UCSC ECON 130 - Economics 130 Study Questions No. 4

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Study Questions No. 4 (February 3, 2011) Economics 130 Winter 2011 Key Terms: Credit rationing Credit risk Interest rate risk Discount rate Discount loans Duration analysis Equity multiplier (EM) Excess reserves Required reserves Liquidity management Gap analysis Money center banks Off-balance sheet activities Return on Assets Return on Equity Secondary reserves Basel Capital Adequacy requirements Leverage ratio Regulatory arbitrage Dodd-Frank Act Disintermediation Shadow Banking System Glas-Steagall Act McFadden Act Questions: 1. Consider a bank with interest-sensitive assets of $10 billion and interest-sensitive liabilities of $20 billion. Interest rates have climbed from 5% to 7%. Using “gap” analysis, calculate the effect on bank profits from the interest rate increase. 2. Consider two banks, one with assets with an average “duration” of 5 years and another with an average duration of 10 years. Calculate the approximate change in the average value of each bank’s assets caused by a fall interest rates from 8% to 5% ? (Use “duration” analysis.) 3. Explain why duration analysis is closely related to calculated net price values of assets using the conventional formulation for NPV. 4. ROE = ROA x EM. How might taking on greater leverage (and therefore risk) might increase, in the short-run, ROE? How might investing in riskier assets also increase ROE? Explain. 5. Why do banks normally hold “excess reserves” with the Fed? 6. If a bank has a deposit withdrawal, what does this do to: (a) required reserves? (b) actual reserves? If there is a shortage of reserves, what four methods may the bank undertake to increase reserves? What are the advantages and disadvantages of each method? 7. If bank shareholders or depositors can’t observe ROA or EM, or the riskiness of investments from which ROA is derived, how can the market evaluate whether ROE is due to good management or high risk taking? 8. How has deposit insurance provided by the FDIC eliminated traditional bank runs by depositors? Has it completely eliminated bank runs? (Hint: sudden withdrawals of other forms of bank liabilities). 9. What is the “too-big-to-fail” doctrine? And why do almost all governments follow this doctrine? What happened when Lehman Brothers was allowed to fail? 10. How do the principles of moral hazard and adverse selection apply to banking?11. How do regulators restrict bank asset holdings in attempt to limit risk taking? 12. How does the Basel Accord (Basel I) work in terms of limiting risk-taking by banks? 13. Restrictions on bank competition were imposed in the 1920s and 1930s. Which Acts were mainly responsible for this? How have these restrictions changed over 1970-2007? 14. What is a financial derivative? Financial engineering? 15. What are the major provisions of the Dodd-Frank bill as it applies to consumers, hedge funds, insurance companies, derivatives trading, propriety trading and


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UCSC ECON 130 - Economics 130 Study Questions No. 4

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