FINC CH 3 Study Guide Test.

FINC CH 3 Study Guide Test. Discuss how and why banks suffered financial difficulties during the financial crisis. - CORRECT ANSWER The first-half of the 2000s decade was characterized by excessive borrowing by individuals, financial institutions, and governments. Individuals with questionable financial qualifications were encouraged to purchase homes as housing prices continued to decline. However, when the housing price bubble burst in mid-2006, both home values, as well as the mortgage-backed securities created by financial institutions based on the value of those homes, declined sharply in price. In many instances all the equity in homes were wiped out and in some instances the amount of the associated mortgage loans were less than the value of the homes. Banks and other financial institutions that held these mortgages and mortgage-backed securities found that the value of these asset holdings declined so much that many of the banks had inadequate equity capital to meet their liabilities causing these banks be on the verge of financial failure. The Federal Reserve and the U.S. Treasury assisted in the acquisition of weaker financial institutions by financially stronger institutions. For example, Wells Fargo Bank purchased Wachovia Bank and JPMorgan Chase & Company purchased Washington Mutual. Describe the major financial institutions engaged in getting the savings of individuals into business firms that want to make investments to maintain and grow their firms. - CORRECT ANSWER There are four major types of financial institutions categories—depository institutions, contractual savings organizations, securities firms, and finance firms. Specific types of financial institutions from the first three categories are involved in directing the savings of individuals into business firms. Commercial banks collect deposits from individuals and lend these pooled deposits to individuals, businesses, and government units. Insurance companies provide financial protection to individuals and businesses for life, property, liability, and health uncertainties. Policyholders pay premiums to insurance companies that invest these funds until the insured claims must be paid. Pension funds receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees. The purpose of a pension fund is to provide income during an individual's retirement years. Investment companies (mutual funds) sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities. A mutual fund, or open end fund, is the most prevalent form of an investment company. Investment banking firms sell or market new securities issued by businesses to individual and institutional investors. Brokerage firms assist individuals who want to purchase new or existing securities issues or who want to sell previously purchased securities. Compare commercial banking with investment banking. What is universal banking? - CORRECT ANSWER Commercial and investment "banks" are involved in the indirect transfer of money from savers to an investor (e.g., a business firm). The commercial bank accepts the deposits of savers in exchange for the bank's securities (e.g., CDs). The bank then loans money to the business firm in exchange for the firm's promise to repay the loan. In contrast, the investment bank markets the business firm's securities to savers either by first purchasing the securities from the firm and then reselling the securities or by just marketing the securities directly to savers. Commercial banking involves depository institutions that accept deposits, issue check-writing accounts, and make loans to businesses and individuals. Investment banking involves selling or marketing new securities issued by businesses to individual and institutional investors. Universal banking involves banks that engage in both commercial banking and investment banking activities. Describe the functions of banks and the banking system. - CORRECT ANSWER Banks and the banking system perform five functions: (1) accepting deposits, (2) granting loans, (3) issuing checkable deposit accounts, (4) clearing checks, (5) creating deposit money, and (6) raising financial capital for businesses (i.e., investment banking). In accepting deposits, banks provide a safe place for the public to keep money for future use. The banking system puts the accumulated deposits to use through loans to persons and individuals having immediate use for them. This is the financial intermediation activity of depository institutions in the savings-investment process. Describe the three basic ways for processing or collecting a check in the United States. - CORRECT ANSWER Assume that you write a check on your account at the First Bank and mail the check to the ABC firm to pay for the purchase of a product. The ABC firm, in turn, deposits your check in its account at the Last Bank. How does the ABC firm collect its money from you? There are three basic ways for processing or clearing a check. First, the Last Bank can present your check directly to the First Bank for collection. The First Bank "pays" the check and deducts the amount of the check from your checking account. Second, the Last Bank can "clear" your check by presenting it through a Bank Clearinghouse. Third, the Last Bank could process your check through its Federal Reserve Bank.