ECON 311 1st EditionExam # 2 Study Guide Chapters: 8 - 12Chapter 8:Solutions to Adverse Selection: 1) Screening of the borrower2) Signaling: using a trusted name/reputation to ensure capability3) Full disclosure requirements4) Looking at SEC filings5) Subscribe to Moody’s and Standard and Poor’s 6) Use a financial intermediary7) Government Regulation8) Collateral, creates a sort of “insurance policy” Solutions to Moral Hazard:1) Monitoring2) Trade debt instruments3) Performance incentives4) Government regulation5) Enforcement of restrictive covenants in the debt markets6) Debt contracts7) Financial intermediation8) Net worth and collateral9) Debt contracts in bond marketChapter 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 UncertaintyStage 2: Banking Crisis- Bank Panic- Fire SalesStage 3: Debt DeflationChapter 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 standpointThe smaller the better from the owners standpointGreater amount reduces likelihood of bank failureChapter 11: CapitalAsset QualityManagementEarningsLiquiditySensitivity to market risk10 Solutions to fix financial crisis:1) Deposit Insurance (FDIC)2) Capital Requirements3) Restrictions on Asset Holdings4) Prompt Corrective Action5) Financial Supervision: Chartering and Examination6) Assessment of Risk Management 7) Disclosure Requirements8) Consumer Protection 9) Restrictions on Competition10) 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’sincentive 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 hazardand risky behavior, high interest rates, principle-agent problemRegulatory Implications: consumer protection, resolution authority, systemic risk regulation, Volcker Rule, financial derivatives, capital requirements, compensation, government sponsored enterprises, credit rating agenciesChapter 12: Demand-Based Financial Innovation:Adjustable Rate MortgagesFinancial DerivativesSupply-Based Financial Innovation: Bank Credit and Debit CardsElectronic Banking (ATM, ABM, virtual bank)Junk BondsCommercial Paper MarketSecuritizationSweep Account: an arrangement in which any balances above a certain amount in a corporation’schecking account at the end of the business day are “removed” and invested in overnight securities thatpay the corporation interestJunk Bond: bonds with ratings below Baa (or BBB) that have high default riskDecline 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 tononfinancial borrowers but today they only provide 22%. Commercial banks’ share of total financialintermediary 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, riskerareas of lending. They increase lending for corporate takeovers and