Advanced Money Exam 3

FDIC

& state banking authorities jointly supervise the 2,300 state banks that have FDIC insurance but ARE NOT MEMBERS of the Federal Reserve System. state banking authorities have sole jurisdiction over state banks without FDIC insurance. (hold less than 0.2% of deposits in banking system.)"

Yearly Statements

investors are sent a yearly statement detailing the federal tax status of distributions received from the fund shareholders are taxed on the fund's income directly, as if the shareholders held the underlying securities themselves any tax-exempt income received by a fund is generally passed on to the shareholders as tax exempt.

mutual fund structure

open end or closed end

Bank Capital

Liability banks net worth -total asset - total liabilities raised by selling new equity (stock) or from retained earnings. cushion against a drop in value of a banks assets, which force bank into insolvency (MORE LIABILITIES THAN ASSETS, BANK CAN BE FORCED INTO LIQUIDATION)

Money Market Mutual Funds (MMMF)

MMMF issue shares that are redeemable at a fixed price (usually $1) by writing checks ex: you buy 5000 shares for $5000. MMMF uses the money to invest in ST money market securities (T-bills, CDs, commercial paper) that give you interest payments also, you can write checks up to the $5000 held as shares in the MMF They work like checking account deposits that earn interest, but aren't legally deposits (they're shares) so they aren't subject to reserve requirements or prohibitions on interest payments so, they can pay higher interest rates than deposits at banks particularly successful during inflation when market interest rates higher than the max interest payable by banks under regulation Q

Investment Adviser

Manages the funds portfolio according to the objectives and policies described in the funds prospectus

Traditional Banking

ONE ENTITY engages in process of asset transformation-- issuing liabilities with one set of desirable characteristics for holders (deposits with high liquidity and low risk) to fund the purchase of assets with a different set of characteristics (loans, low liquidity and high returns ) asset transformation done under One Roof

3. Leave it to Dodd Frank

approach to solving too-big-to-fail problem Dodd-Frank has eliminated too-big-to-fail problem by making it harder for Federal Reserve to bail out FIs, by imposing stricter regulations for SIFIs, and Volcker rule. Although Dodd-Frank takes away someincentives for excessive risk taking by SIFIs, there are doubts that this bill completely removes the too-big-to fail problem. leaves out many details of future regulation and doesn't address some important regulatory issues at all

Liabilities

bank acquires funds by issuing (selling) liabilities, like deposits SOURCES OF FUNDS that banks use funds obtained from issuing liabilities are used to purchase income-earning assets Checkable Deposits, Nontransaction Deposits, Borrowings, Bank Capital

bank failure

bank is unable to meet its obligations to pay its depositors and other creditors so it must go out of business

Shadow Banking System

banks still most important FI in economy, but traditional business of making loans funded by deposits is declining replaced by shadow banking system bank lending has been replaced by lending via securities market with the involvement of a number of different financial institutions

4. Cost Advantages

benefit that attracts investors to mutual funds Institutional investors negotiate much lower transaction fees than are available to individual investors large block trades of 100,000 shares or more trade according to a different fee structure than do smaller trades. By buying securities through a mutual fund, investors can share in these lower fees.

discount loans

borrowings from the Fed "advances"

ABM (Automated Banking Machine)

combines in one location an ATM, an internet connection to the banks website, and a telephone link to customer service

Electronic Banking

computer technology has lowered cost of bank transactions by having customers interact with e-banking facilities rather than employees ATM home banking ABM virtual bank

Fair Credit Billing Act of 1974

requires creditors, esp credit card issuers, to provide info on the method of assessing finance charges and requires that billing complaints be handles quickly

Cash Items

reserves, cash items in process of collection, and deposits at other banks collectively referred to as reserves + cash terms = 16% of total assets

Credit Risk

risk arising because borrowers may default

interest-rate risk

riskiness of earnings and returns on bank assets that results from interest-rate changes

redemption fee

usual fee charged by mutual funds a back-end charge for redeeming shares. expressed as a dollar amount or a percentage of the redemption price

3 approaches to solving too-big-to-fail problem

1. Break up Large, Systemically Important Financial Institutions 2. Higher Capital Requirements 3. Leave it to Dodd Frank

Ownership of Mutual Funds

44% of household own mutual funds beginning 2015: 89% of mutual fund shares owned by households, with the rest held by fiduciaries and other business organizations median mutual fund investor: middle class, married, 51, employed, and has financial assets of about $190000 48% are college graduates, median household income of $87,500 and 93% say they are holding shares to prepare for retirement mutual funds 30% of retirement market at beginning of 2016, which represents 40% of all mutual fund assets Deposits into retirement mutual funds come from 2 sources: employer-sponsored defined-contribution plans, (especially 401(k) plans) and individual retirement accounts (IRAs) Bulk of retirement assets are in equity funds, then guaranteed investment contracts, bond funds, and company stock

-Hardening the 4 pm valuation rule

Government Response to abuse more strictly enforcing the rule that trades received after 4 pm be traded at the next days NAV rather than at the stale NAV should prevent late trading activites controversial because they penalize investors whose trades didn't get completed due to trading backlogs. Fails o prevent market timing arbitrage across time zones

Principal Underwriter

Sells fund shares either directly to the public or through other firms (broker Dealers)

mutual funds

about 7500 mutual funds to choose from, more stocks than those listed on NYSE & NASDAQ combined amount invested in mutual funds is about 15 trillion about the same amount deposited in all commercial banks in the United States

Transfer Agent

executes shareholder transactions, maintains records of transactions and other shareholder account activity, and sends account statements and other documents to shareholders

a branch of the foreign bank

foreign banks engage in banking activities in U.S. bears the foreign bank's name and is usually a full-service office. may also form Edge Act corporations and IBFs.

Measures of Bank Performance

net income gives us idea how well a bank is doing but doesn't adjusts for banks size so makes it hard to compare diff banks ROA, ROE, NM

Danger of Overregulation

"more regulation is needed to prevent such a crisis from occurring again, the danger is substantial that too much or poorly designed regulation could hamper the efficiency of the financial system. If new regulations choke off financial innovation that can benefit both households and businesses, economic growth in the future will suffer."

Federal Reserve

& state banking authorities have joint primary responsibility for the 2000 state banks that are members of the Federal Reserve System also has regulatory responsibility over companies that own one or more banks (bank holding companies) and secondary responsibility for national banks

CAMELS rating

6 areas assessed: Capital Adequacy Asset Quality Management Earnings Liquidity Sensitivity to market risk bank can be closed by regulators if rating is very low

Shell operation

Bahamas and Cayman Islands tax havens, minimal taxation and few restrictive regulations function primarily as bookkeeping centers and do not provide normal banking services

large-denomination Time Deposits (100k or more)

CDs bought by corporations other banks negotiable can be resold in secondary market before maturity like bonds negotiable CDs held by corporations, money market mutual funds, and other fin institutions as alternative assets to treasury bills and other st bonds CDs important source of bank funds (10%)

Conflicts of Interest SEC Survey Reports Mutual Fund Abuses Widespread

NY attorney general announced that his offie was going to indict a number of mutual fund managers in September 2003, caught many regulators off guard focus had been on security abuses by corporation. Revelation that mutual fund industry might also be dirty resulted in rapidly called hearings before Congress. Stephen Cutler, the chief of enforcement for the SEC, presented results that showed that illegal trading in mutual funds was more widespread than anyone had imagined. sample of largest 88 mutual fund companies, which represented 90% of the industry's assets, the SEC said that about 25% of the broker-dealers were allowed to make illegal late trades. Additionally, half the funds let some privileged shareholders engage in market timing trades more than 30% of the funds admitted that their managers had shared sensitive portfolio information with favored shareholders.

Fee Structure of Investment Funds

Originally: shares of mutual funds sold by brokers who received commission for their efforts. paid load funds. 1980s: no-load funds appeared. currently: 55% of equity funds and 65% of bond funds are no load regardless on if a load is charged, all mutual fund accounts have fees. investors should always consider fees the fund charges fees are taken out of portfolio income before its passed on to the investor. Since investor is not directly charged the fees, many won't even realize that they've been subtracted.

Government Response to Abuses

Sec, who is supposed to watch the mutual fund industry, wasnt the first to investigate it. It was New York State Attorney General Eliot Spitzer who caught SEC unaware by filing indictments against many of the major players in the mutual und industry Now that the issues are commonly recognized, both SEC and Congress are attempting to ensure the safety of these funds -More independent Directors -Hardening the 4 pm valuation rule -increased and enforced redemption fees -increased transparency

4 federal laws designed to protect investors

Securities Act of 1933: mandates that funds make certain disclosures Securities Exchange Act 1934: set antifraud rules covering purchase and sale of fund shares Investment Company Act of 1940: requires all funds to register with SEC and to meet certain operating standards Investment Advisers Act of 1940: regulates fund advisers

Structure of mutual Fund

Shareholders --> Mutual Fund Board of Directors --> Investment Adviser, Principal Underwriter, Administrator, Transfer Agent, Custodian, Independent Public Accountant

4 Mutual Fund Classes

Stock Funds (equity Funds Bond Funds Hybrid Funds Money Market Funds largest class is equity funds, then bond, then money market

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall

allows securities firms and insurance companies to purchase banks, and allows banks to underwrite insurance and securities and engage in real estate activities. states retain regulatory authority over insurance activities, while SEC continues to have oversight of securities activities Office of the Comptroller of the Currency has authority to regulate bank subsidiaries engaged in securities underwriting Federal Reserve continues to have authority to oversee the bank holding companies under which all real estate and insurance activities and large securities operations will be housed.

Edge Act corporation

alternative corporate structure for U.S. banks that operate overseas a special subsidiary engaged primarily in international banking US. banks (through their holding companies) can also own a controlling interest in foreign banks and in foreign companies that provide financial services, such as finance companies. The international activities of U.S. banking organizations are governed primarily by the Federal Reserve's Regulation K.

Volcker Rule

banks limited in proprietary trading activities (trading with their own money) allowed to own only small percentage of hedge and private equity funds

Resolution Authority

before this, FDIC could seize failing banks and wind them down, but not for the largest FIs- holding companies Dodd frank now allows u.s. gov authority for financial firms that are deemed systemic -- firms who pose a risk to overall financial system because their failure would cause widespread damage. gives regulators right to levy fees on FIs with more than $50 billion in assets to recoup any losses

Before Credit Cards

charge accounts: some stores gave customers credit cards to buy stuff at the store without cash Diners Club: credit card that could be used at restaurants all over the country & abroad

front end load

commission fee is charged when the funds are deposited between 1-2% but can exceed 6% Class A shares

load funds

commission paid at time of purchase and immediately subtracted from redemption value of the shares front end load, deferred load primary purpose is to provide compensation for sales brokers additional motivation, especially for deferred load funds, is to discourage early withdrawal of deposits

(5) assessment of risk management,

examination that focuses only on a FI's position at a point in time may not be effective in indicating whether it will be taking on excessive risk in the near future. bank examiners now place greater emphasis on evaluating the soundness of a banks management processes with regard to controlling risk now bank examiners give a separate risk management rating from 1 to 5 that feeds into the overall management rating as part of the CAMELS system

Office of the Comptroller of the Currency

has the primary supervisory responsibility for the 1000 national commercial banks, which own more than half of the assets in the banking system also the 400 savings & loans and Mutual savings banks with national charters

Dodd-Frank Bill

passed in 2010 to prevent another global financial crisis 5 categories of Regulation: Consumer Protection, Resolution Authority, Systemic Risk Regulation, Volcker Rule, Derivatives

Financial Derivatives

reduce interest-rate risk product that helps investors and FIs to protect themselves from, or hedge, interest-rate risk Futures Contracts have been around for a long time Futures Contract: seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agree-on price derivatives are futures contracts in financial instruments. their payoffs are linked to (derived from) previously issued securities. cane be used to hedge risk

Regulation of Mutual Funds

regulated under 4 federal laws designed to protect investors providing prospectus and shareholder report free of charge yearly statements detailing federal tax status of distributions from funds required to have independent directors publish extensive info about directors

Separation of Banking and Other Financial Service Industries

separated in U.S. until recently mandated by Glass Steagall Act of 1933 (securities, insurance, real estate) Glass-Steagall allowed banks to sell new offerings of gov securities but prohibited them from underwriting corporate securities or from engaging in brokerage activities also prevented banks from engaging in insurance and real estate activities. In turn, it prevented investment banks and insurance companies from engaging in banking activities and thus protected banks from competition.

secondary reserves

short term u.s. gov securities bc high liquidity

market timing

technically legal but considered unethical and is expressly forbidden by virtually all mutual funds policy standards involves taking advantage of time zone differences that allow arbitrage opportunities, especially in foreign stocks. Mutual funds will set their 4:00 closing NAV using the most recent available foreign prices. However, these prices may be very stale. Japan, for example, closes nine hours earlier. If news is released in Japan that is not reflected in their closing prices, arbitrage opportunities exist by buying at the stale prices embedded in the NAV.

stored value card

type of e-money simplest form: purchased for a preset dollar amount that the consumer spends down more sophisticated: smart card. Contains its own computer chip so that it can be loaded with digital cash from the owners bank account whenever needed. can be loaded from ATMs, personal computers with a smart card reader, or from specially equipped telephones

12b-1 fees

usual fee charged by mutual funds if any, are deducted from the fund's assets to pay marketing and advertising expenses or, more commonly, to compensate sales professionals. By law, 12b-1 fees cannot exceed 1% of the fund's average net assets per year.

contingent deferred sales charge

usual fee charged by mutual funds imposed at time of redemption an alternative way to compensate financial professionals for their services fee typically applies for the first few years of ownership and then disappears.

exchange fee

usual fee charged by mutual funds may be charged when transferring money from one fund to another within the same fund family.

(2) capital requirements,

when FI forced to hold large amount of equity capital, it has more to lose if it fails and more likely to pursue less risky activities capital is a cushion when bad shocks occur making FI less likely to fail, therefore adding to safety and soundness of FIs 2 forms: Leverage Ratio and Basel Accord (risk-based)

FDIC 2 methods to handle failed bank

1. Payoff Method 2. Purchase and assumption method

Reducing Loans

costliest method if bank has a bunch of short term loans renewed at short intervals, it can reduce total amount of loans quickly by calling them in. 1. calling in loans: not renewing some loans when they come due, likely to upset customers bc they didn't do anything wrong and will take their business elsewhere (costly to bank) 2. sell loans off to other banks : costly bc other banks don't know how risky the loans are and so won't be willing to buy loans at full value (lemons adverse selection problem)

small-denomination time deposits (less than 100k)

less liquid for depositor than passbook savings, higher interest rates , more costly source of funds for banks

bank panic

many banks fail simultaneously cause sharp decline in lending which is very harmful caused by depositors lack of info about quality of bank assets

deposit insurance

government safety net FDIC in US gurantees that depositors will get their full money back up to $250k that they have deposited in the bank if the bank fails with insured deposits, depositors dont have to run to the bank to withdraw their money even if they're worried about the banks health bc they will get full money back no matter what

Money Center Banks

explored ways in which liabilities on balance sheet could provide them with reserves and liquidity led to expansion of overnight loan markets, like federal funds market, and development of new financial instruments like negotiable CDs, which helped money center banks get funds quickly

deferred load

fee is charged when funds are taken out (usually a declining fee over 5 years) discourages early withdrawal of deposits Class B shares

no-load funds

funds that dont charge a direct load (or fee) appeared in 1980s can be purchased directly by individual investors and no intermediary is required currently: 55% of equity funds and 65% of bond funds are no load when the initial deposit is immediately reduced, it can take a long time to catch up to the returns offered by no-load funds Class C shares

some legal separation of banking and other financial services industries

Japan Japanese banks allowed to hold substantial equity stakes in commercial firms, while American banks cant banking and securities industries legally seperated, but banks are increasingly being allowed to engage in securities activities and becoming more like British style universal banks

Consumer Protection

created Consumer Financial Protection Bureau funded and housed within Federal Reserve, but independent agency has authority to examine and enforce regulations for all businesses engaged in issuing residential mortgage products that have more than 10 billion in assets as well as for issuers of other financial products marketed to poor people requires lenders to make sure that mortgages can be repaid by requiring verification of income, credit history, and job status bans payments to brokers for pushing borrowers into higher-priced loans allows states to impose stricter consumer protection laws on national banks and gives state attorneys-general power to enforce certain rules issued by the new bureau. Also permanently increases the level of deposit insurance to 250k

Second Bank of United States

created because of abuses by state banks and need for a central bank to help the federal government raise funds during war of 1812 tensions remained between advocates and opponents of centralized banking power charter lapsed in 1836

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

Savings & Loan Associations

can be chartered by fed gov or states members of Federal home Loan Bank System (FHLBS), styled after Federal Reserve System. Has 12 district Federal Home Loan banks that are supervised by Office of Thrift Supervision FDIC insurance up to 250k Office of the Comptroller of the Currency regulates federally insured S&Ls by setting minimum capital requirements, requiring periodic reports, and examining the S&Ls. Also the chartering agency for federally chartered S&Ls , approves mergers and sets rules for branching FHLBS, like the Fed, makes loans to the members of the system (obtaining funds for this purpose by issuing bonds). loans from FHLBS don't have to be repaid for long periods of time, unlike loans made by the Fed that have to be repaid quickly rates charged to S&Ls for loans are usually below the rates that S&Ls have to pay when borrowing in open market the FHLBS loan program provides a subsidy to the savings and loan industry (and implicitly to the housing industry, since most of the S&L loans are for residential mortgages). Because savings and loans now engage in many of the same activities as commercial banks, the charter and regulatory apparatus for S&Ls is now similar to that of commercial banks.

