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The banking system in the U.S. is becoming more concentrated, but we started with many, many banks. Why is this? That is, why does the U.S. generally have more, and smaller, banks than other, similar countries? For that matter, why do we have 12 different branches of our central bank, i.e. the 12 branches of the Federal Reserve System?

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Sixta Kovacek
Sixta KovacekLv2
7 Feb 2019

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Position A: Financial Institutions' role as specialists in risk measurement and management is reduced.

Position B: Financial Institutions' role as specialists in risk measurement and management is increased.

Required:

Read the “background” below. After reading, select the position you agree with and write a position paragraph supporting either Position A or Position B.

Background: A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As Financial Institutions adjusted to regulatory changes brought about in the 1980s and 1990s, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial services holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutuals and similar funds, which invest these funds in the liabilities of other shadow banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and borrowers. However, instead of the bank serving as the middleman, it is the non-bank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system where the complete credit intermediation is performed by a single bank, in the shadow banking system, it is performed through a series of steps involving many non-bank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Thus, the financial institutions, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking.

In your own words, explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Why or Why not? Explain.

1. Different financial institutions have different levels of service. What is the main reason for this?

a. The Federal regulations relating to the institutions make them provide the services at different levels.

b. Levels of financial service are determined in part by the ownership structure of the financial institution, and different financial institutions have different ownership structures.

c. Financial services require specific expertise and the design of financial institutions favors one type of institution over the other.

d. None of these explain the difference between levels of service at different institutions.

2. Which of the following is not an example of a financial intermediary?

a. Savings and Loans.

b. Commercial banks.

c. Pension funds.

d. Stock markets.

e. All of these are examples of financial intermediaries.

3. Which of the following branches of the Federal Reserve Bank has a permanent seat on the Federal Open Market Committee?

a. New York

b. Cleveland

c. St. Louis

d. Boston

e. None of these.

4. Who owns the Federal Reserve Banking system?

a. No one, it owns itself.

b. The member banks.

c. The US Government.

d. The Chinese Government.

e. The shareholders of the Federal Reserve Corporation.

5. Who is the most important member of the Federal Open Market Committee and often thought of as the second most powerful person in the United States?

a. The President of the United States

b. The Treasury Secretary.

c. The Chairman of the Federal Reserve Bank.

d. The President of the Federal Reserve Bank of New York.

e. None of these.

6. Which of the following markets is the most stable?

a. The market for corporate bonds.

b. The real estate market.

c. The market for Treasury bonds.

d. The New York Stock Exchange.

e. The Chicago Mercantile Exchange.

7. All of the following show interactions between markets except:

a. Purchase of a mortgage issued by Freddie Mac by the Federal Reserve Bank.

b. Sale of stock to raise equity for a new company to an insurance provider.

c. Increase in short term target rates by the Fed on the bond market resulting in stock market increases when announced in the press.

d. Restrictions in bank lending as the result of increasing capital requirements resulting in lower real estate prices and fewer sales on the real estate market.

e. All of these are examples of market interactions.

8. Which of the following acts was repealed by the Gramm-Leach-Bliley Act of 1999:

a. The Depository Institutions Deregulation and Monetary Control Act of 1980.

b. The Banking Act of 1933.

c. The Garn-St Germain Depositary Institutions Act of 1982.

d. The Civil Rights Act of 1964

e. None of these.

9. Which of the following problems was a reason for bank panics prior to the establishment of the Federal Reserve bank:

a. Currency was not uniform in value.

b. Currency was not backed by the full faith and credit of the United States Government.

c. Currency could become worthless if the issuing bank went bankrupt.

d. Lack of regulation of the financial markets often led to bank runs.

e. All of these were elements of the bank panics that occurred prior to the establishment of the Federal Reserve system.

10. Why is the Federal Reserve Bank considered to be relatively but not completely free of political influence in the United States?

a. The Federal Reserve Chairman must be appointed by the President and confirmed by the Senate.

b. The Federal Reserve is not owned by the US Government.

c. The Federal Reserve System is designed to divide power among member banks from different regions of the country.

d. The Federal Reserve appointments are for sufficient length of time that it takes at least 8 years for a majority of members to be appointed by one President.

e. All of these are important in defining the degree of independence of the Federal Reserve from political influence.

