1. - Give one example of moral hazard and adverse selection in private insurance arrangements. Moral Hazard: A Bank purposely lend to people whom may not be able to payback knowing insurance will pick up the tab for damages, or eat unhealthy food and get fat and have heat problem but knowing insurance will pay for treatment. Adv. Selection: If the insurance has an attractive rate for overseas depositors, only groups that are those particular demographics will sign up. Meaning that banks know the risk involve but keep do it because compensation. Or if the insurance companies have a rider for say 100% covered cancer treatment, and groups that somehow knows they all have cancer or have a big chance, buy that rider. Adverse selection is when groups that have these "negative" traits apply for quotes from companies that offer attractive rates for those "traits". The result is the insurance compensation gets too many bad groups. 2.- If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result? Moral Hazard: People will be careless, they would not care and Insurances will cover for damages. Adverse selection: People will cause more fire. Therefore the law will be regulated and enforce limits as in which circumstances and to what extend will cover for damages.3.- What bank regulation is designed to reduce adverse selection problems for deposit insurance? Will it always work? Chartering banks helps reduce adverse selection problem because it attempts to screen proposals for new banks to prevent risk placed to entrepreneurs from controlling them. A new bank shall not depend in one lager customer. Therefore new institution has to inform whom and where potential investments come from, and what types of investments are going to be target on future. And other related proposals. Annual report. It will not always work because entrepreneurs and crooks have incentive to hide their true nature. 4.- What bank regulation is designed to reduce Moral Hazard problems created by deposit insurance? Will they completely eliminate the Moral Hazard problem?Restrictions on Asset Holding = Regulations limit the type of assets banks may hold as assets. For instance since land has drop in price cannot be use as a sec in a loanCapital requirements= Banks are also subject to capital requirements. Banks are required to hold a certain level of capital (book equity) that depends on the type of assets that the bank holds measured by ratios of capital structur. To insure proper balance: - Leverage ratio must exceed 5% to avoid restrictionsAnd Capital must exceed 8% of the banks risk-weighted assets and off-balance sheet activities - New capital requirements are forthcoming to address problems with risk-weighted assetsPrompt Corrective Action= it is obvious that undercapitalized bank is more likely to fail and more likely to engage in risky activities even fraudulent. So, Improvement in Act of 1991 requires the FDIC to act quickly to correct or avoid losses when banks get into trouble.No. Example: Eliminate or limit the amount of deposit insurance would be a good idea. So banks dont take excessive risk expecting insurance to pay for it.But; would make bank failures and panics more likely so may not be a very good idea. It can cost Taxpayers Dearly. 5.-What are the costs and benefits of a too-big-to-fail policy? Benefits are that is makes bank panics less likely. Costs are that it increases the incentives of moral hazard by big banks and it discriminates against small banks To big-to-fall, is establish for the larger banks, whom should get premium insurance that exceeds or cover 0ver $250,000 for large depositors. (Among 11) But if T0-Big-to-Fall policy is not enough and banks have to merge, then managers get fired and stockholder lose their investment. 6.- What special problem do off-balance sheet activities present to bank regulators, and what have they done about it? Not showing up on the balance sheets, so they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Bank regulators dealt with this by requiring banks to set aside additional bank capital for different off balance sheet activities 7.- Why does imposing bank capital requirements on banks help limit risk taking? Because with higher amounts of capital, banks have more to lose if they take on too much risk. Thus it makes it less likely banks will take on excessive risk. 8.- What forms does bank supervision take, and how does it help promote a safe and sound banking system? Bank supervision involves bank examinations in which bank examiners assess six areas of the banks represented in the CAMELS ratings (Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to market risk) 9.- What steps were taken in the FDICIA legislation of 1991 t improve the functioning of federal deposit insurance? The Federal deposit Insurance Corporation (FDIC) improvement act of 1991 a adopted a prompt corrective action provision that requires the FDIC to intervene earlier and more vigorously when banks gets into trouble. 10.- why has the trend in bank supervision moved away from a focus on capital requirements to focus on risk management? 11.- How do disclosure requirements help limit excessive risk taking by banks? More public information about the risks incurred by the banks and the quality of their portfolio helps stockholders evaluate and monitor banks and pull funds out if they are taking on too much risk

13.- do you think that removing the impediment to a nation wide banking system will be beneficial to the economy? Explain In general yes. A national banking system will enable banks to diversify their loan portfolios better, thus decreasing likelihood of bank failures. Also increase a banks profitability. 14.- How could higher deposit insurance premiums for banks with riskier assets benefit the economy? The economy would benefit from reduced moral hazard, Banks would not want to take on too much risk because it would increase their deposit insurance premiums.14.- How could higher deposit insurance premiums for banks with riskier assets benefit the economy? The economy would benefit from reduced moral hazard, Banks would not want to take on too much risk because it would increase their deposit insurance premiums

