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Chapter 9-15

ECON 3030 Chapter 9-15: ECON 3030 Post-Midterm 2 Study Guide

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University of Virginia
ECON 3030
Zachary Bethune

ECON 3030 FINAL STUDY GUIDE (CHP 9-15): Chapter 9: • Balance Sheet: List of a bank’s assets and liabilities o Total assets = total liabilities + capital (owner’s equity) o Also a list of a bank’s sources of bank funds (liabilities and capital) and uses to which the funds are put to use (assets) o Banks obtain funds by borrowing and by issuing other liabilities, such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by earning interest on their asset holdings of securities and loans that is higher than the interest and other expenses on their liabilities • Liabilities: o A bank acquires funds by issuing (selling) liabilities, which are the sources of funds the bank uses o 1) Checkable deposits: Bank accounts that allow the owner of the account to write checks to third parties. They include all accounts on which checks can be drawn. ▪ The share of checkable deposits in total bank liabilities has fallen over time ▪ Payable on demand ▪ If a person who receives a check written on an account from a bank presents that check the bank, the bank must pay the funds out immediately ▪ An asset for the depositor because it is part of his or her wealth ▪ They are a liability for the bank because the depositor can withdraw funds and the bank is obligated to pay ▪ The lowest-cost source of bank funds, because depositors are willing to forgo some interest in exchange for access to a liquid asset that they can use to make purchases immediately ▪ Bank’s cost of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts o 2) Nontransaction Liabilities: the primary source of bank funds (58%) ▪ Owners cannot write checks on them, but the interest rate paid on these deposits is generally higher than those on checkable deposits ▪ Two basic types: • 1) Savings accounts: Funds can be added to or withdrawn at any time, and transactions and interest payments are recorded in a monthly statement or in a passbook held by the owner • 2) Time deposits (certificates of deposit – CD): have a fixed maturity length, ranging from several months to over five years, and asses substantial penalties (the forfeiture of several months’ interest payments) for early withdrawal of funds o Small denomination time deposits (<100k) are less liquid for the depositor than passbook savings, earn higher interest, and are a more costly source of funds for the banks o Large-denomination time deposits (CDs) (100k +) are typically bought by corporations or other large banks ▪ Negotiable; they can be resold in a secondary market before they mature • For this reason, they are held by corporations, money market mutual funds, and other financial institutions as alternative assets to Treasury bills and other short-term bonds ▪ 3) Borrowings: Banks can obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. • Borrowings from the Fed are called discount loans (advances) • Banks also borrow reserves overnight in the federal funds market from other US banks and financial institutions o Borrow overnight in order to have enough deposits at the Federal Reserve to meet the amount required by the Fed • Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations, and borrowings of Eurodollars • 20% of banks’ liabilities ▪ 4) Bank Capital: the bank’s net worth • Raised by selling a new equity (stock) or from retained earnings • A bank’s cushion against a drop in the value of its assets • Assets: Referred to as a bank’s use of funds, and the interest payments earning on them are what enable banks to make profits o 1) Reserves: Funds banks acquire as deposits plus currency that is physically held by banks (called vault cash, because it is stored in bank vaults overnight) ▪ Earn low interest rate ▪ Held for two reasons • 1) Required reserves: reserves held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves o This fraction is called the required reserve ration • 2) Banks also hold excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account o 2) Cash items in the process of collection: When you deposit a check from an account at another bank in your bank but the funds have not yet been received ▪ This is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days o 3) Deposits at other banks ▪ Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is one aspect of a system called correspondent banking. o 4) Securities: made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock ▪ Can be classified into 3 categories • 1) U.S. government and agency securities: most liquid because they can be easily traded and converted into cash with low transaction costs o Because of their high liquidity, short-term US government securities are called secondary reserves • 2) State and local government securities: held because state and local governments are more likely to do business with banks that hold their securities o Less marketable (less liquid) and riskier than US government securities, primarily because of default risk • 3) Other securities o 5) Loans: banks make their profits primarily by issuing loans ▪ A liability for the individual or corporation receiving it, but an asset for a bank because it provides income to the bank ▪ Typically less liquid than other assets because they cannot be turned into cash until the loan matures ▪ Higher probability of default than other assets • Because of such and their lack of liquidity, the bank earns its highest returns on loans ▪ Largest categories of loans for commercial banks are commercial and industrial loans made to businesses and real estate loans. Comm. banks also make consumer loans and lend to each other. The bulk of these interbank loans are overnight loans in the federal funds market. ▪ Major difference in the balance sheets of various depository institutions is primarily the type of loan in which they specialize o 6) Other Assets: the physical capital owned by banks • Basic Banking o In general, banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics ▪ This is called asset transformation • Another way to describe this process is by saying the banks “borrows short and lends long” because it makes long-term loans and funds them by issuing short-term deposits ▪ If the bank produces desirable services at low costs and earns substantial income on its assets, it earns profits; if not, it suffers losses • T-Account: