(Chapter 7)
� Asymmetric information exists when one party to a transaction cannot observe the behavior of the other party
� Moral hazard is the "hazard" of harmful behavior
� The risk that one party to a transaction takes actions that harm another party
Moral Hazard
� This is moral hazard that arises when the action of one party (the agent) affects another party that does not observe the action (the principal)
� Moral hazard occurs when workers shirk at their jobs
� Moral hazard arises in financial markets because sa
Principle Agent Problem
� Corporate managers are agents who work for owner shareholders, the principals
� Moral hazard is the risk that mangers behave in ways to benefit themselves at the expense at the expense of the owners
� Moral hazard can make it difficult for firms to sell
Moral Hazard in Stock Markets
� Moral hazard is less severe in bond markets
� Moral hazard arises when firms issue bonds with a high risk of default
o Managers may misuse funds, increasing risk
o The high potential returns to risky projects worsen moral hazard
o Since savers cannot ob
Moral Hazard in Bond Markets
Bonds from a safe and risky firm offer the same payment but in the end, neither firm will issue a bond because the promise of payment is too risky
Concept of asymmetric information
� Savers can reduce adverse selection and moral hazard by gathering information and monitoring firms
� Gathering information and monitoring is costly; it takes time, effort, and money
� Gathering information may not happen due to the free-rider problem
�
Reduce Asymmetric Information
� Exists when one party to a transaction has a more information about the transaction than the other party
� Leads to adverse selection where those most eager to make a deal are the least desirable to the other party
Adverse Selection
� Financial institution that owns large shares in private companies; includes takeover firms and venture capital firms
� Private equity firms reduce information problems
� Two types of private equity firms are takeover firms and venture capital firms
Private equity firm
� Private equity firm that buys entire companies and tries to increase the company's profits
o Acquired companies are typically resold in 3 to 10 years
� In a friendly takeover, company managers agree to sell
� In a hostile takeover, company managers oppo
Takeover firm
� Federal legislation that strengthens the requirements for information disclosure by corporation
� Firms and their CEOs must ensure accuracy of financial data
o Criminal penalties for lying were increased
� The Accounting Oversight Board was created to m
Sarbanes-Oxley Act (pg 206)
� Buying or selling securities based on information that is not public
� "Insiders" know more about a firm than the average saver because they work for or with the firm and learn "inside" information with their positions
� Inside trading worsens adverse s
Insider trading
Case Study: 5 C's of Business Lending
� Capacity: The financial capacity of the firm to repay the loan. Loan officers make sure the forecasted earnings are high enough to support the payments promised under the loan
� Conditions: Conditions outside the fi
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Case Study: Traditional Home Mortgages
For many people, the most important role of a bank is to provide money to buy a home. We'll focus here on traditional mortgage loans, which have fixed interest rates and are made to "prime" borrowers, people with goo
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(Other Things I Felt Important)
4 Types Of Risk
� Credit (aka Default) Risk
� Interest Rate Risk
� Liquidity Risk
� Exchange Rate Risk (516)
Risk that borrower will be unwilling or unable to live up to the terms of the liability.
o FI's employ experts in risk assessment to evaluate default risk
o Use information from balance sheets, income statements, and credit checks
Credit (aka Default) Risk
Risk that the interest rate will unexpectedly change so that the cost of an FI's liabilities exceed its earnings on assets
o An FIs profitability depends on the spread between the interest rate earned on assets and that paid on liabilities
o FIs have resp
Interest Rate Risk
Risk that occurs when an FI is required to make a payment when its assets are long-term and can't be quickly converted to liquid assets without capital loss
o Depositor unexpectedly withdraws funds
o Insurance Co. insures high losses due to an unexpected
Liquidity Risk
Risk that changes in the exchange rate will cause the dollar value of a foreign currency or foreign financial assets to fall
Exchange Rate Risk (516)
Moral hazard that arises when the action of one party (the agent) affects another party (the principal) that does not observe the action
Principle agent problem (pg 196)
Private equity firm that buys shares in new companies that plan to grow
Venture capital (VC) firm-
The price of every stock equals the value of the stock, so no stock is a better buy than any other is
Efficient Market Hypothesis (EMH)
A bank's commitment to lend up to a certain amount whenever a borrower asks
Lines of credit
Interest rate banks charge on business loans with the lowest default risk
Prime interest
Minimum checking deposit that a borrower must maintain at the bank that has lent it money
Compensating balance
Adverse selection in terms of asset problems (Ie: junk bonds)
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Payment on an asset that compensates the owner for taking on risk
Risk premium
These focus on protecting the collateral. Borrower's must maintain homeowner's insurance. Often the bank monitors this by collecting monthly insurance payments along with the mortgage, then passing them on to the insurance company.
