M and B

Business

Quiz 7 :
How Banks Work

Quiz 7 :
How Banks Work

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Describe two services that banks provide at which they are particularly effi cient.
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Bank provides services to savers and the borrowers. Banks are efficient at pooling funds and gathering information about borrowers.
Pooling funds: banks attract the people to deposit the money on banks in small amounts, gather those all small amounts and uses that amount for providing the large loans to the borrowers or to the corporations.
Gathering information about borrowers: Banks are specialized in gathering information about borrowers or firms. If anyone wants to earn interest on their savings, they have to give that savings to the firms as loan then the lender have a risk on that, because they have no guarantee for returns. If the firm is in trouble then that will affect the returns of lenders. Here the lender can't know about the firms, But in banks that gives a guaranty on savings, so that there is no risk factor here the bank can know about the firms for how these firms operate and what their financial conditions and can provide the loans to that firms banks allow the economy to be stronger and to grow faster and can provide the more jobs and can expand the business more easily.

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What are the two main types of asymmetricinformation problems? Give an example of each.
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One party in a transaction knows more than another is called asymmetric information. By the asymmetric information there have a two problems
1. Adverse selection
2. Moral hazard
Adverse selection: The borrower or the lender have a asymmetric information before a contract agreed is called adverse selection in the banks points of view the people or firms who don't want to pay the returns on loans and more likely to enter a contract are called bad borrowers
For example: if the bank offers loans at high interest rates at no one will take the loans but who didn't get loans elsewhere will take the loan at high interest rate and if the bank provide a loan to anyone who asks then the borrower could expect that loan may not pay. by this the bank point of view few desirable borrowers will take the loans at high rate.
Moral hazard: The existence of a contract changes the behavior of a party to the contract moral hazard happens by asymmetric information that occurs after the contract agreed.
For example: if he insured for auto mobile accidents in that case he may drive more recklessly comparing with before insured because they have an asymmetric information for an insurance

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List the major ways that banks attempt to solve asymmetric-information problems. Why are such measures necessary?
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The banks started gathering information about the potential borrowers and made restrictions for borrowers those are
1. Requiring collateral
2. Requiring certain amounts of net worth
3. Writing covenants in to the loan contract.
Requiring collateral: collateral is an asset that the borrower has to give to the bank as a promise to repay the loan borrowed, indeed, it is a legal bond; for example, if he unable to pay the loan then the bank can take out that assets.
Requiring certain amounts of net worth:
The borrower should maintain a certain net worth. The bank will not lend if their net worth falls below certain level. This restriction prevents existing borrowers from engaging in moral hazard, the borrower should pay the loan.
Covenant: it is a legally enforced part of a loan contract; here, the borrower should use their funds on particular purpose like what they mentioned on loan request. They cannot use for any other purpose, because, it has a legal obligation.

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Explain how high infl ation in the late 1970s and early 1980s led to the S L crisis. What other events contributed to the crisis?
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What caused the credit crunch in the early 1990s?
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Describe the major assets and liabilities on a bank's balance sheet. Give an example of each.
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Explain the major options available to a bank that is short of reserves. What determines which option a bank is likely to choose?
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What is the spread, and why is it such an important concept for banks?
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Why did banks desire to hold many excess reserves in late 2008 during the fi nancial crisis?
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How can the Fed affect the amount of reserves that banks hold? What interest rates can it change to manipulate the quantity of reserves?
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Look in the latest Federal Reserve Bulletin (or on the Internet at the Federal Reserve Board's Web site: www.federalreserve.gov ), and fi nd the current set of reserve requirements that banks must meet. Then calculate the reserve requirements for banks with the following amounts of transactions deposits. Calculate both the marginal reserve requirement (the additional amount of required reserves per dollar of additional transactions deposits) and the average reserve requirement (required reserves divided by transactions deposits). Consider four banks with the following amounts of transactions deposits: a $3.8 million b $28.9 million c $193.0 million d $5.7 billion
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The balance sheet of a bank follows. Suppose that the reserve requirement is 3 percent on the fi rst $30 million of checkable deposits and 10 percent on checkable deposits in excess of $30 million. (Amounts on the balance sheet are in millions of dollars.) img
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Consider the example of Barry's Bank described on pages 164 to 167. Show the changes in Barry's Bank's balance sheet for each of the options for using the excess reserves discussed on page 167. Show the amount of excess reserves remaining in the bank after each option.
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In a recent year, a bank earned $37 million in interest on its assets of $462 million, it paid out $23 million in interest on its liabilities (excluding capital) of $416 million, and it paid its workers $8 million in total compensation. Calculate the bank's spread and its return on equity.
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During a credit crunch, small fi rms appear to be harmed more than large fi rms are. Explain why this is true. Can you relate this result to asymmetric-information problems?
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In the fi nancial crisis of 2008, the government raised the amount of deposits that is insured by the Federal Deposit Insurance Corporation (FDIC) to $250,000 per person from its previous level of $100,000. What are the pros and cons of such a change?
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If the Fed pays interest on reserves equal to the federal funds interest rate, would banks ever lend to each other in the federal funds market, given that loans in the federal funds market are made with no collateral requirements? How could the Fed encourage loans in the federal funds market while still paying interest on reserves?
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Bankers have numerous methods for reducing their risk, such as requiring collateral for loans and imposing covenants. Yet, when recessions occur, banks usually suffer losses on loans that are not repaid. Explain how competition between banks might prevent them from protecting themselves completely against risk. Do you think that it would be a good idea for the government to regulate banks and keep them from competing very vigorously so that they would take less risk?
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