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Financial Institutions Markets and Money
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Financial Institutions Markets and Money
Final 1
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1
Question
What is the difference between financial globalization and financialization?
Answer
Financial globalization refers to the increasing integration and interdependence of national financial markets, allowing for the cross-border flow of capital, investments, and financial services. Financialization, on the other hand, describes the growing dominance of financial motives, markets, actors, and institutions in the economy, influencing economic policies and corporate behavior beyond just cross-border activity.
2
Question
What is the financial system (its functions) and its subsystems?
Answer
Financial system: is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. ▬ It includes: borrowers, lenders, and investors exchanging current funds to finance projects and pursue returns on financial assets. ▬ Encompasses: sets of rules and practices that borrowers and lenders use➔ which projects get financed, who finances them, and the terms of financial deals. ▬ Financial systems exist on firm, regional, and global levels ○ Functions: ▬ Channeling funds: from savers (surplus funds)➔ borrowers (need of funds) ▬ Facilitating capital formation (investment): by making excess capital from savers available to borrowers ▬ Providing an efficient medium of exchange (money): for goods and services ▬ Providing efficient and complete financial markets: for the transfer/flow of financial assets (stocks and bonds) and their conversion into cash ○ Subsystems: ▬ Financial markets ▬ Monetary system ▬ Fiscal systems ▬ Regulatory system
3
Question
What is direct finance? (examples of players, products and market segments)
Answer
direct finance: Borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments). Securities are claims on the borrower’s future income or assets. For the person who buys them, securities are assets, while for the issuer, they are liabilities (IOUs or debts). ▬ Direct financing is usually done by borrowers that sell securities and/or shares to raise money and circumvent the potentially high interest rates of financial intermediaries ▬ Direct finance starts when borrowers/spenders and lenders/buyers are directly connected to the market places (e.g., at stock exchanges) ▬ Examples: financial auctions (e.g., government bond auctions) or initial public offerings (IPOs)
4
Question
What is indirect finance and how does a financial intermediary function in this process?
Answer
Indirect finance involves borrowers obtaining funds through a financial intermediary, such as a bank, which moves funds from lenders to borrowers. The intermediary accepts deposits from lenders at a lower interest rate and lends to borrowers at a higher rate, earning a profit from the interest rate margin. Borrowers and lenders interact indirectly through the intermediary.
5
Question
What are examples of financial products associated with direct finance and indirect finance?
Answer
Direct finance products include bonds (government and corporate), stocks/shares, commercial paper, IPOs, securities sold in financial auctions, and Eurobonds. Indirect finance products include loans (bank loans, consumer loans, mortgages), deposits in banks, funds in credit unions, insurance policies, pension fund contributions, mutual fund shares, and money market mutual fund shares.
6
Question
Why are loans from financial intermediaries more important for corporate finance in the United States and the EU?
Answer
In the US and EU, businesses primarily obtain funds indirectly through financial intermediaries rather than directly from securities markets. Loans from intermediaries provide a significant source of corporate finance, with bonds more important than stocks in the US, and bank loans being the largest source of external finance in countries like Germany and Japan.
7
Question
Differentiate between primary and secondary markets in direct finance?
Answer
Primary markets are where new issues of securities (stocks or bonds) are sold for the first time by corporations or governments, often underwritten by investment banks. Secondary markets involve trading previously issued securities, providing liquidity and pricing for these instruments. Brokers and dealers operate in secondary markets, including over-the-counter (OTC) transactions.
8
Question
What are the key characteristics and functions of debt and equity markets?
Answer
Debt markets involve debt instruments like bonds payable with periodic interest and principal repayment, serving as loans with fixed terms. Equity markets involve stocks representing ownership shares, giving holders rights to net income and assets. Both offer ways for entities to obtain funds; debt is like lending, equity is ownership.
9
Question
How do financial intermediaries lower transaction costs and reduce investor exposure to risk?
Answer
Financial intermediaries achieve economies of scale and scope to lower transaction costs by increasing the size and diversity of transactions. They also reduce investor risk via risk sharing (asset transformation and securitization) and diversification, allowing investors to hold safer and more liquid assets than they could access independently.
10
Question
Explain the problems of adverse selection and moral hazard in finance and how intermediaries address them.
Answer
Adverse selection occurs before a transaction when lenders struggle to identify risky borrowers; intermediaries reduce this by gathering borrower information to screen out bad risks. Moral hazard occurs after a transaction when borrowers might engage in risky activities that threaten loan repayment; intermediaries monitor borrowers to prevent such behavior. This reduces asymmetric information problems.
11
Question
What are the main types of financial intermediaries and their primary roles?
Answer
Three main groups: 1) Depository institutions (banks, thrifts) accept deposits and make loans; 2) Contractual saving institutions (life, fire insurance companies, pension funds) acquire funds periodically to invest primarily in long-term securities; 3) Investment intermediaries (finance companies, mutual funds, money market mutual funds, hedge funds, investment banks) raise funds by selling securities and invest or facilitate capital raising and advisory services.
12
Question
How do commercial banks differ from investment banks, and which would you use to get a car loan?
Answer
Commercial banks accept deposits and make loans to individuals and businesses; they provide core banking services including car loans. Investment banks do not take deposits or make traditional loans but advise corporations on capital raising and securities issuance. For a car loan, you would use a commercial bank or credit union, not an investment bank.
13
Question
What are the four characteristics of money and why are they important?
Answer
Portability (easy to transfer), durability (does not deteriorate quickly), divisibility (can be broken into smaller units), and limited supply (to prevent inflation and loss of value). These characteristics ensure money functions effectively as a medium of exchange, store of value, and unit of account.
14
Question
What are the primary functions of money in an economy?
