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FNCE220
N/A
70
Finance
Undergraduate 4
10/24/2010

Additional Finance Flashcards

 


 

Cards

Term
source principle
Definition
taxes assessed where they're incurred
Term
residency principle
Definition
taxes only assessed where someone has residency
Term
ways to alleviate double taxation
Definition
-treaties
-exemption of foreign source income
-foreign tax credits or deductions
Term
Tax Policy Philosophies
Definition
Cosmopolitan View
-Capital Export Neutrality: taxes shouldn't distort US companies seeking to invest abroad
-Capital Import Neutrality: treat foreign companies the same in the US that you'd like US firms to be treated abroad
Nationalistic View
-US should be just as well off as if firms invested domestically
Term
taxes eligible for credit
Definition
-revenue or sales tax deducted as a business expense
-income tax credited
-withholding taxes are income taxes
Term
deferred tax asset
Definition
-when losses occur in one year and can be carried-forward to another

-It may be recorded only if the management considers there will be sufficient future taxable profits to use the tax loss within the permissible carry‐forward period
Term
the role of capital
Definition
-to fund the bank
-to provide a buffer against loss
-to reassure creditors and clients
-to satisfy the regulators
Term
why do regulators require capital?
Definition
-To safeguard deposit insurance funds (and, implicitly) taxpayers
– To provide time to detect and remediate a faltering bank
– To control risk‐taking
– To constrain asset growth
Term
What factors determine the optimal capital structure?
Definition
-Tax Deductibility of Interest
-Costs of Financial Distress
-Explicit and Implicit Guarantees &
Regulatory Costs
Term
cost of equity capital
Definition
inverse of P/E ratio
Term
Why do deposits appear on the liability side?

Why do loans appear on the asset side?
Definition
Deposits: Accounts payable

Loans: Accounts receivable
Term
What is a bubble?
Definition
a sustained departure from long‐run
equilibrium (fundamental) prices
Term
housing price performance 1975-2005
Definition
real increase is ~1%, below the T-Bill. Should have just invested in the S&P 500
Term
Property markets are prone to booms because...?
Definition
-Imperfect information: no central exchange where current prices are instantly recorded
-Illiquidity: assets are heterogeneous,
transactions costs are high, trading is
infrequent
-No short selling: no organized futures or options markets
-Inelastic supply in the short‐ to medium‐ term
-Nominal prices tend to ratchet up
Term
fundamental determinants of property prices
Definition
DEMAND...
-growth in income (and dist of income)
-cost and availability of credit
-demographics (population growth, immigration, household formation trends)
-THE EXPECTATION OF HIGHER PRICES

SUPPLY...
-amount and quality of buildable land
-planning restrictions and zoning laws
-construction costs
-cost and availability of credit
Term
Carey Model of Land Prices
Definition
-number of investors (N) UP, P UP
-fundamental price (P*) UP, P UP
-heterogeneity of beliefs (h) UP, P UP
-supply of real estate (Z) UP, P UP
-supply of resources to investors (L) UP, P UP
Term
Affordability Measures
Definition
The relationship between housing
costs & some ability to pay criteria

price-to-rent and price-to-income ratios
Term
Asset Market Measures
Definition
-interest costs
-property taxes
-depreciation or maintenance costs
-opportunity cost of investment foregone
-offset by anticipated capital gains on home
Term
Take-away of determining overvaluation
Definition
No one can be sure
whether the boom simply reflects
favourable fundamentals, or a worrisome
degree of overvaluation
Term
Desired loan concentration increases when...
Definition
1.expected value of assets increases
2.capital requirement decreases
3.promised returns increase
4.EXPECTED PROBABILITY OF DEFAULT increases
5.PERCEIVED CORRELATION WITH REST OF PORTFOLIO DECREASES
Term
Disaster myopia
Definition
Disaster myopia:
-availability heuristic (people forget things that happened before the recent past)
-threshold heuristic (busy decision-makers try and allocate their scarcest resource, time)
-cognitive dissonance (people protect themselves by being less open to information critical to past decisions (securitization accelerated as the economy slumped)

