Money and Banking Chapter 8, 9, 10, 11

Financial Intermediation

A financial intermediary, such as a bank, becomes an expert in producing information about firms so that it can sort out good credit risks from bad ones. An important element of the bank's ability to profit from the information it produces is that it avoids the free-rider problem by primarily making private loans, rather than by purchasing securities that are traded in the open market.

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

A major boom and bust in the housing market led to huge losses for banks from their holdings of securities backed by residential mortgages. These losses reduced bank capital, which 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.

The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

A study by the World Bank found that deposit insurance actually leads to less banking sector stability and a higher incidence of banking IN COUNTRIES WITH WEAK INSTITUTIONAL ENVIORNMENTS: an absence of rule of law, ineffective regulation and supervision of the financial sector, and high corruption.

How transaction costs influence financial structure (Divisibility and Diversification problems)

About one-half of American households own any securities Because you have only a small amount of funds available, you can make only a restricted number of investments, because a large number of small transactions would result in very high transaction costs. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk.

Liability Management - banks acquire funds to undertake attractive loan opportunities by:

Acquiring checkable and time deposits Borrowing in the Federal Funds market. Selling negotiable CDs.

Restrictions on competition

Although beneficial in preventing bank failures, the negative anti competitive consequences resulted in the repeal of most forms of restrictive regulations other than the chartering requirement discussed above.

Money Market Mutual Funds

Although money market fund shares effectively function as checking account deposits that earn interest, they are not legally deposits and so are not subject to reserve requirements or prohibitions on interest payments. For this reason, they can pay higher interest rates than deposits at banks.

Assessment of risk management

Bank examiners now place far greater emphasis on evaluating the soundness of a bank's management processes with regard to controlling risk. In addition, new guidelines require the bank's board of directors to establish interest-rate risk limits, appoint officials of the bank to manage this risk, and monitor the bank's risk exposure. Lastly, bank processes also require implementation of stress tests and value-at-risk (VaR) analysis of the bank's trading portfolio.

Restrictions on asset holdings

Because banks are the financial institutions most prone to panics, they are subjected to strict regulations that restrict their holdings of risky assets, such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the dollar amounts of loans in particular categories or to individual borrowers.

Adverse Selection and the Government Safety Net

Because depositors and creditors protected by a government safety net have little reason to impose discipline on financial institutions, risk-loving entrepreneurs might find the financial industry a particularly attractive one. Even worse, without government intervention outright crooks might also find finance an attractive industry for their activities.

Test Question: Increase Expected ROE through an Increase in Financial Leverage - the following actions may be taken to increase the bank's financial leverage.

Buy back bank stocks Increase dividend payout Increase bank assets (loans, securities, etc.) by acquiring additional liabilities (time deposits, CDs, etc.), but leave equity capital unchanged

Liabilities include

Checkable Deposits Nontransaction Deposits (Savings Accounts, Time Deposits (CDs), Borrowings)

Collateral and Compensating Balances

Compensating balance arrangements serve as collateral and make it easier for banks to monitor borrowers more effectively.

The following four types of restrictive covenants achieve Monitoring and Enforcement of Restrictive Covenants:

Covenants to discourage undesirable behavior - such as investing in risky investment projects. Covenants to encourage desirable behavior - such as the maintenance of minimum levels of liquidity and financial leverage Covenants to keep collateral valuable - such as the requirement that the firm carry various forms of insurance and carry maintenance contracts on assets used as collateral on loans. Covenants to provide information - such as the requirement to provide quarterly financial information and stipulate the lender has the right to audit the firm's accounting records.

Test Question: Decrease Bank Risk through a Decrease in Financial Leverage - the following actions may be taken to decrease the bank's financial leverage.

Issue new common stock Reduce dividend payout Reduce liabilities using the proceeds from the sale of securities or loans.

The Lemons Problem: How adverse selection influences financial infrastructure

It is called the "lemons problem" because it resembles the problem created by "lemons," that is, bad cars, in the used-car market. Potential buyers of used cars are frequently unable to assess the quality of a car; that is, they can't tell whether a particular used car is one that will run well or a lemon that will continually give them grief. The price that a buyer pays must therefore reflect the average quality of the cars in the market, somewhere between the low value of a lemon and the high value of a good car.

New Firm Security Issues and Securitization Effects

Junk Bonds Commercial Paper Securitization and the Shadow Banking System

What is on the Balance Sheet?

