BFF5916 Suggested Tutorial Solutions – week 3

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BFF5916 Suggested Tutorial Solutions – week 3
  BFF5916 Suggested Tutorial Solutions – week 3 1. What is the Glass-Steagall Act, and why was it important in banking history? • The Glass-Steagall Act, passed by the U.S. Congress in 1933, was one of the most comprehensive pieces of banking legislation in American history. It created the Federal Deposit Insurance Corporation to insure smaller-size bank deposits, imposed interest-rate ceilings on bank deposits, and separated commercial banking from investment banking, thereby removing commercial banks from underwriting the issue and sale of corporate stocks and bonds in the public market. • There are many people who feel that banks should have some limitations on their investment banking activities. These analysts focus on two main areas. First, they suggest that this service may cause problems for customers using other bank services. For example, a bank may require a customer getting a loan to purchase securities of a company it is underwriting. This potential conflict of interest concerns some analysts. The second concern deals with whether the bank can gain effective control over an industrial organization. This could make the bank subject to additional risks or may give unaffiliated industrial organizations a competitive disadvantage. • Today, banks can underwrite securities as part of the Gramm-Leach Bliley Act (Financial Services Modernization Act). However, congress built in several protections to make sure that banks do not take advantage of customers. In addition, banks are prevented from affiliating with industrial firms under this law. 2. How does the FDIC deal with most failures? • Most bank failures are handled by getting another bank to take over the deposits and clean assets of the failed institution—a process known as purchase and assumption. Those that are small or in such bad shape that no suitable bids are received from other banks are closed and the insured depositors are paid off—a deposit payoff approach. Larger failures may sometimes be dealt with by open bank assistance where the FDIC loans money to the troubled bank and may order a change in management as well. Large failing money-center banks may also be taken over and operated as "bridge banks" by the FDIC until disposed of. 3. What services does the Federal Reserve provide to depository institutions?    Many services needed by banks are provided by the Federal Reserve banks. Among the most important services provided by the Fed are checking clearing, the wiring of funds, shipments of currency and coin, safekeeping securities of depository institutions and their customers, issuing new securities from the U.S. Treasury and selected other federal agencies, loans from the Reserve banks to qualified depository institutions, and  the supplying of information concerning economic and financial trends and issues. The Fed began charging for its services in order to help recover the added costs of deregulation which made more institutions eligible for Federal Reserve services and also to encourage the private marketplace to develop and offer similar services (such as check clearing and wire transfers). 4. How did the Federal Reserve and selected other central banks expands their policy tools to deal with the great credit crisis of 2007–2009? Did their efforts work satisfactorily? • Besides the traditional policy tools of open market operations, discount rates, reserve requirements, and moral suasion the Federal Reserve established two new policy tools in 2007 and 2008 to help stem the damage created by the home mortgage crisis. The Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF) were designed to make loans to depository institutions and securities dealers for periods of approximately one month to increase the supply of liquidity in the financial markets and expand credit for businesses and consumers. Four other central banks—the British, Canadian, Swiss, and European central banks—supported the Fed’s action and moved in parallel fashion to encourage their countries’ banks to expand the supply of credit. 5. What happens when a central bank like the Federal Reserve expands its assets? Is there any upper limit to a central bank’s assets? Why? • Central banks, just like the Federal Reserve, occasionally uses changes in reserve requirements as a monetary policy tool. Institutions selling deposits must place a small percentage of each dollar of those deposits in reserve, either in the form of vault cash or in a deposit at the central bank. Changes in the percentage of deposits and other funds sources that must be held in reserve can have a significant impact on credit expansion. Raising reserve requirements means that financial firms must set aside more of the amount raised as deposits into required reserves. This leaves less money available to make new loans and may cause a rise in interest rates. • Lowering reserve requirements, on the other hand, releases reserves for additional lending. This can cause interest rates to decline as financial institutions have more funds to loan. However, central banks usually change reserve requirements very infrequently because the impact can be so powerful and cannot easily be reversed and because banks are less dependent on deposits as a source of funds than in the past. • There is no upper limit on the central bank’s assets. It raises its own funds from sales of its services and from securities trading, and it passes along most of its earnings to the U.S. Treasury.
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