Finance Intermediaries and Their Roles
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Questions and Answers

What is one primary role of financial intermediaries?

  • To regulate stock prices
  • To provide a mechanism for fund allocation (correct)
  • To eliminate all financial risk
  • To manage government spending

Financial markets only serve institutional borrowers and do not accommodate individual borrowers.

False (B)

What are the two types of finance mentioned in the context of fund transfer?

Direct finance and indirect finance

Which market is primarily focused on the trading of government bonds?

<p>Bond market (D)</p> Signup and view all the answers

The financial sector helps channel money from __________ to prospective buyers.

<p>savers</p> Signup and view all the answers

Financial intermediaries only include banks and insurance companies.

<p>False (B)</p> Signup and view all the answers

Match the following units with their financial needs:

<p>Borrowers = Prefer long-term loans with the lowest interest rates Lenders = Aim to minimize costs and prefer high liquidity Investors = Seek to maximize returns on assets Financial intermediaries = Facilitate the transfer of funds between savers and borrowers</p> Signup and view all the answers

What major international institutions were created during the Bretton Woods Conference?

<p>IMF and World Bank</p> Signup and view all the answers

The ____ standard was a significant monetary system before the evolution of modern financial practices.

<p>gold</p> Signup and view all the answers

Match the following financial institutions with their primary functions:

<p>Depository institutions = Accept deposits and make loans Insurance companies = Collect premiums and pay compensation Pension funds = Collect from workers and pay to retirees Finance companies = Use deposits to make loans</p> Signup and view all the answers

What does M2 consist of?

<p>M1 + money market and savings accounts (A)</p> Signup and view all the answers

Adverse selection occurs when both parties have equal information.

<p>False (B)</p> Signup and view all the answers

What is the main source of funds for banks?

<p>customer deposits</p> Signup and view all the answers

The __________ is the difference between a bank's interest income from loans and its interest expenses on deposits.

<p>net interest income</p> Signup and view all the answers

Match the following banking services with their descriptions:

<p>Payment = Facilitating transactions between buyers and sellers Deposits/Lending = Accepting deposits and providing loans Investment/Pension/Insurance = Managing funds for future financial needs E-Banking = Online banking services for users</p> Signup and view all the answers

What phase follows the ‘Boom’ in an asset price bubble?

<p>Profit taking (D)</p> Signup and view all the answers

Zero coupon bonds make interest payments throughout their term.

<p>False (B)</p> Signup and view all the answers

What is an Initial Public Offering (IPO)?

<p>The offering of shares of a private corporation to the public.</p> Signup and view all the answers

A _____ bond allows the bondholder to convert debt into equity.

<p>convertible</p> Signup and view all the answers

Match the type of bond with its characteristic:

<p>Government bonds = Issued by the government, low risk and low interest Corporate bonds = Issued by companies to raise capital Municipal bonds = Issued by states and municipalities Convertible bonds = Allows conversion of debt to equity</p> Signup and view all the answers

What action does a Vlocker take regarding banks?

<p>Restricts how banks can invest their money (A)</p> Signup and view all the answers

The secondary market deals with newly issued securities.

<p>False (B)</p> Signup and view all the answers

What is the primary purpose of mutual funds?

<p>To provide small investors access to diversified portfolios of stocks, bonds, and securities.</p> Signup and view all the answers

The _______ market is where banks primarily trade currency with each other.

<p>interbank</p> Signup and view all the answers

Which of the following best describes a SPAC?

<p>A public company seeking to acquire another company through an IPO (D)</p> Signup and view all the answers

What is the primary goal of managing assets and liabilities in banking?

<p>Maximize profits (C)</p> Signup and view all the answers

SWIFT is used for safe and secure transactions in international banking.

<p>True (A)</p> Signup and view all the answers

What is liquidity risk in banking?

<p>Liquidity risk is the inability of a bank to meet its financial obligations when they come due.</p> Signup and view all the answers

In the interbank market, banks primarily deal with _______ and _______ rate risks.

<p>exchange, interest</p> Signup and view all the answers

Match the following terms with their definitions:

<p>Credit risk = Risk of borrower failing to meet obligations Market risk = Risk of adverse market price movements Liquidity risk = Risk of needing cash unexpectedly Interest rate risk = Risk from mismatch of asset and liability maturities</p> Signup and view all the answers

Which of the following is considered a liquid asset?