Institutionally enabling factors...
-recognition of fees upfront as revenue
-bonuses tied to current revenues
-high job mobility among risk-takers
-intense competition drives out banks that are not myopic (banks cannot survive in the economic environment)
Term
perverse incentives
Definition
-High leverage and risk shifting
-Explicit deposit insurance
-Implicit deposit insurance
–State‐owned banks
–Lender of last resort operations
–Purchase and assumption transactions
-Principal/Agent conflicts between
supervisors and taxpayers
Term
Poor Information and Weak Analysis
Definition
-Inadequate data re: real estate market
conditions
-Inadequate appraisal techniques
-Inadequate measures of exposure
-Lack of transparency
-Imprudent reliance on real estate collateral
-Natural tendency to herd when uncertain
Term
How to combat disaster myopia?
Definition
-measure risk exposure and confront board and management
-encourage diversification
-discourage institutional factors that facilitate disaster myopia
Term
How to diminish perverse incentives?
Definition
-raise capital requirements
-apply minimum loan/value ratios
-institute prompt corrective action/lease cost resolution reforms
Term
Financial Restructuring
Definition
-focuses on balance sheet
-reduce debt relative to equity (enhance solvency)
-often includes a change in ownership/control
Term
Operational Restructuring
Definition
-focuses on the income statement
-adjusting the business model to achieve greater profitability
Term
regulatory intervention of a bad bank
Definition
1.assisted merger with healthy bank
2.continuance under temporary regulatory control
3.restructuring
4.liquidation
Term
Mellon Bank
Definition
-no official aid or intervention
-expanded into international lending, retail expansion, acquired Girard Bank
-failed to control expenses
-new management, flattened structure, reorganized credit, raised capital
Term
Advantages of splitting into good/bad bank structure
Definition
Increased transparency:
– May reduce cost of funding Good Bank
– May reduce cost of funding Bad Bank by tailoring securities to specific preferences

Sharpen strategic focus, increase returns:
– Managers of Good Bank not encumbered by legacy of past blunders, more accountable
– Managers of Bad Bank can focus on maximizing liquidation value of NPLs
Term
Pitfalls in restructuring
Definition
Delays in exit of insolvent institutions may undermine prospects for Good Bank:
– Excess capacity cause weak profitability
If financial restructuring is not accompanied by an effective operational restructuring:
– It may be impossible to get financing
– In any event, it is pointless – merely delaying insolvency, not averting it
Term
Safety Net
Definition
Chartering Authority
Prudential Supervision
Termination Authority
Deposit Insurance
Lender of Last Resort
Monetary Authority
Term
Chartering Authority
Definition
Attempts to bar imprudent,
incompetent & dishonest banks:
–Fit & proper tests
–Tests for continuance
-High barriers -> safe, but inefficient
-Low barriers -> competitive, but
riskier
Term
Prudential Supervision
Definition
Attempts to prevent excessive insolvency
exposure
-Two sources of insolvency exposure:
–1. Leverage: capital adequacy
–2. Risk of portfolio: credit risk, market risk, and liquidity risk
-The CAMELS approach in the US
Term
CAMELS
Definition
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
Term
Capital Adequacy
Definition
-Level and quality of capital relative
to risk profile
-Ability to raise new capital
-Trend in asset quality
-Quality and strength of earnings
-Prospects for growth
Term
Asset Quality
Definition
-Focus on credit risk
-Adequacy of underwriting standards
and credit risk management process
-Loan classifications and adequacy of
reserves
-Diversification
-Adequacy of internal controls and
management information systems
Term
Management
Definition
-Quality and extent of oversight by board of directors and management
-Accuracy, timeliness and effectiveness of management information systems
-Adequacy of audits and internal controls
-Management depth and succession plans
-“Reasonableness” of compensation policies
-Overall performance
Term
Earnings
Definition
-Level, trend and stability of
earnings
-Ability to generate retained
earnings
-Level of expenses relative to
operations
Term
Liquidity
Definition
-Ability to meet liquidity needs without
adversely affecting earnings or net worth
-Holdings of liquid assets
-Access to money markets
-Diversification of funding sources
-Ability to securitize assets
-Trend and stability of deposits
-Ability to measure, monitor & control
liquidity position
Term
Sensitivity to Market Risk
Definition
-Sensitivity of earnings or economic value to adverse changes in market prices
-Ability to measure, monitor and control exposure to market risk
-Nature and complexity of exposure in
trading and non‐trading positions
Term
Termination Authority
Definition
-Attempts to close failing banks
before they cause loss to depositors
-Accounting and disclosure issues
-Political / legal issues
-Forbearance
Term
Deposit Insurance
Definition
-Implicit deposit insurance
–Purchase & assumption transactions
-Attempts to prevent the contagious
transmission of bank runs
-Explicit deposit insurance
–Extent of coverage? Deductible or coinsurance?
–Which depositors should be covered?
-Importance of credibility
Term
Lender of Last Resort
Definition
-Attempts to prevent illiquidity‐induced failures
-Classic view: Lend freely to solvent
institutions at a penalty rate
-Collateral as a substitute for solvency determination
-Danger of perverse signals
Term
Monetary Authority
Definition
-Attempts to prevent bank runs from
reducing the reserve base
-Tension between banking stability
objectives and inflation objectives
-The disastrous example of the Fed
during the 1930s
Term
Moral Hazard
Definition
**The safety net may work too well
– Bank creditors have no incentive to monitor and price bank risk taking
–Banks find that they can increase returns to shareholders by taking larger risks
-Banking system becomes more vulnerable to crisis
-Increased pressure on supervisory function
Term
How do you identify the good assets to put into a new 'good' bank?
Definition
Good assets have a verifiable price, even if its below par.
Term
How should the “bad bank” be financed? Under what circumstances will it not be possible to move
any of the old bank’s uninsured liabilities to the good bank?
Definition
All remaining claims on old bank transferred to the bad bank. If good assets fall short of the insured deposits, all of the uninsured creditors go to the bad bank.
Term
Government subsidizes a good bank...
Definition
if the market hasn't yet warmed to it, but it will as it becomes transparent.
Term
Easier and cheaper to recapitalize good bank?
Definition
transparent...the old bank was paying a substantial opacity premium
Term
How to make sure creditors are just as well off as in bankruptcy?
Definition
give them absolute repayment priority for the liquidation of the bad bank.
Term
How does FDIC protect itself while acting as the lender of last resort?
Definition
it acts as a collateralized lender
Term
How does central bank lending through the discount window give de facto deposit insurance to uninsured depositors?
Definition
Because it means they can support uninsured depositors while increasing the burden to unsecured creditors and the deposit agency.
Term
Why did Continental experience a run in 1982? How did it manage to survive without
recourse to official assistance?
Definition
Penn Square National Bank failed in 1982, from which it had purchased 1.1 billion in loans that if defaulted like they did at Penn Square would have eaten-up its equity. It borrowed from the Eurodollar market
Term
After the run in 1982, what did Continental do to reduce its vulnerability to a funding
shock? What else could it have done?
Definition
It sold its credit card subsidiary, but it should have completed an operational and financial restructuring instead of selling the 'family jewels'
Term
Why was the 1984 run so devastating?
Definition
Because it was a run on the Euromarket, where it had secured its funding. It had to go to the Fed finally.
Term
Why did the Fed save Continental?
Definition
Because it feared the risk of contagion as foreign sourced fled from banks with similar balance sheets and was worried that the other banks that it had been loaned to by would go under as well.