a basic balance sheet with assets on the left and liabilities on the right o When some opens a checking account, the bank’s t-account indicates an increase in its reserves (assets) equal to the increase in checkable deposits (liabilities) o If someone writes a check from one bank and deposits it at another, the receiving bank can deposit its check in its account at the Fed, and the Fed collects the funds from the bank on which the check was written. The net result is that the Fed transfers reserves from the “writing bank” to the receiving bank ▪ Results in increase in reserves, checkable deposits in receiving bank and decrease in such for the writing bank o When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves o Reserves are broken up into required reserves and excess reserves o Reserves earn little interest and are costly to maintain, so they may result in a loss. Situation may be worse if the bank makes interest payments on the deposits (as with NOW accounts) o To make a profit, a bank must put to productive use all or part of its excess reserves it has available ▪ Can do so by investing in securities, making loans • Asymmetric info problems with loans o Banks take steps to reduce the incidence and severity of these problems by evaluating potential borrowings using what are called the “five C’s” – character, capacity (ability to repay), collateral, conditions (in local and national economies), and capital (net worth) ▪ Excess reserves become “loans,” securities on asset side • General Principles of Bank Management: o Bank manager has four primary concerns: ▪ 1) Make sure the bank has enough ready cash to pay its depositors when there are deposit outflows – when depositors make withdrawals and demand payment • To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of assets that are liquid enough to meet the bank’s obligations to its depositors ▪ 2) Must pursue an acceptably low level of risk by acquiring assets that have low rate of default and by diversifying holdings (asset management) ▪ 3) Acquiring funds at low costs (liability management) ▪ 4) Must decide the amount of capital the banks should maintain and then acquire the needed capital (capital adequacy management) o Credit Risk: the risk arising because borrowers may default o Interest-rate risk: the riskiness of earnings and returns on banks assets caused by interest-rate changes o Liquidity management: ▪ When there is deposit outflow, the bank loses an equal amount of deposits and reserves • Required reserves become x% of whatever deposits are left o Difference between this percent and the amount left is excess reserves remaining after the outflow • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet ▪ If a bank does not have ample excess reserves, it must eliminate the short fall via four basic options: • 1) Acquire the reserves by borrowing them from other banks in the federal funds market, or by borrowing from corporations o The cost of this activity is the interest rate on these borrowings, such as the federal funds rate • 2) Bank can sell some its securities to help cover the deposit outflow o Bank incurs some brokerage costs and other transaction costs when it sells these securities ▪ Low for government securities • 3) Can acquire reserves by borrowing from the Fed o Cost is the interest rate paid to the Fed, which is called the discount rate • 4) Bank can acquire the funds by reducing its loans by the specific amount it needs for its required reserves and depositing the money it then receives with the Fed o Costliest way of acquiring reserves when a deposit outflow exists ▪ If loans are short-term at fairly short intervals, the bank can reduce its total amount of loans outstanding fairly quickly by calling in loans – by not renewing them when they come due • Likely to antagonize some customers when they have done nothing wrong, will take their business elsewhere ▪ Can also reduce loans by selling them off to other banks • Costly because other banks don’t know how risky these loans are so they may not be willing to buy the loans at their full value • All of this explains why banks hold excess reserves ▪ Excess reserves enable a bank to escape the costs of 1) borrowing from other banks or corporations, 2) selling securities, 3) borrowing from the Fed, or 4) calling in/selling off loans • They are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves a bank will want to hold. • They do have a cost, though, so banks may take steps to protect themselves like shifting their holdings of assets to more liquid securities (secondary reserves) o Asset management: ▪ To maximize its profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets. They accomplish this in 4 ways: • 1) Banks try to find borrowers who will pay high interst rates and are unlikely to default on their loans. They seek out loan business by advertising their borrowing rates and by approaching corporations directly to solicit loans. o Typically, banks are conservative in their loan policies. Important though that they aren’t too conservative so as to miss out on good opportunities • 2) Banks try to purchase securities with high returns and low risk • 3) Banks must attempt to lower risk by diversifying. o Can do so by purchasing many different types of assets and approving many types of loans to a variety of customers. • 4) Bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets. o Once again, can’t be too conservative because reserves earn low interest, liabilities are costly to maintain, and the bank can suffer losses o Liability management: ▪ Starting in 1960, large banks (money center banks) began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity • Led to expansion of overnight loan markets (fed funds) and the development of new financial instruments (negotiable CDs), which enabled banks to acquire funds quickly ▪ Asset-liability management (ALM) committee: managing both sides of the balance sheet o Capital Adequacy Management: Banks have reasons to make decisions about the amount of capital they need to hold for three reasons ▪ 1) Bank capital helps prevent bank failure (bank can’t satisfy obligations to depositors and other creditors and so goes out of business) • When an asset’s value declines by a certain amount, bank capital also declines by that same amount o Capital provides cushion against loss so that the value of its assets doesn’t fall below that of its liabilities and give it a negative net worth (making it insolvent) • A bank maintains