<p>Treasury bills (D)</p> Signup and view all the answers

What type of loan does a bank extend that allows a customer to withdraw more money than is available in their account?

<p>Overdraft (D)</p> Signup and view all the answers

Eurocurrency refers to deposits held in the home country where the currency is dominated.

<p>False (B)</p> Signup and view all the answers

Default risk refers to the likelihood that a borrower will repay their loan.

<p>True (A)</p> Signup and view all the answers

What is the main purpose of securitization in banking?

<p>To bundle real estate loans into packages and issue securities based on these packages.</p> Signup and view all the answers

What defines the 'forward market' in currency trading?

<p>The forward market involves agreements to exchange currencies at a future date, typically ranging from 30 to 180 days.</p> Signup and view all the answers

The ___________ is primarily responsible for ensuring financial stability and preventing systemic risks.

<p>central bank</p> Signup and view all the answers

A _____ loan is secured by the value of a vehicle.

<p>auto</p> Signup and view all the answers

Match the following risks to their definitions:

<p>Default risk = Risk that borrowers do not repay loans Interest rate risk = Risk due to changes in interest rates Liquidity risk = Risk of sudden withdrawals of funds Market risk = Risk of adverse price movements in financial markets</p> Signup and view all the answers

Which of the following is NOT a type of risk faced by banks?

<p>Behavioral risk (D)</p> Signup and view all the answers

What is the primary income-generating asset for banks?

<p>Loans (D)</p> Signup and view all the answers

Options contracts give the holder the obligation to buy or sell at a set price.

<p>False (B)</p> Signup and view all the answers

What is a bank run?

<p>A bank run is when a large number of customers withdraw their deposits simultaneously due to concerns about the bank's solvency.</p> Signup and view all the answers

Higher bank capital ratios increase the risk of bank insolvency.

<p>False (B)</p> Signup and view all the answers

What is the GAP analysis used for in banking?

<p>To measure the difference between interest rate sensitive assets and liabilities.</p> Signup and view all the answers

___________ requires banks to maintain a minimum amount of capital relative to their risk-weighted assets.

<p>Capital adequacy</p> Signup and view all the answers

Eurodollars are _____ denominated deposits held outside the United States.

<p>USD</p> Signup and view all the answers

Match each type of loan with its description:

<p>Business loan = Regular installment loans or lines of credit Real estate loan = Secured by property a borrower purchases Auto loan = Secured by the vehicle itself Overdraft = Allows withdrawal beyond account balance</p> Signup and view all the answers

What does the term 'Credit Risk' refer to?

<p>A borrower's failure to meet loan terms (B)</p> Signup and view all the answers

Banks can become insolvent if their total assets exceed total liabilities.

<p>False (B)</p> Signup and view all the answers

Define 'Value at Risk' in a banking context.

<p>A measure of the potential loss on a portfolio from market movements.</p> Signup and view all the answers

The _____ refers to financial markets for stocks, bonds, and currencies.

<p>financial market</p> Signup and view all the answers

What is one of the primary roles of financial intermediaries?

<p>Minimize direct lending costs and transaction costs (D)</p> Signup and view all the answers

Banks primarily earn profits from a spread between the interest they pay on deposits and the interest they earn on loans.

<p>True (A)</p> Signup and view all the answers

What term describes the risk that arises when one party has more or better information than another party in a transaction?

<p>Asymmetric information risk</p> Signup and view all the answers

The ratio of change in deposits to the change in the level of deposits is known as the __________.

<p>credit multiplier</p> Signup and view all the answers

Which of the following services do commercial banks provide?

<p>Checking accounts and savings accounts (B)</p> Signup and view all the answers

Deregulation involves the implementation of new rules and restrictions for financial institutions.

<p>False (B)</p> Signup and view all the answers

What do banks maintain as a reserve requirement?

<p>A specific percentage of their deposits</p> Signup and view all the answers

Investment products like stocks, bonds, and mutual funds are designed to potentially provide __________ to investors.

<p>returns</p> Signup and view all the answers

What term defines the banks' ability to convert short-term deposits into long-term loans?

<p>Maturity transformation (C)</p> Signup and view all the answers

Transaction deposits can be withdrawn using checks and are considered highly liquid.

<p>True (A)</p> Signup and view all the answers

What does the term 'bank capital' refer to?

