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05 - Credit Markets Flashcards

1
Q

Some Basic Definitions:

  1. Debtor
  2. Credit
  3. Interest Rate
A
  1. or borrower / is an economic agent who borrows funds
  2. or loan / the amount of funds that the debtor receives
  3. the additional payment above the loan that the borrower has to make on 1 dollar of loan
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2
Q

What is the real interest rate and the corresponding formula?

1.
2.

Optimizing economic agents will….

A
  • r ; refers to the annual real or inflation adjusted cost of a 1 dollar loan, i.e.
  • r = i - t
  • r real interest rate; i nominal rate; t rate of inflation

…. base their decisions on the real interest rate r because they want to compare what they borrowed/ saved to what they have to pay or get back, adjusting gor the purchasing power of the money

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3
Q

Credit demand curve

Facts and what does it look like and why?

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A
  • shows the relationship between the real interest rate and the quantity of credit demanded

Downward sloping because…
- an optimimzing firms borrows new capital until the marginal product of capital is equal to the real interest rate r
- if r lower, more firms have projects with a marginal product of capital larger than r, i.e. more firms demand credit

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4
Q

What are reasons for shifts in the demand curve?

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A
  • perceived business opportunities for firms such as increased demnad for a firms product shifting the curve to the right
  • household preferences or expectations such as an expected future salary increase shifting the curve ti the right
  • government policy such as increased government deficits shifting the curve to the right
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5
Q

What are shifters of the credit supply curve?

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A
  • savings motives of households such as suddenly being nervous about losing the job shifting the curve to the right
  • savings motives of firms such as increased dividend payments demanded by its shareholders shifting the curve to the left
  • in the longer run, demography (such as fewer children per capita allowing potential parents to save more)
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6
Q

What does the equilibrium of the credit market not take into account?

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A
  • does not take into account that there are several different interest rates since
  • credit markets differ in maturity and
  • different borrowers have different risks of defaulting
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7
Q

How did we get into negative real interest rates? (Side of Supply)

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A
  • demographic changes increasing savings (many young people)
  • economic uncertainty and fear of job losses increasing savings (tech development like AI, geopolitical changes, corona)
  • monetary policy increasing available money (ECB)
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8
Q

How did we get into negative real interest rates? (Side of Credit)

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A
  • tech changes reducing credit demand (industry firms used to need a lot of capital for investing in factories; service focused start ups require less)
  • governments fiscal discipline reducing credit demnad (however not anymore since corona) : germanys debt brake
  • monetary policy reducing credit demand; ECB buys many government bonds and thus takes more credit demand out of market (e.g. has bought 25 per cent of all german public debt issued)
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9
Q

Financial Intermediaries such as banks or asset management companies channel….

Financial Capital comes in different forms, including
1.
2.

A

…. funds from suppliers or financial capital (savers) to users of it (borrowers)

  1. credit; loan to another party for promise of repaymnet of loan plus interest
  2. equity; ownership share with claim on future profits of the company
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10
Q

What are Assets of a Bank?

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A
  • bank reserves; vault cash (paper money and coins) and holdings on deposit at the central bank
  • cash equivalents; riskless, liquid assets that a bank can immediately access
  • long term investments; loans to households and firms and the value of the banks properies
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11
Q

What are Liabilties of a Bank?

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A
  • demand deposits; funds that depositors can access on demand
  • short term borrowing; consists of loans from other financial institutions that are short in duration (some of them overnight only)
  • long term debt; debt that is due to be repaid in one year or more
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12
Q

What do Banks even do? What are their interrelated functions?

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A
  1. identify profitable lending opportunities (attracting a large number of potential borrowers; identifying the most creditworthy of them; channeling savings of depositors towards them)
  2. transform short term liabilities into long term investments (maturity transformation)
  3. manage risk
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13
Q

Functions of Banks | What is Maturity (Transformation)? What are the consequences of Maturity Transformation?

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A
  • maturity: the time until debt must be repaid
  • MT: the process by which banks take short term maturity liabilities (such as deposits) and invest in long term maturity assets (such as long run investment projects)
  • this enables economies to invest, but this mismatch also embodies a risk for banks (when many depositors want their money back at the same time)
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14
Q

How do banks manage risks?

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A
  • diversification: having many different assets (business and customer loans, government debt etc) because unlikely that many assets underperform at the same time
  • also managing risk by transferring it to their stockholders
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15
Q

A Bank is solvent when….

A Bank becomes insolvent when….

A

…. the value of the banks assets is greater than the value of its liabilities

…. the value of the banks assets is less than the value of its liabilities

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16
Q

What is a bank run? What are its consequences?

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A
  • happens if there is a concern or lack of trust that a bank might run out of liquid assets
  • large volume of withdrawal
  • initial panis -> even more depositors withdraw before all liquid assets are gone
  • consequence: bank may be forced to sell its illiquid assets in “fire sales” at lower prices
17
Q

Insitutional Bank Run?

A
  • other banks want their money back
18
Q

Some things that happened during the financial crisis?

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A
  • boom in real estate market (many subprime borrowers getting mortages)
  • burst of bubble (housing prices dropping by 30%, many borrowers unable to pay their mortage rates)
  • insolvency of banks and other financial intermediaries holding many of the mortage loans (also due to high leverage ratios)
  • falling confidence in financial instituttions (result: bank runs, fire sales of assets, withdrawal restricitons)
  • credit crunch (nobody trusts anybody and banks cannot perform takss properly)
  • recession (result from CC)
  • europe: sovereign debt crisis
19
Q

What happens when a bank fais?

A
  • government bank regulator steps in and looks for solution, e.g.
  • shut down bank
  • transfer bank to new partial ownership
20
Q

What is the problem with saving banks?

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2.

A
  • costly
  • incentive probloem: if banks does well the shareholder benefits, if not the tax payers pays
21
Q

Why might banks be too big to fail?

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A
  • large banks have more liabilities
  • systemic risk : system wide risk generated by the failure of one or several financial institutions
  • SIFIs: systemically important financial institutitions; large enough to pose such a risk
22
Q

What are strategies to regulate SIFIs?

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3.

A
  • submit a living will: explanation how it would sell of its assets in an emergency
  • take in less risk and hold more stockholders equity (capital requirememts)
  • take stress tests showing how they deal with severe crisis
23
Q

An optimizing firm will borrow new capital until….

If the interest rate is lower than that, ….

A

the marginal product of capital is equal to the real interest rate r

more firms have projects with a marginal product of capital larger than r, i.e. more firms demand credit

24
Q

Agents care more about the x interest rate because…

A

real

adjusts for inflation

25
Q

Assume you have signed up for a loan for the next year. Shortly after you read that the central bank has announced that it will target much lower inflation rate than you had planned. You have signed for a fixed rate loan

  1. Is this good or bad news and why?
  2. If you signed up for a variable loan, would it be good or bad?
A
  1. bad since you have to pay back more than expected in real terms
  2. neither good nor bad since your payments are not affected

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