bank capital to lessen the chance that it will become insolvent ▪ 2) The amount of capital held affects returns for the owners (equity holders) of the bank • Measure of bank profitability = return on assets (ROA) o ROA = net profit after taxes/assets o ROA offers info on how efficiently a bank is being run because it indicates how much profit is generated, on average, by each dollar of assets • Return on Equity (ROE) = how much the bank is earning on their equity investment = net profit after taxes/equity capital • Equity multiplier: the amount of assets per fdollar of equity capital = EM = asses/equity capital • ROE = ROA x EM o Tells us what happens to the return on equity when a bank holds a smaller amount of capital for a given amount of assets • Given the return on assets, the lower the bank capital, the higher the return for the owners of the banks ▪ Bank capital has both benefits and costs • Benefits owners in that it makes their investment safer by reducing the likelihood of bankruptcy • Costly to the owners because the higher it is, the lower will be the return on equity for a given return on assets • In determining the optimal amount of bank capital, the bank must compare the benefit of maintaining higher capital (higher safety) with the cost of higher capital (lower return on equity for owners) • Want to hold more during times of uncertainty (higher possibility of losses on loans), hold less when they have confidence that loan losses won’t occur ▪ 3) A minimum amount of bank capital is required by regulatory authorities • Because of the higher costs of holding capital, bank managers often want to hold less relative to assets than is required by regulatory authorities ▪ To lower the amount of capital relative to assets and raise the equity multiplier, you can do any one of three things • 1) Reduce the amount of bank capital by buying back some of the bank’s stock • 2) Reduce the bank’s capital by paying out higher dividends to its stockholders, thereby reducing the bank’s retained earnings • 3) Keep bank capital constant but increase the bank’s assets by acquiring new funds and tehn seeking out loan business or purchasing more securities with these newly acquired funds ▪ To raise the amount of capital relative to assets, you can: • 1) Raise capital for the bank by having it issue equity (common stock) • 2) Raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account • 3) Keep capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce the bank’s liabilities ▪ A shortfall of bank capital is likely to lead a bank to reduce its assets and therefore is likely to cause a contraction in lending o Managing Credit Risk ▪ Adverse selection in loan markets occurs because bad credit risks are the ones who usually line up for loans because they have much to gain if there loans prove successful and little to lose if they can’t pay back the loan ▪ Moral hazard exists in loan markets because borrowers have incentives to engage in activities that are undesirable from the lender’s point of view • Lender subject to hazard of default ▪ To be profitable, banks must overcome these problems, and do so by screening and monitoring: • 1) Screening: Adverse selection in loan markets requires that lenders screen out the bad credit risks from the good ones, so that loans are profitable to them. Lenders must collect reliable info on the borrowers. o Lender uses information to evaluate your credit risk by calculating your credit score. Lender’s also use judgement. o Similar process when lenders are making business loans. • 2) Specialization in lending: Banks often specialize in lending to local firms or to firms in particular industries o Surprising in the sense that it means banks aren’t diversifying their portfolios, but makes sense because its easier for banks to collect information about local firms and determine their creditworthiness than to collect info on firms that are farther away. Banks also become more knowledgeable about local firms  reduces adverse selection problem • 3) Monitoring and Enforcement: Once a loan has been made, moral hazard issue comes up as borrower has incentive to engage in risky behavior. To reduce this problem, financial institutions must write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. They then monitor the borrower to make sure they follow these covenants, and can therein make that the borrower is not engaging in risky behavior. ▪ Also limit these problems by building long-term customer relationships: • Allow the bank to obtain additional information about borrowers • Banks can look at past activity to learn about the borrower • Reduce costs of information collection and make it easier to screen out bad credit risks • Costs of monitoring long-term customers are lower than those of monitoring new customers • Benefit customers as well o They will find it easier to obtain a loan at a low interest rate from a bank they have worked with in the past • Borrowers have incentive to preserve long-term relationships and avoid risky activities. If a bank doesn’t like what a borrower is doing, they can threaten to cut off new loans in the future and therefore manage unanticipated moral hazard problems ▪ Also limit through loan commitments: • Loan commitments are a bank’s commitment to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. This fosters long-term relationships. o Advantageous for firms in that it gives them a source of credit when they need it o Advantageous for banks in that they promote long-term relationship, which in turn facilitates information collection o Require that firms continuously supply information about their activity, income, etc. o Reduce costs of screening and information collecting ▪ Limit through collateral and compensating balances: • Collateral lessens the consequences of adverse selection because it reduces the lender’s potential losses, and it lessens the consequences of moral hazard because the borrower has more to lose from default o Lenders can sell collateral if borrower defaults to cover loss • Once particular form is called compensating balances: a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank o Increase likelihood a loan will be paid off by helping bank monitor the borrower and reduce moral hazard ▪ Limit through credit rationing: • Credit Rationing: refusing to make loans even though borrowers are willing to pay the stated interest rate, or even a higher rate • Takes two forms: o 1) Occurs when a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate ▪ Adverse selection prevents lending at higher interest rate because those with risky investment plans are exactly those that are willing to pay the high rates ▪ Charging high rates just makes adverse selection worse for the lender; increases likelihood bank will run into a bad credit risk o 2) Occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like ▪ Financial institutions do this to reduce moral hazard. ▪ Do it because the larger the loan, the larger the benefits of moral hazard/incentive to engage in activities that make it less likely you will repay the loan o Managing Interest-Rate Risk: ▪ Some assets are rate-sensitive, meaning their interest rates change frequently (at least once a year). Examples are variable-rate and short- term loans and short-term securities. Examples of rate-sensitive liabilities are variable-rate CDs and money market deposit accounts. ▪ Fixed-rate assets are those whose interest rates remain unchanged for a long period (more than a year). Examples include reserves, long-term loans, long-term securities. Examples of fixed-rate liabilities include checkable deposits, savings deposits, long-term CDs, and equity cap. ▪ If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits, and a decline in interest rates will raise bank profits. ▪ Gap Analysis: • The amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets. By multiplying the gap by the change in the interest rate, one can immediately obtain the effect on bank profits. o = basic gap analysis o However, not all assets and liabilities in the fixed-rate category have the same maturity • The maturity-bucket approach is used to measure the gap for several maturity subintervals, called maturity buckets • Standardized gap analysis accounts for differing degrees of rate sensitivity ▪ Duration analysis: examines the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates. Based on Macaulay’s concept of duration, which measures the average lifetime of a security’s stream of payments • % change in market value of a security ~= - %point change in interest rate x duration in years • Involves using the average duration of assets, liabilities to see how its net worth responds to changes in interest rates o Off-Balance Sheet Activities: ▪ = trading financial instruments and generating income from fees and loan sales, activities that affect bank profits but do not appear on bank balance sheets ▪ 1) Loan Sales: also called secondary loan participation, involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan so that it is no longer on asset on the balance sheet • Banks earn profits by selling loans for amounts that are greater than the amounts of the original loans • Because the high interest rates on these loans make them attractive, institutions are willing to buy them even though the higher price means they earn a lower interest rate than the original rate ▪ 2) Generation of Fee Income: • Generating income from fees that banks receive from providing specialized services to their customers • Off-balance sheet activities incolving guarantees of securities and backup credit lines increase the risk a bank faces. Even though a guaranteed security doesn’t appear on a bank’s balance sheet, it still exposes the bank to default risk ▪ 3) Trading Activities and Risk Management Techniques: • Banks attempt to manage risk by trading in financial futures, options for debt instruments, and interest-rate swaps. Banks engaged in international banking also conduct transactions in the foreign exchange market. All transactions in these markets are off- balance sheet activities because they do not have a direct effect on the bank’s balance sheet. • Trading activities are both highly profitable and highly risky because they ake it easy for financial institutions and their employees to make huge bets quickly. Principal-agent problem is particularly severe problem for management of trading activities. Trader (agent) can place large bets and has incentive to take on excessive risk. Traders can drive healthy firms to insolvency very quickly. o To reduce this problem, managers must set up internal controls to prevent such. ▪ Such include the complete separation of the people in charge of trading activities from those in charge of the bookkeeping for trades. ▪ Managers must also set limits on the total amount of traders’ transactions and on the institution’s risk exposure. ▪ Must also scrutinize risk assessment procedures using recent technology • One such method involves the value-at-risk approach o Involves developing a stat. model that calculates the max loss that a portfolio is likely to sustain over a given time interval • Another method is called stress testing o Manger uses computer to project what would happen if doomsday scenario occurred Chapter 10: • Financial intermediaries are well-suited to solve adverse selection and moral hazard problems because they make private loans that help avoid the free-rider problem. However, this solution to the free-rider problem creates an asymmetric information problem, because depositors lack info about the quality of these private loans. Such leads to other problems that interfere w proper functioning of the financial system: • 1) Bank Panics and the Need for Deposit Insurance: o Bank Failure: a bank’s inability to meet its obligations to pay its depositors and other creditors, so it must go out of business o Prior to the creation of the FDIC, banks would have to wait until a failed bank had been liquidated to get their deposit bank, and even then they would only get a fraction back ▪ Because people couldn’t figure out whether banks were being risky or not, depositors would be reluctant to put money in banks, thus making banking institutions less viable. ▪ Second, depositors’ lack of information about the quality of bank assets can lead to a bank panic in which many banks fail simultaneously • Occur because of a. information: people can’t tell whether a bank is good or one that is insolvent so they withdraw their funds • Incentive to run to the bank because banks operate on first-come first-serve basis • Runs on both good and bad banks because of a. information o Contagion effect o Government safety net to short-circuit bank runs = deposit insurance, such as that provided by the Federal Deposit Insurance Corporation (FDIC) ▪ FDIC: • Guarantees depositors will be paid off in full on the first 250k they have deposited in a bank if it fails. With fully insured deposits, people don’t need