ECON 311 1st Edition Exam 2 Study Guide Chapters 8 12 Chapter 8 Solutions to Adverse Selection 1 Screening of the borrower 2 Signaling using a trusted name reputation to ensure capability 3 Full disclosure requirements 4 Looking at SEC filings 5 Subscribe to Moody s and Standard and Poor s 6 Use a financial intermediary 7 Government Regulation 8 Collateral creates a sort of insurance policy Solutions to Moral Hazard 1 2 3 4 5 6 7 8 9 Monitoring Trade debt instruments Performance incentives Government regulation Enforcement of restrictive covenants in the debt markets Debt contracts Financial intermediation Net worth and collateral Debt contracts in bond market Chapter 9 Review Figure 1 pg 187 Review Figure 7 pg 201 SHORT ANSWER QUESTION What factors could contribute to the subprime mortgage crisis that happened in 2007 2009 Why Explain the potential channels and how those factors impact our economy ANS The crisis was triggered by mismanagement of financial innovations involving subprime residential mortgages and the bursting of a housing price bubble The crisis spread globally with These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute substantial deterioration in banks and other financial institutions balance sheets a run on the shadow banking system and the failure of many high profile firms Channels include the housing market impacts the economy because for the houses that are not paid off yet they are used as collateral if the borrower defaults on their loan If the housing market crashes like it did it is detrimental to the economy the banking system impacts the economy because if something happens like a bank panic they may have to resort to calling in their loans which ultimately effects the consumer causing even more financial uncertainty the foreign exchange system impacts the economy because if our dollar appreciates or depreciates sporadically there are negative effects on our domestic economy General Rules of Financial Crisis Stage 1 Initiation of Financial Crisis Mismanagement of Financial Innovation Liberalization Asset Boom and Bust Increase in Uncertainty Stage 2 Banking Crisis Bank Panic Fire Sales Stage 3 Debt Deflation Chapter 10 Capital Adequacy Banks have to make decisions about the amount of capital they need to hold for 3 reasons 1 Helps prevent bank failure a situation in which a bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business 2 The amount of capital affects returns for the owners equity holders 3 A minimum amount of bank capital is required by regulatory authorities bank capital requirements The more the better in from the depositors standpoint The smaller the better from the owners standpoint Greater amount reduces likelihood of bank failure Chapter 11 Capital Asset Quality Management Earnings Liquidity Sensitivity to market risk 10 Solutions to fix financial crisis 1 2 3 4 5 6 7 8 9 10 Deposit Insurance FDIC Capital Requirements Restrictions on Asset Holdings Prompt Corrective Action Financial Supervision Chartering and Examination Assessment of Risk Management Disclosure Requirements Consumer Protection Restrictions on Competition Macroprudential and Microprudential Supervision SHORT ANSWER QUESTION What is the cause and adv disadvantages of too big to fail ANS The two big to fail issue is when a large bank becomes insolvent but because it is so large failure of the bank would be detrimental To prevent failure the government will infuse capital into the bank and will find a willing merger partner to take over the bank and its deposits The advantage to this is that depositors will not lose their deposits but the disadvantages are that the employees of the insolvent bank will likely be fired and the stockholders will lose their investments In addition to that the existence of the too big to fail policy encourages moral hazard in the banking system because creditors know the bank will get bailed out if it does become insolvent there is little incentive to constantly monitor the investment decisions of the institution SHORT ANSWER QUESTION What is the risk based premium for deposit insurance How could higher deposit insurance premiums for banks with riskier assets benefit the economy ANS The risk based premium for deposit insurance is the fact that riskier institutions will have a higher premium for deposit insurance compared to institutions with a lower risk Higher deposit insurance for banks with riskier assets could help the economy because it would reduce the bank s incentive to involve themselves in risky investments and encourage them to involve themselves in better investment choices Savings and Loan Crisis Factors that Contributed increased competition increased moral hazard financial innovations that caused increased risk taking new legislation like deposit insurance increased moral hazard and risky behavior high interest rates principle agent problem Regulatory Implications consumer protection resolution authority systemic risk regulation Volcker Rule financial derivatives capital requirements compensation government sponsored enterprises credit rating agencies Chapter 12 Demand Based Financial Innovation Adjustable Rate Mortgages Financial Derivatives Supply Based Financial Innovation Bank Credit and Debit Cards Electronic Banking ATM ABM virtual bank Junk Bonds Commercial Paper Market Securitization Sweep Account an arrangement in which any balances above a certain amount in a corporation s checking account at the end of the business day are removed and invested in overnight securities that pay the corporation interest Junk Bond bonds with ratings below Baa or BBB that have high default risk Decline of Traditional Banking Is there a decline in traditional banking Yes according to the passage states that in 1974 the banks provided 35 of funds to nonfinancial borrowers but today they only provide 22 Commercial banks share of total financial intermediary assets fell from around 40 in the 1960 80 period to below 30 by the end of 1994 What are the banks responses to the decline in traditional banking They attempt to maintain their traditional lending activity by expanding into new risker areas of lending They increase lending for corporate takeovers and leveraged buyouts which are highly leveraged transactions They have also increased their lending to less creditworthy borrowers They have sought