Basel Accord 4 Asset Categories:

1. 0% weight, items that have little default risk, like reserves & gov securities issued by the Organization for Economic Cooperation and Development (OECD—industrialized) countries. 2. 20% weight, claims on banks in OECD countries. 3. 50% weight, municipal bonds & residential mortgages. 4. max weight of 100%, loans to consumers and corporations. Off-balance-sheet activities: are assigned a credit-equivalent percentage that convert to on-balance-sheet items to which the appropriate risk weight applies

5 Benefits of Mutual Funds

1. Liquidity intermediation 2. Denomination intermediation 3. Diversification 4. Cost advantages 5. Managerial expertise

2. consequences of Bank Consolidation

1. different types of financial intermediaries are encroaching on each other's territory, making them more alike 2. consolidation has led to the development of large, complex banking organizations. Faciliated by repeal of Glass-Steagall restrictions on combinations of banking and other financial service industries

3 areas of possible Future Regulation

Compensation in the Financial Services Industry, Government-Sponsored Enterprises (GSEs), Credit-Rating Agencies

Hedge Fund Regulation

Despite argument that wealthy dont need regulatory protection from risk incurred by hedge fund investments, SEC passed regulation in 2006 requiring that hedge fund advisers register. SEC cited 2 concerns prompting the new move: 1. concerned about the growing incidence of fraudulent conduct by hedge fund advisers. 2. concern that more investors were participating in hedge funds through "retailization," and that this justified increased oversight. By requiring advisers to register, SEC can conduct on-site examinations. SEC argues these examinations are necessary to protect the nation's securities market as well as hedge fund investors.

Borrowings

Liability borrowing from Federal Reserve System, Federal Home Loan banks, other banks & corporations discount loans from Fed, overnight loans reserves in fed funds market to meet reserve requirements from other banks and institutions loans made to banks by parent companies (bank holding companies) loan arrangements with corporations (repurchase agreements) borrowing Eurodollars ( deposits in U.S. dollars in foreign country) important source of bank funds, 19% of bank liabilities

Structure of U.S. banking overseas

U.S. banks have most of their foreign branches in Latin America, Far East, Carribbean, and London largest volume of assets held by branches in London bc major international financial center and central location for the Eurodollar market Latin America and Far East have many branches bc of the importance of U.S. trade with these regions. Parts of the Caribbean (especially Bahamas and Cayman Islands) are important as tax havens, minimal taxation and few restrictive regulations. "Shell operations" -Shell operation -Edge Act corporation -International banking facilities (IBFs)

ROA

basic measure of bank profitability corrects for size of bank net income/assets measures how well bank manager is doing on job bc indicates how well a banks assets are being used to generate profits

Government vs. state charter

controversy in early years of banking industry. should banks be chartered on federal or state level? Federalists wanted greater centralized control of banking and federal chartering of banks Bank of U.S. was created: combo of private and central bank, gov institution that was responsible for the amount of money and credit supplied in the economy as a whole Farmers and other interests wanted chartering by states suspicious of centralized power. Their distrust of moneyed interest in big cities led to political pressures to eliminate bank of us

Capital Surplus

large amount of bank capital causing ROE to be too low bank has capital surplus & should increase EM to increase ROE To lower amount of capital relative to assets and raise EM, can do 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—say, by issuing CDs—and then seeking out loan business or purchasing more securities with these new funds

Sweep Account

innovation that enables banks to avoid the "tax" from reserve requirements 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 the "swept out" funds are no longer classified as checkable deposits, they are not subject to reserve requirements and so are not "taxed" advantage: allow banks in effect to pay interest on these checking accounts, which otherwise is not allowed under existing regulations lowered the amount of required reserves to the degree that most banking institutions do not find reserve requirements binding: In other words, they voluntarily hold more reserves than they are required to.

Deposit Outflows with insufficient excess reserves

instead of keeping 10 million in excess reserves, bank makes loans of 10 million instead. Only has 10 million of required reserves deposit outflow of 10 million bank now has 0 reserves, but required reserves are still 9 million Bank has 4 options to eliminate shortfall.

banks cost of maintaining checkable deposits

interest payments , about 5% on banks operating expenses costs for servicing accounts (processing, preparing, sending out monthly statements, providing tellers, maintaining buildings and branches, advertising & marketing, salaries, rent), about 50% of operating expenses

Bond Funds

investment grade funds invest in high-quality, relatively low risk securities high grade bonds offered by large corporations high quality investments with possible low returns. investors are trading safety for greater returns gov bonds are also popular. low returns but default risk free state and municipal bonds are tax free bonds aren't as risky as stocks so its not usually as important for investors to diversify across a large number of different bonds it is relatively easily to buy and sell bonds through the secondary market, so Bond mutual funds hold less than half of the assets held by stock mutual funds still, many investors value the liquidity intervention any automatic reinvestment features provided by bond mutual funds

British-style universal banking system

U.K, Canada, Australia, U.S., and other countries with close ties to it engages in securities underwriting differs from German style: separate legal subsidiaries more common, bank equity holdings of commercial firms less common, and combinations of banking and insurance firm are less common

Money Market Funds

have existed since early 70s but low market interest rates which were always slightly below or above Regulation Q requirements kept them from being advantageous over bank deposits before MMMFs, customers had to write and pick up checks to invest but this account allows them to direct brokers on buying and selling securities through this account got popular when inflation and interest rates increased with low rates on money market securities in recent years, deposits in MMMFs have dropped open-end investment funds that invest only in money market securities doesnt charge investors any fee for buying or redeeming any shares usually have a minimum initial investment of $500-$2000 yield depend entirely on the performance of the securities purchased many have check-writing privileges dont charge fees for writing checks or have minimum check amount as long as the balance in the account is above the stated level This convenience, along with market interest rates, makes the accounts very popular with small investors. Investors often take their money out of federally insured banks and thrifts and put it into uninsured MMMFs. Risk has historically been very small. money invested in MMMFs is in turn invested in money market instruments. Treasury bills, U.S. agency issues, and repurchase agreements make up the bulk of these funds. Because the risk of default on these securities was thought to be very low, the risk of MMMFs was considered very low. Investors recognized this and so were willing to abandon the safety of banks for higher returns. Confidence in MMMFs was shaken during credit crisis when for a short period of time mutual funds weren't able to redeem their holdings of commercial paper Commercial paper is ST and issued by strong companies but the near panic situation in the markets caused the market for these securities to evaporate The day after Lehman Brothers Holdings, Inc., declared bankruptcy on September 15, 2008, the Reserve Primary Fund "broke the buck" by failing to redeem money market accounts at the $1.00 NAV. This initiated a run around the world on money market funds, with rapid withdrawals threatening the liquidity of hundreds of other funds. 2 days later, Treasury announced a Temporary Guarantee Program for money market funds, and the Fed agreed to finance the purchase of asset-backed commercial paper from money market funds, which restored confidence

Mini Case Long Term Capital Debacle

hedge fund required private rescue plan by federal reserve bank of new york showed that hedge funds aren't risk free even though they're market-neutral LT capital thought that the spread between LT treasury bonds and corporate bonds would narrow. Shortly after making the investment, markets plunged causing a flight to quality investors bid up the price of treasury securities and price of corporate securities fell (exactly the opposite of what LT capital predicted) As losses increased, LT capitals lenders required that they increase their equity position Weren't able to raise enough capital to meet demands or creditors potential collapse of fund, 80 billion in equities, 1 trillion in derivatives fed stepped in to prevent fund from failing bc they thought sudden liquidation of LT capital would cause a lot of systemic risk potential huge losses for other lenders and institutions A group consisting of banks and brokerage firms contributed $3.6 billion to a rescue plan that prevented the fund's failure. Some critics argue that the intervention increases moral hazard by weakening the discipline imposed by the market on fund managers. However, others say that the tremendous economic damage the fund's failure would have caused was unacceptable

4 elements of sound risk management

(1) quality of oversight provided by board of directors 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.

5 groups based on bank capital:

1. "well capitalized,"- banks that significantly exceed minimum capital requirements & are allowed privileges like the ability to do some securities underwriting. 2., "adequately capitalized,"- meet minimum capital requirements & arent subject to corrective actions but arent allowed the privileges of the well-capitalized banks. 3. "undercapitalized,"- fail to meet capital requirements. FDIC is required to take prompt corrective actions such as requiring them to submit a capital restoration plan, restrict their asset growth, and seek regulatory approval to open new branches or develop new lines of business. 4. "significantly undercapitalized"-not allowed to pay interest on their deposits at rates that are higher than average. 5, "critically undercapitalized,"- not allowed to pay interest on their deposits at rates that are higher than average. Very undercapitalized, equity capital less than 2% of assets. FDIC must take steps to close them down."

E-bank Cons

1. depositors want to know savings are secure, so reluctant to put money in new institutions without long track record 2. customers worry about security of online transactions and if they will be private. Traditional banks viewed as more secure and trustworthy in terms of releasing private info 3. customers might prefer services provided by physical branches like buying long term savings products face to face 4. Internet banking has run into technical problems—server crashes, slow connections over phone lines, mistakes in conducting transactions—that will probably diminish over time as technology improves.

why do companies wants to hold dollar deposits outside U.S.? (eurodollars)

1. the dollar is the most widely used currency in international trade, so companies might want to hold deposits in dollars to conduct international transactions 2. eurodollars are "offshore" deposits, held in countries that won't subject them to regulations like reserve requirements or restrictions (capital controls) on taking the deposits outside the country

Structure of U.S. Banking Industry

6000 banks in U.S., more than any other country in the world bunch of small banks 5 or fewer banks dominate industry in U.K. and Canada in U.S., 10 largest banks in U.S. together hold around 50% of assets in industry Most industries in u.S. have fewer firms than the banking industry large firms dominate the industry to a greater extent than in banking industry

Great Depression

9000 bank failures wiped out savings to prevent this from happening again, FDIC created in 1933

Hedge Funds

A special type of mutual fund that received considerable attention following the collapse of Long Term Capital Management. often attempt to be market-neutral (protected from changes in the overall market) but they are NOT riskless. accumulate money from many people and invest on their behalf have minimum investment requirement of 100k-20M, with typical minimum investment being 1 million set up as limited partnerships. Federal law limits hedge funds to no more than 99 limited partners with steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes Funds may have up to 499 limited partners if each has $5 million in invested assets. All of these restrictions are aimed at allowing hedge funds to exist largely unregulated, on the theory that the rich can look out for themselves. Many of the 4,000 funds are domiciled offshore to escape all regulatory restrictions. continued to fail since LT capital many hedge funds with significant losses high risk game for well heeled investors hedge funds are unique in that they usually require investors to commit their money for long periods of time, often several years. The purpose of this requirement is to give managers breathing room to attempt long-range strategies. often charge large fees to investors. The typical fund charges a 1% annual asset management fee plus 20% of profits. Some charge significantly more

"Are Bank Consolidation and Nationwide Banking Good Things?"

Advocates: produce more efficient banks and healthier banking system less prone to bank failures Critics: eliminate small banks (community banks) which will result in less lending to small businesses. Also worry that a few banks will come to dominate the industry, making the banking business less competitive Skepticism: research indicates that even after bank consolidation is completed, U.S. will still have plenty of banks, remain highly competitive, maybe even more since banks that were protected from competition from out-of-state banks now have to compete with them more to stay in business Also doesn't look like community banks will disappear. NY & CA both have had liberal branching laws for a while New York: big banks found that the small banks were able to run rings around them in the local markets. California: has many community banks

Shadow Banking

Asset transformation not done under One Roof securitization is process of asset transformation that involves a # of diff financial institutions working together that are part of the shadow banking system 4 institutions specialize in each element of the financial intermediation process At each step of process, loan originator, servicer, bundler, and distributor earn a fee comprised of all of the FIs involved in the securitization process, and so can be very profitable if transactions costs and costs of collecting info are low advances in info tech critical for growth low costs in getting info makes it easier to sell capital market securities lower transaction costs make it cheaper for FIs to collect interest & principal payments on bundled loans and then pay them out to the securities holders

Money Market Mutual Fund (MMMF) Panic

Bruce Bent, an originator of MMMF told shareholder that fund was managed on basis of "unwavering discipline focused on protecting your principal", "designed with tenets of safety and liquidity" but, principles had fallen as portfolio managers chased highest yield and compromised integrity of money fund lost $785 million, Bents fund couldn't afford to redeem its shares at $1 par value "breaking the buck" Shareholders started pulling money out, Bent lost 90% of assets fear that this could happen to other MMMF led to a panic where shareholders began to withdraw their funds at an alarming rate. whole MMMF industry looked like it could come crashing down. to prevent this, federal reserve and us treasury came to rescue Fed set up a facility to make loans to purchase commercial paper from MMMF so they could meet the demands for redemptions from their investors Treasury then put in temporary guarantee for all MMMF redemptions and the panic subsided given the extension of a gov safety net to the MMMF industry there are calls to regulate it more heavily

(4) chartering and examination,

Chartering FIs prevents adverse selection. Proposals for new institutions are screened to prevent undesirable people from controlling them Regular on-site examinations- allows regulators to monitor if institution is complying with capital requirements and restrictions on asset holdings, limits moral hazard Bank examiners give banks a CAMELS rating with this info about bank activities, regulators can enforce regulations by enforcing cease and desist orders to alter banks behavior or even close a bank if its CAMELS rating is sufficiently low reduces adverse selection problem; with less opportunity for risk taking, risk loving entrepreneurs will be less likely to be attracted to banking industry Chartering similar to the screening of potential borrowers, regulations restricting risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risky investment activities, capital requirements act like restrictive covenants that require minimum amounts of net worth for borrowing firms, regular examinations are similar to the monitoring of borrowers by lending institutions.

Lower costs in Mutual Fund industry

Competition in the industry has produced substantially lower costs. average total shareholder cost of equity mutual funds decreased by more than 20%. cost of bond funds dropped by 31%. Also, SEC requirements SEC requires that mutual funds clearly disclose all fees and costs that investors will incur. SEC further requires mutual funds to include in their prospectus a standardized sample account where $10,000 is invested for one, three, five, and ten years The analysis shows investors exactly what fees they will be subject to if they choose the fund. The fee disclosure requirement makes it very easy for investors to compare funds, and therefore increases competition among them.

Government-Sponsored Enterprises (GSEs)

Dodd-Frankk doesn't address privately owned GSEs like Fannie Mae and Freddie Mac 4 routes to prevent financial trouble and taxpayers taking the blow: 1. Fully privatize GSEs by taking away gov sponsorship, removing the implicit backing for their debt. 2. Completely nationalize them by taking away private status and make them gov. agencies. 3. Leave them privately owned GSEs but strengthen regulations to restrict the amount of risk they take and impose higher capital standards. 4. Leave them as privately owned GSEs but force them to shrink dramatically so they no longer expose the taxpayer to huge losses or pose a systemic risk to the financial system when they fail.

Eurodollar Market

Eurodollars created when deposits in accounts in the U.S. are transferred to a bank outside the country and are kept in the form of dollars ex: Rolls-Royce PLC deposits a $1 million check, written on an account at an American bank, in its bank in London—specifying that the deposit is payable in dollars—$1 million in Eurodollars is created. more than 90% of eurodollar deposits are time deposits , more than half are CDs with maturities of 30 days or more total Eurodollars outstanding are around 5 trillion, important financial market in world economy London is main center of Eurodollar market also held outside Europe in locations the provide offshore status to these deposits-- Singapore, Bahamas, Cayman Islands minimum transaction in Eurodollar market is usually $1 million and approx 75% of eurodollar deposits are held by banks Rather than using an intermediary and borrowing all the deposits from foreign banks, American banks decided that they could earn higher profits by opening their own branches abroad to attract these deposits. Consequently, the Eurodollar market was an important stimulus to U.S. banking overseas.

