Money and banking - Assignment Example

Consider a bank with the following income ment: It has $100 in loans with an interest rate of 5 percent; $50 in security holdings, paying 10 percent; reserves of $10; $100 in savings accounts that earn an interest rate of 2.5 percent; checking deposits equal to $30, a net worth of $30, and other expenses of $15. Find bank profit, the return on equity, and return on assets. (10 points)Interest on loans: 5%X$100= $5Revenue from securities 10%X$50=$5Reserves $5Checking deposits $30Interest paid on deposits 2.

5%X$130=$3.25Other Expenses $15Bank profit= Total Interested earned -Total Interest paid = ($5+$5) - $3.25 = $6.75Return on Equity= Net income Shareholder’s Equity = 71.5 30 = 2.392Return on Assets= Net Income Total Assets =71.5 290 =0.24742- Briefly explain the reason for the decline in banks core funds beginning in the 1970s and the consequences of this shift. (10 points) Financial innovation and technical changes were instrumental in the declining banks’ core funding.

First, disintermediation resulting from the adjustment of the ceiling point by a 1,000 basis points caused a shift in customers investing in other financial institutions instead of investing in banks. Conversely, introduction of money market mutual funds constrained deposit to banks since they paid higher money market values. Finally, the introduction of ATMs in the banking sector reduced the cost of transactions, which the banks used to benefit from due to the paper work required (DeYoung). Hence, the consequence of this shift was a reduction in banks fundamental sources of funds.

3- Explain the role of adjustable-rate mortgages (ARMs) in exacerbating the financial crisis. (10 points) Experts cite adjustable-rate mortgages (ARMs) as a dubious practice that exacerbated the financial crisis. In this case, ARMs enticed borrowers with low credit to enable them borrow against the value of homes. This way, families were able to own homes that were beyond their reach. Consequently, there was an inflation of a new bubble in the housing sector as prices were indicative of families’ inability to pay (Mackaman).

4- Explain how the financial crisis of 2007–2009, which was triggered by defaults on subprime mortgages, affected commercial banks and savings institutions. (10 points) Subprime mortgages, like ARMs, contributed to underpaid-workers owning homes that they could not afford to pay. In effect, this led to creditors risk managing the default payments through shadowy techniques that involved bundling, selling, and repackaging debt. With the number of defaulters rising, what followed was a number of foreclosures that were in contrast with the value of debt bundling from banks and saving institutions.

In effect, these institutions resulted to liquidity and solvency status that lead to the crisis (Mackman).5- Explain how the threat of a bank run reduces moral hazard in the form of risky loans. (5 points) Strictly put, banks that follow proper lending procedures will ensure that the borrowers are credit worthy and they will not become defaulters, which can make a bank lose money. However, a bank with high nonperforming loans runs the risk of a low capital base to do business and they can run into trouble with financial regulators.

In addition, such publicity might result to substantial withdraws from depositors (a run on the bank).6- Explain the Basel requirements and how banks got around the Basel Accords, which limited the amount of mortgages and other risky assets that banks could hold on their books. (10 points; Hint: structured investment vehicles) The Basel accords are requirements that guide the operations of financial institutions in international capital, liquidity requirements, and other banking functions. Banks utilized a loophole in the Basel accord that gave banks the ability to provide liquidity facilities to structured investment vehicles (SIVs) without the banks holding capital against the SIVs provided that it was undrawn, which extended for a period of 360 days.

In effect, banks were able to make such an investment due to the limitation of the buy-side of the market. 7-Explain the differences in how the use of derivatives affected Barings Bank in the 1990s and AIG in the 2007–2009 financial crisis. (5 points) For Baring Bank, the head of trade, who coupled up as the floor manager for Barings’ trading at the international market, was responsible for bringing the bank down due to unauthorized trading on derivatives. The head of derivatives acted under little supervision from London and engaged in seeking to profit in Nikkei 225 future contracts listed in Japan and Singapore (“A Fallen Star” 19).

On the other hand, AIG involved itself in credit derivatives. In line with this, the company fell because it dealt with over the counter derivatives that eliminated the regulations of federal and state laws that lessened their failure (“What the Financial Crisis”). These unregulated products resulted to massive losses in the company.Works Cited“A Fallen Star.” The Economist 334.7904 (4 Mar. 1995): 19–21. Print.DeYoung, Robert. Safety, Soundness, and the Evolution of the U.S. Banking Industry.

Economic Review (First and Second Quarters 2007) 41-66. Web. . Mackaman, Tom. Behind the Economic Crisis. May 2008. Web. 20 Jan. 2012. . “What the Financial Crisis Commission Concluded about AIG’s Failure.” Insurance journal. 27 Jan. 2011. Web. 20 Jan. 2012. .