11. Which of the following examples is an illustration of interest rate risk?

a. A consumer buys a house with a fixed mortgage that will not change for 30 years.

b. A consumer buys a car with a fixed rate loan at 5.99% for five years.

c. A bank borrows funds from the Federal Reserve discount window for 0.25% and lends that money to a consumer for a car or auto loan of longer duration.

d. A consumer opens a passbook savings account.

e. None of these illustrate interest rate risk

12. If the yield curve is said to be steep, this means:

a. Banks will make a lot of money lending at long term rates that are higher than the short term rates at which they borrow money.

b. The bond market expects inflation to increase in the future.

c. The bond market expects that the economy will grow in the immediate future.

d. None of these are conclusions that can be reached from a steep yield curve.

e. a, b and c are all conclusions that can be reached when the yield curve is steep.

13. According to the expectations theory of interest rates:

a. The total interest rate is equal to the sum of the real interest rate and the expected inflation rate.

b. The total interest rate is equal to the sum of the real interest rate, the expected inflation rate, and a series of additional premiums based on the risks taken in the instrument of interest.

c. The Fed sets interest rates, which cannot be changed by the market.

d. The interest rate in the economy is a balance between the supply and demand of funds.

e. None of these are true.

14. If the real interest rate in the economy is 3% and the expected inflation is 2% per year over a five year period, assuming the maturity risk premium is 0, what is the interest rate that the expectations theory would predict for a five year Treasury note?

a. 10%

b. 3%

c. 2%

d. 6%

e. 5%

15. What is the most important economic function of the money markets?

a. To provide an efficient means of liquidity adjustment for businesses, individuals and governments.

b. To provide a place where buyers and sellers can negotiate a price of funds.

c. To provide a social interaction between borrowers and sellers of funds, allowing for easier relationship-based transactions in the future.

d. To provide a place where stocks and bonds can be sold.

e. None of these are important economic functions of the money markets.

16. The ideal instrument sold in a money market has all of the following characteristics except:

a. High liquidity

b. Low Default Risk

c. Are long term obligations

d. Are short term obligations

e. None of these are characteristics of an ideal money market instrument.

17. What is the reason for the 35% rule in the bid process for Treasury securities?

a. It prevents a single entity from controlling the interest rate in the market.

b. It allows regular consumers access to the treasury market through non-competitive bids.

c. It prevents the government from controlling and regulating banks.

d. It prevents the Chinese from buying too many treasury bills.

e. None of these are reasons for the establishment of the 35% rule.

18. What is the name for the risk that a financial institution might not receive promised cash flows in the form of interest and principal payments from its borrowers?

a. Interest Rate Risk

b. Financial Payment and Principal Risk

c. Market Risk

d. Credit Risk

e. None of these are the correct term.

19. The risk that a financial institution might have to sell a lot of assets in a short period of time at below market prices to pay obligations demanded by its creditors is called:

a. Liquidity Risk

b. Market Risk

c. Credit Risk

d. Interest Rate Risk

e. None of these

20. What is the main difference between firm-specific and systemic credit risk?

a. Firm specific risk can be managed by proper underwriting and diversification in a loan portfolio.

b. Systemic risk affects all borrowers.

c. Firm-specific risk is determined by the individual circumstances of the firm involved.

d. Derivitives can be used to manage systemic risk

e. The Federal Reserve Bank of New York uses open market operations to manage firm-specific risk.

21. A credit crisis in the financial markets can improve bank efficiency by:

a. Focusing the bank underwriting department on firm-specific risk factors associated with default.

b. Forcing banks to reduce staffing needs by eliminating wasteful or unnecessary functions.

c. Marking banks compete more rigorously for customers in a tougher market.

d. None of these are reasons that a recession helps improve bank efficiency.

e. Items a, b and c are all reasons that a bank improves efficiency during a recession.

