Midterm 2 Review Questions

Chapter 9

1. What could cause a bank run

Bank runs occur when a large enough fraction of the depositors believe the bank can not pay back all
deposits and attempt to withdraw all their money as quickly as possible. Since banks hold little cash on
had, bank runs can force even good banks into insolvency.

2. What does it mean that the central bank is the lender of last resort

The central bank will provide loans to financially viable banks if they are unable to borrow money from
other market entities.

3.What are the possible negative side effects of the government’s safety net for banks

Banks have an incentive to take on more risk. Depositors don’t monitor banks.

Know each type of financial regulation and be able to give a sentence or two describing how it works

4. How should regulators decide on the appropriate level of regulation to use

Should choose the level which maximizes social welfare when considering the costs and benefits of
regulation. The benefits of regulations is that it reduces risk of financial crisis, creates better functioning
markets and reduces losses when financial crisis happen. The costs are compliance costs, forgone
opportunities, reduced innovation, unwanted secondary effects and higher regulatory control of the
industry.

Chapter 10

1. What is shadow banking and how does it create problems for regulators

Shadow banking is when companies/individuals go outside the regulated banking sector to get loans.
This creates the problem that if the banking sector is too heavily regulated then more businesses will
resort to shadow banking which is unregulated. This puts a limit to how much effective regulation can
be imposed on the banking sector.

2. How has recent financial innovations affected banks

Reduced their general profitability and driven them to seek higher profits through riskier behaviour.
3.How does the merger of different parts of the financial sector into single companies affect risk

Increases the too big to fail problem. Means that financial problems in one part of the financial system
can quickly be transferred into a general financial crisis.

Chapter 11

1.What is a financial crisis

A financial crisis is when the financial system stops functioning correctly due to a sudden shock.
Financial frictions increase rapidly and financial markets stop functioning correctly.

2.What are the four stages of a financial crisis

Initial Phase; deterioration of balance sheets, increase in uncertainty

Banking crisis; financial firms bear costs of drop in asset value, bank runs/ investor panic/inability to
borrow force some into insolvency

Debt deflation; in a sharp downturn, depression, inflation turns negative and the real value of debts
increases, forces many more businesses into insolvency

Recovery; eventually through government or central bank actions the financial markets are repaired and
began functioning again

Be able to give a brief description of the great depression and the financial crisis of 2007-2008

3. Why do credit spreads increase during a financial crisis

Uncertainty increases. The belief that companies will default on their debts increases which means
lenders demand higher interest rates to compensate for this risk.

4. What are some of the regulatory reasons learned from the financial crisis of 2007-2008

Focus on macroprudential regulation, ensure health of entire financial sector instead of looking at it on a
company by company basis. Increase in capital requirements, increase in risk level regulation, increase
in power of central bank to oversee financial firms.

Chapter 12

1.What are the assets and liabilities of a bank

Assets are the loans they make or securities they purchase.

Liabilities are the deposits that they have accepted.

2.How do banks make profit

Banks make profit by accepting deposits which pay low interest because they can be withdrawn at any
time and are very low risk because the stability of the bank is assumed to be high; and making loans at
higher interest rate because the loans are higher risk and are long term. This means that banking has a
risk that a bank will not have enough money on hand to pay out depositors if too many of them ask for
their money at once.

Know the basic principles of bank management and what each of them refers to

3. Why is it hard to raise bank capital during a financial crisis

During a financial crisis people are very unwilling to lend or spend money because they are uncertain
that the bank is financially viable and they may need the money for themselves.

4. What does duration mean in reference to interest rate risk

The longer term a debt instrument is for, the greater its value will change when interest rates change.
Hence, the higher the average duration of assets held by a firm, the higher the interest rate risk that
they face.

5. What are off balance sheet activities

These are activities that do not show up on the bank’s balance sheet because they are either short term
or involve providing services. It also includes derivatives which may not change the balance sheet totals
but increase the risk that the bank faces. For example, a credit swap may have a current value of 20
dollars but have a downside risk of millions if interest rates move abruptly but it will show up on the
balance sheet as the same value as a 20 dollar bill which obviously doesn’t have any such risk.

Chapter 13

1. What is hedging

Hedging is to take an investment position that offsets another. For example, if you have a long position
you can hedge it by adding a short position.
2. What is the difference between a short and a long position and why would you take each

A short position is one that will increase in value if the underlying asset falls in value, a long position is
on that will increase in value if the underlying asset increases in value. You will take a short position if
you think the asset will fall in value and a long position if you think it will increase in value.

3.What is a forward contract and how does it differ from an option

A forward contract is an agreement to buy/sell an asset at an agreed upon price at a point in the future.
It differs from an option in that an option gives you the ability to buy/sell the asset but does not force
you to do so if you would lose money by doing so.

Know how to calculate the profit/loss for call/put options

4.What factors affect the option premium

Strike price; higher strike price increases the option premium on a put option, lower premium on a call
option

Term to expiration; longer the term the higher the option premium

Price volatility of asset; the more volatile the higher the option premium

5.What is the benefit/problem with financial derivatives

Benefit is that it gives an instrument to reduce risk. Problem is that it can be used to increase risk,
reduce transparency of the risk being held by institutions and creates links that transfer financial
problems from one asset class to others.

Chapter 14

1. What are the arguments for and against central bank independence

For; reduces incentive problems of politicians about inflation and short run vs long run growth

-Reduces ability to disguise deficit spending

Against; undemocratic, unaccountable

-reduces coordination between monetary and fiscal policy

Chapter 15

1. How do open money operations work

Bank of Canada increases money supply by purchasing government bonds. Bank of Canada decreases
the money supply by selling government bonds.

2.What are the factors that affect the money supply

Other than the central bank, changes in the money base are affected by government deposits, reserves
and interventions in the foreign exchange market. Other factors are changes in currency holding and
changes in excess reserves.

3.What is the money multiplier

The money multiplier is how much total money is created by a given base money. It represents how an
addition to the money supply filters through the fractional reserve banking system into people’s bank
accounts.

Know how to do the accounts for deposit creation