Problems with Financial Regulation

FIs, in search for profits, have strong incentives to avoid existing regulations by loophole mining regulation applies to a moving target: Regulators are continually playing cat-and-mouse with FIs—they think up clever ways to avoid regulations, which then lead regulators to modify their regulation activities. Regulators continually face new challenges in a dynamically changing financial system—and unless they can respond rapidly, they may not be able to keep FIs from taking on excessive risk. problem can be exacerbated if regulators and supervisors do not have resources or expertise to keep up with clever people in financial institutions seeking to circumvent the existing regulations. Subtle differences in details may have unintended consequences; unless regulators get the regulation and supervision just right, they may be unable to prevent excessive risk taking. regulated firms may lobby politicians to lean on regulators and supervisors to go easy on them. no guarantee that regulators and supervisors will be successful in promoting a healthy financial system.

Avoiding Existing Regulations

Financial innovation occurs in response to changes in supply and demand fin. industry heavily regulated, so gov. regulation is greater spur to innovation gov regulation leads to financial innovation by creating incentives for firms to skirt regulations that restrict their ability to earn profits "loophole mining"- process of avoiding regulations when economic environment changes and regulatory constraints are so burdensome that large profits can be made by avoiding them, loophole mining and innovation are more likely to occur. loophole mining especially likely to occur in banking industry bc its so heavily regulated 2 sets of regulations have seriously restricted the ability of banks to make profits 1. reserve requirements that force banks to keep a certain fraction of their deposits as reserves (vault cash and deposits in the Federal Reserve System) 2. restrictions on the interest rates that can be paid on deposits these regulations have been major forces behind financial innovation the desire to avoid restrictions on interest payments and the tax effect of reserve requirements led to 2 important financial innovations: Money Market Mutual Funds & Sweep Accounts stimulated not only by the desire to avoid a costly regulation but also by a change in supply conditions—in this case, information technology. Without low-cost computers to inexpensively process the additional transactions required by these accounts, these innovations would not have been profitable and therefore would not have been developed. Technological factors often combine with other incentives, such as the desire to get around a regulation, to produce innovation.

Derivatives

Financial instruments whose payoffs are linked to (derived from) previously issued securities derivatives like credit default ended up being "weapons of mass destruction" that helped lead to a financial meltdown when AIG had to be rescued after making overly extensive use of them. To prevent this from happening again, Dodd-Frank requires many standardized derivative products to be traded on exchanges and cleared through clearinghouses to reduce risk of losses if one counterparty in the derivative transaction goes bankrupt. More customized derivative products subject to higher capital requirements Banks banned from some of their derivatives-dealing operations like those involving riskier swaps. bill also imposes capital and margin requirements on firms dealing in derivatives and forces them to disclose more info about their activities.

Example Hedge Fund transaction

Fund managers note that 29.5 year treasury bond is cheap relative to 30 year bonds. managers believe the value of the two bonds will converge over time as they have nearly identical risk since the maturity risk difference between the two is insignificant. (.5 yr) to make money from the temporary divergence of the bond prices, the fund bought $2 billion of the 29.5 year bonds and sold short $2 billion of the 30-year bonds. Selling short: fund borrowed bonds it did not own and sold them. Later the fund must cover its short position by buying the bonds back, hopefully at a lower price net investment: 12 million 6 months later, fund covered short position buy buying 30 year bonds and sold its 29.5 year bonds. transaction yielded 25 million profit In the transaction, managers didn't care if overall bond market rose or fell. In this sense, transaction was market-neutral. only thing required for profit was that the prices of the bonds converge, which they did Hedge fund managers scour the world in their search for pricing anomalies between related securities. Securities A and B move in lockstep over time. At some point they diverge, creating an opportunity. The hedge fund would buy security B, because it is expected to increase relative to A, and would sell A short. The fund managers hope that the gain on security B will be greater than the loss on security A. At times, the search for opportunities leads hedge funds to adopt exotic approaches that are not easily available elsewhere, from investing in distressed securities to participating in venture-capital financing. In addition to investing money contributed by individuals and institutions, hedge funds often set up lines of credit to use in leveraging their investments. Long Term Capital earned $25 million on an investment of $12 million, a 108% return ($25 million - $12 million)/$12 million = 1.08 = 108%]. Suppose that half of the $12 million had been borrowed funds. Ignoring interest cost, the return on invested equity would then be 317% [($25 million - $6 million)/$6 million = 3.17 = 317%]. Long Term Capital advertised that it was leveraged 20 to 1; however, by the time of the crisis, the figure was actually closer to 50 to 1.

-increased and enforced redemption fees

Government Response to abuse many funds already have policy against market timing and have a redemption fee that is imposed for shares that are sold within 60 or 90 days of purchase fees are usually discretionary and were waived in the cases where abuses occurred problem with mandatory fees is that it may penalize the investors who needs to make an unexpected withdrawal due to an emergency penalty makes mutual funds less attractive and, critics contend, would reduce their popularity. As a result of this argument, a voluntary redemption fee rule was adopted. The rule requires that the board consider whether they should impose the fee to protect shareholders from market timing abuses

-increased transparency

Government Response to abuse most common approach taken by SEC—increased disclosure of operating practices to the public. Directors required to more clearly and openly reveal any relationships that exist between fund owners and investment managers. Investment managers are required to more clearly disclose compensation arrangements and how fees are charged. more information is required about compensation arrangements between the mutual fund and sales brokers. This strategy leaves it to the market to discipline firms that seek to exploit conflicts of interest.

-More independent Directors

Government Response to abuse required to have an independent board chairman and a majority of the board must be independent independent board members must hold annual executive sessions outside the presence of fund managers independent board members have authority to hire staff to support their oversight efforts

(3) prompt corrective action,

If FI's capital falls to low levels, 2 problems result: 1. bank more likely to fail bc it has smaller capital cushion if it suffers loan losses or other asset write-downs 2. With less capital, FI has less skin in the game and more likely to take on excessive risks. moral hazard problem becomes more severe, making it more likely that FI will fail and taxpayers have to deal with it To prevent this, FDIC Improvement Act of 1991 adopted prompt corrective action provisions that require FDIC to intervene earlier and more vigorous when bank gets into trouble banks in U.S. classified into 5 groups based on bank capital: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized

Changes in economic environment

Increase in inflation and interest rates: changed DEMAND conditions Rapid advance in computer technology: changed SUPPLY conditions Financil Regulations became more burdensome Old ways of doing business no longer profitable, products not selling, can't raise funds with traditional financial instruments Engaged in financial engineering to survive in new economic environment

(8) restrictions on competition,

Increased competition can also increase moral hazard incentives for financial institutions to take on more risk declining profitability bc of the increased competition could increase incentive for financial institution to take on more risk to maintain former profit levels many governments have instituted regulations to protect financial institutions from competition 2 forms in U.S.: 1. restrictions on branching but was eliminated in 1994 2. preventing nonbank institutions form competing with banks by engaging in banking business, apart of Glass-Steagall act, repealed in 1999

Mutual Fund Abuses

NY attorney general began investigating tips that mutual funds were engaging in activities that undermined their fiduciary duty to shareholders, violated their own policies, and broke SEC laws abuses centered on 2 activities: late trading and market timing, both take advantage of the structure of open-end mutual funds that provide daily liquidity to shareholders by marking all trades to the NAV as of the close of business at 4:00 p.m. most mutual funds have fees that are supposed to discourage these rapid in and out trades but if an investor places large deposits in the fund, the fees can be waved ex: tech fund holds stock in various firms with total current market value of $350. you own 1 of 10 shares outstanding in fund NAV of fund will be $35 per share ($350/10) After market closes, tech industry announces good news that will drive value of shares held by fund to $400 when the market opens the next morning NAV of your share would be $40 ($400/10). if another investor with special privileges is allowed to buy a share in the fund for $35 after hours, your NAV will be diluted. $35 received by the fund from the privileged investor has to be held as cash, since the market is closed and no additional stock can be purchased by the fund value of the fund's assets the next morning will be $435 ($400 in stock and $35 in cash). NAV will be $435/11 = $39.54 instead of $40. original investors in the fund will have lost $0.46 privileged investor will have gained $4.54 ($39.54 - $35.00).

Chartering

National bank gets charter from Comptroller of the Currency State bank gets charter from a state banking authority people planning to organize bank must submit application that shows how they plan to operate the bank regulatory authority checks to see if bank will be sound by examining quality of banks intended management, likely earnings of the bank, and amount of banks initial capital; After chartered, bank required to file periodic CALL REPORTS that show banks assets & liabilities, income & dividends, ownership, foreign exchange operations, and other details also subject to examination by bank regulatory agencies to ascertain its financial condition at least once a year 3 federal agencies work together & accept each others examinations national banks- examined by Office of the Comptroller of the Currency state banks that are members of Federal Reserve System- examined by the Fed insured nonmember state banks- examined by FDIC

Structure of U.S. Banking Industry in future

Now that true nationwide banking in the United States is a reality, the benefits of bank consolidation for the banking industry have increased substantially, driving the next phase of mergers and acquisitions and accelerating the decline in the number of banks. With great changes occurring in the structure of this industry, the question naturally arises: What will the industry look like in 10 years? -industry might become like that of countries, with only a couple of hundred banks -industry might look like Canada & U.K., with only a few large banks dominating industry -likely to remain unique, but not like it once was consolidation will result in smaller # of banks and a shift in assets from smaller banks to larger banks

Board of Directors

Oversees the funds activities, including approval of the contract with the management company and certain other service providers

Global International Financial Regulation

Particular problems in financial regulation occur when financial institutions operate in many countries and thus can readily shift their business from one country to another. Financial regulators closely examine the domestic operations of financial institutions in their country, but they often do not have the knowledge or ability to keep a close watch on operations in other countries, either by domestic institutions' foreign affiliates or by foreign institutions with domestic branches. In addition, when a financial institution operates in many countries, it is not always clear which national regulatory authority should have primary responsibility for keeping the institution from engaging in overly risky activities Cooperation among regulators in different countries and standardization of regulatory requirements provide potential solutions to the problems of international financial regulation. The world has been moving in this direction through agreements like the Basel Accord and oversight procedures announced by the Basel Committee in July 1992, which require a bank's worldwide operations to be under the scrutiny of a single home-country regulator with enhanced powers to acquire information on the bank's activities. The Basel Committee also ruled that regulators in other countries can restrict the operations of a foreign bank if they believe it lacks effective oversight. Whether agreements of this type will solve the problem of international financial regulation in the future is an open question.

Cashless Society

Pilot projects in recent years with smart cards to convert consumers to use e-money have not been a success. Britain: Mondex, stored-value card not widely used Germany & Belgium: people carry banks cards with computer chips in them that allow them to use e-money but very few use them e-money more convenient and efficient than paper system but: 1. very expensive to set up computer, card reader, and telecommunications networks necessary to make e-money the dominant form of payment 2. e-payments raise security & privacy concerns. Many media reports about unauthorized hackers accessing computer databases and altering stored info. Very common, so bad people might be able to access bank accounts in e-payments systems and steal funds by moving them from someone else's accounts into their own. Preventing this type of fraud is hard and a whole new field of computer science has developed to handle security issues 3. using e-payments leaves electronic trail that contains large amount of personal data on buying habits. People worry that gov, employers, and marketers might be able to access these data, encroaching on our privacy.

providing prospectus and shareholder report free of charge

Prospectus: describes fund's goals, fees and expenses, and investment strategies and risks; also gives info on how to buy and sell shares. SEC requires a fund to provide a full prospectus before an investment or together with the confirmation statement of an initial investment. Shareholder reports: Annual and semiannual shareholder reports discuss fund's recent performance and other important info, like the fund's financial statements. By examining these reports, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund's prospectus.

Credit-Rating Agencies

Regulations to restrict conflicts of interest at credit-rating agencies and to give them greater incentives to provide reliable ratings have already been strengthened in the aftermath of the global financial crisis, but even more is likely to be done. The inaccurate ratings provided by credit-rating agencies helped promote risk taking throughout the financial system and led to investors' not having the info they needed to make informed choices about their investments. The reliance on credit ratings in the Basel 2 capital requirements may also have to be rethought, given the poor performance of credit-rating agencies in recent years.

Implications for Financial Consolidation

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 stimulated consolidation of banking industry and further hastened by the Gramm-Leach-Bliley Act of 1999 the way is now open to consolidation in terms of banking institutions and across financial service activities information tech is increasing economies of scope, mergers of banks with other financial service firms have become increasingly common, and more mega-mergers are likely to be on the way. banking institutions are becoming larger and increasingly complex, engaging in wide range of financial service activities trend towards larger and more complex banking organizations accelerated by global financial crisis of 2007-2009

(6) disclosure requirements,

To ensure better info is available in marketplace, regulators can require FIs to adhere to certain standard accounting principles and disclose info that helps market assess quality of an institution's portfolio and amount of its exposure to risk. More public info about risks incurred by FIs and quality of their portfolios can better enable stockholders, creditors, and depositors to evaluate and monitor FIs and deter excessive risk taking. SEC imposes imposes disclosure requirements on any corporation including FIs that issues publicly traded securities SEC requires FIs to provide additional disclosure regarding off-balance-sheet positions and more info about how they value their portfolios regulation to increase disclosure is needed to limit incentives to take on excessive risk and to upgrade quality of info in marketplace so investors can make informed decisions, improving the ability of fin markets to allocate capital to its most productive uses efficiency of markets is assisted by SEC's disclosure requirements and its regulation of brokerage firms, mutual funds, exchanges, and credit-rating agencies to ensure that they produce reliable info and protect investors. Sarbanes-Oxley Act 2002- increased incentives to produce accurate audits of corporate income statements and balance sheets, established PCAOB to oversee audit industry, put in place regulations to limit. conflicts of interest in financial services industry moved to mark-to-market accounting, (fair-value accounting), where assets are valued in the balance sheet at what they could sell for in the market

Financial Innovation and Decline of Traditional Banking

Traditional financial intermediation role of banking: make LT loans and fund them by issuing ST deposits, "borrowing short and lending long" asset transformation Financial innovations have created more competitive environment for banking industry, causing it to change dramatically, with traditional banking business declining importance of banks as a source of funds to non-financial borrowers has shrunk need to look at how financial innovations have caused banks to suffer declines in their cost advantages in acquiring funds (liabilities side of balance sheet) while also losing income advantages on assets side of balance sheet. simultaneous decline of cost and income advantages has resulted in reduced profitability of traditional banking and an effort by banks to leave this business and engage in new and more profitable activities.

Decline in Cost Advantages in Funds (Liabilities)

Until 1980, banks had deposit rate ceilings that restricted them from paying interest on checking deposits and (reg Q) max interest rate limit of 5% on time deposits. Worked to banks advantage bc their main source of funds (60%) was checkable deposits and the 0% interest cost on them gave banks a very low cost of funds cost advantage didn't last. Inflation in 60s led to higher interest rate which made investors more sensitive to yield differentials on different assets. Disintermediation. People began to take money out of banks, with low interest rates on checkable and time deposits, and started seeking out higher yield investments At same time, MMMF were created to get around reserve requirements and deposit rate ceilings. Put banks at more disadvantage. People could now get checking account-like services while earning high interest on their MMMF account the low-cost source of funds, checkable deposits, declined in importance for banks, went from 60% of bank liabilities to around 10% today. Hard for banks to raise funds legislation : Regulation Q ceilings on time deposit interest rates eliminated and allowed checkable deposits to pay interest changes in regulation helped make banks more competitive in their quest for funds, but also meant that cost of acquiring funds had risen substantially, reducing their earlier cost advantage over other financial institutions.

leverage cycle

a feedback loop from a boom in issuing credit, which led to higher asset prices, which resulted in higher capital buffers at financial institutions, which supported further lending in the context of unchanging capital requirements, which then raised asset prices further, and so on; in the bust phase of the cycle, the value of the capital dropped precipitously, leading to a cut in lending.