Liabilities Bank Capital (Net Worth) Assets

Asset Management - four bank asset management strategies include the following:

Make high rate loans that have low default risk. Purchase securities with high returns and low risk. Extend loans across a diversified group of borrowers and invest in a diversified portfolio of securities. Manage the liquidity of its assets so that it can meet deposit outflows, including carrying an appropriate level of excess reserves.

Tools to Help Solve Moral Hazard in Debt Contracts

Net worth and collateral Monitoring and enforcement of restrictive covenants Financial intermediation

"Too big to fail"

One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. 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. Similarly, the too-big-to-fail policy increases the moral hazard incentives for nonbank financial institutions that are extended a government safety net (e.g., Bear Stearns, Lehman Brothers, and AIG).

Financial Supervision: Chartering and Examination

Overseeing who operates financial institutions and how they are operated, referred to as financial supervision or prudential supervision , is an important method for reducing adverse selection and moral hazard in the financial industry. As a part of the ongoing bank monitoring effort, bank examiners give banks a CAMELS rating. The acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk.Financial Supervision: Chartering and Examination`

Test-question: Two FDIC Methods for Handling Failed Banks

Payoff Method Assumption Method (Usually used more)

Capital Adequacy Management - banks need to maintain adequate capital (equity or net worth) for the following three reasons.

Prevent bank failure Impact on the bank's return on equity (ROE) Meet the minimum level of capital as per regulatory requirements

How the Amount of Bank Capital Affects Returns to Equity Holders

ROE= ((Net Income of available consumer sales/ Sales) * (Sales/Total assets)) = ROA * (Total Assets/ Consumer Equity) = ROE

Disclosure requirements

Regulation to increase disclosure is needed to limit incentives to take on excessive risk and to upgrade the quality of information in the marketplace so that investors can make informed decisions, thereby improving the ability of financial markets to allocate capital to its most productive uses.

Assets include

Reserves (Required reserves, excess reserves) Cash Items in Process of Collection Deposits at other banks Securities (Secondary reserves) Loans Other assets

Financial Innovation and the Growth of the "Shadow Banking System" - as discussed in the textbook, there are three basic types of financial innovation:

Responses to Changes in Demand Conditions Responses to Changes in Supply Conditions Avoidance of Existing Regulations

Managing Credit Risk - To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely. Financial institutions attempt to solve these problems by focusing on the following five principles.

Screening and Monitoring Long-term customer relationships Loan commitments Collateral and Compensating balances Credit rationing

Restrictions on Deposit Interest Rates

Until 1980, legislation prohibited banks in most states from paying interest on checking account deposits, and through Regulation Q, the Fed set maximum limits on the interest rate that could be paid on savings and time deposits.

Consumer protection

Various forms of regulations directed toward protecting consumers include the Truth in Lending Act, The Fair Credit Billing Act of 1974, The Equal Credit Opportunity Act of 1974, The Community Reinvestment Act of 1977, and most recently, the creation of the Consumer Financial Protection Bureau.

Test-Question: Trade-Off Between Safety and Returns to Equity Holders

While financial leverage increases the bank's expected return on equity, it also makes the return to equity holders more uncertain due to a greater variability in the possible ROE outcomes. Accordingly, the bank is faced with a trade-off between expected ROE and ROE uncertainty (equity-holder risk). In effect, the bank wants to carry the appropriate amount of financial leverage in order to realize as high an expected ROE without realizing too much ROE dispersion. (Note that the higher the ROE dispersion, the higher the equity holder's required return. Consequently, both too much and too little financial leverage will adversely affect the bank's stock price.)

Moral Hazard and the Government Safety Net

With a safety net, depositors and creditors know they will not suffer losses if a financial institution fails, so they do not impose the discipline of the marketplace on these institutions by withdrawing funds when they suspect that the financial institution is taking on too much risk. Likewise, financial institutions with a government safety net have an incentive to take on greater risks than they otherwise would, because taxpayers will foot the bill if the bank subsequently goes belly up.

Financial Consolidation and the Government Safety Net

With recent financial innovations and the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, financial consolidations have both increased the size and scope of the too-big-to-fail problem to include additional nonbank financial institutions, thus increasing and extending the moral hazard problem and resulting risk-taking.

Mutual Funds

a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks

Required Reserves

a fraction of checkable deposits the bank must hold at the Fed based on the required reserve ratio

Loan commitments

a loan commitment arrangement is a powerful method for reducing the bank's costs of screening and information collection.

Asymmetric Information

a situation that arises when one party's insufficient knowledge about the other party involved in a transaction makes it impossible for the first party to make accurate decisions when conducting the transaction.