to run to the bank to make withdrawals. • Uses 2 methods to handle a failed bank: o 1) Payoff method: FDIC allows the bank to fail and pays of depositors up to the 250k insurance limit (with funds acquired from insurance premiums paid by the banks who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets. Typically, with this method, depositors with deposits in excess of 250k receive 90 cents on the dollar, although it can take several years to receive this. o 2) Purchase and Assumption Method: FDIC reorganizes the bank, typically by finding a willing merger partner who takes over all of the failed bank’s liabilities so that no depositor or creditor loses a penny. FDIC makes it easier for partner by providing it with subsidized loans or by buying some of the failed bank’s weaker loans. The net effect of this method is the FDIC has guaranteed all liabilities and deposits, even those greater than 250k. This is the more costly method, but most popular before 1991. • 2) Other forms of the Government safety net: o In other countries, governments have often stood ready to provide support to domestic banks facing runs even in the absence of explicit deposit insurance o Governments can provide support through lending from a central bank to troubled institutions, as the Federal Reserve did during the financial crisis ▪ Called the “lender of last resort” role of the central bank ▪ Sometimes, government can provide funds directly to the troubled institution o Governments can also take over (nationalize) troubled institutions • Drawbacks of the government safety net: o 1) Moral Hazard: ▪ Most serious problem, prominent concern ▪ Existence of insurance provides increased incentives for taking risks that might result in an insurance payoff ▪ Depositors and creditors know they will not suffer losses if a financial institution fails, so they do not impose discipline of the marketplace on these institutions by withdrawing funds when they suspect the institution is taking on too much risk ▪ Consequently, financial institutions with a government safety net have an incentive to take on greater risk because taxpayers will foot the bill if they fail o 2) Adverse Selection: ▪ People who are most likely to produce adverse outcome the bank is insured against are those mostly likely to seek to take advantage of the insurance ▪ Because depositors and creditors protected by a government safety have little reason to impose discipline on financial institutions, risk-loving entrepreneurs might find the financial industry very attractive – they know they will be able to engage in highly risky activities ▪ Also no incentive for people to monitor the activity of the bank so crooks might find the financial industry attractive too because they may be able to get away with fraud and embezzlement o 3) Too Big to Fail: ▪ Regulators are reluctant to close down large financial institutions and impose losses on their depositors and creditors because doing so my precipitate a financial crisis ▪ Government provides guarantees of repayment of large, uninsured creditors of the largest banks so that no depositor or creditor suffers a loss when these depositors and creditors are not automatically entitled to this guarantee ▪ FDIC does this by purchase and assumption method, giving the insolvent bank a large infusion of capital and tehn finding a willing merger partner to take over the bank and its deposits ▪ Increases moral hazard problem for big banks • Depositors have no incentive to monitor the bank and pull out their deposits when it takes on too much risk. Result is that big banks make take on even greater risks • Wouldn’t hold if they followed payoff method ▪ Also increases moral hazard problem for non-bank financial institutions that are extended a government safety net o 4) Financial Consolidation and the Government Safety Net: ▪ F. consolidation has proceeded had a rapid pace since Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the Gramm- Leach-Biley Financial Services Modernization Act of 1999 ▪ F.C. poses 2 challenges to financial regulation because of the existence of a government safety net: • 1) Increased size of financial institutions resulting from F.C. increases too big to fail problem  more firms of such size  increased moral hazard for these firms to take on greater risk and increase the fragility of the financial system • 2) F.C. of banks with other financial services firms means that the government safety net may be extended to new activities which increases incentives for greater risk taking in these activities which weakens the fabric of the financial system • Types of Financial Regulation: o 1) Restrictions on Asset Holdings: ▪ Such restricts moral hazard problem, which can cost tax payers dearly ▪ Because banks are the financial institutions most prone to panixs, they are subjected to strict regulations that restrict their holdings of risky assets, such as common stocks. ▪ Bank regulations also promote diversification, which reduces risk o 2) Capital Requirements: ▪ Government-imposed capital requirements are another way of reducing moral hazard problems ▪ When a financial institution is forced to hold a large amount of equity capital, it suffers greater losses if it fails and is more likely to pursue less risky activities ▪ Capital functions as a cushion when bad shocks occur ▪ Take two forms • 1) Based on leverage ratio: capital/total assets o To be classified as well-capitalized, it must exceed 5%; one lower than 3% triggers increased regulatory restrictions on the bank • 2) Concerns risk-based capital requirements o Basel Accord: requires that banks hold at least 8% of their risk-weighted assets ▪ Assets allocated into 4 categories • 1) Carries a zero weight and includes items that have little default risk, such as reserves and government securities • 2) 20% weight and includes claims on banks in OECD (Organization for Economic Cooperation and Development) countries • 3) 50% weight and includes municipal bonds and residential mortgages • 4) Maximum weight of 100% and includes loans to consumers and corporations. Off- balance sheet activities are treated in a similar manner  they are assigned a credit- equivalent percentage that converts them to on-balance sheet items to which appropriate risk weight applies ▪ Limited in that regulatory measure of risk can differ substantially from the actual risk faced by the bank ▪ This discrepancy resulted in regulatory arbitrage: a practice in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off