E-finance Information Technology and Bank Consolidation

achieving low costs in banking requires large investment in info tech large investments require a business line of large scale credit card business: huge tech investments made to provide customers with convenient Web sites and developing better systems to handle processing and risk analysis for both credit and fraud risk. result: substantial consolidation Info tech has also spurred increasing consolidation of bank custody business. Banks hold the actual certificate for investors when they purchase a stock or bond and provide data on value of the securities and amount of risk an investor is facing. this business is also computer-intensive, so it requires very large-scale investments in computer technology for the bank to offer these services at competitive rates. The percentage of assets at the top 10 custody banks has therefore risen from 40% in 1990 to more than 90% today. increasing importance of e-finance, where computers play a more central role in delivering financial services, is bringing tremendous changes to the structure of the banking industry. many banks are willing to offer a full range of products to their customers, but most no longer find it profitable to produce all of them. Instead, they are contracting out the business, a practice that will lead to further consolidation of technology-intensive banking businesses in the future.

The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks

all 5 of the largest, free-standing investment banks ceased to exist in their old form Bear Stearns had large losses, bailed out by Fed, forced sale to J.P. Morgan at 1/10th of its price in previous year , gov safety net now extended to investment banks trade-off: investment banks now subject to more regulation, along the lines of banks, in the future same thing happened with Lehman Brothers and Merill Lynch Goldman Sachs and Morgan Stanley saw that investment banks would soon become regulated on a similar basis and so they decided to become bank holding companies so they could access insured deposits, a more stable funding base.

Before 1863

all banks in U.S. chartered by banking commission of the state where it operated. No national currency banks obtained funds by issuing banknotes (currency circulated by banks that could be redeemed for gold). Because of lax banking regulations in states, banks regularly failed due to fraud or lack of sufficient bank capital; their banknotes became worthless.

Equity Funds

all invest in stock but can have different objectives 3 classes reported by Investment company Institute: capital appreciation funds, world funds, and total return funds the 3 types oversimplify the range of stock mutual funds available to investors. Vanguard offers over 60 different stock funds. Each one has a different goal. Some hold stock from specific industries; others hold stock with certain historical growth rates. Others are chosen by their PE ratio. Mutual fund companies try to offer a fund that will appeal to every investor's needs.

Banking Crises in different countries

all started with financial liberalization or innovation, weak bank regulatory systems and a government safety net. financial liberalization is generally good bc it promotes competition and can make a financial system more efficient, but can lead to an increase in moral hazard, with banks taking on more risk if regulation and supervision are lax; the result can then be banking crises differ in that deposit insurance has not played an important role in many of the countries experiencing banking crises. Ex: the size of the Japanese equivalent of the FDIC, was so tiny relative to the FDIC that it did not play a prominent role in the banking system and exhausted its resources almost immediately with the first bank failures, which indicates that deposit insurance is not to blame for some of these banking crises common to all the countries : existence of a government safety net, where the gov stands ready to bail out banks whether deposit insurance is an important feature of the regulatory environment or not. gov safety net increases moral hazard incentives for excessive risk taking on the part of banks."

2. Higher Capital Requirements

approach to solving too-big-to-fail problem bc institutions that are too-big-to-fail have incentives to take on excessive risk, we can reduce their risk by raising their capital requirements will give them larger buffer to withstand losses if they occur, more to lose "more skin in the game", reducing moral hazard and giving them less incentive to take on excessive risk higher capital requirements reduce risk taking for institutions that are too big to fail. bc risk taking by SIFIs is greater during booms, capital requirements could be increased when credit is expanding rapidly and reduced when credit is contracting. capital requirements would become more countercyclical and could help restrain the boom-bust credit cycle. Swiss central bank: has the highest capital requirements among advanced countries for its largest banks and raises them when credit markets become particularly frothy. Legislation has been proposed in U.S. Congress to double capital requirements for large FIs, opposed by FIs.

1. Break up Large, Systemically Important Financial Institutions

approach to solving too-big-to-fail problem make sure that no FIs are so big that they can bring down the financial system then, regulators won't have to worry about bailing them out, subjecting them to market discipline 2 ways to shrink institutions: 1. reimpose restrictions in place before Glass-Steagall was repealed, forcing large SIFIs to break up their different activities into smaller, cohesive companies. 2. regulations could specify that no FI can have assets over a specified maximum limit forcing SIFIs to break up into smaller pieces. opposed by SIFIs one issue: if there are synergies that enable large institutions to manage risk better or provide financial services at a lower cost, breaking them up might decrease efficiency of the financial system.

Sources of Conflicts of Interest

arise when there is asymmetric info and principal and agents interest are not closely aligned. governance structure of mutual funds creates this situation Investors in mutual funds are the shareholders. They elect directors who are supposed to look out for their best interest. Directors select investment advisors who actually run the fund Large # of shareholders, so free rider problem prevents them from monitoring either the directors or the investment advisors shareholders depend on directors to monitor investment advisers but recent evidence shows that directors efforts aren't enough to prevent abuses. The incentive structure for compensating investment advisors does not ensure that they will be motivated to maximize shareholder wealth absence of monitoring, investment advisers will attempt to increase their own fees and income, even at the expense of shareholders. Example: suppose an institutional investor offers to make a large deposit into the fund in exchange for special trading privileges not afforded other investors. Since investment advisers are compensated as a percentage of the funds under management, they may choose to provide the special treatment because it increases their income. The recent negative publicity about mutual funds is due to this type of misaligned interest.

(7) consumer protection,

asymmetric info suggests consumers may not have enough info to protect themselves Consumer Protection Act/ Truth in Lending Act Fair Credit Billing Act of 1974 Passed by Congress to reduce discrimination in credit markets: Equal Credit Opportunity Act of 1974 Community Reinvestment Act (CRA) of 1977

Automated Teller Machines

avoided restrictions on branching if they did not own or rent the ATM but instead let it be owned by someone else and paid for each transaction with a fee, the ATM would not be considered a branch of the bank and thus would not be subject to branching regulations. enable banks to widen their markets, a number of these shared facilities ( Cirrus and NYCE) have been established nationwide even when an ATM is owned by a bank, states typically have special provisions that allow wider establishment of ATMs than is permissible for traditional "brick and mortar" branches. advent of cheaper computer and telecommunications technology enabled banks to provide ATMs at low cost, making them a profitable innovation technological factors often combine with incentives such as the desire to avoid restrictive regulations like branching restrictions to produce financial innovation.

Junk Bonds

before computers and advanced telecommunications, hard to get info about financial situation of firms that might want to sell securities hard to tell if good or bad credit risk, so only high credit rated, well-established corporations could issue bonds before 1980s, only corporations that could issue bonds were those with credit rating of Baa or above bonds issued by firms fallen on bad times "fallen angels". their previously issued LT bonds who's ratings fell below Baa rating with improvement in info tech, it became easier for investors to get info about corporations, making it easier to screen out bad from good credit risks with Easier screening, investors more willing to buy LT debt securities from less well-known corporations with lower credit ratings In 1977 junk bonds became important factor in corporate bond market. change in supply conditions Michael Milken from Drexel, investment banking firm, pioneered concept of selling new public issues of junk bonds. Not for fallen angels, but for companies that hadn't achieved investment-grade status yet

5. Managerial expertise

benefit that attracts investors to mutual funds Even though research has shown that mutual funds dont outperform a random pick from the market, investors still prefer to rely on professional money managers to select their stocks. Financial markets still remain a mystery to a large number of investors who are willing to pay fees to let someone else pick their stocks

2. Denomination intermediation

benefit that attracts investors to mutual funds allows small investors access to securities they wouldn't be able to buy without the mutual funds for example, most money market securities are only available in large denominations like over $100000. By pooling the money, the mutual fund can buy these securities on behalf of the investors

1. Liquidity Intermediation

benefit that attracts investors to mutual funds investors can convert investments into cash quickly at low cost if you buy a CD or bond, there is usually a penalty for early withdrawal or transactions fees if you need the money before maturity Also, if you bought a $10000 CD but only need $5000 right now, you still have to break the whole CD and take out the full 10000 even though you only need 5000 mutual funds allow investors to buy and redeem at any time in any amount Some funds are designed especially to meet short term transaction requirements and have no fees associated with redemption, while others are designed for LT investment and might have redemption fees if they're only held for a short period of time

3. Diversification

benefit that attracts investors to mutual funds risk can be lowered by holding a portfolio of diversified securities small investors buying stocks individually might find it hard to buy enough securities in enough different industries to capture this benefit also, mutual funds provide a low-cost way to diversify into foreign stocks. It can be difficult and expensive to invest in a foreign security not listed on U.S. exchanges.

independent public accountant

certifies the funds fianncial statements

Electronic Payment

cheap computers, smartphones, and access to internet makes it very cheap for banks to let their customers make bill payments electronically banks provide website/app that you can log onto and make payments electronically rather than mailing in checks save costs of stamps, and more convenient you can also avoid logging on to make payments by setting up autopay where bills are automatically deducted from bank account these services increase bank profitability in 2 ways: 1. paying bills electronically means that banks dont need people to process what would have otherwise been a paper transaction Estimates of the cost savings for banks when a bill is paid electronically rather than by a check exceed one dollar. 2. extra convenience for customers makes means they're more likely to open an account with the bank europeans and Scandinavians more ahead/advanced in their use of electronic payments

total return funds

class of Equity Fund reported by Investment company Institute 29% of equity mutual fund assets goal is to seek a combination of current income and capital appreciation. include both mature firms that are paying dividends and growth companies that a re expected to post large stock price increases expected to be less risky than capital appreciation funds since they include more large well established firms borne out in 2000 when capital appreciation funds lost 16.5% of their assets and total return funds lost only 5.7%

world funds

class of Equity Fund reported by Investment company Institute invest primarily in stocks of foreign companies allow investors easy access to international diversification many financial planners recommend that investors hold at least a small portion of their investments in foreign stocks world funds provide the primary vehicle

capital appreciation funds

class of Equity Fund reported by Investment company Institute largest, hold about 44% of all equity mutual fund assets seek rapid capital appreciation (increases in share prices) and are not concerned with dividends relatively risky as fund managers are attempting to select companies incurring rapid growth ex. many capital appreciation funds invested heavily In high technology and internet stocks during the 1990s

Hybrid Funds

combine stocks and bonds into 1 fund provide an investment that diversifies across different types of securities and different issuers of a particular type of security if an investor found a hybrid fund that held the percentage of stocks and bonds he wanted, he could own just one fund instead of several despite this convenience, most investors still prefer to choose separate funds. Only about 7% of all mutual fund accounts are hybrid accounts

Commercial Paper Market

commercial paper: ST debt security issued by large banks and corporations market has grown tremendously, one of the fastest-growing money market instruments grew partly bc of improvements in info technology, which made it easier for investors to screen out bad from good credit risks, making it easier to raise funds by issuing ST debt securities like commercial paper many corporations that used to do their ST borrowing from banks now frequently raise ST funds in commercial paper market instead CP market also grew rapidly bc of Money Market Mutual Funds. Money Market Mutual Funds needs to hold liquid, high quality, ST assets like commercial paper, so the growth of assets in these funds to about 2.6 trillion has made a ready market in commercial market growth of pension and other large funds that invest in commercial paper has also stimulated the growth of this market.

Response to Branching Restrictions

competition can be repressed by regulation but not completely squashed existence of restrictive regulation stimulates financial innovations that get around these regulations in banks' search for profits Regulations restricting branching have stimulated similar economic forces and have promoted the development of two financial innovations: bank holding companies and automated teller machines

Bank Examinations

conducted by bank examiners unannounced visits (so nothing can be hidden before scheduled exams) study banks books to see if its complying with rules and regulation that apply to its holdings of assets If bank is holding securities or loans that are too risky, bank examiner can force bank to get rid of them. If bank examiner decides that a loan is unlikely to be repaid, examiner can force bank to declare the loan worthless (write off the loan, which reduces bank's capital). If examiner feels that bank doesn't have sufficient capital or has engaged in dishonest practices, bank can be declared a "problem bank" and will be subject to more frequent examinations.

Bank Holding Companies

corporation that owns several different companies advantages for banks: allows them to circumvent restrictive branching regulations because the holding company can own a controlling interest in several banks even if branching is not permitted. can engage in other activities related to banking, like provision of investment advice, data processing and transmission services, leasing, credit card services, and servicing of loans in other states. bank holding companies own almost all large banks, and more than 90% of bank deposits are held in banks owned by holding companies.

Debit Cards

created after CCs look just like CCs and can be used to make purchases in similar fashion debit card purchase is immediately deducted from the card holders bank account depend even more on low transaction costs bc their profits are generated solely from the fees paid by merchants on debit card purchases at their stores

Regulation Z of Truth in Lending Act

created because of mortgage brokers selling complicated and expensive mortgage products to unknowing consumers, no disclosures, just looking out for themselves, didn't care if consumers could actually pay back mortgages. led to many foreclosures Federal Reserve issued a final rule for subprime mortgage loans with the following four elements: (1) a ban on lenders making loans without regard to borrowers' ability to repay the loan from income and assets other than the home's value, (2) a ban on no-doc loans, (3) a ban on prepayment penalties (i.e., a penalty for paying back the loan early) if the interest payment can change in the first four years of the loan (4) a requirement that lenders establish an escrow account for property taxes and homeowner's insurance to be paid into on a monthly basis. rule stipulated the following new regulations for all mortgage loans, not just subprime mortgages: (1) prohibition on mortgage brokers coercing a real estate appraiser to misstate a home's value, (2) prohibition on putting one late fee on top of another and a requirement to credit consumers' loan payments as of the date of receipt, (3) a requirement for lenders to provide a good-faith estimate of the loan costs within three days after a household applies for a loan, (4) a ban on a number of misleading advertising practices, including representing that a rate or payment is "fixed" when the payment can change.

FDIC

created in 1933 to prevent bank failures (9000 in Great Depression) Federal Deposit Insurance Corporation provided federal insurance on bank deposits member banks of federal reserve system REQUIRED to purchase FDIC insurance non Federal Reserve banks have option to choose to buy FDIC insurance, most did Purchase of FDIC insurance makes banks subject to another set of regulations imposed by FDIC

National Bank Act of 1863

created to eliminate abuses of state-chartered banks (state banks) created new banking system of federally chartered banks (national banks), supervised by office of comptroller of currency (dept of us treasury) intended to dry up sources of funds to state banks by imposing prohibitive tax on banknotes and not taxing banknotes of the federally chartered banks state banks avoided this by acquiring funds through deposits as a result we now have dual banking system where banks supervised by federal gov and banks supervised by states operate side by side

Systemic Risk Regulation

creates Financial Stability Oversight Council, chaired by Treasury secretary monitors markets for asset-price bubbles and the buildup of systemic risk designates which financial firms are systemically important and receive official SIFI (Systemically Important Financial Institutions) designation SIFIs subject to additional regulation by Federal Reserve including higher capital standards and stricter liquidity requirements, and require they draw up a "living will" : a plan for orderly liquidation if firm gets into financial difficulties.

mark to market accounting and the global financial crisis

critics claim mark to market accounting was an important factor driving the recent global financial crisis because the seizing up of financial markets has led to market prices being well below their fundamental values Mark-to-market accounting requires that financial firms' assets be marked down in value. This markdown creates a shortfall in capital that leads to a cutback in lending, which causes a further deterioration in asset prices, which in turn causes a further cutback in lending. The resulting adverse feedback loop can then make the financial crisis even worse. criticisms are somewhat valid, but also self-serving on bankers part. criticism was made only when asset values were falling and when mark-to-market accounting was painting a bleaker picture of banks' balance sheets, as opposed to when asset prices were booming and mark-to-market accounting made banks' balance sheets look very good. global financial crisis shows the need for greater consumer protection bc many borrowers took out loans with terms they didn't understand and that were well beyond their means to repay. result was millions of foreclosures, with many households losing their homes. Because weak consumer protection regulation played a prominent role in this crisis, demands to strengthen this regulation have been increasing

International Banking

currently have around 100 American banks with branches abroad, assets totaling more than 1.5 trillion growth in international banking explained by 3 factors: 1. Rapid Growth In International Trade and Multinational (worldwide) corporations: When American firms operate abroad they need banking services in foreign countries to help finance international trade. Ex: might need a loan in foreign currency to operate a factory abroad. When they sell goods abroad, need to have a bank exchange the foreign currency they have received for the goods into dollars. Firms could use foreign banks for these international banking services, but many prefer to do business with the U.S. banks that they have established long-term relationships with and understand American business customs and practices. As international trade has grown, international banking has grown with it 2. American banks have been able to earn substantial profits by being active in global investment banking, where they underwrite foreign securities. They also sell insurance abroad, and get substantial profits from these investment banking and insurance activities. 3. American banks have wanted to tap into the large pool of dollar-denominated deposits in foreign countries known as Eurodollars. To understand the structure of U.S. banking overseas, let's first look at the Eurodollar market, an important source of growth for international banking.

