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Questions and Answers
What is a key advantage of depository financial institutions like banks?
What is a key advantage of depository financial institutions like banks?
Which statement best describes adverse selection?
Which statement best describes adverse selection?
What does agency theory analyze?
What does agency theory analyze?
What distinguishes moral hazard from adverse selection?
What distinguishes moral hazard from adverse selection?
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Which type of deposit is associated with depository institutions that allows writing checks?
Which type of deposit is associated with depository institutions that allows writing checks?
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How do savings and loan associations primarily obtain funds?
How do savings and loan associations primarily obtain funds?
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What is a potential outcome of asymmetric information in financial transactions?
What is a potential outcome of asymmetric information in financial transactions?
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What mechanism do insurance companies utilize to address adverse selection?
What mechanism do insurance companies utilize to address adverse selection?
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How do insurance companies typically manage the unpredictability of losses from policies such as property and casualty?
How do insurance companies typically manage the unpredictability of losses from policies such as property and casualty?
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What distinguishes direct investment from indirect investment in assets like equities?
What distinguishes direct investment from indirect investment in assets like equities?
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What are the three types of investment companies mentioned?
What are the three types of investment companies mentioned?
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What financial benefit do insurance companies derive from interest and dividend income?
What financial benefit do insurance companies derive from interest and dividend income?
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What is the primary purpose of off-balance-sheet activities for banks?
What is the primary purpose of off-balance-sheet activities for banks?
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How do banks profit from loan sales in secondary loan participation?
How do banks profit from loan sales in secondary loan participation?
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What type of financial activity can expose banks to risk despite not appearing on their balance sheets?
What type of financial activity can expose banks to risk despite not appearing on their balance sheets?
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What is a potential downside of structured investment vehicles (SIVs) for banks?
What is a potential downside of structured investment vehicles (SIVs) for banks?
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Which activity is NOT mentioned as a source of fee income for banks?
Which activity is NOT mentioned as a source of fee income for banks?
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What risk management technique involves banks engaging in speculation?
What risk management technique involves banks engaging in speculation?
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What is one major consequence if the issuer of a guaranteed security defaults?
What is one major consequence if the issuer of a guaranteed security defaults?
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Which activity is primarily aimed at reducing risk for banks?
Which activity is primarily aimed at reducing risk for banks?
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What financial product can banks issue to back up commercial paper?
What financial product can banks issue to back up commercial paper?
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Why can trading activities be considered dangerous for financial institutions?
Why can trading activities be considered dangerous for financial institutions?
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What is a primary strategy banks use to manage liquidity risk?
What is a primary strategy banks use to manage liquidity risk?
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Which of the following actions may negatively impact a bank's customer relationships?
Which of the following actions may negatively impact a bank's customer relationships?
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How can banks increase their liquidity without affecting the asset side of their balance sheet?
How can banks increase their liquidity without affecting the asset side of their balance sheet?
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What type of risk is primarily concerned with the possibility of loans not being repaid?
What type of risk is primarily concerned with the possibility of loans not being repaid?
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What is a potential challenge of diversification for banks?
What is a potential challenge of diversification for banks?
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What do banks rely on for assessing the likelihood that a borrower will default?
What do banks rely on for assessing the likelihood that a borrower will default?
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During the financial crisis of 2007-2009, what was a major issue faced by banks related to their assets?
During the financial crisis of 2007-2009, what was a major issue faced by banks related to their assets?
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What does credit risk analysis help banks determine regarding loans?
What does credit risk analysis help banks determine regarding loans?
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What could be a consequence of banks underestimating the risks of mortgage credit during the financial crisis?
What could be a consequence of banks underestimating the risks of mortgage credit during the financial crisis?
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In managing credit risk, why is diversification important for banks?
In managing credit risk, why is diversification important for banks?
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What is the initial reserve requirement for the First National Bank if it has $100 million in deposits?
What is the initial reserve requirement for the First National Bank if it has $100 million in deposits?
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Which option is NOT a method for a bank to handle a deposit outflow when it lacks excess reserves?
Which option is NOT a method for a bank to handle a deposit outflow when it lacks excess reserves?
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If the First National Bank loans out all of its excess reserves, what situation does it create?
If the First National Bank loans out all of its excess reserves, what situation does it create?
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What cost does a bank incur when acquiring reserves through borrowing in the federal funds market?
What cost does a bank incur when acquiring reserves through borrowing in the federal funds market?
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What is the primary concern of liability management in banks?
What is the primary concern of liability management in banks?
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If the First National Bank's reserves are $20 million and it has $100 million in deposits, what is its excess reserve amount?
