Extra Credit (Fall 2008)

Glossary

Conservatorship—The legal procedure provided by statute for the interim management of financial institutions.

Currency swap lines—A term for temporary reciprocal currency arrangements between central banks, which agree to keep a supply of their countries' currency available to trade to other central banks at the going exchange rate. Currency swap lines, which are typically overnight or short-term lending, are used to keep liquidity available for central banks to lend to private banks to maintain reserve requirements and thus to keep financial markets functioning smoothly.

Federal funds rate—The interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. The rate may vary from depository institution to depository institution and from trade to trade.

Discount rate—The interest rate at which an eligible depository institution may borrow funds, typically for a short period, directly from a Federal Reserve Bank. The law requires that the board of directors of each Reserve Bank establish the discount rate every fourteen days subject to the approval of the Board of Governors.

Discount window—A now figurative expression for the Federal Reserve facility that extends credit directly to eligible depository institutions (those with transaction accounts or nonpersonal time deposits).

Liquidity—The quality that makes an asset easily convertible into cash with relatively little loss of value in the conversion process. Sometimes the term is used more broadly to encompass credit in hand and promises of credit to meet needs for cash. The term is also used to describe the ability of a bank or business to meet its current obligations.

Moral hazard—The prospect that a party (in a contract) that is insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions and therefore has a tendency to act less carefully than it otherwise would, leaving another party in the contract to bear some responsibility for the consequences of those actions. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement. Moral hazard can be somewhat reduced by the placing of responsibilities on both (or all) parties of a contract.

Mortgage-backed security—An asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans. However, not all securities backed by mortgages are considered mortgage-backed securities. Housing bonds, which are backed by the mortgages they fund, aren't classified as mortgage-backed securities.

Reserves—A depository institution's vault cash (up to the level of its required reserves) plus balances in its reserve account (not including funds applied to its required clearing balance). Required reserves are funds that a depository institution is required to maintain as vault cash or on deposit with a Federal Reserve Bank; the required amount varies according to ratios set by the Board of Governors and the volume of reservable liabilities held by the institutions. Excess reserves are the amount of reserves held by an institution in excess of its reserve requirement and required clearing balance.

Systemic risk—In finance, systemic risk describes the likelihood of the collapse of a financial system, such as a general stock market crash or a joint breakdown of the banking system. As such, it is a type of aggregate risk as opposed to idiosyncratic risk, which is specific to individual stocks or banks. Systemic risk should also be carefully distinguished from nonsystemic risk, which describes risks the whole economy faces, such as business cycles or wars.

Sources: Definitions were derived from the following: www.federalreserveeducation.org/fred/; www.frbsf.org/tools/glossary/ (the Federal Reserve Bank of San Francisco); Investopedia.com; Wikipedia.com; www.bankingglossary.net/; "Swap Lines," by Kimberly Amadeo, About.com

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