Adverse Selection

an asymmetric information problem that occurs before a transaction occurs, wherein over-valued equity and potential bad credit risks are the ones that most actively seek out new capital. Largely explains the first seven of the eight facts about financial structure. ex. people who tend to like to go into banking; especially attractive to criminals

Sweep Accounts

any balances above a certain amount in a corporation's checking account at the end of a business day are "swept out" of the account and invested in overnight securities that pay interest. This enables banks to avoid the "tax" from reserve requirements on these account balances.

Moral Hazard

arises after the transaction occurs, wherein the lender runs the risk that the borrower will engage in activities that are undesirable from the lender's point of view, because such activities make it less likely that the loan will be paid back. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. ex. borrower undertakes an unreasonable action that was unexpected based on the original terms

The Tyranny of Collateral

as Hernando De Soto documents in his book The Mystery of Capital, it is extremely expensive and time-consuming for the poor in developing countries to make their ownership of property legal. Without legal title, however, none of this property can be used as collateral to borrow funds, a requirement for most lenders. When the financial system is unable to use collateral effectively, the adverse selection problem worsens because the lender needs even more information about the quality of the borrower in order to distinguish a good loan from a bad one. The institutional environment of a poor legal system, weak accounting standards, inadequate government regulation, and government intervention through directed credit programs and state ownership of banks all help explain why many countries stay poor while others grow rich.

Loans

banks make profits primarily by issuing loans, which account for approximately 57% of bank assets. The largest categories of loans for commercial banks are commercial and industrial loans made to businesses and real estate loans. The major difference in the balance sheets of the various categories of depository institutions is primarily in the type of loan in which they specialize.

Secondary Reserves

because of their high liquidity, short-term U.S. government securities

Capital requirements

come in the form of an overall leverage ratio and risk- based capital requirements as structured via the Basel Accord, which REQUIRES THAT BANKS HOLD AS CAPITAL AT LEAST 8% OF THEIR RISK-WEIGHTED ASSETS - with different capital requirements across four asset risk categories.

Reserves

consist of deposits at the Fed and vault cash.

Credit Rationing

decisions regarding whether to make a loan, the interest rate on the loan, and the loan amount.

Deposits at Other Banks

deposits at another bank necessary for a variety of services, including check collection, foreign exchange transactions, etc., and represents one aspect of a system called correspondent banking

Capital Adequacy Management

determine the appropriate level of and manage the bank's equity capital (net worth).

Screening and Monitoring

differentiate good from bad credit risks by looking at the borrower's credit score and other relevant information. Once a loan has been made, the lender monitors the activities of the borrower to ensure the borrower is complying with the loan's restrictive covenants. Although counterproductive from a diversification standpoint, note that the specialization of lenders in making loans to local firms within certain industries allows banks to both better monitor borrowers and attain industry-specific knowledge and expertise.

How Financial Intermediaries Reduce Transaction Costs

financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets. Economies of scale advantages (Higher the scale, lower the transaction cost)

Cash Items in Process of Collection

for example, a check deposited at the bank and in process.

Borrowings

funds borrowed from the Federal Reserve (discount loans), the Federal Home Loan banks, other banks, and corporations. Account for approximately 17% of bank liabilities.

Government Regulation to Increase Information (Agent Problem)

governments everywhere have laws to force firms to adhere to standard accounting principles that make profit verification easier.

Time Deposits (CDs)

have a fixed maturity length with penalties for early withdrawal Large-denomination time deposits

Enron

illustrates that government regulation can lessen asymmetric information problems but cannot eliminate them.

Test question: what affected the decrease in relative competitiveness of banks in relation to bonds?

improvements in information technology

Economies of Scale

the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows

General Principles of Bank Management

toward the goal of earning the highest possible profit for a given level of risk, the bank manager has the following four primary concerns. Liquidity Management and the Role of Reserves Asset Management Liability Management Capital Adequacy Management

Test-Question: Avoidance of Existing Regulations

two forms of regulations, reserve requirements and restrictions on deposit interest rates, have proven to be major forces behind financial innovation.

Debt Contracts

unlike equity-holders, creditors are only concerned with firm performance that impacts the firm's ability to service its debt payments. The less frequent need to monitor the firm, and thus the lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital. Accordingly, high net worth and collateral makes the debt contract incentive-compatible; ; that is, it aligns the incentives of the borrower with those of the lender.