Decline in Income Advantages on Uses of Funds (Assets)

decline in income advantages on assets side from financial innovations (junk bonds, securitization, and rise of commercial paper market.) resulted in a loss of market share and led to growth of shadow banking system, which uses these innovations to enable borrowers to bypass traditional banking system. improvements in info technology made it easier for firms to issue securities directly to the public. instead of going to banks to finance ST credit needs, many of banks' business customers find it cheaper to go instead to commercial paper market for funds. junk bond market has also eaten into banks' loan business. Improvements in info technology have made it easier for corporations to sell their bonds to the public directly, bypassing banks. now lower-quality corporate borrowers use banks less often because they have access to junk bond market. improvements in computer tech have led to growth of shadow banking system and securitization, where illiquid financial assets like bank loans and mortgages are transformed into marketable securities Computers enable other FIs to originate loans because they can now accurately evaluate credit risk with statistical methods, while computers have lowered transaction costs, making it possible to bundle these loans and sell them as securities. When default risk can be easily evaluated with computers, banks no longer have advantage in making loans. Without their former advantages, banks have lost loan business to other FIs even though the banks themselves are involved in the process of securitization. Securitization has been a particular problem for mortgage-issuing institutions such as S&Ls because most residential mortgages are now securitized.

Banks Responses

decline in profitability led to many banks exiting the industry due to widespread bankruptcies and shrinkage of market shares. 1980s- banking industry declined, many consolidations and bank failures 2 options to survive and maintain adequate profit levels: 1. attempt to maintain traditional lending activity by expanding into new and riskier areas of lending. Ex: U.S. banks increased risk by place greater percentage of total funds in commercial real estate loans (a riskier type of loan) Also increased lending for corporate takeovers and leveraged buyouts, which are highly leveraged transaction loans. Decline in profitability of banks traditional business might have led to banking crisis 1980-90 2. pursue new off-balance-sheet activities that are more profitable and embrace shadow banking system. U.S. banks increased the share of income from off-balance-sheet, non-interest-income activities by more than fivefold. this strategy raised concerns about what activities are proper for banks and whether nontraditional activities might be riskier and, therefore, result in excessive risk taking by banks. decline of banks' traditional business has forced banking industry to seek out new lines of business could be beneficial because by doing so banks can keep vibrant and healthy but, new directions in banking have led to increased risk taking, and required regulators to be more vigilant. Poses new challenges for bank regulators who must now be more concerned about banks off balance sheet activities

Decline of Traditional Banking in Other Industrialized Countries

decline of traditional banking has occurred in other industrialized countries as well for similar reasons loss of banks monopoly power over depositors and borrowers has occurred outside U.S. as well Financial innovation and deregulation occurring worldwide has created attractive alternatives for both depositors and borrowers Japan: deregulation opened a wide array of new financial instruments to the public, causing a disintermediation process Europe: Innovations have steadily eroded the barriers that have traditionally protected banks from competition. other countries: increased competition from the expansion of securities markets and the growth of the shadow banking system. financial deregulation and fundamental economic forces in other countries have improved availability of info in securities markets, making it easier and less costly for firms to finance activities by issuing securities rather than going to banks even in countries where securities markets have not grown, banks have still lost loan business because their best corporate customers have had increasing access to foreign and offshore capital markets, such as the Eurobond market. In smaller economies like Australia: lost loan business to international securities markets same forces that drove the securitization process in the United States have been at work in other countries and have undercut the profitability of traditional banking in these countries as well. decline in traditional banking happening worldwide

home banking

developed due to drop in cost of telecommunications cost effective for banks to set up e-banking facility banks customer is linked up with the banks computer to carry out transactions by using either a telephone or personal computer customers can conduct many bank transactions without leaving home advantage for customer: convenience of home banking advantage for banks: lower cost of transactions

Central Banking

didn't reappear in u.s. until Federal Reserve System (the Fed) was created in 1913 to promote safer banking system. All national banks required to become members of Federal Reserve System and subject to new regulations issued by Fed. State banks could choose (but not required) to become members of the system most didn't bc of high costs of membership stemming from the Fed's regulations.

ATM (Automated Teller Machine)

electronic machine that allows customers to get cash, make deposits, transfer funds from one account to another, and check balances advantages: ATM doesn't have to be paid, never sleeps, can be used 24/7 Cheaper transactions for the banks, more convenience for the customer low cost, so ATM can be placed at locations other than the bank, making it more convenient for customers available everywhere (500k+ in U.S.) easy to get foreign currency

Important Benefits from Bank Consolidation and Nationwide Banking

elimination of geographic restrictions on banking increases competition and drives inefficient banks out of business, enhancing the efficiency of the banking sector. move to larger banking organizations means that there is some increase in efficiency because they can take advantage of economies of scale and scope. increased diversification of banks' loan portfolios may lower the probability of a banking crisis in the future. bank failures were often concentrated in states with weak economies example, after the decline in oil prices in 1986, all of the major banks in Texas, which had been very profitable, found themselves in trouble. At that time, banks in New England were doing fine. However, when the 1990-1991 recession hit New England hard, some New England banks started failing" With nationwide banking, a bank could make loans in both New England and Texas and would thus be less likely to fail because when loans go sour in one location, they would likely be doing well in the other. Thus, nationwide banking is seen as a major step toward creating a banking system that is less vulnerable to banking crises.

Community Reinvestment Act (CRA) of 1977

enacted to prevent "redlining," a lender's refusal to lend in a particular area (marked off by a hypothetical red line on a map) requires that banks show that they lend in all areas in which they take deposits, and if banks are found to be in noncompliance with the act, regulators can reject their applications for mergers, branching, or other new activities.

Mutual funds fees

even if no load is charged, all mutual fund accounts have fees. investors should always consider fees the fund charges fees are taken out of portfolio income before its passed on to the investor. Since investor is not directly charged the fees, many won't even realize that they've been subtracted. usual fees: contingent deferred sales charge, redemption fee, exchange fee, account maintenance fee, 12b-1 fees very carefully evaluate a mutual fund's fee structure before investing, since they can range from 0.25%- 8% per year. No research supports the argument that investors get better returns by investing in funds that charge higher fees. most high-fee mutual funds fail to do as well, after expenses, as low-fee funds. Competition in the industry has produced substantially lower costs. average total shareholder cost of equity mutual funds decreased by more than 20%. cost of bond funds dropped by 31%. Also, SEC requirements

Agency Office

foreign banks engage in banking activities in U.S. can lend and transfer funds in the United States, but it cannot accept deposits from domestic residents. has advantage of not being subject to regulations that apply to full-service banking offices (such as requirements for FDIC insurance

Loan Origination --> Servicing --> Bundling --> Distribution

ex. Loan Origination: mortgage broker (loan originator) arranges for a residential mortgage loan to be made by a financial institution, which will service the loan (Collect interest & principal payments) Servicing: servicer sells the mortgage to another financial institution that bundles the mortgage with a large number of other residential mortgages Bundling: Bundler takes interest & principal payments on the portfolio of mortgages and "passes them through" (pays them out) to 3rd parties. Bundler goes to a distributor. Distribution: Distributor (usually Investment Bank) designs a security that divides the portfolio of loans into standardized amounts. Distributor sells claims to interest & principal payments as securities, usually to other financial intermediaries that are also apart of the shadow banking system like money market mutual fund or pension fund

universal banking

exists in Germany, Switzerland, and Netherlands no separation at all between banking and securities industries banks provide full range of banking, securities, real estate, and insurance services, all within a single legal enitity banks allowed to own sizable equity shares in commercial firms

subsidiary U.S. bank

foreign banks engage in banking activities in U.S. is just like any other U.S. bank (it may even have an American-sounding name) and is subject to the same regulations, but it is owned by the foreign bank.

closed-end funds

first mutual funds a fixed # of nonredeemable shares are sold at an initial offering and then traded in the over-the-counter market like common stock market price of these shares fluctuate with the value of the assets held by the funds market value of shares may be above or below the value of the assets held by the fund, depending markets assessment of how likely managers are to pick stocks that will increase fund value Problem: once shares have been sold, the fund cannot take in any more investment dollars so to grow the fund, managers must start a whole new fund Advantage to managers: investors can't make withdrawals. Only way investors have of getting money out of their investment in the fund is to sell shares largely replaced with the open-end fund

(9) macroprudential regulation.

focuses on the safety and soundness of the financial system in the aggregate When troubled FI has to have fire sales and sell off assets to meet capital ratios or haircut requirements, leads to a decline in asset values which causes other FIs to engage in fire sales leading to rapid deleveraging process and a systemic crisis. Even otherwise healthy firms will be in trouble seeks to mitigate systemwide fire sales and deleveraging by assess overall capacity of financial system to avoid them bc many institutions that were well capitalized faced liquidity shortages and found that their access to short-term funding was cut off, macroprudential supervision focuses not only on capital adequacy as a whole but also on whether the financial system has sufficient liquidity.

Equal Credit Opportunity Act of 1974

forbid discrimination by lenders based on race, gender, marital status, age, or national origin. This act is administered by the Federal Reserve under Regulation B.

1. reserve requirements

force banks to keep a certain fraction of their deposits as reserves (vault cash and deposits in the Federal Reserve System) major force behind financial innovation seriously restricted ability of banks to make profits act, in effect, as a tax on deposits up until 2008 Fed didn't pay interest on reserves so opportunity costs of holding them was the interest that a bank could otherwise be earning by lending the reserves out For each dollar of deposits, reserve requirements imposed cost on bank = interest rate (i) that could be earned if reserves could be lent out instead * fraction of deposits required as reserves (r) The cost of i × r imposed on bank is just like a tax on bank deposits of i × r per dollar of deposits. banks seek to increase their profits by mining loopholes and producing financial innovations that allow them to escape the tax on deposits imposed by reserve requirements

Compensation in the Financial Services Industry

high fees and executive compensation creates incentives for financial industry to issue securities that are riskier than advertised Federal Reserve is closely studying regulations to modify compensation in the financial services industry to reduce risk taking ex. Regulators in process of issuing requirements that bonuses be paid out for a number of years AFTER they have been earned, and ONLY IF firm has remained in good health. such "clawbacks" encourage employees to reduce riskiness of their activities so that they're more likely to get the bonus in the future

Foreign Banks in the US

hold 25% of total U.S. domestic bank assets and do a large portion of all U.S. bank lending, with over a 20% market share for commercial and industrial loan foreign banks engage in banking activities in U.S. by: operating an agency office of the foreign bank, a subsidiary U.S. bank, or a branch of the foreign bank internationalization of banking has made financial markets throughout the world become more integrated

custodian

hold the funds assets, maintaining them separately to protect shareholder interests and reconciling the funds holding against the custodians records

Securitization and Shadow Banking System

important financial innovation arising from improvements in both transaction and info technology process of bundling small and otherwise illiquid assets (mortgages, auto loans, credit card receivables, the bread & butter of banking institutions) into marketable capital market securities fundamental building block of shadow banking system

Scandinavians and E-banking

in U.S.: biggest users of checks, most non cash transactions conducted with paper Europe: bulk of non cash transactions are electronic Scandivanians outpace American in use of e-payments. Why? 1. Europeans made payments without checks even before computers were invented used "giro payments" where banks and post offices transfer funds for customers to pay bills 2. Scandinavians use their phones and internet more. Finland has highest per capita use of cell phones in the world/ Finland & Sweden have highest % of population that accesses the internet Why high-tech culture? Maybe low population densities or cold/dark winters or: Good education systems, high degree of computer literacy, top tech companies like Nokia and Ericsson, gov. policies promoting increased use of personal computers like tax incentives for companies to provide employees with home computers biggest users of online banking in the world (percentage wise) u.s. behind on use of e-payments, which has imposed high cost on U.S. economy switching from checks to e-payments might save U.S. economy 10s of billions $ per year U.S. gov is trying to switch all payments to electronic ones by directly depositing them into bank accounts, in an effort to reduce expenses use of e-money will increase in future, but won't be cashless society

Bank Credit Cards

in early stages, bc of high cost of operating credit card programs, cards were only issued to select people and businesses that could afford expensive purchases firm issuing CC earns income from loans it makes to credit card holders and from payments made by stores on credit card purchases (a % of the purchase price) CC companys costs: loan defaults, stolen cards, expense involved in processing CC transactions early attempts to expand CC business by banks failed bc of high costs per transaction After the 60s, improved computer technology lowered the transaction costs for providing CC services and were more profitable banks re-entered business and created Visa and MasterCard Nonfinancial institutions have also entered CC business bc so profitable (AT&T, Sears) Consumers benefit bc CCs more widely accepted than checks to pay for purchases (esp abroad) and allow consumers to take out loans more easily CCs extend the purchaser a loan that doesn't have to be paid off immediately success of CCs led to creation of Debit Cards

Opening checking account

increase in bank reserves equal to increase in checkable deposits

Increase in Pension Plans

increase in the number of defined-contribution pension plans has also been a factor in mutual fund growth. In the past, most pension plans either invested on behalf of the employee and guaranteed a return or required employees to invest in company stock Now, most new pension plans require the employee to invest his or her own pension dollars. With pension investments being made every payday, the mutual fund provides the perfect pension conduit. about 57% of all retirement dollars are invested in mutual funds. This amount is likely to grow as more pension plans convert from the defined-benefit to the defined-contribution structure.

Restriction on Competition Disadvantages

led to higher charges to consumers and decreased the efficiency of banking institutions, which did not have to compete as vigorously. although the existence of asymmetric info provided a rationale for anticompetitive regulations, it did not mean that they would be beneficial. the impulse of governments in industrialized countries to restrict competition has been waning. Electronic banking has raised a new set of concerns for regulators to deal with.

Why Bank Consolidation?

loophole mining by banks reduced effectiveness of branching restrictions, resulting in many states recognizing that it would be in their best interest to allow ownership of banks across state lines resulting in the formation of reciprocal regional compacts where banks in one state are allowed to own banks in other states in the region early 1990s, almost all states allowed some form of interstate banking with barriers to interstate banking breaking down in early 1980s, banks recognized that they could gain benefits of diversification because they would now be able to make loans in many states rather than just one. advantage: if one state's economy was weak, another state where they operated might have a strong economy, decreasing the likelihood that loans in different states would default at the same time allowing banks to own banks in other states also meant that they could increase their size through out-of-state acquisition of banks or by merging with banks in other states. Mergers and acquisitions explain the first phase of banking consolidation another result of the loosening of restrictions on interstate branching is the development of a new class of banks, the superregional banks, bank holding companies that have begun to rival the money center banks in size but whose headquarters are not in one of the money center cities advent of the Web and improved computer technology has also driven bank consolidation Economies of scale have increased because large up-front investments are required to set up many information technology platforms for financial institutions. To take advantage of these economies of scale, banks have needed to get bigger, and this development has led to additional consolidation. Information technology has also been increasing economies of scope, the ability to use one resource to provide many different products and services. details about the quality and creditworthiness of firms not only inform decisions about whether to make loans to them but also can be useful in determining at what price their shares should trade once you have marketed one financial product to an investor, you probably know how to market another. Business people describe economies of scope by saying there are "synergies" between different lines of business, and information technology is making these synergies more likely. consolidation is taking place not only to make financial institutions bigger but also to increase the combination of products and services they can provide consolidation has had 2 consequences

open-end fund

main mutual fund structure (98% of all mutual fund dollars) investors can contribute to an open-end fund at any time. Find simply increases the number of shares outstanding the fund agrees to buy back shares from investors at any time. Each day the funds net asset value is computed based on the number of shares outstanding and the net assets of the fund all shares bought and sold that day are traded at the same net asset value have 2 advantages that have contributed to the growth of mutual funds 1. because the fund agrees to redeem shares at any time, the investment is very liquid, this liquidity intermediation has great value to investors 2. the open-end structure allows mutual funds to grow unchecked. as long as investors want to put money in the fund, it can expand to accommodate them

bank consolidation and nationwide banking

many bank failures in 1985-92 # of insured banks declined, double the amt of bank failures bank failures played important but not main role in reduction of # of banks global financial crisis has led to additional declines in number of banks bc of bank failures bank consolidation: banks merging to create larger entities/buying up other banks has also led to reduction of # of banks

mark-to-market accounting

market prices provide best basis for estimating true value of assets, and hence capital, in the firm made standard in 1993, before this used Historical Cost (book value) accounting flaw: sometimes markets stop working. the price of an asset sold at a time of financial distress doesn't reflect its fundamental value fire-sale liquidation value of an asset can at times be well below the present value of its expected future cash lows critics claim it was an important factor driving the recent global financial crisis Mark-to-market accounting requires that the financial firms' assets be marked down in value. This markdown creates a shortfall in capital that leads to a cutback in lending, which causes a further deterioration in asset prices, which in turn causes a further cutback in lending. The resulting adverse feedback loop can then make the financial crisis even worse. criticisms are somewhat valid, but also self-serving on bankers part. criticism was made only when asset values were falling and when mark-to-market accounting was painting a bleaker picture of banks' balance sheets, as opposed to when asset prices were booming and mark-to-market accounting made banks' balance sheets look very good. criticisms led to Emergency Economic Stabilization Act of 2008