22. A mutual fund that invests only in Treasury funds has which of the following risk exposures?

a. Interest Rate Risk

b. Liquidity Risk

c. Default Risk

d. Treasury’s are risk free, so a mutual fund that invests in them is also risk free.

e. Credit risk

23. Foreign Stocks carry additional risks beyond those of US companies for US investors. Which of the following risks is not an additional risk that a US investor in foreign stocks faces?

a. Interest Rate Risk

b. Foreign Currency Risk

c. Sovereignty Risk

d. Both a and b are additional risks faced by these investors.

e. All of these risks (a, b and c) are faced by investors in domestic and foreign stocks.

24. According to the theory of Purchasing Power Parity, if the price of a widget in the US is $3.00 and the Euro is worth $1.50, the price of the widget in Germany would be:

a. €5.00

b. €3.00

c. €4.50

d. €7.00

e. €10.00

25. For many years, the current account of the United States has been in deep deficit. In theory, this should lead to a weak dollar. What factors could counteract the effect of the current account deficit on the strength of the dollar?

a. Foreigners use dollars as stores of value

b. When inflation is expected to be low in the USA and interest rates are high, foreigners want to invest here, driving up the price of the dollar.

c. The Dollar is king in the world currency markets

d. Dollars are backed by the full faith and credit of the US Government and therefore maintain a constant value on the market.

e. None of these explains the relative strength of the dollar in the global currency market.

Many Fedwatchers are convinced the central bank is just hours away from announcing the first increase to its benchmark federal-funds rate in nearly a decade. If that happens, there will be repercussions for stocks and bonds, on Main Street and Wall Street, and for economies in all corners of the world. For some, the impact could be felt right away, and for others, the shakeout may be felt more acutely over time, especially if the Fed follows the first rate hike with sustained tightening.

Here’s a roundup from Journal staffers about who wins and who loses when rates rise.

Banks. Banks have been yearning for the Federal Reserve to start raising rates for years to stem the decline in their net interest margin, an important measure of banks’ profitability. The interest rates banks charge on many loans are directly tied to the Fed’s target rate, meaning they immediately earn more interest on those items, while deposit rates move more gradually. Goldman Sachs Group Inc. analysts recommends owning the stocks of banks whose depositors are likely to stick around: Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co., PNC Financial Services Group, Inc. and E*Trade Financial Corp. –Peter Rudegeair

Corporate bonds. Corporate bonds could take a hit if the Fed raises rates, but should outperform benchmark U.S. Treasury debt, analysts say. Part of the reason is bond math: When rates rise, prices fall. But corporate bonds carry higher interest rates than Treasurys, to compensate investors for the added risk of default, so these bonds have more cushion to absorb a rate increase. After a major selloff in the market for higher-yielding junk debt in recent weeks, some analysts now expect that junk bonds–excluding the hardest hit energy and commodity sectors–will perform better than investment-grade debt should the Fed make a move. “As long as we’re selective about credits, [high-yield bonds] probably offers us a better opportunity in a rising-rate environment,” said Priscilla Hancock, global fixed income strategist at J.P. Morgan Asset Management. “When the Fed raises rates, it’s supposed to suggest the economy is strengthening.” –Mike Cherney

Dollar. Most investors and analysts say the dollar’s nearing the end of its bull run, even if the Federal Reserve raises rates Wednesday or early in 2016. The greenback’s risen ahead of past tightening cycles, and then sold off before interest rates reached their apex. “The European Central Bank probably has to step up and ease policy again in 2016, and the Fed will likely have more than one interest-rate move next year; add those up and yield spreads still are generally moving in the dollar’s favor,” said Westpac Bank’s Richard Franulovich. “The dollar’s rally is hitting its mature phase, but it’s definitely got further to run.” The dollar has already strengthened 24% against other currencies since June 2014. Many investors predict that uneven U.S. growth or volatile global markets would discourage the Fed from raising rates as rapidly as in previous tightening cycles, limiting further upside. –James Ramage