their books low-risk assets, such as a loan to a company with a very high credit rating. The basel accord thus might lead to increased risk-taking, the opposite of its intent o 3) Prompt Corrective Action: ▪ If the amount of a financial institution’s capital falls to low levels, two serious problems result. • 1) Bank is more likely to fail bc of its lower capital cushion • 2) With less capital, an institution has less skin in the game and might take on excessive risk  increased moral hazard problems ▪ To limit such, the FDIC Improvement Act of 1991 adopted prompt corrective action provisions that require the FDIC to invervene earlier and more vigorously when a bank gets into trouble ▪ Banks are now classified into 5 groups • 1) Group 1: Classified as “well-capitalized,” comprises banks that significantly exceed min. capital requirements and are allowed privileges such as the ability to do some securities underwriting • 2) Group 2: “Adequately capitalized,” meet min. cap requirements, are not subject to corrective actions, but are not allowed Group 1 privileges • 3) Group 3: “undercapitalized,” fail to meet capital requirements • 4 and 5) “Significantly undercapitalized” and “critically undercapitalized,” respectively, and are not allowed to pay interest on their deposits at rates higher than average o FDIC required to take prompt corrective actions o 4) Financial Supervision: Chartering and Examination: ▪ Financial supervision: overseeing who operates financial institutions and how they are operated • Important in reducing adverse selection and moral hazard problems ▪ Chartering one way to prevent adverse selection; proposals for new institutions are screened to prevent undesirables from controlling them • Commercial bank obtains a charter from either the Comptroller of the Currency (national bank) or from a state banking authority (state bank) ▪ Once a bank has been chartered, it is required to file a periodic call report that revels its assets and liabilities, income and dividends, ownership, etc. ▪ Bank also subject to examination by bank regulatory agencies to verify its financial condition ▪ State banks that are members of the Federal Reserve System are examined by the Fed ▪ Insured nonmember state banks are examined by the FDIC ▪ Regular on-site examinations function to limit moral hazard • Bank examiners give banks a CAMELS rating o With such, regulators can enforce regulations by taking formal actions such as issuing cease and desist orders to alter the bank’s behaviors, or even closing the bank o 5) Assessment of Risk Management ▪ Traditionally, examinations focused primarily on quality of a financial institution’s balance sheet t a point in time and whether it complies with cap requirements and restrictions on asset holdings • No longer adequate because financial innovation has produced new markets and instruments that make it easy for financial institutions and their employees to make huge bets easily and quickly o Now, a healthy institution can be drive into insolvency extremely rapidly by trading losses ▪ Now, examiners place much greater emphasis on evaluating the soundness of a bank’s management processes with regard to controlling risk • Now give separate risk management rating from 1 to 5 that feeds into the overall rating as part of the CAMELS system ▪ 4 elements of sound risk management: • 1) Quality of oversight provided by the B.O.D. and senior management • 2) Adequacy of policies and limits for all activities that present significant risks • 3) Quality of risk measurement and monitoring systems • 4) Adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees ▪ Stress tests: calculate potential losses and the need for more capital under fictional dire scenarios ▪ Value-at-Risk calculations: measure the size of the loss on a trading portfolio that might happen 1% of the time o 6) Disclosure Requirements: ▪ Securities Act of 1993 and Securities and Exchange Commission (SEC) impose disclosure requirements on any corporation that issues publicly- traded securities ▪ Also requires disclosure of info regarding off-balance sheet activities from financial institutions ▪ Needed to limit incentives to take on excessive risk and to upgrade the quality of information in the marketplace so that investors can make informed decisions and therein improve the efficiency of the market ▪ Sarbanes-Oxley Act of 2002 furthered disclosure requirements by establishing the Public Company Oversight Board (PCAOB) ▪ Move to mark-to-market accounting or fair-value accounting, in which assets are valued in the balance sheet at what they could sell for in the market • Before this, they relied on historical-cost accounting, in which the value of an asset is set at its initial purchase price o Problem: doesn’t reflect fluctuations in the price of assets or liabilities • Subject to major flaw: at times, markets stop working, and the price of an asset sold at a time of financial distress does not reflect its fundamental value o Fire-sale value of an asset can be below the present value of its future expected cash flows o Requires that firms’ assets be marked down in value, which causes a shortfall in capital that leads to a cutback in lending, which causes further deterioration of asset prices, which in turn causes further cutbacks in lending o Criticized only when asset values were falling and such a form of accounting was painting a bleaker picture of banks’ balance sheets, as opposed to when asset prices were booming and it made the balance sheets look good o 7) Consumer Protection: ▪ Consumer Protection Act of 1969 (Truth in Lending Act) requires all lenders to provide info to consumers about the cost of borrowing, including the disclosure of a standardized interest rate (annual percentage rate) ▪ Fair Credit Billing Act of 1974 requires creditors to provide info on the method of assessing financial charges ▪ Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination by gender, race, marital status, age, or national origin • Administered by Fed. Reserve under Regulation B ▪ CRA (Community Reinvestment Act) of 1966 enacted to prevent “redlining” (a lender’s refusal to lend in certain areas) • Requires banks show that they lend in all areas o 8) Restrictions on Competition: ▪ Increased competition can increase moral hazard incentives for financial institutions to take on more risk • Competition can reduce profitability so banks make turn to risker activities in hopes of revamping profitability ▪ 2 forms: • 1) Restrictions on Branching: reduced competition between banks but were eliminated in 1994 • 2) Prevented nonbank institutions from competing with banks by preventing them from engaging in banking business, as embodied in the Glass-Steagall Act (repealed in 1999) ▪ Some disadvantages: • Higher charges to consumers • Decreased the efficiency of the banking institutions, which now didn’t have to compete as vigorously Chapter 11: • Financial innovation has increased the competitive environment for the banking industry and is causing fundamental changes in it • Commercial banks = largest depository institutions • A major controversy involving the undustry in its early years was whether the federal government should charter banks o Federalists, including Hamilton, advocated for greater centralized control of banking and chartering of banks ▪ Results in creation in 1791 of Bank of the US, which had elements of both a private bank and a central bank – a government institution that has responsibility for the amount of money and credit supplied in the economy as a whole • First federal bank charter o Agriculture and other interests didn’t like centralized power and advocated for state authority o 1811: Charter for Bank of US not renewed o 1816: 2 bank of US • Until 1863, all commercial banks in the US were chartered by the banking commission of the state in which each operated o No national currency o Banks obtained funds by issuing banknotes (currency redeemed for gold) o Banks regularly failed o Free-banking era • National Bank Act of 1863 creates a new banking system of federally chartered banks (national banks) supervised by the Office of the Comptroller of the Currency, a department of the treasury o Intended to dry up sources of funds to state banks • Dual Banking system: banks chartered by the federal government and the state operate side by side • Central banking did not reappear in this country until the Fed was created in 1913 to promote an even safer banking system o All banks required to become members of Federal Reserve System, subject to regulations of Fed o State banks could choose to become members of the system, and most did not • Great Depression years (1900-33) wiped out 9,000 banks • Legislation in 1933 established FDIC, whcihc provided federal insurance on bank deposits o Member banks of Fed. Reserve system were required to buy this, non-members could choose • Glass Steagall (1933) prevents banks from underwriting corporate securities, limited banks to purchase of debt securities approved by bank regulatory agencies • Office of the Comptroller of the Currency has primary supervisory responsibility for national banks that own more than half of the assets in the commercial banking system • Federal Reserve and the state banking authorities have joint primary responsibility for state banks that are members of the Federal Reserve System • Fed also has regulatory responsibility over companies that own one or more banks (bank holding companies) and secondary responsibility for national banks • FDIC and state banking authorities jointly supervise state banks that have FIDIC insurance but are not members of the Federal Reserve System • State banking authroties have sole jurisdiction over state banks without FDIC insurance • Shadow Banking System: Bnak lending has been replaced by lending via securities markets, with the involvement of a number of different financial instutions • 3 basic types/causes of financial engineering: responses to changes in demand conditions (interest rate volatility), responses to changes in supply conditions (information technology), and avoidance of existing regulations/rise in institutional investing • Responses to Changes in Demand Conditions: Interest-Rate Volatility o Most significance change in the economic environment that altered the demand for financial products in recent years has been the dramatic increase in the volatility of interest rates ▪ Due to changes in monetary policy and interest rate deregulation o Large fluctuations of interest rates lead to substantial capital gains or losses or greater uncertainty about returns on investments ▪ Higher volatility = higher risk o Some innovations, developed in the 70s, were created to help lower interest rate risk o Adjustable Rate Mortgages (and other long term contracts): ▪ 1975, savings and loans in California began to issue these: mortgage loans on which the interest rate changes when a market interest rate (usually the Treasury rate) changes  one to one relationship with market rate • Encourage mortgage issuing institutions to issue adjustable rate mortgages with lower initial interest rates than those of conventional fixed-rate mortgages, making them popular with many households ▪ Because rates can increase, some households prefer fixed-rates ▪ Allow people to hedge against rise in rates o Financial Derivative (insurance): ▪ Hedging risk = to protect oneself from risk, in this case interest rate risk ▪ Futures contracts: seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed upon price ▪ Payoffs are linked to previously issued securities • Responses to changes in Supply Conditions: Information Technology o Increase in information tech has: lowered cost of processing financial transactions (making it profitable for financial institutions to create new financial products and services for the public) and made it easier for investors to acquire information, thereby making it easier for firms to issue securities ▪ Higher rates of household borrowing o Bank Credit and Debit Cards: ▪ A firm issuing credit cards earns income from loans it makes to credit card holders and from payments made by stores on credit card purchases • Costs arise from loan defaults, stolen cards • Now more widely accepted than checks ▪ Debit cards depend even more on low costs of processing transactions, because their profits are generated entirely from the fees paid by merchants on debit card purchases at their stores o Electronic banking: ▪ One form is the automatic teller machine (ATM): allows customers to get cash, make deposits, transfer funds from one account to another, and check balances) • Cheaper transactions for a bank (work 24/7 for little cost – don’t need to be paid), more convenience for customer ▪ Home-banking: bank customers can conduct many of their bank transactions without ever leaving the comfort of their home • Convenient for customer, little cost for bank ▪ Virtual Bank: a bank that has no physical location