Answer
Money serves as a medium of exchange (facilitates buying and selling), a unit of account (common measure to value goods and services), a standard of deferred payments (used for future payments and debts), and a store of value (holds purchasing power over time). These functions reduce transaction costs and enable efficient trade.
15
Question
Rank the liquidity of different assets from most to least liquid.
Answer
Most liquid to least: cash; transaction deposits; certificates of deposit; stocks and bonds; cars; houses; old master paintings; commercial office buildings; antique furniture. Liquidity reflects how quickly and easily an asset can be converted into cash without significant loss of value.
16
Question
What are the components of monetary aggregates M0, M1, M2, and M3?
Answer
M0 (Monetary base) includes physical currency plus central bank reserves. M1 (Narrow money) includes M0 plus demand deposits and other checkable deposits. M2 (Intermediate money) adds small denomination time deposits, savings deposits, and money market mutual fund shares to M1. M3 (Broad money) includes M2 plus larger time deposits, institutional money market funds, and short-term repurchase agreements.
17
Question
How does using an online payment system like PayPal affect monetary aggregates M1 and M2?
Answer
Transferring funds to PayPal moves money within components of M1 and M2 but does not change the total money supply, as PayPal balances are not included in standard M1 or M2 definitions. Payments within PayPal accounts also stay outside official measures until funds are withdrawn back into bank accounts that count towards M1 and M2.
18
Question
What distinguishes fiat money from commodity money?
Answer
Commodity money has intrinsic value and alternative uses (e.g., gold, silver), while fiat money has no intrinsic value and is valuable only by government decree and public trust. Fiat money is easier to transport and more flexible but depends entirely on confidence in the issuing authority.
19
Question
What are electronic money (e-money), digital money, and cryptocurrencies?
Answer
E-money is a digital representation of fiat currency stored electronically, enabling electronic payments (e.g., debit cards, prepaid cards). Digital money includes all money in digital form, including decentralized cryptocurrencies like Bitcoin, which are not issued or regulated by governments. Not all digital money is e-money.
20
Question
Describe the advantages and limitations of Bitcoin as a form of money.
Answer
Advantages include decentralization, lower transaction costs, privacy, security, and global accessibility. Limitations include extreme price volatility preventing use as a stable unit of account or store of value, limited acceptance, regulatory concerns, and security risks like hacking. Bitcoin functions best as a medium of exchange but is unlikely to replace traditional money fully.
21
Question
What are the main pros and cons of a cashless society?
Answer
Pros: reduced costs of cash handling, convenience, efficiency, and reduced issues like old banknotes. Cons: financial exclusion for vulnerable groups, higher risks of cyber fraud and attacks, privacy concerns, reliance on technology and internet access, and risks of monopolies by tech companies.
22
Question
How do cooperative banks and credit unions better tackle information asymmetry in local communities compared to commercial banks?
Answer
Cooperative banks and credit unions have member ownership, aligning interests between savers and borrowers. Their members often live locally, enabling better knowledge and monitoring, reducing adverse selection and moral hazard. Longer-term relationships build trust, and shared community ties foster better information about customers' creditworthiness.
23
Question
What is universal banking and what main services does it combine?
Answer
Universal banking is a system where banks provide a wide variety of financial services under one roof, combining wholesale banking, retail banking, and investment banking services, as well as insurance.
24
Question
How does wholesale banking differ from retail banking?
Answer
Wholesale banking involves services like lending, borrowing, and payments for large clients such as institutions and corporations, dealing with massive amounts of money. Retail banking provides financial services directly to individual customers, including deposit accounts, loans, and payment services.
25
Question
What are the key differences between commercial banks and non-bank thrifts like credit unions and savings and loan associations?
Answer
Commercial banks accept deposits and make loans to businesses and consumers, funding themselves mainly through checkable, savings, and time deposits. Non-bank thrifts primarily deal in short-term deposits and mortgages, are often mutual companies owned by depositors, and include entities like credit unions and savings and loan associations which focus on specific community or residential lending.
26
Question
Describe the three 'pillars' of universal banking in Germany and their characteristics.
Answer
1. Commercial banks: privately owned, profit-driven, serving retail and corporate clients with universal banking services. 2. Savings banks: publicly owned by municipalities, aim for profit and regional promotion, serving customers within designated regions. 3. Cooperative banks: owned by members/customers, focusing on profit and member promotion, mainly serving individuals and small businesses with a central institution supporting them.
27
Question
What were some key milestones in the historical development of US banking regulations?
Answer
Key milestones include: 1863 National Bank Act (federal bank chartering), 1913 Federal Reserve System creation, 1927 McFadden Act (restricted interstate branching), 1933 Glass-Steagall Act (separated commercial and investment banking, created FDIC), 1956 Bank Holding Company Act, 1994 Riegle-Neal Act (removed branching restrictions), and 1999 Gramm-Leach-Bliley Act (repealed Glass-Steagall separation).
28
Question
Why was the US banking system historically fragmented and geographically segmented?
Answer
Due to restrictions on interstate branching (especially from the McFadden Act of 1927), fear of concentrated power in a central bank, and a preference for local, independent banks, the US banking system developed many small banks with limited geographic expansion.
29
Question
What is shadow banking, and how does it differ from traditional banking?
Answer
Shadow banking refers to financial intermediaries that create credit but operate without regulatory oversight, involving entities like hedge funds and investment banks engaging in off-balance-sheet activities, unlike traditional banks which are regulated and hold deposits.
30
Question
Explain securitization and its role in financial markets.
Answer
Securitization transforms illiquid financial assets like mortgages or auto loans into marketable securities by bundling them, allowing these assets to be sold and traded in capital markets, enabling lending outside of traditional banking.