Covenants
Case Study (pg 196): Case of Dennis Kozlowski is a case of moral hazard. Kozlowski was the former president of Tyco. In 2005, he was convicted of larceny and fraud for appropriating Tyco's funds for his own use and sentenced to 8-25 yrs in prison. He and
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(Chapter 8)
� Largest part of the financial system based on total assets which include loans outstanding and other assets
� Accept deposits and make loans
� Split into three groups based on size
o Money center banks
o Regional and superregional banks
o Co
Commercial banks
� Also accepts deposits and make loans
Savings and credit unions (2 institutions) know what they are and the differences
� Two types of thrift institutions
o Savings institutions:
o Credit unions:
� Include savings institutions making mostly mortgage loan
Thrift institutions
Type of bank created to accept savings deposits and make loans for home mortgages; also known as savings banks or savings and loan associations (S&Ls)
Savings institutions
Nonprofit bank owned by its depositor members, who are drawn from a group of people with something in common
Credit unions
� A nonbank financial institution that makes loans but does not accept deposits
� Often specialize in certain kinds of lending including loans for business equipment, automobiles, and subprime lending
� Many finance companies are subsidiaries of financial
Finance Companies
Table 8.1 Types of Banks
Commercial Banks
� Money-center banks: Located in a major financial center
� Regional Bank : Assets above $1 billion that operates in one geographic region Superregional Banks: Assets above 1 billion that operates across most of the US
� Community banks: Less than $1 bill
Table 8.1 Types of Banks
Thrift Institutions
� Savings Institutions
� Credit Unions
Financial institution that makes deposits and takes loans
What a bank is:
Decline in number of banks Securitization Sub-prime lending Government involvement in lending
4 Trends in Banking Industry
Financial institution or intermediary that buys a large block of bank loans then issues securities entitling the holders to share payments on the loans, has become very common for mortgage loans
Securitization
Why securitization occurs?
Occurs because banks want to sell loans and because securities backed by bank loans are attractive to many institutions
Four reasons why securitization is important:
1. Banks sell loans for more than their worth = profit 2. % that control to overall profit depend on time length of loan 3. Helps reduce asymmetric information 4. Helps avoid default risk in Fannie Mae but opposite for subprime loans
� Company that lend to people with weak credit histories
� Subprime lenders are a fringe of the banking industry
� Subprime lenders range from finance companies to pawn brokers
� Government regulations to protect deposits increase credit rationing
� Peopl
Sub-prime lending
Proposed by Abraham Lincoln; Allowed Federal government to charter national banks which would issue a uniform currency. Required to collateralize their bank notes more than 100% with interest bearing Fed government bonds deposited with the comptroller of
National Banking Act of 1863
� Separated commercial and investment banking because populists believed risky and unethical behavior by banks caused the bank failures of the 1930s
� Didn't apply outside of the United States
� After WW II banking deregulation began
o Court rulings in th
Page 228 Glass - Steagall Act
Cost reductions from combining different activities
Economies of scope
Private Corporation with links to the government
Government sponsored enterprise (GSE)
(Other Things I Felt Important )
Splitting your wealth in a sizeable number of stocks, buy shares in a mutual fund A saver can reach diversification with around 30 or 40 stocks.