Eight Basic Facts About Financial Structure

1) Stocks are NOT the most important source of external financing for businesses. 2) Issuing marketable debt and equity securities is NOT the primary way in which businesses finance their operations. 3) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4) Financial intermediaries, particularly banks, are the most important source. of external funds used to finance businesses 5) The financial system is among the most heavily regulated sectors of the economy. 6) Only large, well-established corporations have easy access to securities markets to finance their activities. 7) Collateral is a prevalent feature of debt contracts for both households and businesses. 8) Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.

Federal Deposit Insurance Corporation (FDIC)

During the Great Depression years 1930-1933, some 9,000 bank failures wiped out the savings of many depositors at commercial banks. To prevent these occurrences in the future, the Federal Deposit Insurance Corporation (FDIC) was created. Member banks of the Federal Reserve System were required to purchase FDIC insurance for their depositors, and non-Federal Reserve commercial banks could choose to buy this insurance (almost all of them did). The purchase of FDIC insurance made banks subject to another set of regulations imposed by the FDIC.

Is China a Counterexample to the Importance of Financial Development?

Even though available savings have not always been allocated to their most productive uses, the huge increase in capital, combined with the gains in productivity achieved by moving labor out of low-productivity, subsistence agriculture, have been enough to produce high growth. As China gets richer, however, this strategy is unlikely to continue to work. The Soviet Union provides a graphic example.

Test-Question: Payoff Method

FDIC pays off all deposits of $250,000 or less, liquidates the bank assets, and pays out the remaining proceeds to depositors with bank accounts in excess of $250,000. The liquidation of bank assets and final payouts often took several years to complete.

Test-question: Assumption Method

FDIC reorganizes the bank, typically finding a willing merger partner that is often enticed with subsidized loans or purchase of some of the weaker loan assets. Although this method was typically more costly, it was the general method of choice practiced by the FDIC.

Expertise

Financial intermediaries are also better able to develop expertise that can be used to lower transaction costs. Their expertise in computer technology, for example, enables them to offer their customers convenient services such as check-writing privileges on their accounts and toll-free numbers that customers can call for information on how well their investments are doing.

Asymmetric Information (Financial Regulation)

Given that depositors lack information about the quality of a bank's private loans, there exists an asymmetric information problem that drives adverse depositor behavior should they become concerned of a potential bank failure. This asymmetric information problem leads to other problems that interfere with the proper functioning of the financial system and an argued need for government involvement.

Bank Panics

Given the previously noted asymmetric information problem, depositor concerns regarding the quality of a bank's assets and the possibility of the bank's failure often resulted in a run on the bank to withdraw deposits - events commonly referred to as a bank run . Given that depositors didn't have adequate information to differentiate healthy from unhealthy banks, news of a potential problem at one bank often led to a contagion effect across the entire banking system, setting off bank panics that occurred approximately every 20 years.

Prompt corrective action

If the amount of a financial institution's capital falls to low levels, banks will not only be more likely to fail, but they will also be more inclined to take on excessive risks - more prone to the moral hazard problem. In order to allow the FDIC to intervene earlier in order to mitigate these problems, banks are classified into five groups based on bank capital.

Test-Question-Where Is the Basel Accord Heading After the Global Financial Crisis? - A few of the more important changes of "Basel 3" include:

Improving the quality of capital, Making capital requirements less procyclical New rules on the use of credit ratings (previously determined to be undependable), and Increased requirements on financial institutions to have more stable funding to better handle liquidity shocks

Government Safety Net (Deposit Insurance)

In order to mitigate the negative effects of bank runs on the financial system and the economy in general, legislation was passed in 1934 that created the Federal Deposit Insurance Corporation (FDIC), which currently guarantees bank deposits up to $250,000.

Other assets

The physical capital (bank buildings, computers, and other equipment) owned by banks.

Assets Management

acquire assets that have a good rate of return with a low rate of default that are diversified with respect to their risk characteristics.

Liability Management

acquire desired funds across a range of appropriate sources (deposits, loans, etc.) at reasonable interest rates.

Test-Question: Problem with Reserve Requirements?

acts as a tax on bank deposits.

Long-term customer relationships

allows the lender to gather information on the borrower over time, and given the ongoing nature of the relationship, encourages the borrower to avoid risky activities that could jeopardize availability of future loans.

Financial Intermediation (Agent Problem)

as a private investment provider for start-up firms, venture capital firms take equity positions and hold management positions in start-up firms. Because start-up firms funded by venture capital are not publicly traded, there is no free-rider problem associated with costly monitoring activities. In other words, the benefits of costly monitoring are realized by the venture capitalists. (Note that private equity firms solve the free-rider problem in a way like that of venture capital firms.)