byt rather exists only in cyberspace • Bank of America and Wells Fargo o Junk Bonds ▪ Fallen angels = firms that had fallen on bad times ▪ Junk bonds = bonds that have rating below Baa ▪ Improvement in tech makes it easier for investors to acquire financial information about corporations so more institutions that those that were very well established and had high credit ratings could sell securities, so more investors could screen out bad from good credit risks ▪ With easier screening, investors were more willing to buy long-term debt securities from less-well-known corporations with lower credit ratings ▪ Thus, the innovative process of selling junk bonds was born in the 70s ▪ Junk bonds become important factor in the bond market ▪ Means high credi-risk firms can borrow (at higher rates) o Commercial Paper Market: ▪ Commercial paper is short-term debt security issued by large banks and corporation ▪ Tremendous growth since the 70s ▪ Due to improvement in tech • Easy to screen out bad from good credit risks, so firms can issue more debt security more easily • Allows firms to raise funds through both long-term securities like bonds and junk bonds but also through short-term debt securities • Many short term corps that used to do short term borrowing with banks now did it in commercial paper market ▪ Development of money market mutual funds also helped commercial paper market grow fast • Securitization and the Shadow Banking System o Securitization: process of bundling small and otherwise illiquid financial assets into marketable capital securities ▪ Fundamental building block of shadow banking system ▪ Involves asset transformation that involves a number of different financial institutions working together that comprise the shadow banking system ▪ transform otherwise illiquid and risky financial assets into marketable and safe securities o How shadow banking works: ▪ EX: Mortgage broker (loan originator) arranges for a residential mortgage loan to be made by a financial institution that will then service the loan (collect interest and principal payments) • This servicer then sells the mortgage to another financial institution, which bundles the mortgage with a large number of other residential mortgages o The bundler takes the interest and principal payments on the portfolio of mortgages and “passes them through” to third parties o The bundler goes to a distributor (investment bank), which designs a security that divides the portfolio of loans into standardized amounts ▪ Distributor then sells the claims to these interest and principal payments as securities, mostly to other financial institutions that are part of the shadow banking system (ex: money market mutual funds or pension funds) ▪ Loan origination -> servicing -> bundling  distribution ▪ Originate – to distribute business model ▪ Each person earns a fee ▪ Can be very profitable if transaction costs and costs of collecting info are low ▪ Still involves maturity transformation ▪ Subprime Mortgage Market: • new class of residential mortgages offered to borrowers with less- than-stellar credit records • Bundled together into mortgage-backed security, providing a new source of funding for these mortgages • Avoidance of existing regulations: o 2 sets of regulations have inhibited firms ability to turn profits: res. requirements and restrictions on interest rates that can be paid on deposits o 1. Reserve Requirements ▪ essentially a tax on deposits (before Fed paid interest on reserves in 2008) ▪ Tax rises as rates rise o 2. Restrictions on interest paid on deposits: ▪ Regulation Q – limited interest payment on demand & time deposits • ended in 2011 Dodd-Frank ▪ FDIC insurance limits – only up to $250,000 ▪ Through regulation Q, Fed set a maximum limit on the interest rate that could be paid on time deposits • Deposit rate ceilings o If market rate rose above this, depositors withdrew their funds from banks to put them in higher-yielding securities ▪ Loss of deposits from the banking system restricted the amount of funds that a bank could lend (disntermediation) and thus limited bank profits • o Innovations: ▪ Money Market Mutual Funds: issue shares that are redeemable at a fixed price by writing checks • EX: If you buy 5k shares for $5k, the mmmf uses these funds to invest in short-term money market securitiesthat provide you with interest payments o Able to write checks on $5k • Essneitally function as checking account deposits that earn interest that are not legally deposits so are not subject to reserve requirements o Can therefore pay higher rates than deposits at banks • First created in 1970 ▪ Sweep Accounts: • Any balances above a certain amount in a corporation’s checking account at the end of a business day are swept out of the account and invested in overnight securities that pay interest • Because they are swept out and are no longer classified as checkable deposits, they are not subject to reserve requirements and are thus not “taxed” • They also allow banks to pay interest, essentially, on these checking accounts, which otherwise isn’t allowed under existing regulations ▪ Introduction of Repos • Formally “sale and repurchase agreement” • A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. • Repos are classified as a money-market instrument. Usually used to raise short-term capital, think of a repurchase agreement as having the same effect as a short-term, collateral-backed, interest- bearing loan. The buyer acts as a short-term lender, the seller acts as a short-term borrower, and the security is the collateral. Thus the goals of both parties, secured funding and liquidity, are met. • Repurchase agreements are generally considered safe investments because the security in question functions as collateral, which is why most agreements involve U.S. Treasury bonds. • Transfer liquid asset (deposit) in return for assets as collateral (short-term) o Looks just like a secured loan • Similar in function to traditional banking o Still can make spread • Doesn’t require a bank charter to issue! o Firms can issue repo • Requires ‘safe’ collateral • Traditional intermediation process: “borrowing short and lending long” • In US, importance of commercial banks as source of funds for nonfinancial borrowers has fallen dramatically o Reasons: ▪ 1) decline in cost advantages in acquiring funds • Regulation Q worked to bank’s advantage because their major source of funds was checkable deposits, a
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