Diversification
Small lender that holds an item of value as collateral
Pawnshop
Lender that violates usury laws and collects debts through illegal means; traditional business of organized crime
Loan shark
Government promise to pay off a loan if the borrower defaults
Loan guarantee
Company that owns a group of financial institutions
Financial Holding Company (FHC)
Act of 1956; prohibits a nonfinancial company from owning a bank or vice versa. (Ie: Citigroup can acquire other financial institutions, but it cannot merge with General Motors or Microsoft. This restriction is called the separation of banking and commerc
Bank Holding Company (BHC)
Financial Institution Reform Recovery Act
Passed in 1989; full effect 1995
Alexander Hamilton appointed 1st Secretary of Treasurer
1789 - 1795
First Bank
1791 - 1811
(Chapter 9)
� Bankers must identify and take steps to to reduce the various risks banks face
o Liquidity risk
o Credit risk
o Interest-rate risk
o Market risk
o Economic risk
Management Risk
KNOW the difference of liabilities and assets (pg 250)
Assets - Any item of economic value owned by an individual or corporation that could be converted to cash. Ie: Securities, cash, and loans
Liabilities - Amount of money owed to others
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Loans from one bank to another, usually for one day
Federal Funds
Security that promises predetermined payments at certain points in time. At maturity, bond pays its face value. Before that, owner may receive coupon payments
Bond
Financial statement summarizing income, expense, and profits over some period of time
Income statement
� Financial statement that summarizes an entity's assets, liabilities, and net worth at a given date
� Assets are items of value that a person or entity owns (How they profit)
� Liabilities are amounts of money owed to others
� Net worth (equity or capita
Balance Sheet
� Banks assets include loans which generate interest income for banks
� Bank liabilities include deposits and other liabilities that the bank owes to others
� A banks' net worth is the amount of assets that would remain if all liabilities were paid off
�
Banks' Balance Sheets
The risk that withdrawals from the bank will exceed its liquid assets. A bank may be forced to sell illiquid assets at final-sale prices, losing money in the process. Illiquid assets are difficult to sell due to asymmetric information
Liquidity Risk
(default risk) The risk that loans will not be repaid. In nonemergency situations, banks can sell some loans profitably, including loan syndication of large loans between several lenders. In the case of default, writing off a loan reduces net worth
Credit risk
Instability in bank profits caused by fluctuations in short-term interest rates
Interest Rate Risk
Risk arising from fluctuations in asset prices
Market Risk
Risk arising from fluctuations in the economy's aggregate output
Economic Risk
Over time, a country's exchange rate sometimes rises and sometimes falls. So for any firm or asset holder, the effects of exchange-rate changes are sometimes good and sometimes bad. Overall, exchange-rate fluctuation creates risk
Exchange rate risk
Banks can borrow from the Federal Reserve. They can approach the Fed to request a discount loan, or they can bid in loan auctions that the Fed holds periodically
Loans from Feds
Financial statement summarizing income, expenses, and profits over some time period
Income Statement
Bank activities that produce income but are not reflected in the assets and liabilities reported on the balance sheet
Off-balance-sheet activities
Liabilities exceed assets, producing negative net worth
Insolvency
(repo) Sale of a security with a promise to buy it back at a higher price on a future rate
Repurchase agreements
Bank profits have remained healthy in spite of many changes in banks' competitive and regulatory environment
� Competition from securities markets: Growth of mutual funds ? banks lose deposits Development of junk bonds and commercial paper ? fewer C&I loa
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Banks can manage assets for others. A small pension fund might want to buy securities but lack the expertise to choose the right mix so it gives money to a bank that purchases securities on the funds behalf. Bank receives a fee for their service. Wealthy
Private banking
Gives an individual or firm the right to borrow a certain amount of money at any time. Banks grant lines of credit to build long-term relationships with borrowers.
Lines of credit - (aka loan commitment)
Not currently assets or liabilities rather, they are agreements about future transactions
Derivatives
Vault cash plus banks' deposit at the Federal Reserve
Reserve
A bank's guarantee, in return for a fee, of a payment promised by a firm
Letters of credit
ROA = profits/assets
Return of a bank's profits to its assets;
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ROE = profits/capital (Weighed more heavily than ROA)
Return on equity - Ratio of banks profits to its capital
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Table 9.3 Changes in Commercial Banking: Causes and Effects (pg 258)
Competition from Securities Markets
Growth of mutual funds ? banks lose deposits Development of junk bonds and commercial paper ? fewer C&I loans
Table 9.3 Changes in Commercial Banking: Causes and Effects (pg 258)
Deregulation
Elimination of interest-rate caps ? banks compete with mutual funds, retain savings and time deposits Repeal of Glass-Steagall ? banks offer investment banking services
Table 9.3 Changes in Commercial Banking: Causes and Effects (pg 258)
Financial Innovation
Credit scoring and securitization ? more real estate loans Development of derivatives ? opportunities for speculation