Emerging markets. A rise in U.S. interest rates could provide a litmus test for many emerging economies and show how prepared they are to withstand the potential capital outflows triggered by higher U.S. yields and a stronger dollar. Retaining foreign capital has already been challenging for emerging countries, many of which are struggling with slowing growth and substantial debt. So far, emerging-market currencies have absorbed most of the pains, losing 18% against the dollar this year through last week. Stocks, which are priced in local currencies, were down 17%, but dollar-denominated EM bonds have fared better, still managing to hold on to single-digit gains this year. “Given how much EM currencies have already fallen this year, we don’t expect much turmoil in the near term,” if the Fed begins to tighten as expected, said Jorge Mariscal, chief investment officer of emerging markets at UBS Wealth Management, which oversees $1.9 trillion in invested assets. “What matters is the path of the interest rates in the U.S. going forward.” UBS expects four more rate increases next year, which will be problematic for a number of vulnerable emerging countries, including Brazil, Turkey, South Africa and Indonesia. –Carolyn Cui

Euro. Expectations for higher U.S. interest rates and easier monetary policy in the eurozone drove the euro down 22% against the dollar since May 2014. In theory, a Fed rate increase should push the euro even lower. But the common currency’s future has been complicated by investors’ penchant for using euros to fund trades for higher-yielding assets. Thus, the euro stands to gain whenever investors grow risk-averse and trim or exit those bets. In addition, euro-bears have proven particularly sensitive to central-bank expectations. The euro isn’t likely to reach parity with the dollar anytime soon, says Mizuho Bank’s Sireen Harajli. “Fundamentals would call for a weaker euro,” she says. “But unless the ECB asks for more stimulus, it would be difficult for the euro to weaken significantly from here.” However, few investors foresee a substantial euro rally in the coming weeks, either. –James Ramage

Gold. Prices slumped to five-year lows in recent weeks as expectations of higher rates from the Fed hit fever-pitch. Bets that benefit if gold prices fall outpaced wagers that gold will rally by a record margin of 17,949 contracts on Dec. 1, according to CFTC data. Tighter monetary policy is likely to make it harder for gold, which doesn’t pay interest, to compete with yield-bearing assets like Treasury bonds. However, some market watchers say the policy shift is already reflected in low gold prices, and the market could pop higher if the Fed reiterates that subsequent rate increases will be spread out. –Tatyana Shumsky

High-quality stocks. Stocks with healthy balance sheets, high returns on capital, muted volatility, elevated margins and track records of stable sales and earnings growth stand to benefit when rates are rising. Per data compiled by Goldman Sachs Group Inc., these names have a history of outperforming their lesser-quality counterparts in the three months following an initial rate rise. Companies with strong balance sheets, for instance, typically outperform those with weak ones by an average 5% three months after liftoff, according to Goldman. –Kristen Scholer

Housing market. Higher short-term interest rates won’t wreck housing, and in the near-term might have hardly any impact at all. For one, the rate of mortgages, as with those of other long-term loans, have only an indirect relationship with short-term rates and are influenced more heavily by factors such as inflation expectations and economic growth. The rate on a 30-year fixed-rate mortgage–which last week was at 3.95% according to Freddie Mac–almost surely is already pricing in expectations of a Fed move on Wednesday. That said, over the next year, some economists expect mortgage rates to rise about half a percentage point. All else being equal, that would hurt home prices as borrowers would need to buy a cheaper house to keep the same monthly payment. A recent poll of home buyers by real-estate broker Redfin Corp. said that higher mortgage rates would have the biggest impact on the lower-end of the housing market. –Joe Light

