School of Business
FIN350 Global Financial Markets & Institutions
Questions & Problems Set 5
1. Explain why commercial banks are regulated and describe the major pieces of legislation enacted to prevent bank failures.
Financial institutions are regulated because they provide products and services that the economy needs to function efficiently. Also they function in an environment where there is a great deal of asymmetric information, so they help in the screening process. Another reason why banks are regulated is to limit predatory lending practices, for example charging excessively high interest rates or imposing unreasonable conditions and penalties. A final reason why financial institutions are regulated is that some of the profits earned by financial institutions can be attributed to these financial institutions being able to create money and borrow at low costs because of explicit or implicit government guarantees. Because of this politicians often try to convince financial institutions to invest in government securities, making loans to certain classes that wouldn’t normally qualify, and making loans at lower than normal interest rates. Commercial banks are regulated because policy makers believe that the public will suffer a greater loss than the individual loss that the banks would experience if they were to go under. Due to this Congress has enacted many different pieces of legislation to prevent banks from failing. Some of the major pieces of legislation are The National Banking Act 1863, The Federal Reserve Act 1913, McFadden Pepper 1928, The Banking Act of 1933 (Glass Steagall Act), Federal Deposit Insurance Corporation 1935, Riegle- Neal 1994 (repealed McFadden Pepper), Gramm–Leach–Bliley Act 1999 (repealed Glass Steagall), Dod Frank Act 2010.
2. What are the major sources of bank funds? How do these differ between large and small banks?
The principal source of funds for most banks is deposit accounts. There are several different types of deposit accounts include transaction, savings, and time deposits. Transaction accounts include demand deposits which are checking accounts and NOW accounts are demand deposits that pay interest. Savings deposits include savings accounts and money market deposit accounts. Time deposits are accounts that require you to hold your money in them until their maturity date, much like CD’s. Another source of bank funds comes from the whole sale money markets or a Federal Reserve Bank. Banks use these borrowed funds to fill the gap between loan demand and deposits with the bank. Types of borrowed funds include federal funds, repurchase agreements, trading liabilities, Eurodollars, banker’s acceptance, federal home loan bank advances, and Federal Reserve Bank loans. Banks use these borrowed funds to do several things that include meeting reserve requirements, and making more loans. In recent years banks have found that issuing short-term capital notes or longer-term bonds can be another source of their funds. Lastly banks use their own capital as a source of funds. There are three types of capital accounts for a commercial bank: capital stock, undivided profits, and special reserve accounts. Not all banks use these sources of funds the same way. Smaller banks rely on deposits mostly due to the fact that the money markets call for large amounts of money to make a transaction. Large banks also rely on deposits, however, not to the same extent as small banks because they can tap into the money markets.
3. How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Why do you think bankers prefer to use higher leverage than regulators would like them to?
For a bank, capital levels are measured against risk-weighted assets. Risk weighted assets are a measure of total assets that weighs high risks more heavily than low risk assets. Bank capital represents the...