Decline in Income Advantages in Uses of Funds (Assets)

as noted above, improvements in information technology have made it easier for firms to issue securities directly to the public. This change means that instead of going to banks to finance short-term credit needs, many of the banks' best business customers now find it cheaper to go instead to the commercial paper market for funds. The emergence of the junk bond market has also eaten into banks' loan business. As noted above, due to the increased competition driven by securitization, banks began to focus on earning realized from loan origination and loan servicing, selling off many of the banks' originated loans to be packaged into mortgage- backed bonds sold to investors hungry for higher yielding but collateralized investment instruments.

Decline in Cost Advantages in Acquiring Funds (Liabilities)

as noted above, the improvements in information technology and Regulation Q resulted in a competitive disadvantage for banks in raising funds, particularly given relatively high rates of inflation and a competitive advantage for money market mutual funds. These effects resulted in a decline in the amount of funds provided by bank checkable, savings, and time deposits - a process termed disintermediation. One manifestation of these changes in the financial system was that the low-cost source of funds, checkable deposits, declined dramatically in importance for banks, falling from more than 60% of bank liabilities to 11% today.

Financial Intermediation (Moral Hazard in Debt Contracts)

as previously discussed, financial intermediaries—particularly banks—can avoid the free-rider problem by primarily making private loans. loans. Unfortunately, this is not the case in the securities markets, which is why moral hazard continues to be a severe problem for marketable debt.

Other forms of the government safety net

as the "lender of last resort," central banks often provide funds directly to troubled institutions or even nationalize institutions whose failure are deemed to pose a systemic threat to the financial system. These institutions are often described as "Too Big to Fail."

Large-denomination time deposits

available in denominations of $100,000 or more, are negotiable, and purchased by corporations or other banks. Account for approximately 10% of bank liabilities.

Securities

made up entirely of debt instruments, because U.S. banks are not allowed to hold stock, and account for approximately 21% of bank assets and 10% of bank revenue.

Liquidity Management and the Role of Reserves

make sure the bank has the desired level of reserves (required and excess), including cash on hand to meet depositor withdrawals.

Collateral and Net Worth (equity)

mitigates the negative effects of adverse selection

Production of Information: Monitoring

note that costly state verification is subject to the free-rider problem.

Tools to Help Solve the Principal-Agent Problem

note that the principal-agent problem would not arise if the owners of a firm had complete information about what the managers were up to and could prevent wasteful expenditures or fraud. Economists refer to the costly process in which stockholders gather information by monitoring the firm's activities as state verification . Each of the following represent methods by which the principal - agent problem is mitigated.

Free-Rider Problem

prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. ex. not doing any work in a group project and getting by; banking aspect: joining in on an investment that looks good to get the same benefits, causing interest rates to spike

Financial Development and Economic Growth

recent research has found that an important reason why many developing countries and ex-communist countries like Russia (which are referred to as transition countries) experience very low rates of economic growth is that their financial systems are underdeveloped (a situation referred to as financial repression). In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, and the absence of corruption) functions poorly, making it hard for these two tools to function effectively.

Private Production and Sale of Information

reduces the asymmetric information problem

Monitoring and Enforcement of Restrictive Covenants

restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior.

Bruce Bent and the Money Market Mutual Fund Panic of 2008

the Reserve Primary Fund, with assets over $60 billion, was unable to redeem its shares at par value of $1, a situation known as "breaking the buck."

Agency Theory

the analysis of how asymmetric information problems affect economic behavior

Securities and Exchange Commission (SEC)

the government agency that requires firms selling their securities to undergo independent audits, in which accounting firms certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings

Excess Reserves

the most liquid of all bank assets.

Securitization

the process of bundling small and otherwise illiquid financial assets (such as residential mortgages, auto loans, and credit card receivables), which have typically been the bread and butter of banking institutions, into marketable capital market securities. While securitization provided the banks an ability to better manage their interest rate risk - in that they could eliminate select loans from their balance sheets, this financial innovation also resulted in a considerable increase in competition in this area of the loan markets. In effect, like other financial institutions competing in this space, banks began to focus on earning realized from loan origination and loan servicing, effectively replenishing their available funds with the sale of loans that in prior periods would have been carried on the books of the bank.

Net Worth and Collateral

when borrowers have more at stake because their net worth is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard is greatly reduced because the borrowers themselves have a lot to lose.

Scenario I: The required reserve ratio is 10% of deposits and the bank begins with the following balance sheet. Note that the bank has Deposits of $100m and Reserves of $20m,

which means the bank has $10m in excess reserves.