It could have allowed Continental to have gone under while guaranteeing deposits elsewhere for a period of 2 years.
Term
Why did Continental's competitors help it out?
Definition
Because they wanted to reduce the worries of the market which had caused the spread between CDs and T-bills to increase by more than 100 points.
Term
Why was Bank of America OK even as people worried that it wasn't solvent?
Definition
Because it had a large retail banking deposit base that was completely insured by the FDIC...no one was worried about default or closure of the bank. Continental did not have insured deposits.
Term
Evaluate: Can a bank increase ROE?
Definition
Look at:
-leverage
-credit risk
-liquidity risk
Term
Evaluate: profit margin
Definition
profit/revenues...
Term
Evaluate: asset utilization rate
Definition
gross revenues/assets
Term
Evaluate: How do you boost non-interest income?
Definition
increase:
-trading income
-fees
Term
Evaluate: Which bank has the higher credit risk?
Definition
Look at gross interest income
Term
increase of heterogeneity of beliefs causes an increase in RE prices because...
Definition
the # of optimists increases who will bid and drive-up prices
Term
User Cost Approach
Definition
P/R = 1/u
Term
Equation for pre/post-tax cost of equity capital
Definition
Pre-tax cost of equity capital * (1-tax rate) = after cost
Term
Why have 100% equity banks?
Definition
There's no incentive to be at the front of the line for bank runs (everyone shares losses equally)
Term
Loan Adjusted Yield...
Definition
= gross int. income - gross loan provision
Term
Diseconomies of scope
Definition
when the costs of managing conflicts of interest overwhelm synergies
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