<p>The difference between a bank's assets and liabilities</p> Signup and view all the answers

__________ loans are provided by banks to retail customers without collateral and have a short to medium time frame.

<p>Consumer</p> Signup and view all the answers

Match the following types of cards with their attributes:

<p>Credit Cards = Pre-arranged credit limits, attract interest if unpaid. Debit Cards = Withdraw funds directly from a bank account. Check Guarantee Cards = Require identification for guaranteed payment. Travel and Entertainment Cards = Used for business expenses, repaid at the end of the month.</p> Signup and view all the answers

Flashcards

Financial Intermediaries

Institutions that connect savers (those with excess funds) with borrowers (those needing funds).

Stock Market

A marketplace where shares of publicly traded companies are bought and sold.

Bond Market

A marketplace where government and corporate bonds are traded. Bonds represent debt securities.

IMF (International Monetary Fund)

An international organization that promotes global monetary cooperation, financial stability, and international trade.

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Depository Institutions

Financial institutions that accept deposits from customers and make loans. Examples include banks, credit unions, and savings & loan associations.

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Financial System

A network of institutions that enable the exchange of funds, including banks, insurance companies, and stock exchanges.

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Financial Sectors

Parts of the financial system that move funds from savers to borrowers for purposes like buying homes or paying for college.

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Borrowers

Entities that need funds and are willing to pay interest for them. They prefer long-term loans at the lowest possible interest rate.

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Lenders

Entities that have surplus funds and lend them out, seeking high liquidity, short-term investments, and low risk.

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Asymmetric Information

A situation where one party in a transaction has more information than the other party.

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Adverse Selection

When one party in a transaction has more information about the quality of the goods or services being exchanged, leading to an imbalance in the deal.

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Moral Hazard

When one party in a transaction changes their behavior after the transaction is complete, because they are not fully responsible for the consequences.

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Credit Multiplier

A concept that explains how a change in bank reserves can lead to a larger change in the money supply.

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What does a bank's net interest income line tell us?

The net interest income line represents the difference between the interest earned on the bank's assets (loans) and the interest paid on its liabilities (deposits). The size of the spread (the difference) reflects the bank's profitability.

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Financial claims

Represent claims on money, goods, or services. Examples include deposits, bonds, shares, loans, and life insurance.

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Bank

Provides payment services (transferring value), deposits/lending, investment, pensions, and insurance. They act as a bridge between savers and borrowers.

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Size Transfer

Banks collect small deposits from savers and transform them into larger loans.

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Maturity Transfer

Banks accept short-term deposits and convert them into medium- or long-term loans, managing liquidity risk.

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Risk Transformation

Banks minimize individual risk by diversifying investments and holding capital as a buffer against unexpected losses.

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Bank Assets

Income-earning assets (85%): loans and securities. They must maintain noninterest-earning reserves (coins, currency, central bank deposits).

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Check

Debit transfer, written request to debit the creditor's account.

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Credit Transfer

Customer instructs bank to transfer funds to a beneficiary's account.

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Debit Card

Issued by a bank, allows immediate withdrawal from the account, obtain cash from ATMs.

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Credit Card

Prearranged credit limit, attracts interest if not paid off in time.

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Open Market Operations

Central bank buys/sells securities in open markets to influence money supply, interest rates, and overall economic activity.

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Reserve Requirements

The amount of funds banks must hold in reserve, used by the central bank to influence money supply and interest rates.

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Loan Types

Different types of loans offered by banks, each with its own purpose, features, and risks.

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Overnight Loan

A loan from one bank to another, usually for a very short duration, often overnight, to meet short-term liquidity needs.

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Real Estate Loan

A loan secured by real estate property, typically used for purchasing homes or commercial properties.

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Mortgage

A long-term loan secured by real estate property, used specifically for financing the purchase of a home.

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Securitization

The process of bundling together similar loans and issuing securities based on these bundled loans, allowing for risk distribution and investment opportunity.

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Business Loan

Loans provided to businesses for various operational needs, including working capital, equipment purchases, or expansion.

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Installment Loan

A loan repaid in regular fixed installments over a specific period.

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Line of Credit

A pre-approved credit line that allows businesses to borrow funds up to a certain limit, providing flexibility for short-term funding needs.

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Compensating Balance

A minimum deposit requirement that a borrower needs to maintain in their account, often as a condition of a business loan.

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Auto Loan

A loan secured by a vehicle, used to finance car purchases.

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Overdraft

A banking service that allows customers to withdraw funds even if their account balance is zero, providing flexibility for short-term cash needs, but usually carries high fees.

