Short Answers: These are candidate answers for the short answers, and are representative of what you should have written. In some cases, there are many more responses that were potentially correct.

Answer Key Second Midterm

DEFINITIONS

1. REPO: A Repurchase Agreement is a financial instrument that allows the holder of a security, usually a government bond, to obtain short term financing. A REPO works in the following manner, the party that is in need of funds “sells” his/her securities to a second party and he/she compromises to re-purchase the security at a specific date (usually overnight) at a higher value, which will have implicit the financing cost. REPO’s are widely used in the financial markets to meet reserve requirements and also were used by banks to pay interest on checking accounts.

2. Regulatory Forbearance: Many things could be said about this. The book says the following: ”Regulators refraining from exercising their right to put an insolvent bank out of business”. Other important points that should have been included are: it implied the modification of usual accounting regulations so as to allow otherwise insolvent banks to continue operating, and it increased the possibility of moral hazardous behavior from part of financial institutions.

3. Securitization: the book says “The process of transforming illiquid financial assets into marketable capital market instruments”. An example would have been nice, e.g. mortgages, and the influence of government agencies in the development of such a market.

4. Dual Banking System: the book, again, says, “the system in the US in which banks supervised by the federal government and banks supervised by the states operate side by side”. This, plus a little historical comment about why this is so would have been enough.

SHORT RESPONSES

1. TRUE: Not only is ambiguous because of the nature of accounting regulations but also because NW by itself doesn’t say anything about bank performance.

2. TRUE: This is basically true, since the principal-agent problem involved in an organization where the owners are not the workers is eliminated. There are still special cases to consider but this is basically it.

3. TRUE: It is true that it seems that only implies a reduction of the moral hazard since loaners will have less incentives to perform moral hazardous activities, but it also decreases the adverse selection problem since collateral is a way banks use in screening possible good and bad credits.

4. FALSE: To answer this just keep in mind that if there are branching restrictions, the possibility of competition is limited so it is possible to have a large number of banks (only a few per city) but since they are isolated from each other, competition among them would be non existent.

5. TRUE/FALSE/UNCERTAIN: depending on how you weight two different and opposing arguments: it would be a bad idea since in case of a failure depositors obviously would not receive anything; however it could be a good idea if the increased awareness of depositors about this fact make them invest only in the safest banks so the potential of moral hazardous behavior for banks is reduced, and so the possibility of their failure, and the cost (in terms of taxes) of the insurance would be eliminated.

6. TRUE/UNCERTAIN: again it depends on how you answer the question. It is true that financial institutions will try to reduce to a minimum their amount of ER but if all make the same thing, the possible cost if there is a generalized liquidity shortage could be substantially large. So it can be expected that the decision of the financial institutions will take into consideration these two opposing forces.

Essays: These are candidate answers for the four essays, and are representative of what you should have written. In some cases, there are many more responses that were potentially correct. The point totals were generally, but not absolutely, abided by – any deviation from the point totals was usually to your advantage.

1. Question #1
1. Three means of circumventing bank branching restrictions (4 points)

Ø Bank Holding Companies: companies that hold one or more banks – bank holding companies can own a controlling interest in several banks even if branching is not permitted

Ø Nonbank banks: taking advantage of a loophole in the 1956 Bank Holding Act which defines a bank as “an institution that accepts deposits and makes loans” – nonblank banks do one or the other

Ø ATMs: not brick-and-mortar bank institutions, and can be owned and operated in multiple states; banks get fee income from ATMs

2. Costs of consolidation (4 points)

Ø Reduced lending to small businesses: small businesses are heterogeneous and idiosyncratic – large non-local banks may reject small business loan applications on credit scoring or objective grounds, and do not have sufficient information to make subjective loan acceptances

Ø Increased asymmetric information problems: expansion of lending into new geographic regions may result in increased risk-taking

3. Benefits of consolidation (4 points)

Ø Increased competition and efficiency, and economies of scale

Ø Geographic diversification of assets, reducing the probability of insolvency

2. Question #2
1. Three examples of government regulation of the banking system (4 points)

Ø Regulation Q: ceiling on interest payments on demand deposit accounts

Ø Capital adequacy requirements: minimum capital/asset ratio

Ø Reserve requirements: minimum reserves/demand deposits ratio

2. How this regulation effects asymmetric information (4 points)

Ø Regulation Q: increased competition among banks along margins other than interest rates, with concomitant moral hazard problems; caused disintermediation into arguably riskier securities with less oversight

Ø Capital adequacy requirements: reduced moral hazard on the part of banks, as they have a vested interest in their solvency

Ø Reserve requirements: reduced moral hazard on the part of banks, as they have an obligation to retain liquid assets

3. How this regulation has led to financial innovation (4 points)

Ø Regulation Q: MMDAs, NOW accounts, CDs

Ø Capital adequacy requirements: securitization

Ø Reserve requirements: sweep accounts, time deposits

3. Question #3
1. Bank management principles (6 points)

Ø Liquidity management: keep sufficient liquid assets (including reserves) on hand to cover potential deposit outflows and meet reserve requirements

Ø Asset management: acquire assets with low default risk and high returns that are suitably diversified

Ø Liability management: acquire funds at low cost and in sufficient quantity to support desired asset acquisition

Ø Interest-rate risk management: use gap and duration analysis, etc. to assess the sensitivity of bank’s portfolio to fluctuations in interest rates; use financial futures markets, etc. to balance potential losses from interest rate changes against returns

Ø Capital management: meet capital adequacy requirements, attempt to mitigate the effect of default on bank solvency

2. Conflicts between these principles (6 points)

Ø Liquid assets tend to provide low returns

Ø Riskier assets pay high returns but are subject to greater default risk

Ø Longer-term liabilities are generally less sensitive to interest rate fluctuations, and have highly predictable outflows, but are typically more expensive than demand deposits

Ø On the basis of asset and liability management alone (i.e., no derivatives), you necessarily cannot minimize risk of interest rate increases and decreases while maximizing profits

Ø The greater the capital you hold, the lower the return on equity

4. Question #4
1. Table (6 points)

Agent A	Period 0	Period 1	Period 2
Income	30	30	40
Expenditures	30	65	95
Assets	100	115	170
Liabilities	30	80	190
Net Worth	70	35	-20

Agent B	Period 0	Period 1	Period 2
Income	50	120	40
Expenditures	50	30	80
Assets	200	250	180
Liabilities	220	180	150
Net Worth	-20	70	30

Agent C	Period 0	Period 1	Period 2
Income	45	50	130
Expenditures	45	105	35
Assets	100	200	150
Liabilities	150	305	160
Net Worth	-50	-105	-10

2. Definition and significance of net worth (2 points)

Ø NW = Assets – Liabilities

Ø Is a measure of the degree of solvency of a financial institution

3. Distinction between flows and stocks (2 points)

Ø Flows are measured over a period of time (e.g. income, expenditures)

Ø Stocks are measured at a point in time (e.g. assets, liabilities)

4. Synopsis of findings (2 points)

Ø Agent A is dissaving each period

Ø Agent B first saves, then dissaves

Ø Agent C first dissaves, then saves