2 Concerns about effects of bank consolidation

may lead to a reduction in lending to small businesses banks rushing to expand into new geographic markets may take increased risks, leading to bank failures. most economists see the benefits of bank consolidation and nationwide banking as outweighing the costs.

financial supervision/ prudential supervision

overseeing who operates financial institutions and how they are operated reduces adverse selection and moral hazard

median mutual fund investor

middle class, married, 51, employed, and has financial assets of about $190000 48% are college graduates median household income of $87,500 93% say they are holding shares to prepare for retirement

E-money

money that exists only in electronic form, substitute for cash as well first form: stored-value card, smart card second form: e-cash

Changes in Supply Conditions: Information Technology

most important source of changes in supply conditions that stimulate financial innovation: the improvement in computer and telecommunications technology (information technology) 2 effects: -Lowered the cost of processing financial transactions, making it profitable for FIs to create new financial products and services for the public -Made it easier for investors to acquire info, thereby making it easier for firms to issue securities rapid developments in info technology have resulted in many new financial products and services

Responses to Changes in Demand Conditions: Interest Rate Volatility

most significant change in economy affecting demand for financial products: increase in volatility of interest rates large fluctuations in interest rates lead to substantial capital gains/losses and greater uncertainty about returns on investments interest rate risk: risk related to the uncertainty about interest-rate movements and returns high volatility of interest rates leads to higher level of interest rate risk increase in interest rate risk increases demand for fin products and services that reduce the risk this stimulates the search for profitable innovations by FIs that meet this new demand and spurs creation of new financial instruments that help lower interest rate risk 2 examples: Adjustable Rate Mortgage Financial Derivatives

Multiple Regulatory Agencies

multiple regulatory agencies with overlapping jurisdictions Office of the Comptroller of the Currency Federal Reserve FDIC U.S/ treasury has been trying to centralize the regulation of all depository institutions under one independent agency ... who knows if it will happen

Conflicts of Interest in Mutual Fund Industry

mutual fund industry has been subject to scandals, fines, nd indictments. Several top mutual funds managers and CEOs have even been sentenced to jail time investor confidence in the stability and integrity of the mutual fund industry is critical large portion of population Is now responsible for planning their own retirement and most of these investments are being funneled into various funds if the funds take advantage of investors or fail to provide the returns they should, people will find themselves unable to retire or having to scale back their retirement plans funds need to treat all investors equally and accurately disclose risks and fees. Must also follow the policies and rules they publish as governing the management of each fund

Administrator

oversees performance of other companies that provide services to the fund and ensures that the funds operations comply with applicable federal requirements

Calculating Mutual Fund's Net Asset Value (NAV)

mutual fund investors receive periodic state ents summarizing account activity statement shows funds added to investment balance, funds withdrawn, and any accrued earnings NAV tells investments performance NAV is the total value of the mutual funds stocks, bonds, cash, and other assets minus any liabilities such ass accrued fees divided by number of shares outstanding computed by dividing net worth by # of shares outstanding NAV rises and falls as the value of the underlying assets changes when you buy and sell shares in the mutual fund, you do so at the current NAV

Independent Directors

mutual funds are only companies in America that are required by law to have independent directors SEC believes that independent directors play a critical role in the governance of mutual funds substantive rule amendments designed to enhance the independence of investment company directors and provide investors with more information to assess directors' independence. These rules require that: -Independent directors constitute at least a majority of the fund's board of directors. -Independent directors select and nominate other independent directors. -Any legal counsel for the fund's independent directors be an independent legal counsel. " SEC rules also require that mutual funds publish extensive information about directors, including their business experience and fund shares held. This system of overseeing the interests of mutual fund shareholders has helped the industry avoid systemic problems and contributed significantly to public confidence in mutual funds.

complexes

mutual funds frequently offer a number of separate mutual funds a group of funds under substantially common management, composed of one or more families of funds advantage to investors: investments can usually be transferred among different funds within a family very easily and quickly. also, account info can be summarized by the complex to help investors keep their assets organized

virtual bank

new type of banking institution resulting from the decline in price of computers & increasing presence in homes a bank that has no physical location but exists only in cyberspace offers array of banking services on internet -- checking account and savings deposits, selling CDs, issuing ATM cards, providing bill-paying facilities, etc customer has full set of banking services at home 24 hours a day BOA is largest internet bank in U.S.

Separation of Banking and Other Financial Services Industries Throughout the World

not many other countries separate banking and other financial services like the U.S. 3 basic frameworks for banking and securities industries around the world: universal banking, British-style universal banking system, some legal separation of banking and other financial services industries

First Mutual Funds

originated in England and Scotland investment companies were formed that pooled funds of investors with modest means and used the money to invest in a number of different securities became more popular when they started investing in the economic growth in U.S., mainly by buying American railroad bonds First fund that issued new shares as new money was invested (dominant structure today) was created in Boston allowed for continuous offering of shares, ability to cash out of fund at any time, and a set of restriction on investments aimed at protecting investors from losses stock market crash of 1929 set mutual fund growth back for several decades bc small investors distrusted stock investments generally and mutual funds in particular Investment Company Act of 1940, which required more disclosure of fees and investment policies, boosted industry, and mutual funds began steady growth.

Glass-Steagall Act 1933

passed because Investment Banking activities of banks were blamed for many bank failures prohibited banks from underwriting or dealing in corporate securities (sill allowed to sell new issues of gov securities ) limited banks to only purchase debt securities approved by bank regulatory agencies prohibited investment banks from engaging in banking activities essentially separated activities of banks from those of securities industry banks had to sell off their investment banking operations investment banking firms usually discontinued their deposit business REPEALED IN 1999

regulatory arbitrage

practice in which banks keep assets on their books 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 low-risk assets their books, such as a loan to a company with a very high credit rating. Basel Accord thus led to increased risk taking, the opposite of its intent.

late trading

practice of allowing trades received after 4p.m. to trade at 4p.m. price when they should trade at next day's price Ex: Wednesday at 4p.m. NAV for a tech fund is $20. news is received by traders at 6:00 p.m. that HP, Intel, and Microsoft have reported their income surged 50% over the last quarter. Traders, knowing the industry impact this will have, want to enter buy orders for the fund at the $20 price. They are sure the NAV on Thursday will be substantially higher and they can earn a quick profit late trader can trade at the stale 4p.m. price and buy or sell the funds the next day at a profit. attorney general reported in hearings before Congress that "late trading is like betting on a horse race after the horses have crossed the finish line. It is illegal under SEC regulations. went undetected for many years bc some late trades were accepted and legal. If a broker received a buy order at 2, the order might not get consolidated with other orders and transmitted to the fund by 4. Since the investor placed the order before the market closed, the investor could not benefit from the late trade. Late trades were simply an opportunity to catch up with order processing. when large investors took advantage of their special arrangements at the expense of other shareholders, legal line was crossed.

Restrictions on Branching

presence of so many banks in U.S. reflects past regulation that restrict ability of financial institutions to open branches each state had its own regulations on the type and # of branches that a bank could open both coasts: regulations allowed banks to open branches throughout a state, middle of country: more restrictive regulations on branching McFadden Act of 1927: designed to put state and national banks on equal footing. Prohibited banks from branching across state lines and forced all national banks to conform to the branch regulations of the state where their headquarters were located strong anticompetitive forces in banking industry, allowing many small banks to stay in existence because larger banks were prevented from opening a branch nearby American public has historically been hostile to large banks States with the most restrictive branching regulations were typically ones where populist antibank sentiment was strongest in the 19th century. (these states usually had large farming populations whose relations with banks periodically became tempestuous when banks would foreclose on farmers who couldn't pay their debts.) legacy of 19th century politics was a banking system with restrictive branching regulations and a large number of small banks

FDIC Improvement Act of 1991

prevent moral hazard problems and bank failure adopted prompt corrective action provisions that require FDIC to intervene earlier and more vigorous when bank gets into trouble

Treasury Strips

problem for investors in LT coupon bonds: even if you have long holding period, there is some uncertainty in returns arising from reinvestment risk even if holding period is 10 years, return on bond is not certain. Problem is that coupon payments are made before bond matures in 10 years and these coupon payments must be reinvested since interest rates at which the coupon payments will be reinvested fluctuate, the eventual return on the bond fluctuates as well. LT zero-coupon bonds have no reinvestment risk bc they make no cash payments before bond matures. return on a zero-coupon bond if it is held to maturity is known at the time of purchase. no reinvestment risk is attractive feature of zero-coupon bonds so investors are willing to accept a lower interest rate on them than on coupon bonds which have some reinvestment risk. lower interest rates on zero-coupon bonds and the ability to use computers to create hybrid securities (securities derived from other underlying securities) gave Salomon Brothers and Merill Lynch the idea to use computers to separate (strip) a LT Treasury coupon bond into a set of zero-coupon bonds Called Treasury Strips lower interest rates on more desirable Treasury strip zero-coupon bonds means that value of these bonds exceeds the price of the underlying LT Treasury bond, allowing Salomon Brothers and Merrill Lynch to make a profit by purchasing the LT Treasury bond, separating it into Treasury strips, and selling them as zero-coupon bonds.

Securitization

process of asset transformation that involves a # of diff financial institutions working together that are part of the shadow banking system sequence: Loan Origination --> Servicing --> Bundling --> Distribution process involves origination of loans and then distributions of securities so also called "originate to distribute" model At each step of process, loan originator, servicer, bundler, and distributor earn a fee 4 institutions specialize in each element of the financial intermediation process

Erosion of Glass-Steagall

profits and financial innovation stimulated banks and other FIs to bypass intent of Glass-Steagall Act and encroach on each other's traditional territory. Brokerage firms engaged in traditional banking business of issuing deposit instruments through money market mutual funds and cash management accounts After Federal Reserve used loophole in section 20 of glass-steagall to allow bank holding companies to underwrite previously prohibited classes of securities, banks began to enter this business the loophole allowed affiliates of approved banks to engage in underwriting activities as long as the revenue didn't exceed a specified amount, which started at 10% but was raised to 25% of the affiliates total revenue After u.s. Supreme Court validated the Fed's action in July 1988, Federal Reserve allowed J.P. Morgan, a bank holding company, to underwrite corporate debt securities and stocks and later extended privilege to other bank holding companies regulatory agencies also allowed banks to engage in some real estate and insurance activities

regulation of thrift industry

regulation and structure of thrift industry (savings and loan associations, mutual savings banks, and credit unions) closely parallel regulation and structure of commercial banking industry

interest rate risk regulations

require banks board of directors to establish interest-rate risk limits, appoint officials of the bank to manage this risk, and monitor the banks risk exposure also require senior management to develop formal risk management policies and procedures to ensure that board of directors' risk limits are not violated and to implement internal controls to monitor interest-rate risk and compliance with the board's directives. also important: implementation of stress testing, which calculates losses under dire scenarios, and value-at-risk (VaR) calculations, which measure the size of the loss on a trading portfolio that might happen 1% of the time—say, over a two-week period.

Emergency Economic Stabilization Act of 2008

required SEC, in consultation with Federal Reserve and U.S. Treasury, to submit a study of mark-to-market accounting applicable to financial institutions.

Consumer Protection Act 1969/ Truth in Lending Act

requires all lenders, not just banks, to provide info to consumers about cost of borrowing, including disclosure of a standardized interest rate (APR) and the total finance charges on the loan

3 types of financial innovation

responses to changes in demand conditions responses to changes in supply conditions avoidance of regulations often interact to produce particular financial innovations

2. Restrictions on interest paid on deposits

restrictions on the interest rates that can be paid on deposits major force behind financial innovation seriously restricted ability of banks to make profits Until 1980, legislation prohibited banks in most states from paying interest on checking account deposits Regulation Q: Fed set maximum limits on the interest rate that could be paid on time deposits To this day, banks aren't allowed to pay interest on corporate checking accounts desire to avoid these deposit rate ceilings led to financial innovations If market interest rates rose above max rates that banks paid on time deposits under Regulation Q, depositors withdrew funds from banks & put into higher-yielding securities. The loss of deposits from banking system restricted the amount of funds that banks could lend (disintermediation) and thus limited bank profits. Banks had incentive to get around deposit rate ceilings because then they could acquire more funds to make loans and earn higher profits.

superregional banks

result of loosening restrictions on interstate branching new class of banks bank holding companies that have begun to rival the money center banks in size but whose headquarters are not in one of the money center cities

Subprime Mortgage Market

result of securitization and shadow banking system new class of residential mortgages to borrowers with less than stellar credit records Before 2000, only most credit worthy (prime) borrowers could get mortgages. Advances in tech & new statistical techniques (data mining) led to enhanced quantitative evaluation of credit risk for residential mortgages people could now get numerical FICO credit score that would predict how likely they would be to default on loan payments becamee easier to assess risk in a pool of subprime mortgages, so it became possible to bundle them in a mortgage-backed security, providing a new source of funding for these mortgages. The result was an explosion of subprime mortgage lending which was a key factor that led to the global financial crisis from 2007 to 2009.

Financial Markets integration

resulting in growing trend toward international coordination of bank regulation. ex: the Basel Accords to standardize minimum bank capital requirements in industrialized countries encouraged bank consolidation abroad, culminating in the creation of the first trillion-dollar bank with the proposed merger of the Industrial Bank of Japan, Dai-Ichi Kangyo Bank, and Fuji Bank importance of foreign banks in international banking.

organizational structure

same organizational structure for open end and closed end mutual funds investors in the fund are shareholders shareholders receive the earnings, after expenses, of the mutual fund board of directors: oversees the funds activity and sets policy. Responsible for appointing the investment advisor, usually a separate company to manage the portfolio of investments and a principal underwriter, who sells the fund shares. SEC regulation requires that majority of the directors be independent of the mutual fund investment advisers manage the fund in accordance with the funds states objectives and policies. they pick the securities that will be held by the fund and make buy and sell decisions. their expertise determines success of the fund fund will also contract with other firms to provide additonal services including underwriters, transfer agents, and custodians contracts will also be arranged with an independent public accountant large funds may arrange for some of these function to be done in house, while other funds will use all outside companies

E-banking challenges for Bank Regulation

security and privacy concerns secure encryption technologies used to prevent fraud gov has to regulate e banking since most customers dont know about computer security issues bank examiners in U.S. assess how a bank deals with e-banking security issues and oversees 3rd party providers of banking platforms to make sure transactions executed correctly, also assess technical skills of banks in setting up e-banking services and banks capabilities for dealing with problems another concern: validity of e-signatures. Electronic Signatures in Global and National Commerce Act of 2000 makes electronic signatures as legally binding as written signatures in most circumstances. Privacy concerns: electronic transactions can be stored on databases, banks are able to collect a huge amount of info about customers—their assets, creditworthiness, purchases, etc that can be sold to other financial institutions and businesses Gramm-Leach-Bliley Act of 1999 : limited distribution of data, but doesn't go as far as European Data Protection Directive, which prohibits the transfer of info about online transactions.

Mutual Savings Banks

similar to S&Ls but are jointly owned by the depositors approx half are chartered by states primarily regulated by the states in which they're located majority have their deposits insured by FDIC up to 250k per account subject to many of the FDICs regulations for state-chartered banks mutual savings banks whose deposits aren't insured by FDIC are inured by state insurance funds

Credit Unions

small cooperative lending institutions organized around a particular group of individuals with a common bond only depository institutions that are tax-exempt and can be chartered by states or federal gov; more than half are federally chartered NCUA issues federal charters and regulates federally chartered credit unions by setting minimum capital requirements, requiring periodic reports, and examining the credit unions. federal deposit insurance (up to 250k per account) is provided to federally chartered and state-chartered credit unions by a subsidiary of the NCUA, the National Credit Union Share Insurance Fund (NCUSIF) majority of credit union lending is for consumer loans with short terms to maturity, so these institutions did not suffer the financial difficulties of the S&Ls and mutual savings banks. small, hold less than 10 million of assets their ties to a particular industry/company make them more likely to fail when large numbers of workers in that industry or company are laid off and have trouble making loan payments. recent regulatory changes allow individual credit unions to cater to a more diverse group of people by interpreting the common bond requirement less strictly, and this has encouraged an expansion in the size of credit unions that may help reduce credit union failures in the future.