15.- How could market value accounting for bank capital requirements benefit the economy? How difficult would it be to implement? It would let the deposit insurance agency know quickly if a bank was falling below its capital requirement so it could be closed down before substantial losses.If the president of a bank told you that the bank was so well run it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? No, because bank president is not managing bank well. Since the bank has never incurred costs as result of deposit outflow means the bank is holding a lot of reserves, earning no interest. Profits are low, hence would not but stock. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down? Why and what other options are available? No, you may lose that customer's business forever, which is extremely costly. You may go out and borrow from other banks, corporations, or Fed to obtain funds. Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves? Because when a deposit outflow occurs a banks can borrow reserves in overnight loan markets and does not need to acquire reserves at high cost by calling in or selling off loans. Reduces the costs associated with deposit outflows, so banks will hold fewer excess reserves. If you are a banker and expect interest rates to rise in the future, would you want to make short term or long term loans? Short term so when these loans mature, you will be able to make loans at higher interest rates, generating more income. "Bank managers should always seek the highest return possible on their assets." Is this true, false, or uncertain? Explain. False, If an asset has a lot of risk a bank manager might not want to hold it even if it has a higher return than other assets. "Banking has become a more dynamic industry because of more active liability management." Is this true, false, or uncertain? Explain. True, banks can now pursue new loan business much more aggressively because when they see profitable loan opportunities, they can use liability management to acquire new funds and expand banks business. What bank regulation is designed to reduce adverse selection problems for deposit insurance? Will it always work? Chartering banks helps reduce adverse selection problem because it attempts to screen proposals for new banks to prevent risk prone entrepreneurs from controlling them. It will not always work because entrepreneurs and crooks have incentive to hide their true nature. What are the costs and benefits of a too-big-to-fail policy? Benefits are that is makes bank panics less likely. Costs are that it increases the incentives of moral hazard by big banks and it discriminates against small banks What special problem do off-balance sheet activities present to bank regulators, and what have they done about it? Not showing up on the balance sheets, so they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Bank regulators dealt with this by requiring banks to set aside additional bank capital for different off balance sheet activities

Why does imposing bank capital requirements on banks help limit risk taking? Because with higher amounts of capital, banks have more to lose if they take on too much risk. Thus it makes it less likely banks will take on excessive risk. What forms does bank supervision take, and how does it help promote a safe and sound banking system? Bank supervision involves bank examinations in which bank examiners assess six areas of the banks represented in the CAMELS ratings(Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to market risk) Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain. It would help reduce the moral hazard of excessive risk taking on the part of banks, but would make bank failures and panics more likely so may not be a very good idea. Do you think that removing the impediments to a nationwide banking system will be beneficial to the economy? In general yes. A national banking system will enable banks to diversify their loan portfolios better, thus decreasing likelihood of bank failures. Also increase a banks profitability. How could higher deposit insurance premiums for banks with riskier assets benefit the economy? The economy would benefit from reduced moral hazard, Banks would not want to take on too much risk because it would increase their deposit insurance premiums. How could market value accounting for bank capital requirements benefit the economy? How difficult would it be to implement? It would let the deposit insurance agency know quickly if a bank was falling below its capital requirement so it could be closed down before substantial losses. Checkable Deposits (Liability) Includes all accounts that allow the owner (depositor) to write checks to third parties. Checkable deposits are banks lowest cost funds. Non-Transaction Deposits (Liability) The overall primary source of bank liabilities and are accounts from which the depositor cannot write checks; savings accounts and CDs Bank Capital (Liability) The source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings What four liabilities are on a banks balance sheet? Checkable Deposits, Non-Transaction Deposits, Borrowings, Bank Capital What are the assets on a banks balance sheet? Reserves, Reserve Requirement, Cash items in process of collection, Securities, Loans, Deposit at other bank "Too big to Fail" Regulators are reluctant to let the largest banks fail because of the potential impact on the entire system ***How does the FDIC handle failed banks? (Two Ways) Payoff Method- where the bank is permitted to fail Purchase and Assumption Method- where the bank is folded into another banking organization Regulatory Arbitrage For any given category, they seek assets that are riskiest Dual Banking System Banks supervised by the federal government and banks supervised by the states operate side by side Glass-Steagall Act Separated the activities of commercial banks from those of the securities industry; allowed commercial banks to sell on the run government securities, but prohibited underwriting Shadow Banking System Lending has been replaced by lending via the securities market Commercial Paper Unsecured debt issued by corporations with short original maturity Securitization The transformation of illiquid assets into marketable capital market instruments Money Market Mutual Funds MMMFs Allow investors similar access to their funds as a bank savings account, but offered higher rates Sweep Accounts Funds are "swept" out of checking accounts nightly and invested at overnight rates Treasury STRIPS Developed in early 1980s to help investors avoid reinvestment risk associated with coupon bonds Thrift Industry: Savings and Loan Associations (S&L) Can be charted by federal government or by the states; Office of the Comptroller of Currency regulates federally insured S&Ls by setting minimum capital requirements, requiring periodic reports and examinations Thrift Industry: Mutual Savings Bank Jointly owned by the depositors and subject to many of the FDICs regulations for state chartered banks Thrift Industry: Credit Unions Organized around a particular group of individuals with a common bond; regulatory changes allow individual credit unions to cater to a more diverse group of people Mutual Funds Mutual Funds pool together resources of many small investors by selling them shares and using the proceeds to buy securities What are the five principal benefits of mutual funds? 1.Liquidity Intermediation 2.Denomination Intermediation 3.Diversification 4.Cost Advantages 5.Managerial Expertise Liquidity Intermediation Investors can quickly convert investments into cash while still allowing the fund to invest for the long term Denomination Intermediation Investors can participate in equity and debt offerings that, individually, require more capital than they possess Diversification Investors immediately realize the benefits of diversification even for small investments Cost Advantages The mutual fund can negotiate lower transaction fees than would be available to the individual investor Managerial Expertise Many investors prefer to rely on professional money managers to select their investments Close End Fund A fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market Open End Fund Investors may buy or redeem shares at any point where the price is determined by the net asset value of the fund