ECONOMICS 0281

MONEY AND BANKING VOCABULARY-PART 2

38. PRINCIPAL-AGENT PROBLEM: A moral hazard problem that occurs when the managers in control, the agents, act in their own interest rather than in the interest of the owners, the principals, due to the different sets of incentives facing each party. Because of specialization an information asymmetry arises between the two parties so that the agent will oftentimes act in ways that benefit the agent but inflict costs on the principal.

39. ADVERSE SELECTION PROBLEM: The problem created by asymmetric information before a transaction occurs. The people who are most undesirable from the other party’s point of view are the ones who are most likely to engage in the financial transaction.

40. FREE-RIDER PROBLEM: The problem that occurs when people who do not pay for information take advantage of the information that other people have paid for.

41. COSTLY STATE VERIFICATION: Monitoring a firm’s activities is an expensive process in both time and money.

42. MORAL HAZARD: The risk that one party to a transaction will engage in behavior that is undesirable from the other party’s point of view. Such behavior normally occurs after a contractual agreement is reached.

43. VENTURE CAPITAL FIRM: A financial intermediary that pools the resources of its partners and uses the funds to help entrepreneurs start up new businesses.

44. RESTRICTIVE COVENANTS: Provisions that restrict and specify certain activities that a borrower can engage in.

45. INCENTIVE COMPATIBLE: Aligning the incentives of both parties to a contract (so that each party is reaping the full benefits of their actions while bearing the full costs of their actions).

46. CAUSE OF FINANCIAL CRISES: Financial crises are major disruptions of financial markets that are characterized by sharp declines in asset prices and the failure of many financial and non-financial firms. The causes of such disruptions are fourfold: (1) Increases in interest rates, (2) Increases in uncertainty, (3) Asset market effects on balance sheets, and (4) Bank panics.

47. DEBT DEFLATION: A situation in which a substantial decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness.

48. BANK PANIC: The simultaneous failure of many banks, as during a financial crisis.

49. LIQUIDITY MANAGEMENT: The decisions made by a bank to maintain sufficiently liquid assets to meet its obligations to depositors who wish to withdraw funds. Additionally, banks must ensure that it keeps enough liquid assets to avoid violating the legal reserve requirements set by the Fed.

50. CAPITAL ADEQUACY MANAGEMENT: A bank’s decision about the amount of capital it should maintain and then the acquisition of the needed capital. The acquisition and maintenance of the necessary amount of capital which is consistent with the goals of preventing failure of the bank and provide normal rates of return for equity holders.

51. LOAN COMMITMENTS: A bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. Such commitments which are a way of creating and fostering long-term relationships reduce the costs of monitoring loans, and also aid the bank in gathering information that can be used again, thereby lowering the cost of gathering information.

52. COMPENSATING BALANCES: A required minimum amount of funds that a firm receiving a loan must keep in a checking account at the lending bank. (Firms receiving loans must keep a minimum amount of funds in a checking account at a bank as a sort of collateral.)

53. GAP ANALYSIS: A method used to measure the sensitivity of bank profits to changes in interest rates, calculated by subtracting the amount of rate sensitive liabilities from the rate sensitive assets.

54. DURATION ANALYSIS: A measurement of the sensitivity of the market value of a bank’s assets and liabilities to changes in interest rates. This method uses the weighted average duration of a financial institution’s assets and liabilities to see how its net worth responds to a change in interest rates.

55. ARMs: Mortgages in which the interest rate changes when some market interest rate changes such as a T-Bill. As opposed to a fixed rate mortgage whose interest rate is fixed for the life of the mortgage.

56. OFF-BALANCE SHEET ACTIVITIES: These activities which involve the trading of financial instruments and generating income from fees and loan sales, activities that affect the bank’s profits and risks but do not appear on the bank’s balance sheet.

57. DISINTERMEDIATION: A reduction in the flow of funds into the banking system that causes the amount of financial intermediation to decline. For example, depositors will withdraw funds from banks which are constrained by deposit ceilings when interest rates rise above the ceiling rate and put them into higher yielding securities.

58. DEPOSIT RATE CEILING: Maximum limits on interest paid on time deposits. Market competition would normally produce much higher interest rates.

59. SECURITIZATION: The process of transforming otherwise illiquid financial assets into marketable capital market securities.

60. TOO BIG TO FAIL DOCTRINE: Because the failure of a very large bank makes it more likely that a major financial disruption will occur, bank regulators are reluctant to allow a big bank to fail and cause losses to its depositors. This means that the FDIC was insuring deposits beyond the $100,000 limit, providing depositors at such banks with 100% deposit insurance.

61. REGULATORY FORBEARANCE: When a large proportion of S&Ls became insolvent in the early 1980s, S&L regulators did not close them down but instead allowed them to continue in business with the help of irregular regulatory accounting principles. Such principles made many S&Ls appear more solvent than they really were.

*62. PROMPT CORRECTIVE ACTION: FDICIA, 1991 requires FDIC to intervene earlier and more vigorously when a bank gets into trouble. Specifically, the act divides banks into 5 groups: (1) well capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, (5) critically undercapitalized (capital less than 2%). Starting with the third group, the FDIC is required to intervene and restrict the ability of banks to expand their assets, pay dividends, etc. and when banks fall into the 5th group they must be shut down. Prompt corrective action should avoid the problem of regulatory forbearance and reduces the potential losses of the FDIC and the taxpayers.

63. RISK-BASED INSURANCE PREMIUMS: Those banks with lower capital or more risky assets (measure of risk?) will be charged a higher deposit insurance premium. This pricing structure is designed to counter the moral hazard problems that arise when banks have incentives to take on more risk.