Index Funds

special kind of mutual fund that doesn't fit any of the above classes^ represents an alternative investment style traditional funds employ investments managers who select stocks and bonds for the funds portfolio If we believe in the concept of market efficiency, we would say that investment managers aren't likely to pick stocks any better than could randomly selecting one. If investment managers are not superior stock pickers, then why would we pay them a fee to provide a service that may not have any marginal benefit. Many investors want the benefit of mutual fund investing without the cost of paying for investment manager services index fund contains the stocks in an index ex: mammoth Vanguard S&P 500 index fund contains the 500 stocks in that index. stocks are held in a proportion such that changes to the fund value closely match changes to the index level. many other index funds available that mimic the behavior of various stock and bond indexes. dont require managers to choose securities so as a result they tend to have lower fees than other actively managed funds Some are that these funds will outperform most fund managers because they will ignore the fads, trend, emotions, and hysteria that often cloud investment adviser and individual investor judgement

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

stimulated bank consolidation further expanded the regional compacts to entire nation and overturned McFadden Act and Douglas Amendments prohibition of interstate banking allows bank holding companies to acquire banks in any other state and allows them to merge the banks they own into one bank with branches in diff states. states also have the option of opting out of interstate branching established the basis for a true nationwide banking system interstate banking was accomplished previously by out-of-state purchases of banks by bank holding companies, but until 1994 interstate branching was virtually nonexistent because very few states had enacted interstate branching legislation allowing interstate banking important because many bankers feel that economies of scale can't be fully exploited through the bank holding company structure, but only through branching networks in which all of the banks operations are fully coordinated nationwide banks now emerged, consolidation has led to banking organizations with operations in almost all 50 states

financial innovation

to maximize profits, FIs develop new products to satisfy their own needs as well as needs of customer. innovation is driven by the desire to get (or stay) rich A change in the financial environment will stimulate a search by FIs for innovations that are likely to be profitable

Adjustable Rate Mortgage

to reduce interest rate risk lenders dont want to give out a 10% mortgage then 2 months later find that they could be earning 12% on the same mortgage mortgage loans on which the interest rate changes when a market interest rate (usually T-bill rate) changes initially the mortgage might have a 5% interest rate. In 6 months, the interest rate might increase of decrease by the amount of the increase/decrease in the T-bill rate and the mortgage payments would change allow mortgage-issuing institutions to earn higher interest rates on mortgages when rates rise, and profits are high during these periods issued at lower initial rates than conventional fixed-rate mortgages, so popular with households since payment on adjustable rate mortgage can increase, many still prefer fixed-rate mortgages both types are popular

Macroprudential Policies

to short circuit leverage cycle, make capital requirements counter cyclical. adjusted upward during a boom and downward during bust during upward swing in leverage cycle, policies might involve forcing FIs to tighten credit standards or even direct limits on the growth of credit. downward swing, supervision might be needed to force banking system as a whole to raise an aggregate amount of new capital so that banks would not curtail lending in order to reduce the level of their assets and raise capital ratios. To ensure that FIs have enough liquidity, macroprudential policies could require that FIs have a sufficiently low net stable funding ratio (NSFR), which is the percentage of the institution's short-term funding in relation to total funding

e-cash

type of e-money used on the internet to buy goods or services consumer gets e-cash by setting up an account with a bank that has links to the internet and then has the e-cash transferred to her PC. When they want to buy something with e-cash, it is automatically transferred from their computer to merchants computer merchant then has funds transferred from consumers bank account to their bank account before the goods are shipped

micro prudential supervision

used by regulatory authorities before global financial crisis focuses on safety and soundness of INDIVIDUAL financial institutions looks at each institution separately and assess riskiness of its activities and whether it complies with disclosure requirements checks if institution satisfies capital ratios and, if not, it engages in prompt corrective action to force the institution to raise its capital ratios or supervisor closes it down focus on micro prudential supervision is not enough to prevent financial crisis problems of one fin institution can harm other fin institutions that are otherwise healthy

Savings Account (Non-transaction Deposits)

used to be most common funds can be added or withdrawn transactions & interest payments recorded in monthly statement or in owners passbook

account maintenance fee

usual fee charged by mutual funds charged by some funds to maintain low balance accounts.

Historical Cost (book value) accounting

value of an asset set at its initial purchase price problem: fluctuations in value of assets and liabilities bc of changes in interest rates or default arent reflected in calculation of firms equity capital. But changes in market value of assets and liabilities—and hence changes in the market value of equity capital—are what indicates if a firm is in good shape or getting into trouble and may therefore be more susceptible to moral hazard.

Financial Engineering

when FIs have to research and develop new products and services to meet customer needs and prove profitable in order to survive in new economic environemnts

Will "clicks" dominate "bricks" in banking industry ?

will virtual banks eliminate need and demand fo physical banks? probably not early internet-only banks had bad revenue growth and profits usually merged into larger banking organizations internet banking has a lot of cons in future: no pure internet banks likely online banking is used to COMPLEMENT services provided by traditional banks more & more banking services delivered over internet and number of physical bank branches likely to decline in future

International banking facilities (IBFs)

within the U.S. that can accept time deposits from foreigners but are not subject to either reserve requirements or restrictions on interest payments allowed to make loans to foreigners, but not to domestic residents. states have encouraged establishment of IBFs by exempting them from state and local taxes. treated like foreign branches of U.S. banks and are not subject to domestic regulations and taxes purpose of establishing IBFs is to encourage American and foreign banks to do more banking business in U.S. rather than abroad

Five Cs

Character Capacity (ability to repay) Collateral Conditions (in local and national economies) Capital (net worth) Used by bank loan officers to evaluate potential borrowers before agreeing to lend reduces incidence and severity of asymmetric info problems of moral hazard and adverse selection

Productive Uses of Excess Reserves

Invest in Securities or Make Loans (half of total value of bank assets)

loan commitment

for a fee, bank agrees to provide a loan at the customers request, up to a given dollar amount, over a specified period of time

Reserves

Asset all banks hold some of the funds they get as deposits in an account at the Fed deposits at the Fed + currency that is physically held by banks (vault cash) earn low interest rate held for 2 reasons: required reserves and excess reserves to meet obligations (withdrawals, checks)

Time Deposits (Non-transaction Deposits)

CDs, Certificates Deposits (long term) fixed maturity (few months to few years) penalties for withdrawing early (forfeiting several months interest) small-denomination time deposits (less than 100k) large-denomination Time Deposits (100k or more)

How Bank Rearranges Balance Sheet to make Profit after change in deposits

First Bank: receives $100 checkable deposit bank has to keep required reserves required reserves ratio: 10% required reserves: +$10 excess reserves: +$90 servicing deposits is expensive, so bank needs to put excess reserves to good use if it wants to make a profit. can't just leave money have to do something with it

Checkable Deposits

Liability bank accounts that allow owner of account to write checks to third parties includes all accounts on which checks can be drawn : Non-Interest-Bearing checking accounts (demand deposits) , interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposits accounts (MMDAs) subject to reserve requirements (except MMDA) makes up 10% of bank liabilities payable on demand (depositor goes to bank for withdrawal, bank must pay depositor immediately) or (if person receives check from an account at a bank, she can go to bank and they have to immediately give her the money) asset for depositor, part of their wealth Liability for bank bc depositor can withdraw funds and bank has to pay lowest-cost source of bank funds bc depositors willing to give up some interest in exchange for access to a liquid asset that can be used to make purchases

Non-transaction Deposits

Liability primary source of bank funds 60% of bank liabilities owners can't write checks, but interest rates paid is much higher than checkable deposits 2 types: Savings Accounts & Time Deposits (CDs)

how amount of capital affects returns to equity holders

basic measures of bank profitability: ROA & ROE ROA: measures how efficiently bank is run ROE: measures how well owners are doing on their investment EM: direct relationship between ROA & ROE owners of a bank may not want it to hold too much capital. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Leverage Ratio

capital/total assets high leverage ratio: above 5% , well capitalized low leverage ratio: below 3%, triggers increased regulatory restrictions on the bank.

too big to fail

caused by moral hazard created by a gov safety net and desire to prevent fin institution failure regulators reluctant to close down large fin institutions and impose losses on the depositors and creditors because doing so might bring financial crisis first happened with Continental Illinois in 1984. guaranteed deposits over the limit and prevented losses for bondholders a policy in which gov provides guarantees of repayment of large uninsured creditors of the largest banks, so that no depositor or creditor suffers a loss, even when the depositors and creditors are not automatically entitled to this guarantee. FDIC does this by using purchase and assumption method. gives insolvent bank large infusion of capital and then finds merger partner to take over banks and deposits applies to largest banks **when fin institution closes or merges, managers fired and stock holders lose investment increases moral hazard incentive for big bansk

NIM

difference between interest income and interest expenses as a percentage of total assets banks primary function: to issue liabilities and use the proceeds to purchase income-earning assets. If bank manager has done good job of asset and liability management, earns substantial income on its assets and has low costs on its liabilities, profits will be high. How well a bank manages its assets and liabilities is affected by the spread between the interest earned on the bank's assets and the interest costs on its liabilities. This spread is exactly what the net interest margin measures. If the bank is able to raise funds with liabilities that have low interest costs and is able to acquire assets with high interest income, the net interest margin will be high, and the bank is likely to be highly profitable. If the interest cost of its liabilities rises relative to the interest earned on its assets, the net interest margin will fall, and bank profitability will suffer.

Equity Multiplier (EM)

direct relationship between ROA & ROE amount of assets per dollar of equity capital = assets / equity capital owners of a bank may not want it to hold too much capital. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Financial Consolidation

financial consolidation leading to larger and more complex financial institutions poses 2 challenges to financial regulation bc of gov safety net 1. increased size of financial institutions resulting from financial consolidation increases too-big-to-fail problem bc there are now more large institutions whose failure would expose the financial system to systemic (systemwide) risk. more financial institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk increases the fragility of the financial system 2. financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance, or real estate activities, as occurred during the global financial crisis. increases incentives for greater risk taking in these activities, which can also weaken financial system. Limiting moral hazard incentives for larger, more complex financial organizations that have arisen as a result of recent changes in legislation is one of the key issues facing banking regulators in the aftermath of the global financial crisis.

How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis

financial crisis: slowdown in the growth of credit triggered a "credit crunch" in which credit was hard to get. was caused in part by the capital crunch where shortfalls of bank capital led to slower credit growth there was major boom and bust in housing market that led to huge losses for banks from their holdings of securities backed by residential mortgages banks also had to take back onto their balance sheets many of the structured investment vehicles (SIVs) they had sponsored. The losses that reduced bank capital, along with the need for more capital to support the assets coming back onto their balance sheets, led to capital shortfalls: Banks had to either raise new capital or restrict asset growth by cutting back on lending. Banks did raise some capital, but with the growing weakness of the economy, raising new capital was extremely difficult, so banks also chose to tighten their lending standards and reduce lending. Both of these helped produce a weak economy in 2008 and 2009.

Asset Management: 4. Manage liquidity so it can satisfy reserve requirements without bearing large costs

hold liquid securities even if they earn lower return than other assets bank has to decided how much excess reserves it will hold to avoid costs from deposit outflow want to hold us gov securities as secondary reserves so even if a deposit outflow forces some costs, they won't be too high bank shouldn't be too conservative, if it avoids all costs of deposit outflows by only holding excess reserves, bank will suffer losses bc reserves dont earn interest. Banks liabilities are costly to maintain, need to be earning money to keep up. Bank has to balance liquidity against earnings that can be made from less liquid assets like loans

Deposit Outflows with ample excess reserves

if a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet Required Reserve Ratio: 10% Bank Deposits: 100 million Required Reserves: 10 million Excess Reserves: 10 million Total Reserves: 20 million 10 million withdrawal (deposit outflows). Subtract 10 million from deposits (liabilities) and 10 million from reserves (assets). New deposits balance is 90 million, so new reserves requirement is 9 million. We still have 1 million in excess reserves bc our remaining balance of reserves in 10 million, 9 mil is required, 1 mil is excess

Payoff method

used by FDIC to handle bank failures FDIC allows bank to fail and pays off deposits up to 250k they get these funds from insurance premiums paid by banks that bought FDIC insurance After bank is liquidated, FDIC and other creditors line up, and paid their share of the proceeds from the liquidated assets those with more than $250k in the bank usually get back more than 90 cents on the dollar, but the process can take many many years to complete

Capital Shortage

worry that bank is short on capital relative to assets bc it doesn't have a sufficient cushion to prevent bank failure can raise the amount of capital relative to assets in 3 ways: (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 its liabilities

Bank Panics and need for Deposit Insurance

Before FDIC, if a bank failed depositors had to wait until the bank was liquidated (assets turned into cash) to get their $$ in the bank, when they did it would usually only be a fraction of total value of deposits Since they dont know if bank managers are taking on too much risks depositors didn't wanna put money in the bank , making banks less viable lack of info about the quality of bank assets can lead to a bank panic banks panics cause sharp decline in lending which is very harmful

Return on Assets (ROA)

basic measure of bank profitability net profit after taxes per dollar of assets net profit after taxes / assets provides info on how efficiently a bank is being run as it shows how much profit is generate on average by each dollar of assets

Asset Management: 3. Lower risk by diversifying

buying diff types of assets like ST & LT U.S. treasury & Municipal bonds and approving diff types of loans to bunch of customers. Avoid "too many eggs in one basket" problem

Return on Equity (ROE)

equity holders / bank owners care about how much bank is earning on their equity investment basic measure of bank profitability net profit after taxes per dollar of equity (bank) capital = net profit after taxes / equity capital

Why banks hold excess reserves

even though securities loans or securities earn higher return, holding excess reserves allows the bank to escape the costs of 1) borrowing from other banks or corporations 2) selling securities 3) borrowing from Fed 4) calling in or selling off loans Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold. bank is willing to pay cost of holding excess reserves (opportunity cost, earnings forgone by not holding income-earning assets like loans or securities) to ensure against losses due to deposit outflows. Excess reserves, like insurance, have a cost, so banks take other steps to protect themselves; might shift holdings of assets to more liquid securities (secondary reserves).

Operating Expenses

expenses incurred in conducting the banks ongoing operations interest payments that it must make on liabilities, (deposits) interest expenses vary with level of interest rate, 74% of total expenses when interest rates were at their highest, 9.3% when interest rates at lowest Noninterest expenses: cost of running a banking business like salaries, rent, utilities, equipment, servicing costs, etc PROVISIONS FOR LOAN LOSSES

Measuring Bank Performance

look at income statement to see how well a bank is doing income statement is a description of the sources of income and expenses that affect the banks profitability

government safety net

protects depositors, so overcomes reluctance to put funds in the banking system short-circuits runs on banks and bank panics ex: deposit insurance in countries without deposit insurance, gov had stood by to support bank runs other fin institutions failures, not just banks, also pose a threat to functioning of financial system (large, interconnected with market and institutions) gov lends from the central bank to troubled institutions. "Lender of last resort" role of central bank sometimes funds are provided directly to troubled institutions gov can also take over (nationalize) troubled institutions and guarantee that all creditors loans will be paid in full

Stress Testing

risk assessment procedure manager asks models what would happen if a doomsday scenario occurs; looks at the losses the institution would sustain if an unusual combination of bad events occurred.

