisions"? These are features of insurance company practices
and contracts to help to reduce the adverse selection and moral hazard problems related to providing insurance to policyholders.
~What is meant in insurance management by "prevention of fraud", "deductibles" and "coinsurance"? These are insurance contract provisions to help insurance
companies manage the moral hazard problems related to providing insurance to policyholders.
~Pensions: What is the difference between a "Defined-Benefit plan" and a "Defined-Contribution plan"? Which type of plan is growing faster in use? What is
"ERISA" and "PBGC"? "Defined-Benefit" plan: the plan beneficiary is promised defined retirement benefit(s) from a retirement income fund owned and
operated by the beneficiary's employer or union; "Defined-Contribution" plan: the plan beneficiary owns his/her own retirement income fund and
receives reduced income taxes by contributing certain amounts of money into the fund, and also may receive matching contributions from the
beneficiary's employer or union; "Defined-Contribution" plan is the current state-of-the-art plan.
~What is "ERISA" and "PBGC"? "ERISA": the federal law called Employee Retirement Income Security Act of 1974 to protect employees from abusing
employers and unions which operate defined-benefit pensio plans; "PBGC": the Pension Benefit Guaranty Corporation, a federal government agency
that guarantees pension benefits for defined benefit pension plans in the event the employer or union as plan sponsor-owner goes bankrupt and fails to
fulfill its pension benefit commitments (operates like the FDIC).
~What is best way to describe how the U.S. Social Security System ("SSS") works?
In 2013, approximately 163 million employees and their employers paid payroll taxes into the SSS Trust Fund, and approximately 58 million persons
collected income and other benefits paid from those funds; it is a cross-generational "pay-as-you-go" system and is not a pension fund.
~What current challenges exist for the U.S. Social Security System ("SSS")? What are the several most-likely solutions for these challenges? Beginning in 2020,
total expenditures will exceed total income, such that a portion of the OASDI Trust Fund assets would have to be sold each year to cover the future
annual deficit, and the Trust Fund assets' balance would be depleted by 2033; increase payroll tax rates, decrease benefits, or a combination of those
two things.
~What were the total assets for the Old Age and Survivors Insurance and Disability Insurance ("OASDI") Trust Funds at December 31, 2013? What was total income
and total expenditures for 2013? $2.8 trillion; $855 billion; $823 billion.
~What are the conventional sources of funds for Finance Companies, and in what kinds of assets do they invest? Sources: Equity capital, long-term debt, and
short-term debt;
Assets: medium term loans to consumers and loans to businesses who are not able to easily obtain credit/loans from commercial banks.
~What are some of the key differences between investment banks and commercial banks? Commercial banks sell government-insured deposits, and use the
proceeds to make loans to businesses and invest in government debt instruments; investment banks provide advice to businesses and governments
about which kind of financial instruments they can sell to raise capital, underwrite the sale of those securities into the financial markets, and operate
brokerage/dealer operations to facilitate the trading of marketable securities.
~What are the conventional sources of funds for Mutual Funds, and in what kinds of assets do they invest? What is the distinctive of Money Market Mutual Funds?
Mutual Funds sell shares of stock to investors when investors (usually individuals) open accounts with those mutual funds; Mutual Funds invest in longterm debt and equity securities usually according to a designated investment orientation (e.g., growth stock fund, corporate bond fund, dividend-paying
stock fund, foreign companies stock fund, etc.);
Money Market Mutual Funds also sell shares of stock in their fund when investors open accounts (individuals and corporations) and invest the
proceeds in high-quality money
market securities (U.S. Treasury Bills, Corporate Commercial Paper, commercial bank certificates of deposit, etc.) because investors are usually
investing for a short-term period.
~How are Hedge Funds different from Mutual Funds in general? Hedge Funds: investment companies designed to be exempt from regulation by the
Investment Company Act of 1940 and the Securities and Exchange Commission and can have a wide variety of themes, and must have qualified
investors; Mutual Funds: investment companies regulated by the Investment Company Act of 1940 and the Securities and Exchange Commission and
generally invest in corporations and governments which have publicly-traded equity and debt securities.
~What are Private Equity Funds, and how are Private Equity Funds different from Hedge Funds?
Hedge Funds: investment companies designed to be exempt from regulation by the Investment Company Act of 1940 and the Securities and
Exchange Commission and can have a wide variety of themes, and must have qualified investors;
Private Equity Funds: investment companies regulated by the Investment Company Act of 1940 and the Securities and Exchange Commission and
generally invest in corporations which have privately-held stock that is not publicly-traded.(A Venture Capital Fund is a special kind of Private Equity
Fund that specializes in start-up companies that have the potential of going public and issuing stock to the investing public).
~How can "financial derivative" be defined, and what is its primary purpose? A legal contract between two counterparties, usually to exchange one set of cash
flows for another set of cash flows, with the cash flows/payoffs linked to previously-issued securities; they are used to hedge/offset various risks (interest raterelated risks, stock price-related risks, foreign exchange rate risks, commodity price risk, credit default risks, etc.).
~What is a general definition of "hedging"? How is "hedging" different from "investing", "speculation"?"Hedging": engage in a transaction that offsets (partially
or completely) a risk position already taken separately; "Investing": to purchase an asset that is reasonably expected to increase in market value or
otherwise produce a return commensurate with the risks taken by owning the asset; "Speculation": to purchase an asset assuming a risk position in
anticipation of gain but there is a higher-than-average probability of a loss (note: entering into a derivatives contract when a party does not already own
a risk position is a speculative position because using derivatives usually incurs some kind of net cost).
~How does a "forward contract" work (for example: an interest-rate forward)? A legal contract between two counterparties negotiated privately, wherein the
counterparties agree to buy-sell transaction for a defined future date for a defined asset, to lock-in the buy-sell price in advance.
~What are some of the pros and cons for forward contracts? Pros: can have custom-negotiated terms and a long-term expiration/settlement date;
Cons: difficult to find a counterparty, counterparty default risk can be high, the contract is not very liquid, and settlement usually requires the delivery of
the referenced asset.
~How do "futures contracts" work (for example: an interest-rate future)? A legal contract with standardized terms to promote high-volume trading, between a
exchange company and a qualified trader on the exchange, wherein the counterparties agree to buy-sell a referenced asset/pool of assets or an index
for a referenced asset/pool of assets for a fixed price, with the referenced asset/pool of assets to be delivered at its current floating market value (or the
cash equivalent of such) on the settlement date.