Chapter 14

Question 1

4 parts of a financial system

Answer 1

1. money
2. financial martkets
3. banks
4. financial institutions and instruments

Question 2

Factors that increase effectiveness of financial system

Answer 2

1. Greater investor participation
2. Competition amongst institutions
3. Lower costs
4. Correct security pricing
5. Fair play in trading

Question 3

Financial markets

Answer 3

Trade instruments to determine prices of securities and enable allocation of capital

Question 4

Financial instruments

Answer 4

Share and bonds transfer resources from savers to investors

Question 5

Financial institutions

Answer 5

Financial products and services that act as financial intermediaries

Question 6

Regulatory authorities

Answer 6

Protect investors by enforcing rules and encourage participation in financial markets

Question 7

4 changes to Western financial systems

Answer 7

1. Financial integration - financial markets in neighbouring, regional, or global economies are closely linked.
2. Globalisation - countries are interconnected by trade links
3. Deregulation - increasing competition by decreasing intervention
4. Financial innovation - creating new investment products

Question 8

5 services provided by financial intermediaries

Answer 8

1. Expert advice
2. Expertise in channelling funds
3. Maturity transformation (tranfering funds from short-term savers to long-term borrowers)
4. Risk transformation (spreading risk)
5. Transmission of payments (cheques/ATMs etc)

Question 9

Role of retail banks

Answer 9

Banking for individuals at published rates of interest and charges

Question 10

Role of wholesale banks

Answer 10

Large scale deposits and loans - often with other banks/companies. Interest rates can be negotiable

Question 11

Role of building societies

Answer 11

Specialise in mortgages - also provide retail banking services for customers

Question 12

Retail bank liabilities

Answer 12

1. Sight deposits (money that can be withdrawn immediately without consequence)
2. Time deposits (notice of withdrawal is required)
3. Certificates of deposits CDs (issued by banks, tradeable, interest bearing deposits)
4. Sale and repurchase agreements Repos (agreement between two institutions, one to borrow by selling assets to the other, then the other will buy them back at a fixed date and price)
5. Capital and other funds

Question 13

Retail bank assets

Answer 13

1. Cash
2. Deposits at central bank (reserve balances and cash ratio deposits
3. Short term loans (market loans/bank and treasury bills/reserve repos)
4. Long-term loans (overdrafts, mortgages, credit cards)
5. Investments (government bonds or gilts)

Question 14

Liquidity

Answer 14

Ease by which an asset can be converted to cash without loss

Question 15

Liquidity ratio

Answer 15

Proportion of a banks assets held in liquid form

Question 16

Maturity gap

Answer 16

Difference in average maturity of loans and deposits

• -Big gap big profit
• -Big gap small liquidity

Question 17

Bank and liquidity conflict

Answer 17

Banks want to lend long-term (more profitable)
Customers want cash (so they need liquid assets)
Must balance profitability (low liquid) and avoiding being unable to meet demand (high liquid)

Question 18

Secondary marketing

Answer 18

Sale of assets before maturity

Question 19

Securitisation

Answer 19

Pooling assets (eg mortgages and loans) and selling securities (e.g. bonds) backed by the assets

Question 20

Special purpose vehicle

Answer 20

legal entity created by financial institutions for a specific function (e.g. securitisation)

Question 21

Collateralised debt obligation

Answer 21

Fixed-income bond backed by range of assets (eg corp bonds, mortgage debt, credit card debt)

Question 22

Sub-prime debt

Answer 22

debt with high risk of default by borrowers (sub-prime mortgages)

Question 23

Capital adequacy

Answer 23

Measure of banks capital relative to assets (assets weighted according to risk)

Question 24

Capital adequacy ratio

Answer 24

Banks capital (ie reserves and shares) divided by risk-weighted assets

Question 25

Why can securitisation lead to moral hazard

Answer 25

Securitisation reduces cash flow risk facing investors. It enables originator banks to pass risk of default onto buyers of CDOs. Encourages banks to offer higher income multiples, and/or higher loan values, increasing the over all risk of default

Question 26

Potential negatives of securitisation

Answer 26

1. Lower liquidity ratio - expansion of credit therefore asset bubbles 2. moral hazard - banks take greater risk for lending 3. Systemic risk of banking collapse - fortunes of banks are intertwined

Question 27

Functions of the central bank

Answer 27

1. Issuer of notes 2. Banker to government 3. Operator of gov monetary policy 4. Acts as liquidity backstop (provides liquidity) 5. Overseer - ensures other banks and financial institutions maintain adequate liquidity 6. Operator of country's exchange rate policy

Question 28

Capital market

Answer 28

Long-term debt instruments can be bought and sold here

Question 29

Money market

Answer 29

short-term loans between banks, government and industry. Contains: discount and repo markets (treasury bills and corp bills), and parallel money markets (CDs, foreign currency)

Question 30

Lender of last resort

Answer 30

BoE. - Guarantor of sufficient liquidity in the monetary system. Banks can sell gilts to the BoE (in exchange for cash) and buy them back at a later date (repo agreement) Or sell BoE treasury bills before they mature (at a price below face value) (rediscounting)

Question 31

Asset bubble

Answer 31

Asset price increases rapidly over a short period of time (normally because of speculation) - these bubbles can burst and the asset price falls dramatically.

Question 32

Banking crisis

Answer 32

Occurs when a bank (or a number of) fail or are close to failure.

Question 33

What causes a banking crisis

Answer 33

Asset bubbles. Banks lend to investors in the asset expecting the rise to continue. This is not the case and the bubble collapses. Falling prices lead to losses for investors and undermine confidence in the banks. Consumers will then remove their money from banks causing collapse.

Question 34

Financial Market Contagion

Answer 34

Spread of financial difficulties between banks (one has it and the others sort of catch it). Banks sell assets to pay back investors, which forces the price of the asset down (as there is large supply.) This has a knock on effect because each banks that also hold these assets are forced to sell them at reduced rates and then run into difficulties.

Question 35

Factors affecting a country’s ability to respond to a banking crisis

Answer 35

Having good economic conditions. Healthy government finances. This is only effective because it allows normal economic policy to minimise economic shocks.

Question 36

Failings of classic economic policy

Answer 36

Assumes humans make decisions rationally.

Question 37

Four main functions of money

Answer 37

1. A medium of exchange 2. A means of storing wealth 3. A means of evaluation 4. A means of establishing the value of future claims and payments

Question 38

Monetary base

Answer 38

(Or narrow money) is notes in circulation outside the central bank

Question 39

Broad money

Answer 39

Cash in circulation plus retail and wholesale bank and building society deposits

Question 40

Bank deposit multiplier

Answer 40

Number of times greater the expansion of banks is than the additional liquidity in banks that causes it (1/L where L is the liquidity ratio)

Question 41

Money multiplier

Answer 41

Number of times greater the expansion of money supply is than the expansion of the monetary base that caused it