Asset Management

to maximize profits: seek highest returns, reduce risk, and make adequate provisions for liquidity by holding liquid assets accomplished in 4 ways 1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on loan 2. Purchase securities with high returns and low risk 3. Lower risk by diversifying 4. Manage liquidity so it can satisfy reserve requirements without bearing large costs

Purchase and Assumption method

used by FDIC to handle bank failures FDIC reorganizes bank by finding merging partner who takes over all of failed banks liabilities so that no depositor or other creditor loses money incentivizes merger partner by giving it subsidized loans or buying some of the failed banks weaker loans net effect: FDIC has guaranteed all liabilities and deposits, not just deposits under 250k limit more costly for FDIC most common method before new legislation in 1991

Liability Management

used to be thought of as fixed 1960s: Money Center Banks new flexibility in liability management dont have to depend on checkable deposits as primary source of bank funds anymore liabilities (sources of funds) no longer a "given" aggressively set target goals for asset growth and tried to acquire funds by issuing liabilities as they were needed today money center banks can get funds for a loan opportunity by issuing negotiable CDs can borrow funds from another bank in federal funds market if it needs reserves without high transaction costs fed funds market can also be used to finance loans increased importance of liability management: ALM Committee negotiable CDs, bank borrowings more important source of funds than checkable deposits search for higher profits & flexibility in liability management: more loans in assets (earn higher income)

Assets

uses of funds bank uses funds that it got by issuing liabilities to buy income-earning assets. the interest income on the assets is what lets banks make profits Reserves, Cash Items in Process of Collection, Deposits at Other Banks, Securities, Loans, Other Assets

ROE

what equity holders/owners care about most net income per dollar of equity capital

required reserves

held because of reserve requirements: regulation that for every dollar of checkable deposits at a bank, a certain fraction (ex. 10 cents) must be kept as reserves. fraction is called required reserve ratio (10% in ex)

4 ways to eliminate shortfall of required reserves

1. Acquire reserves to meet deposit outflow by borrowing from other banks in federal funds market or from corporations (cost of this is the interest rate on the borrowings, like federal funds rate) 2. Sell some of its securities to help cover the deposit outflow ex. sell 9 mil of securities and deposit at the Fed (brokerage and transaction fees, low for U.S. gov securities bc very liquid "secondary reserves" higher for other securities that are less liquid) 3. borrow from Fed (discount loans) cost is discount rate (interest rate that must be paid to Fed) 4. Reduce loans and deposit the 9 million in proceeds with the Fed ( costliest)

4 concerns of Bank Manager

1. Make sure bank has enough cash on hand for deposit outflows (when depositors make withdrawals and demand payment) To keep enough cash on hand, bank has to engage in Liquidity management (acquiring sufficient liquid assets to meet obligations to depositors) 2. Asset management (pursue acceptably low level of risk by acquiring assets that have low rate of default and diversifying asset holdings) 3. Liability Management (acquire funds at low cost) 4. Capital Adequacy Management (decide the amount of capital the bank should maintain and then acquire the needed capital)

2 reasons for emphasis on Asset Management

1. more than 60% of bank funds were acquired through checkable (demand) deposits that by law couldn't pay any interest so banks couldn't compete with each other for the deposits by paying interest on them, and so their amount was effectively a given for an individual bank. (fixed liability) 2. Markets for overnight loans between banks weren't well developed so they rarely borrowed from one another to meet reserve needs

how bank capital helps prevent bank failure

A bank maintains bank capital to lessen the chance that it will become insolvent. if bank has to write off any losses, it wants a high enough bank capital cushion to absorb the losses so that way its net worth doesn't become negative and forced into insolvency. Want the net worth to remain positive even after a loss

Loans

Asset banks make profits mainly by issuing loans 55% of bank assets, responsible for more than 50% of bank revenues asset for the bank bc it provides income to bank liability for individual/ corporation receiving it less liquid, can't be turned into cash until loan matures higher probability of default than other assets bc of lack of liquidity and higher default risk, bank earns its highest return on loans largest category: commercial and industrial loans made to businesses and real estate loans banks also make consumer loans and lend to each other most interbank loans are overnight loans lent in the federal funds market difference in balance sheets among depository institutions is based on type of loan they specialize in Credit unions: consumer loans Savings & Loans & Mutual Savings Banks: Residential Mortgages

Cash Items in Process of Collection

Asset check written on an account at another bank is deposited in your bank and the funds for this check have not yet been received (collected) from the other bank. The check is a "cash item in process of collection" an asset for your bank because it is a claim on another bank for funds that will be paid within a few days

Securities

Asset important income-earning asset only debt instruments for banks bc banks can't hold stock 20% of bank assets account for 10% of revenue 3 categories: U.S. gov & agency securities, state & local gov securities, & other securities u.s. gov and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs banks hold state & local gov securities bc they will be more likely to do business with banks that hold their securities State & local gov and other securities are tax deductible but are less marketable (less liquid) and riskier than U.S. gov securities, primarily because of default risk: There is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature.

Deposits at Other Banks

Asset many small banks hold deposits in larger banks in exchange for services like check collection, foreign exchange transactions, & help with securities purchases aspect of "correspondent banking"

Other Assets

Asset physical capital (bank buildings, computers, and other equipment) owned by the bank

ALM Committee

Asset-Liability Management Committee Because of the increased importance of liability management, most banks now manage both sides of the balance sheet together in an asset-liability management (ALM) committee.

Capital Adequacy Management

Banks decide amount of capital they need to hold for 3 reasons. 1. bank capital helps prevent bank failure, (bank can't satisfy its obligations to pay its depositors & other creditors and so goes out of business.) 2. amount of capital affects returns for the owners (equity holders) of the bank. 3. a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities.

Financial Institution (FI)

FI MEANS FIANCIAL INSITUTION FROM HERE ON

How banks gain and lose reserves

First National Bank deposits the check in its account at the Fed, and the Fed collects the funds from the Second National Bank the Fed transfers $100 of reserves from the Second National Bank to the First National Bank, When a check written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount. when a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves.

Backup Lines of Credit

Generates fee income mos important: loan commitment now available to bank depositors with overdraft privileges, customers can write checks in excess of their deposit balances and in effect write themselves a loan other lines of credit: standby letters of credit to back up issues of commercial paper and other securities and credit lines (called note issuance facilities, NIFs, and revolving underwriting facilities, RUFs) for underwriting Euronotes, which are medium-term Eurobonds. increase the risk a bank faces doesn't appear on balance sheet, but still exposes bank to default risk guaranteed security risk: if security issuer defaults, bank has to pay off securitys owner. credit lines risk: might force bank to provide loans when it doesn't have enough liquidity or when borrower is a very poor credit risk

Principal Agent problem in managing trading activities

Given the ability to place large bets, a trader (the agent), whether she trades in bond markets, in foreign exchange markets, or in financial derivatives, has an incentive to take on excessive risks: If her trading strategy leads to large profits, she is likely to receive a high salary and bonuses, but if she takes large losses, the financial institution (the principal) will have to cover them. management of firms must set up internal controls like: -complete separation of the people in charge of trading activities from those in charge of the bookkeeping for trafes managers must set limits on the total amount of traders transactions and on the institutions risk exposure managers must also scrutinize risk assessment procedures using latest computer technology: Value At Risk Approach and Stress Testing use the above to assess risk exposure and take steps to reduce it U.S. bank regulators are concerned with increased risk that banks face from off balance sheet activities and encourage banks to pay more attention to risk management Bank for International Settlements is developing additional bank capital requirement based on VAR calculations for a bank trading activities

Asset Management: 1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on loan

banks seek out loan business by advertising borrowing rates and approaching corporations directly to solicit loans banks loan officer decides if potential borrowers are good credit risks (will make payments on time) by screening them to reduce adverse selection problem conservative loan policies, default rate less than 1% shouldn't be too conservative or will miss out on good opportunities that earn high interest rates

Bank Panic / Bank Run

To understand why bank panics occur, consider the following situation. Deposit insurance does not exist, and an adverse shock hits the economy. As a result of the shock, 5% of banks have such large losses on loans that they become insolvent (have a negative net worth and so are bankrupt). Because of asymmetric information, depositors are unable to tell whether their bank is a good bank or one of the 5% that are insolvent. Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits and therefore are inclined to withdraw them. Indeed, because banks operate on a "sequential service constraint" (a first-come, first-served basis), depositors have a very strong incentive to be first to show up at the bank because if they are last in line, the bank may have paid out all its funds and they will get nothing. The incentive to "run" to the bank to be first is why withdrawals when there is fear about the health of a bank is described as a "bank run." Uncertainty about the health of the banking system in general can lead to runs on both good and bad banks, and the failure of one bank can hasten the failure of others (referred to as the contagion effect). If nothing is done to restore the public's confidence, a bank panic can ensue.

excess reserves

additional reserves held by banks most liquid of all bank assets and it can use them to meet its obligations (withdrawals, checks)

9 Types of Financial Regulation

aimed at lessening asymmetric info problems and excessive risk taking in financial system: (1) restrictions on asset holdings, (2) capital requirements, (3) prompt corrective action, (4) chartering and examination, (5) assessment of risk management, (6) disclosure requirements, (7) consumer protection, (8) restrictions on competition, (9) macroprudential regulation.

Trade-off Between Safety and Returns to Equity Holders

bank capital benefits: makes owners investment safer by reducing the likelihood of bankruptcy costly: bc the higher the bank capital, the lower the ROE for a given return on assets managers have to decide how much safety that comes with higher capital (benefit) they are willing to trade off against the lower return on equity that comes with higher capital (cost) Uncertain times: if possibility of large losses on loans increases, managers might want to hold more capital to protect equity holders Confident times: if they dont think loan losses will occur, managers might want to reduce amount of capital, have a higher EM, and therefore increase ROE

Provision for Loan Losses

bank has a bad debt or anticipates that a loan might become a bad debt, it can write up the loss as a current expense in its income statement under the "provision for loan losses" heading. directly related to loan loss reserves When a bank wants to increase its loan loss reserves account by, say, $1 million, it does this by adding $1 million to its provisions for loan losses. Loan loss reserves rise when this is done because by increasing expenses when losses have not yet occurred, earnings are being set aside to deal with the losses in the future. major element in fluctuating bank profits in recent years

Basic Operation of a Bank

bank makes profit by selling liabilities with one set of characteristics (specific combo of liquidity, risk, size, and return) and using the proceeds to buy assets with a diff set of characteristics also called asset transformation "borrows short and lends long" makes LT loans and funds them by issuing short dated deposits If bank produces good services at low cost and earns good income on assets, it earns profits. if not, bank suffers loss

Asymmetric info problems

banks are well suited to solve adverse selection and moral hazard problems because they make private loans that help avoid the free rider problem but this solution to the free rider problem creates another asymmetric info problem bc depositors dont have information about the quality of these loans this asymmetric info problem leads to other problems in financial system

Trading Activities and Risk Management

banks engaged in international banking also conduct transactions in the foreign exchange market these are off balance sheet activities bc they dont have direct effect on the balance sheet directed towards reducing risk or facilitating other bank business but, sometimes banks also engage in speculation which is very risky and leads to insolvency trading is highly profitable but dangerous bc it makes it easy for financial institutions and their employees to make huge bets quickly severe principal agent problem

Bank Capital Requirements

banks required by regulatory authorities to keep bank capital high costs of holding capital so managers usually want to hold less bank capital relative to assets than is required. so, amount of bank capital is determined by bank capital requirements

Moral Hazard and Government Safety Net

incentive of one party in a transaction to engage in activities detrimental to other other party issue in insurance existence of insurance provides increased incentives for taking risks that might result in an insurance payoff depositors and creditors know they won't suffer loss if fin. institution fails so they dont impose disciple of marketplace on the institutions by withdrawing funds when they suspect the fin institution is taking on too much risk fin institutions have incentive to take on greater risks bc taxpayers will take the bill if bank fails.

Loan Sales

income generated by loan sales off-balance sheet activity 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 from the banks balance sheet banks earn profits by selling loans for slightly larger amount than that of original loan high interest rates on loans makes them attractive, so institutions are willing to buy even though higher price means that they earn lower interest rate than the original rate on the loan, usually on the order of 0.15 percentage point

Operating Income

income that comes from a banks ongoing operations mainly generated by interest on its assets, mainly loans (abt 65.4% of operating income) interest income fluctuates with the level of interest rates, so its percentage of operating income is HIGHEST when Interest rates are at PEAK LEVELS non interest income (34.6% of operating income) generated partly by service charges on deposit accounts , but mainly from OFF BALANCE SHEET activities, which generate fees or trading profits for the banks

Bank Balance Sheet

list of the banks assets and liabilities total assets = total liabilities + capital a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets)

Asset transformation

makes profit by selling liabilities with one set of characteristics (specific combo of liquidity, risk, size, and return) and using the proceeds to buy assets with a diff set of characteristics person A's savings deposit @ bank provides the funds that bank uses to make a mortgage loan to person B savings deposit transformed into a mortgage loan asset held by depositor --> asset held by bank

(1) restrictions on asset holdings

moral hazard with gov safety net encourages too much risk taking on part of financial institutions even with gov safety net, fin institutions have incentive to take on too much risk risky assets provide higher earnings if they pay off but if they dont and institution fails, depositors and creditors are hurt the most acquiring info on institutions activities is hard, monitoring is not easy depositors and creditors can't really do anything even before gov safety nets, desire for gov regulation existed to make financial institutions reduce risk banks most prone to panics, so subject to strict regulations to restrict holding risky assets like common stocks. regulations also promote diversification, which reduces risk by limiting the dollar amount of loans in particular categories or to individual borrowers it is likely that nonbank financial institutions may face greater restrictions on their holdings of risky assets. worry that these restrictions may become so onerous that efficiency of financial system will be impaired

insolvency

negative net worth, bank doesn't have sufficient assets to pay off all holders of its liabilities government regulators close the bank, assets are sold off, and managers fired

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 make profits by charging an interest rate on their asset holdings of securities and loans that is higher than the interest and other expenses on their liabilities

Basel Accord (risk-based)

off balance sheet activities dont appear on balance sheet but still expose banks to risk involving trading financial instruments and generating income from fees requires that banks hold at least 8% of their risk-weighted assets as capital Assets allocated in 4 categories, each with different weight to reflect the degree of credit risk limitation: regulatory measure of bank risk as stipulated by the risk weights differed substantially from the actual risk the bank faced resulted in regulatory arbitrage Basel Accord thus led to increased risk taking, the opposite of its intent. revised to Basel 2 and Basel 3

Generation of Fee Income

off-balance-sheet activity income from fees that banks charge their customers for services like foreign exchange trades on their behalf, servicing mortgage-backed security by collecting interest and principal payments and then paying them out, guaranteeing debt securities like bankers acceptances (bank promises to make interest and principal payments if issuing party cannot) and providing backup lines of credit guaranteed security risk: if security issuer defaults, bank has to pay off securitys owner. credit lines risk: might force bank to provide loans when it doesn't have enough liquidity or when borrower is a very poor credit risk

Income

operating income- operating expenses = net operating income net operating income closely watch by managers, shareholders, and regulators as it indicates how well the bank is doing on an ongoing basis Two items: gains (or losses) on securities sold by banks and net extraordinary items ( events or transactions that are both unusual and infrequent) are added to net operating income to get net income before taxes. Net income before taxes : more commonly referred to as profits before taxes Subtracting income taxes then results in net income. Net income: more commonly referred to as profits after taxes, tells us most directly how well the bank is doing because it is the amount that the bank has available to keep as retained earnings or to pay out to stockholders as dividends.

Adverse Selection and Government Safety Net

people most likely to produce adverse outcome insured against (bank failure) are the ones who want to take advantage of insurance the most. since depositors and creditors are protected by gov, they won't check up on fin institutions, they can engage in super risky activities no reason to monitor, too much fraud without gov safety net

Moral Hazard and 'Too Big to Fail'

policy increases moral hazard incentives for big banks If FDIC using payoff method, paying depositors up to $250,000 limit, depositors with more than $250,000 would suffer losses if the bank failed. So they would have an incentive to monitor bank by examining bank's activities and pulling their money out if bank was taking on too much risk. To prevent loss of deposits, bank will engage in less risky activities. once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk because No matter what the bank does, large depositors will not suffer losses. result of the too-big-to-fail policy is that big financial institutions might take on even greater risks, thereby making bank failures more likely also increases moral hazard incentives for nonbank financial institutions that are extended a government safety net. Knowing that the financial institution will be bailed out, creditors have little incentive to monitor the institution and pull their money out when the institution is taking on excessive risk. As a result, large or interconnected financial institutions are more likely to engage in highly risky activities, making a financial crisis more likely.

Value At Risk Approach

risk assessment procedure institution develops a statistical model with which it can calculate the Max loss that its portfolio is likely to sustain over a given time interval, dubbed value at risk, or VAR ex: bank might estimate that the maximum loss it would be likely to sustain over one day with a probability of 1 in 100 is $1 million; the $1 million figure is the bank's calculated value at risk.

Basel Committee

set up by banking officials from industrialized nations implemented Basel Accord

money market deposits accounts (MMDAs)

similar to money market mutual funds not subject to reserve requirements