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ACF 104 Final Test Review

ACF 104 Final Test Review. Types of Government Bank Regulation. Government Safety Net: Deposit Insurance and the FDIC Restrictions on Asset Holdings and Bank Capital Requirements Bank Supervision: Chartering and Examination Assessment of Risk Management Disclosure Requirements

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ACF 104 Final Test Review

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  1. ACF 104 Final Test Review

  2. Types of Government Bank Regulation • Government Safety Net: Deposit Insurance and the FDIC • Restrictions on Asset Holdings and Bank Capital Requirements • Bank Supervision: Chartering and Examination • Assessment of Risk Management • Disclosure Requirements • Consumer Protection (e.g. APR) ACF 104 Financial Institutions

  3. Types of Government Banking Regulation • Restrictions on Competition • Branching restrictions, which reduced competition between banks • Separation of banking and securities industries: Glass-Steagall. In other words, preventing nonbanks from competing with banks. ACF 104 Financial Institutions

  4. The “Too Big to Fail” Policy of Government Regulators • Regulators are reluctant to let the largest banks fail because of the potential impact on the entire system. This is known as the “Too Big to Fail” doctrine. This increases the moral hazard problem for big banks and reduces the incentive for large depositors to monitor the bank. • This treats large depositors of small banks inequitably when compared to depositors of large banks. ACF 104 Financial Institutions

  5. Problems with Deposit Insurance • Can increase the likelihood that depositors will need deposit protection, as banks with deposit insurance are likely to take on greater risks than they otherwise would. (moral hazard)

  6. Investment Banks • Investment banks perform a variety of crucial functions in financial markets • Underwrite the initial sale of stocks and bonds (help companies raise funds) • Deal maker in mergers, acquisitions, and spin-offs • Middleman in the purchase and sale of companies • Private broker to the very wealthy ACF 104 Financial Institutions

  7. Investment Banks: Underwriting Stocks and Bonds • The goal of underwriting is to be Fully Subscribed. However, this may not occur. • Fully subscribed: all shares are spoken for • Undersubscribed: underwriting syndicate unable to generate interest in all of the available shares • Oversubscribed: interest in more shares than are available (may lead to rationing). ACF 104 Financial Institutions

  8. Investment Banks: Underwriting Stocks and Bonds • Best Efforts: An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort” to sell the entire issue. No guarantees, sells on a commission basis. • Private Placements: The entire issue is sold to a small, select group of investors. This is rarely done with equity issues; mostly for debt. ACF 104 Financial Institutions

  9. The Difference Between Stock Brokers and Dealers • Brokers are pure middlemen; act for customers only. • Dealers make markets by standing ready to buy and sell at given prices. They own inventories.

  10. Bank Tools for Managing Credit Risk • Screening: collecting reliable information about prospective borrowers. This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firms or individuals. ACF 104 Financial Institutions

  11. Bank Tools for Managing Credit Risk • Monitoring: requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact. • Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness. ACF 104 Financial Institutions

  12. Bank Tools for Managing Credit Risk • Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan. • Collateral: a pledge of property or other assets that must be surrendered if the terms of the loan are not met ( the loans are called secured loans). ACF 104 Financial Institutions

  13. Bank Tools for Managing Credit Risk • Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default. • Credit rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part come from equity financing. ACF 104 Financial Institutions

  14. Hedging with Derivatives • A financial transaction that reduces or eliminates risk. • Definitions • long position: an asset which is purchased or owned • short position: an asset which must be delivered to a third party as a future date, or an asset which is borrowed and sold, but must be replaced in the future ACF 104 Financial Institutions

  15. Advantages of Financial Futures Markets over Forward Contracts • Success of Futures Over Forwards • Futures are more liquid: standardized contracts that can be traded • Delivery of range of securities reduces the chance that a trader can corner the market • Mark to market daily: avoids default risk • Don't have to deliver: cash netting of positions ACF 104 Financial Institutions

  16. Large Fluctuations (changes) in Interest Rates Lead to: • substantial capital gains and losses to owners of securities. • greater uncertainty about returns on investments. • greater interest-rate risk. Therefore banks need to hedge!

  17. Risk Facing Finance Companies • Roll over risk refers to the need to continue to borrow in the commercial paper market. If the market dries up, they may not be able to maintain their loans. • Interest rate risk is also present but lower than for banks. Most of their assets are medium-term loans, funded by short-term commercial paper. ACF 104 Financial Institutions

  18. Risk Facing Finance Companies • Default risk is the greatest risk, and finance companies often lend to those who can’t get financing otherwise. • Liquidity risk can be an issue, as their assets (loans) are not easily sold. A need for cash can cause problems. ACF 104 Financial Institutions

  19. Financial Innovation and the Decline in Traditional Banking • The traditional role of transforming short-term deposits into long-term loans has been greatly affected by financial innovation. • The importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically. ACF 104 Financial Institutions

  20. Causes of Financial Innovation • Changes in Technology • Changes in Financial Market Conditions • Changes in Regulation

  21. Financial Innovation and the Decline in Traditional Banking Figure 18.2 Bank Share of Nonfinancial borrowings, 1960–2004 ACF 104 Financial Institutions

  22. Bank Consolidation and Nationwide Banking • Are Bank Consolidation and Nationwide Banking a Good Thing? • Cons • Fear of decline of small banks and small business lending • Rush to consolidation may increase risk taking • Pros • Community banks will survive • Increase competition • Increased diversification of bank loan portfolios: lessens likelihood of failures ACF 104 Financial Institutions

  23. Financial Innovation and the Decline in Traditional Banking • Loss of Cost Advantages in Acquiring Funds (Liabilities) • πi then disintermediation because • Deposit rate ceilings and regulation Q • Money market mutual funds • Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool ACF 104 Financial Institutions

  24. Financial Innovation and the Decline in Traditional Banking • Loss of Income Advantages on Uses of Funds (Assets) • Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization • Finance companies more important because easier for them to raise funds ACF 104 Financial Institutions

  25. Banks' Response • Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking • Expand lending into riskier areas (e.g., real estate) • Expand into off-balance sheet activities • Creates problems for U.S. regulatory system • Similar problems for banking industry in other countries ACF 104 Financial Institutions

  26. Decline in Traditional Banking in Other Industrialized Countries • Forces similar to those in the U.S. have led to a similar decline in other industrialized countries (e.g. Japan, Australia). • For example, deregulation in Japan has led to new financial instruments, leading to disintermediation. • In many countries, as securities markets develop, banks also face competition from the products offered. ACF 104 Financial Institutions

  27. But Still............. • Lack of drop in bank profits!

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