If the First National Bank's reserves are $20 million and it has $100 million in deposits, what is its excess reserve amount?
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What happens when a bank sells securities after a deposit outflow?
What happens when a bank sells securities after a deposit outflow?
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During a deposit outflow scenario, what is a bank's required reserve based on $90 million after a withdrawal?
During a deposit outflow scenario, what is a bank's required reserve based on $90 million after a withdrawal?
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Which of the following is a primary concern for bank management?
Which of the following is a primary concern for bank management?
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Study Notes
Financial Institutions
- Financial institutions act as intermediaries, transferring funds from savers to investors.
- They manage risk through diversification, reduce transaction costs, and provide payment mechanisms, thereby lowering information asymmetry.
- Stocks are not the primary source of funding for businesses; indirect financing is more important.
- Banks are the most essential source of external financing.
Facts About Financial Structure
- The United States relies most heavily on bank loans for external funding.
- Germany, Japan, and Canada utilize nonbank loans and bonds more in comparison.
- Stock financing is not the most vital funding method for businesses overall.
- Issuing marketable securities isn't the primary funding source.
Depository Financial Institutions (Banks)
- Depositories accept deposits and make loans to individuals and organizations.
- Types of depositories include commercial banks, savings associations, mutual savings banks, and credit unions.
- Commercial banks commonly offer checkable deposits, savings deposits, and time deposits.
Banking and the Management of Financial Institutions
- Banks play a crucial role in directing funds to productive investments.
- Banks provide loans for business, education, and mortgages.
- Crucial aspects of commercial banking are loan management, balance sheet management, and income determinants.
Banking Industry: Structure and Competition
- Financial institutions have become increasingly similar, leading to greater competition.
- Historically, there was more segmentation in markets.
Non-Depository (Non-Bank) Financial Institutions
- Non-depositories, unlike banks, don't accept deposits.
- They manage lending by selling securities or offering insurance policies.
- Examples of non-depositories include investment companies, insurance companies, brokerage firms, and pension funds.
Investment Companies (Mutual Funds)
- Investment companies pool investor funds to purchase a diversified portfolio.
- Shares represent proportional interests in a portfolio managed by the company.
- Investments are guided by the company's stated goals.
Asset Management
- Management focuses on maximizing return while minimizing risk.
- Strategies include selecting borrowers with minimal default risk, high-yielding and low-risk securities, portfolio diversification, and liquidity management.
Liability Management
- Managing the sources of funds, including deposits, certificates of deposit, and overnight loan markets, is crucial.
- Banks are increasingly independent of checkable deposits as sources of funds.
Capital Adequacy Management
- Capital acts as a cushion to prevent bank failure.
- Banks consider potential loses in security, loan risk, and market downturns.
- The equity multiplier and return on equity are critical considerations.
- Trade-offs between capital and returns exist, influenced by economic conditions and confidence levels.
Measuring Bank Performance
- Bank income statements have unique components.
- Measuring bank performance entails assessing operating income, expenses, and net operating income, which are distinct from comparable manufacturing firms.
Liquidity Risk
- Liquidity risk is the likelihood of a sudden, high demand for liquid funds.
- Banks face liquidity risk on both asset and liability sides.
- One way to manage this risk is to hold excess reserves; other methods include adjustments to assets or liabilities.
Credit Risk
- Credit risk is the chance that loans won't be repaid.
- Diversification of loans is a technique for managing this risk.
- Banks assess borrowers' credit histories to determine suitable interest rates.
Interest-Rate Risk
- Interest rate risk is created by the disparity between short-term liabilities and long-term assets.
- Banks use tools like gap analysis to anticipate and mitigate interest-rate changes.
- Mismatched maturity levels of assets and liabilities can reduce profits if interest rates rise.
Trading Risk
- Trading risk is the potential for declines in the value of traded instruments and assets.
- Traders face moral hazard, potentially exceeding acceptable levels of risk.
- The bank's risk manager sets and monitors limits on trading activities to mitigate this risk.
Other Risks
- Foreign exchange risk is the uncertainty from assets or liabilities denominated in different currencies.
- Sovereign risk originates with the potential for foreign governments to restrict dollar-denominated payments or default on loans.
- Operational risk is a result of events like computer system failures or building disasters.
Summary of Risks and Management
- Banks face several types of risk; risk management strategies are crucial.
- Recommended Responses to such risks include maintaining cash reserves, diversifying assets, managing maturities, employing risk management tools, and using capital to cushion against potential losses.
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Description
This quiz covers key concepts of financial institutions, including their role as intermediaries in the economy. It highlights the importance of banks in external financing and contrasts various funding methods used globally. Understand the different types of depository institutions and their functions.
