Banking Chapter 11 Homework Bank China Keep Inflation Bay And Prevent Asset Price Bubbles Central banks Usually

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Chapter 11

ANSWERS TO QUESTIONS

1. Do you think that before the National Bank Act of 1863 the prevailing conditions in the

banking industry fostered or hindered trade across states in the United States?

Two important conditions hindered trade across states before 1863: there was no national

currency, and banknotes issued by state banks could become worthless any day. Given these

2. Why does the United States operate under a dual banking system?

Throughout most of the history of banking in the United States, there has been a fear of

centralized banking power. As a result, all banks had been chartered locally by each state.

Due to lax regulation by some states, banks regularly failed due to lack of sufficient capital or

fraud. To stabilize the banking system, the federal government introduced the National

Banking Act of 1863, which created a system of federally chartered banks that were subject

3. In light of the recent financial crisis of 2007–2009, do you think that the firewall created by

the Glass-Steagall Act of 1933 between commercial banking and the securities industry

proved to be a good thing or not?

Answers will vary. In general, one could say that the Glass Steagall Act was a good choice in

term of separating a risky industry (the securities industry) from traditional commercial

4. Which regulatory agency has the primary responsibility for supervising the following

categories of commercial banks?

a. National banks

b. Bank holding companies

5. How does the emergence of interest-rate risk help explain financial innovation?

Large fluctuations in interest rates during the 1970s and 1980s led to a need for financial

6. Why did new technology make it harder to enforce limitations on bank branching?

7. “The invention of the computer is the major factor behind the decline of the banking

industry.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. The invention of the computer did help lower transaction costs and the costs of

8. “If inflation had not risen in the 1960s and 1970s, the banking industry might be healthier

today.” Is this statement true, false, or uncertain? Explain your answer.

True. Higher inflation helped raise interest rates, which caused the disintermediation process

9. How do sweep accounts and money market mutual funds allow banks to avoid reserve

requirements?

With a sweep account, any account funds left at the end of the business day are technically

transferred to another account, which is invested in overnight securities. Since they are no

writing functions like checkable deposits, they are also not subject to reserve requirements.

10. Securitization changes the systemic (system-wide) risks in the regulated and unregulated

shadow banking system. What is securitization? Does it pose a problem for effective banking

systems?

Securitization, like a mortgage-back security (MBS), refers to the process of bundling illiquid

financial assets into marketable capital market securities. Securitization is one of the main

reasons for the creation of shadow banking systems where typical lending is substituted by

lending via the securities market; the system invests in long-term loans, such as auto loans

11. Why is loophole mining so prevalent in the banking industry in the United States?

Since the banking sector is so heavily regulated, there is a strong incentive for banks to find

ways to skirt regulations that restrict their ability to earn profits. Through loophole mining,

12. Why have banks been losing cost advantages in acquiring funds in recent years?

The rise in inflation and the resulting higher interest rates on alternatives to checkable

13. Why have banks been losing income advantages on their assets in recent years?

The growth of the commercial paper market and the development of the junk bond market

meant that corporations were now able to issue securities rather than borrow from banks, thus

14. According to Reuters, the People’s Bank of China has been using targeted increases in

banks’ reserve requirement ratios (RRR) in recent months. Explain why central banks impose

reserve requirements for commercial banks. Why do commercial banks try to avoid this

requirement?

Increasing reserve requirement ratios (RRR) is one of the primary tools employed by the

People’s Bank of China to keep inflation at bay and prevent asset price bubbles. Central

banks usually impose reserve requirements on commercial banks to control the money supply

following which banks need to hold a certain amount of reserve at the central bank (or other

15. Why are the number of traditional banking systems in industrialized and developed countries

declining?

Answers may vary. However, there are some common issues across countries like expansion

of securities markets and shadow banking system. Deregulation and information technologies

increase the availability of information regarding securities markets, owing to which instead

16. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did

not have restrictions on setting up branches in other states. Why, then, are credit unions

typically smaller than the other depository institutions?

Credit unions are small because they only have members who share a common employer or

are associated with a particular organization.

17. Why has the number of bank holding companies dramatically increased?

Because becoming a bank holding company allows a bank to: (a) circumvent branching

18. Given the role of the loan originator in the securitization process of a mortgage loan

described in the text, do you think the loan originator will be worried about the ability of a

household to meet its monthly mortgage payments?

Given that the loan originator or mortgage broker is mostly worried about getting the

household to accept the terms of the mortgage loan, so that the servicer can sell it to the

19. How did competitive forces lead to the repeal of the Glass-Steagall Act’s separation of the

banking and securities industries?

Brokerage firms began to engage in the traditional banking business of issuing deposit

instruments, while foreign bank activities in the United States further eroded the competitive

20. What has been the likely effect of the Gramm-Leach-Bliley Act on financial consolidation?

The Gramm-Leach-Bliley Act opened the door to consolidation, not only in terms of the

21. What factors explain the rapid growth of international banking?

There are three main factors that have contributed to rapid growth in international banking:

22. What incentives have regulatory agencies created to encourage international banking? Why

have they done this?

International banking has been encouraged by giving special tax treatment and relaxed

23. How could the approval of international banking facilities (IBFs) by the Fed in 1981 have

reduced employment in the banking industry in Europe?

IBFs encourage American and foreign banks to do more banking business in the United

24. If the bank at which you keep your checking account is owned by foreigners, should you

worry that your deposits are less safe than if the bank were owned by Americans?

No, because the foreign-owned bank is subject to the same regulations as the American-

owned bank.

25. Implementing a structural separation of commercial banking and investment banking

activities is a way to reduce systemic risks when a potential bank failure threatens an entire

economic system. Do you think separating banking service industries from other financial

service industries is a good idea? Explain your argument.

Answers will vary. Encourage students to conduct research on the internet about different

systems. You could refer to the separation proposal made by the OECD in 2009 (following

the global financial crises). Those who argue in favor of separation will cite the economics of

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database and find data on the 30-year fixed rate

average mortgage rate (MORTGAGE30US) and the 5/1-year adjustable-rate mortgage

(MORTGAGE5US).

a. What are the mortgage rates reported for the most recent week of data available?

For the week of July 6, 2017, the 30-year fixed rate mortgage was 3.96%, and the 5/1

b. If the principal payment for a given month were $2,000, then what would be the interest

payment per month (using simple interest) for each of the mortgage types, using the most

recent week of data?

At 3.96%, the interest payment for the 30-year mortgage using simple interest would be

c. Over a one-year period, how much would the difference in interest payments between the

two mortgage types amount to?

The two imply a difference of $15 per month, or $180 per year.

2. Go to the St. Louis Federal Reserve FRED database and find data on the level of money

market mutual fund assets (MMMFFAQ027S). Download the data into a spreadsheet.

a. When did assets start entering money market mutual funds? What was the total worth of

assets in money market mutual funds at the end of 1970?

b. For each decade period, calculate the total percentage change in assets from the

beginning of the decade to the end of the decade: 1980:Q1–1990:Q1; 1990:Q1–

2000:Q1; 2000:Q1–2010:Q1. For each decade period, divide the total percentage

change by 10 to get the average yearly percentage increase. Which decade had the

largest average yearly growth in money market mutual funds?

c. Calculate the growth rate from the most recent quarter of data available to the same

quarter a year prior. How does this growth rate compare to the highest average yearly

growth rate for the decades from part (b)?

For the most recent one year period from 2016:Q1 to 2017:Q1, money market mutual