Principals of Finance

FIN-3005

June 3, 2014 Questions and Applications
7) Borrowing from the Federal Reserve: Describe the process of “borrowing at the Federal Reserve.” What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve?

“Borrowing at the discount window” represents the borrowing by depository institutions from the Federal Reserve. The interest rate charged on these loans is known as the discount rate is set by the FED.
Banks tend to prefer the federal funds market over the discount window because the Fed may monitory the bank’s reasons for borrowing. The Fed’s discount window is intended to accommodate banks that experience “unanticipated” shortage of funds.

9) Bullet Loan: Explain the advantage of a bullet loan.

A bullet loan is a loan that specifies a date in the future in which the principal is paid off in a lump sum. This type of loan is useful for a borrower will have limited funds in the near future.

10) Bank Use of Funds Why do banks invest in securities even though loans typically generate a higher return? Explain how a bank decides the appropriate percentage of funds that should be allocated to each type of asset.

Securities provide a bank with liquidity, because they can often be sold easily in the secondary market. In addition, many securities purchased by banks have low risk. Therefore, the securities can be used to minimize liquidity risk and default risk.

The optimal allocation of funds is dependent on a bank’s degree of risk aversion and anticipated economic conditions. There is no formula to determine the optimal allocation, so banks must weigh the higher potential return from some uses of funds against the lower return and lower risk of other uses of funds.
How Commercial Banks are Structured

In order to avoid another banking collapse banks were separated into two entities. The commercial banks were one of those entities. Commercial banks were created to provide financial services directly to business and consumers. The banks sources of funds are received through deposit accounts, borrowed funds, and long-term sources of funds. They can borrow from other banks, Federal Reserve, and other sources to solve temporary deficiency in funds.

1) Regulation of Bank Sources and Uses of Funds: How are a bank’s balance sheet decisions regulated?

Banks are required to pay a premium on deposits, and to maintain a minimm level of capital, and are restricted to a maximum loan amount to any single borrower. They cannot use borrowed or deposited funds to purchase common stock They can only invest in bonds that are considered “investment-grade” quality.

3) Moral Hazard and the Credit Crisis: Explain why the moral hazard problem received so much attention during the credit crisis.

Moral hazard was a serious problem during the credit crisis because the government was attempting to prevent failures of banks. Yet, some critics argued that the government should not bail out banks because it could send a signal that banks can take excessive risk without worry about failure.

9) Value at Risk: Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital.

The VaR model can be used in multiple ways to determine capital requirements. The bank defines the VaR as the estimated potential loss from it trading business that could result from adverse movements in market prices. The validity of a bank’s estimated VaR is assessed by comparing the actual daily trading gains or losses to the estimated VaR over a particular period. If the VaR is estimated properly, only 1 percent of the actual daily trading days should show results that are worse than the estimated VaR. In reality, banks may not be very concerned if all their trading results exceed their estimated VaR, because this suggests that their risk may have been overestimated for that period.

Reference

Madura, J. (2012). Financial Markets and Institutions. Mason: South-Western.