Life insurers. Few companies are rooting for a sustained rise in interest rates as loudly as U.S. insurers are, and life insurers are leading the cheers. Most insurers earn substantial income from investing premiums, and they typically favor high-quality bonds, whose yields have plummeted in recent years amid the sustained low interest-rate environment. Life insurers depend more heavily on investment income than do car, home and some sorts of business insurers. That’s because life insurers can collect premiums for decades before paying out a claim, and rely on that investment income to make a policy profitable. For many older policies on life insurers’ books, the companies expected to earn far-higher yields than newly invested cash fetches today. MetLife Inc. Chief Executive Steve Kandarian argues that life-insurance buyers will benefit too, as low rates make the cost of the coverage “much more expensive than it needs to be.” Low rates also raise the cost of running risk-management programs. Such hedging programs are important for those life insurers selling certain types of income-stream guarantees. –Leslie Scism

Money-market funds. The Fed’s 0.25% interest-rate increase will begin showing up in the yields of money-market mutual funds within days, welcome news for investors. Funds for individual investors that invest in both corporate and government debt currently yield just 0.01% on average, according to researcher iMoneyNet Inc. The higher rates should be fully reflected in just over a month, but investors in some money funds may not see the full increase, says Peter Crane, president of Crane Data LLC. Fund managers have temporarily trimmed fees to keep expenses from eating up the funds’ paltry yields and taking a bite out of investors’ principal. As interest rates rise, some part of the increase is likely to go toward increasing funds’ fee charges, Mr. Crane says. Across the industry, “my wild guess is that half of the first rate hike might flow through to investors, but it could be more,” he says. –Daisy Maxey

Oil. The latest plunge in oil prices has pummeled the stock and bond prices of some U.S. energy producers and raised fears of a spate of defaults across the sector. Increased interest rates could hurt producers that are already struggling to pay debts amid sharply lower cash flow. That could be positive for oil prices in the long run, if U.S. producers are forced out of business and domestic production declines as a result, reducing the global glut of crude. But in the near-term, the most direct effect on oil prices would probably come from the dollar. If the dollar still has room to run in the wake of a rate hike, the rising dollar could weigh on oil prices by making dollar-traded oil more expensive for buyers using foreign currencies. –Nicole Friedman

Rate-sensitive stocks. Companies considered rate-sensitive are those that have high dividend yields. Consumer staples, telecoms and utilities fall into this category, as all three sectors yield more than the S&P 500. They have been attractive investments amid the low-yield environment the past several years. But, as rates rise, bonds are poised to become more attractive than their current state, which could steal some of the thunder away from high-dividend yielding shares. –Kristen Scholer

Stocks with a large portion of floating-rate debt. Firms that have a decent amount of variable debt–where interest payments adjust as market rates rise or fall–stand to take a hit. As rates rise, so too will the cost of floating-rate debt. “When the tightening cycle finally starts, the immediate impact will be felt by firms with high proportions of variable rate borrowing,” wrote Goldman. Among the 10 S&P 500 sectors, financials and industrials have the greatest portion of floating-rate debt with it accounting for 16% and 10%, respectively, of all debt for those sectors. –Kristen Scholer

Treasurys. The Fed’s policy has a more direct impact on short-term government debt whose yields are highly sensitive to changes in the fed-fund rate. The yield on the two-year note recently traded near 1%, headed for the highest closing since May 2010. Many investors expect the yield to rise if the Fed raises interest rates on Wednesday. But some argue the yield has nearly doubled in the past two months and if the Fed signals that further tightening will happen at a very slow pace, some may book profit from their short bets on the two-year notes.

The Fed’s impact on long-term bonds is more subdued. The value of those bonds are influenced by a broad basket of factors, including the global growth and inflation outlook. A rate increase by the Fed may drive some investors to sell long-term bonds. But given concerns about the global economic outlook, there likely plenty of investors who could seek safety in long-term Treasury debt, especially with many focusing on the recent stress from the junk debt market. Any signal of a slow tightening path would keep a lid on long-term bond yields.

One way an interest-rate increase could weigh on the U.S. government debt market is by making newly-minted bonds more attractive to buy, thus dragging down the value of outstanding bonds. –Min Zeng

In the discussion of "housing market," if we keep the same monthly payment (note: these are future cash outflows), will mortgage borrowers be able to buy a cheaper or more expansive house with the rate hike (note: the mortgage loan the borrower takes out to buy the house is the present value)? Explain briefly please.

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