Study Guide FIN 3244 Exam 1 1 Borrowers Impacted by Financial Crisis 2 Bank Lending impact on community Borrowers were greatly impacted by the financial crisis as small businesses were cut off from their normal source of credit Banks tightened their loan guidelines making it difficult for households and businesses to qualify for loans Many small businesses had to borrow from pawn shops running up balances on credit cards or borrow from friends and family to survive After the crisis from 2007 2009 banks became extremely cautious in making loans greatly affecting small to medium sized firms who rely on bank loans to meet their credit needs Banks were especially cautious in loaning to construction firms as they had been particularly hard hit in the crisis Loans by large banks to small businesses declined more than twice as much from all other loans Falling real estate prices made borrowing with buildings held as collateral more difficult Small businesses employing fewer than 50 workers struggling to get bank loans accounted for 45 of the employment loss Monetary Policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives These objectives include 3 Monetary Policy 1 High levels of employment 2 Low rates of inflation 3 High rates of growth 4 Stability in the financial system 4 Bond Market Features The bond market is also subject to adverse selection Less moral hazard in the bond market than the stock market but Restrictive Covenants still present limits on the uses of funds that a borrower receives A clause in a bond contract that places Bonds are the most important source of external credit to corporations The bond market contains considerably less risk 5 PV FV calculation PV FV 1 i n FV PV x 1 i n On calculator there is no PMT unless working with a bond 6 True value of money concepts 7 Information Transaction Costs The way that the value of a payment changes depending on when the payment is received Discounting The process of finding the present value of funds that will be received in the future The further in the future a payment is to be received the lower the PV The higher the interest rate used to discount future payments the smaller the PV Transaction Costs the costs of making a direct financial transaction such as buying a stock or bond or making a loan EX Brokerage commision charged for buying or selling an asset Information Costs The costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired Because of these costs savers receive a lower return on their investment and borrowers must pay more for the funds they borrow In some cases these costs will prohibit funds from being lent or borrowed at all Though they reduce the efficiency of the financial system an opportunity arises for those who can lower these costs One of the problems which arises from asymmetric information Adverse Selection distinguishing low risk borrowers from high risk borrowers before making an investment The problem investors experience in 8 Adverse Selection of information 9 Bank Balance Sheet Areas Classifications The problem with this is that it can cause investors to only lend money to borrowers who are transparently low risk George Akerlof was the first economist to analyze this issue Adverse selection often results in small to medium sized firms unable or unwilling to issue stock as many investors are concerned they ll end up with a lemon stock In the stock market adverse selection makes it difficult for anyone but large firms to issue stock and in the bond market it leads to credit rationing The best way to avoid adverse selection is through the disclosure Asset Something of value that an individual or firm owns in particular a financial claim Securities Liquid assets that banks trade in financial markets Loans Largest category of bank assets illiquid compared to securities but pay higher interest rates Other Assets Include bank s physical assets Liability Something that a firm owes particularly a financial claim on a firm Checkable Deposits Accounts against which depositors can write checks also called transaction deposits Non transaction Deposits offered by the bank to savers who are willing to sacrifice immediate access to teir funds in exchange for higher interest payments Savings Accounts Borrowings The way that banks raise funds Include short term loans in the federal funds market loans from a banks subsidiaries repurchase agreements and discount loans from the FED Bank Capital The difference between the assets and liabilities Checkable deposits on which banks do not Demand Deposits Now Accounts Checking accounts that pay interest have to pay interest Savings Accounts before withdrawal interest but only three checks per month can be written and several years with a penalty for early withdrawal MMDA s CD s hybrid of savings and checking accounts as they pay Have specified maturities ranging between several months Depositors must give the bank 30 days notice also called shareholder s equity 10 Types of Bank Accts 11 Types of Bank Interest Rates 12 Required and Excess Reserves 13 Financial Crisis negative impact on firms securities Prime Rate Formerly the rate charged on six month loans to high quality borrowers currently the rate banks charge primarily to small borrowers market rate over the period of the loan Fixed Rates Adjustable Rates Rates that can change usually based on the Rates that do not change over the period of the loan Reserves are the most liquid assets a bank holds Required Reserves hold against demand deposit and NOW account balances Any reserves banks hold above those necessary to meet reserve requirements Excess Reserves Reserves that the Fed requires banks to The Fed pays interest on Required and Excess reserves which become an important source of liquidity for banks Failing Banks frozen markets and plummeting stock prices Mortgage backed securities greatly declined in value through the increasing default and crash of what seemed to be an optimistic housing market People began to lean more towards bonds issued by the US Treasury Many Banks were hit hard especially commercial banks who had made loans to real estate developers Many firms filed for bankruptcy due to the default on the loans The bankruptcy of Lehman brothers produced a sharp decline in which they d given out most types of lending Many firms were taken over by the FED as
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