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Interest Rate Risk

The risk that changes in interest rates can negatively impact a bank's profits, especially when mismatches exist between the maturities of assets and liabilities.

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GAP Analysis

A technique used to measure the difference between interest-rate-sensitive assets and liabilities, assessing a bank's vulnerability to interest rate changes.

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Liquidity Risk

The risk that a bank may not be able to meet its short-term financial obligations because of a sudden large withdrawal of funds by depositors.

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Bubble

A rapid increase in asset prices, followed by a sharp decline and crash. Often characterized by excessive speculation and unrealistic valuations.

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Displacement (Bubble stage)

Triggers the bubble. Often involves new products, low interest rates, or anything that attracts widespread attention and investment.

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Boom (Bubble stage)

Prices surge rapidly as people rush to buy assets, fueled by optimism and speculation.

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Euphoria (Bubble stage)

The peak of the bubble. Prices rise dramatically, driven by irrational exuberance and a belief that the boom will continue indefinitely.

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Profit Taking (Bubble stage)

Early signs of the bubble bursting. Investors start selling off assets, realizing the price increases are unsustainable.

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Panic (Bubble stage)

The final stage of the bubble. Prices crash as investors rush to sell their assets, leading to a rapid decline in value.

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Government Response to Bubbles

Measures implemented to mitigate the effects of a bubble burst, including lowering interest rates, buying back debt and mortgages, and providing bailouts to struggling companies.

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Inverse Relationship between Bond Price and Interest Rates

As interest rates rise, bond prices fall, and vice versa.

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Yield Curve

A graphical representation showing the relationship between interest rates and maturities for bonds of different durations.

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What is the primary goal of a bank?

To earn profits while maintaining low exposure to risk, high liquidity, and a strong financial cushion to protect against insolvency.

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What is Eurocurrency?

A deposit made in a bank located outside the country where the currency is officially issued.

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SWIFT

Society for Worldwide Interbank Financial Telecommunication. A secure network used for global financial transactions.

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Interbank Market

A market where major banks trade currencies, manage risks, and deal with interest rates.

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Forward Market

A market where currencies are traded for delivery at a future date (e.g., 30, 90, or 180 days).

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Eurobonds

Bonds issued in a currency different from the country where they are issued.

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Liquidity Tradeoff

A balance between the level of risk and potential return in relation to the liquidity of an asset.

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Credit Risk

The risk that a borrower will fail to repay their debt obligations.

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Market Risk

The risk of losses due to unfavorable movements in market prices.

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RAROC (Risk-Adjusted Return on Capital)

A measure of profitability considering the risk associated with an investment or a loan.

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What is the primary asset generating income for a bank?

Loans are the most important income-generating asset for a bank.

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What is ALM (Asset Liability Management) in banking?

A comprehensive approach to manage assets well, while maximizing returns on loans and securities, and taking into account liquidity and risk.

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Study Notes

Financial Intermediation and Markets

  • Financial intermediaries facilitate the transfer and allocation of funds to productive opportunities.
  • The financial system comprises institutions allowing fund exchange, operating at firm, regional, and global levels (e.g., banks, insurance companies, stock exchanges).
  • Financial sectors facilitate the movement of money from savers to investors (e.g., paying for college, buying a house).
  • Financial markets enable negotiation of loans, projects, investments, and return on assets.

Borrowers and Lenders

  • Borrowers (deficit units) seek low-cost, long-term funding.
  • Lenders (surplus units) face default risk and asset fluctuation, seeking high liquidity and short-term, high-return options.
  • Investors play a crucial role in these transactions.

Direct vs. Indirect Finance

  • Direct finance involves funds flowing directly from lenders/savers to borrowers/investors.
  • Indirect finance uses intermediaries as conduits, transferring funds from lenders/savers to intermediaries, and then to borrowers/investors.

Types of Financial Markets

  • Stock markets: trading of shares.
  • Bond markets: trading of government or other bonds.
  • Currency markets: buying and selling currencies.
  • Commodity markets: trading of agricultural, energy, or metal products.
  • Futures and options markets: trading of derivatives.

Financial Market Importance

  • Essential for fund transfer, resource allocation, and improved economic welfare.
  • Increase investment returns and firm value.
  • Facilitate risk management.

Global Financial Systems

  • Composed of regulated entities (banks, insurance), regulators, supervisors, and institutions.
  • Evolution includes the gold standard, WWI/WWII impacts, the Great Depression, the Bretton Woods Conference (creation of IMF and World Bank), and the rise of the dollar as a reserve currency, with reduced barriers to trade.
  • International institutions (IMF, World Bank) play roles in maintaining international balance and supporting developing countries.

Financial Institutions

  • Depository institutions (banks, credit unions, savings and loans) accept deposits (liabilities), provide loans (assets), manage payment services, and offer investment products.
  • Insurance companies: collect premiums from policyholders, paying compensation in case of loss.
  • Pension funds: collect contributions, invest and pay out to retired workers.
  • Finance companies: use deposited funds to issue loans.
  • Security firms: provide access to financial markets (e.g., investment banks, brokerage services).
  • Government-sponsored enterprises: support loans (e.g., mortgages).

Financial Intermediaries

  • Reduce direct lending costs and transaction costs.
  • Enable fund transformations (size, maturity, risk).
  • Banks: handle payments, deposits, lending, investments, and insurance.

Bank Services and Operations

  • Provide deposit and lending services (checking, savings, consumer loans).
  • Offer investment, pension, and insurance products.
  • Engage in e-banking.
  • Generate revenue from the interest rate spread between loans and deposits.

Asymmetric Information

  • Adverse selection: one party possesses relevant information unavailable to the other—financial intermediaries mitigate this.
  • Moral hazard: occurs when one party with superior information acts against another's interest.
  • Credit scoring and assessments reduce information asymmetry

Economic Imbalances and Interdependence

  • Economic imbalances occur when imports exceed exports, and global imbalances involve differing asset holdings across nations.
  • Economic interdependence is driven by specialization.
  • Credit multiplier: the relationship between changes in reserves and changes in the money supply.

Central Banks and Monetary Policy

  • Central banks control the money supply and interest rates via open market operations, reserve requirements, and interest rate manipulations.
  • Open market operations: buying/selling government securities.
  • Reserve requirements: percentage of deposits banks must hold as reserves.
  • Interest rates: influence the demand for loans and economic activity.

Deregulation and Reregulation

  • Deregulation liberalizes financial markets, leading to increased competition and consolidations.
  • Reregulation addresses potential adverse effects, such as moral hazard, and creates stability mechanisms.

Financial Innovation

  • Innovations create new financial instruments and technologies, driving efficiency, market expansion, and product differentiation.

Bank Assets and Liabilities

  • Assets: primarily income-generating assets (loans, securities).
  • Liabilities: customer deposits, borrowings.
  • Capital: difference between assets and liabilities; serves as buffer against losses.

Risk Management in Banking

  • Types of risks: Credit, interest rate, liquidity, market, country, management risks.
  • Management tools: GAP analysis, duration analysis, value-at-risk (VaR) modeling to assess and quantify losses.

Loan Portfolio Management

  • Diversify to reduce impact of potential defaults.
  • Risk-adjusted return on capital (RAROC) and value at risk (VaR) are risk assessment tools.

Banking Operations

  • Commercial banks are the main retail banks in the market

Financial Market Instruments

  • Bonds (corporate, municipal, government), stocks, mutual funds, hedge funds, private equity, and derivatives (futures, options, swaps).

Financial Crises

  • Characterized by asset value declines, debt defaults, and liquidity shortages.
  • Bubbles (Tulip Mania, 1772 credit crisis) are characterized by rapid price increases leading to crashes.
  • Government responses typically involve lowering interest rates, buying back debt to improve market confidence.

Financial Regulations

  • Regulators (e.g., FED, SEC, OCC) establish rules to mitigate risks (bank runs, systemic risk).
  • Safety and soundness regulations protect the banking system from insolvency.
  • Monetary policy regulation ensures minimal cash reserve against deposits.
  • Credit allocation regulations support specific economic sectors.

Financial Markets

  • Primary and secondary markets: trading of new and pre-existing financial instruments (stocks, bonds).
  • IPOs and SPACs are methods of raising capital.
  • Equity markets facilitate capital raising for companies and investment opportunities for savers.

Global financial systems

  • International banks, international financial instruments (eurocurrencies); LIBOR and Euribor are key indicators.

Financial intermediaries

  • Key role in transforming financial instruments and raising capital for other sectors

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Explore key concepts related to financial intermediaries and their functions in the market. This quiz covers the types of finance, the role of banks, characteristics of financial markets, and important historical institutions. Test your knowledge on how money is channeled from savers to borrowers.

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