Econ Exam 3
information cost
adverse selection and moral hazard are examples of
1791
- Congress created First Bank of the United States
What makes the Fed independent?
- Congress created the Fed - President can elect the chairman of the Board of Governors every four years
Power and Authority with the Fed
- During its first 20 years, the decentralized District Bank system could not adequately respond to national economic and financial disturbances - the Banking Act of 1935 centralized the Board of Governors' control of the system, giving it a majority of seats (7 of 12) on the FOMC - the secretary of the Treasury and the comptroller of the currency were also removed from the Board of Governors - the information power structure within the Fed is more concentrated than the formal power structure. the Fed chairman is most powerful in the system - the distinction between ownership and control is clear
open market purchase
- Fed's purchase of securities
open market sale
- Fed's sale of securities
Member Banks
- Historically, state banks often chose not to join: 1. membership is costly 2. banks could also avoid the Fed's reserve requirements - the opportunity cost of being a member of the Fed increased during the 1960's and 1970's - The Fed urged Congress to compel all commercial banks to join the Federal Reserve System - Congress has not yet legislated such requirement - DIDMCA of 1980 required that all banks maintain reserve deposits with the Fed on the same terms
the Effect of Increase in Currency Holdings and Increases in Excess Reserves
- Key assumptions for deriving the simple deposit multiplier 1. Banks hold no excess reserves 2. the nonbank public does not increase its holdings of currency - need to relax the assumptions of the simple deposit multiplier: 1. to show a link between the monetary base and the money supply 2. to include the effects of changes in the nonbank public's desire to hold currency relative to checkable deposits - the more currency the nonbank public holds relative to checkable deposits, the smaller the multiplier deposit creation process 3. to include the effects of changes in banks' desire to hold excess reserves - the more excess reserves banks hold relative to their checkable deposits, the smaller the multiplier deposit creation process
the money multiplier
- MS = MB x m - the money multiplier is determined by the actions of three actors in the economy: the Fed, the Nonbank Public, and Banks - the money multiplier helps us understand the factors that determine the money supply
item's in the Fed's assets
- SDR (Special Drawing Rights): international type of monetray reserve created by IMF to supplement member countries' official reserves - coins: coins not in circulation are under the Fed's assets - cash items in the process of collection: funds of the check that the Fed is processing but for which the Fed has not yet collected the payment
Public Interest View
- a theory of central bank decision making that holds that officials act in the best interest of the public
Principal-Agent View
- a theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public
vault cash
- currency held by banks
Federal Reserve Bank
- district bank of the Federal Reserve system that, among other activities, conducts discount lending - there are 12 federal reserve banks
The Federal Open Market Committee
- has 12 members that direct open market operations -12 members include: 1. 7 members of the Board of Governors 2. other 5 members including the president of the Federal Reserve Bank of New York, and other 4 serve on rotating basis - the chairman of the Board of Governors serves as chairman of the FOMC - only 5 Federal Reserve bank presidents are voting members of the FOMC, but all 12 attend meetings and participate in discussions - the committee meets in Washington DC, 8 times each year - prior to each meeting, FOMC members access data from three books: 1. Green Book: national economic forecast for the next two years 2. Blue Book: projections for monetary aggregates 3. Beige Book: summaries of economic conditions in each district - the FOMC sets a target for the federal funds rate by buying and selling Treasury securities to adjust the level of bank reserves - the FOMC issues a domestic policy directive to the Fed's trading desk at the New York Fed - the manager for domestic open market operations carries out the directive by buying and selling Treasury securities with primary dealers (private financial firms that deal in these securities)
discount rate
- interest rate the Fed charges on discount loans - discount rate is set by the Fed
Board of Governors
- is headquartered in Washington DC - consists of seven members appointed by the president of the United States - members are confirmed by US Senate, and serve 14 year, non-renewable terms - the president chooses one member of the Board of Governors to serve as chairman. Chairmen serve four-year terms and may be reappointed - board members are professional economists fro business, government, and academia - administers monetary policy: 1. determine reserve requirements 2. set the discount rate charged on loans to banks - influences the setting of guidelines for open market operations - informally influences national and International economic policy decisions - advises the president and testifies before Congress on economic matters - is responsible for some financial regulation - exercises administrative controls over individual Federal Reserve banks
Roles of the Fed
- lender of last resorts - banker of banks - government's bank (treasury's general account) - partners with other countries' central banks
discount loan
- loan made by the Fed to a commercial - discount loans alter bank reserves - an increase in discount loans affects both sides of the Fed's balance sheet 1. $1 million of discount loans increases bank reserves and the monetary base by $1 million
Who makes the Fed Independent?
- long-term: members of the Board of Governors have 14-year staggered nonrenewable terms - instrumental independence - goal independence - financial independence
Changes to the Fed Under the Dodd-Frank Act
- main provisions of the bill that affected the Fed 1. the Fed was made a member of the new Financial Stability Oversight Council, which was charged with preventing the failure of large financial firms - one member of the Board of Governors will coordinate the Fed's regulatory actions - the Government Accountability Office (GAO) was ordered to perform an audit go the Fed's emergency lending programs - Class A directors will no longer participate in elections of the bank presidents - the Fed was ordered to disclose the names in elections of the bank presidents - the Fed was ordered to disclose the names of financial institutions to which it makes loans and with which it buys and sells securities - a new Consumer Financial Protection Bureau was established at the Fed to write rules concerning consumer protection from financial firms
Functions of District Banks
- manage check clearing in the payments system - manage currency in circulation - conduct discount lending - perform supervisory and regulatory functions -collecting and making available data on district business activities and publishing articles on monetary and banking topics - serve on the FOMC
excess reserves-to-deposit ratio (ER/D)
- mesures banks' holdings of excess reserves relative to their checkable deposits
Monetary Base
- monetary base (MB) = currency in circulation (C) + reserves (R)
Argument for Fed Independence
- monetary policy is too important and technical to be determined by politicians - politicians may be shortsighted, concerned with short-term benefits without regard for potential long-term costs - the public may well prefer that the experts at the Fed, rather than politicians, make monetary policy decisions - complete control of the Fed by elected officials increases the influence of political business cycle of the money supply
moral hazard
- outcome of asymmetric information
currency in circulation
- paper money and coins held by the nonbank public
multiple deposit creation
- part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits - as a result an increase in the money supply that is a multiple of the initial increase in reserves
bank reserves
- reserves = bank deposits with the Fed + vault cash
items in the Fed's liabilities
- reverse repurchase agreement: sell securities and agree to buy them back at a later date (short-term loan) - deferred availability cash items: the funds of the check that the Fed is processing but soon will credit to the bank that receive the check
How the Fed Changes the Monetary Base
- the Fed changes the monetary base by changing the levels of its assets: 1. open market operations 2. discount loans - open market operations are carried out electronically with primary dealers by the Fed's trading desk - as of 2019, there are 24 primary dealers (commercial banks. investment banks, and securities dealers)
Comparing Open Market Operations and Discount Loans
- the Fed has greater control over open market operations
How the Fed Operates
- the Fed is designed to operate largely independently of external pressures - the Fed foes not have to ask Congress for the funds to operate - most of the fed's earnings come from: 1. interest on the securities it holds and discount loans 2. fees for check-clearing and other services - but the Fed isn't completely insulated from external pressure: 1. the president can exercise control over the membership and may appoint a new chairman every four years 2. the US Constitution does not specifically mandate a central bank, so Congress can even abolish it entirely
Factors that motivate the Fed
- the Fed seeks to achieve economic goals that are in the public interest - some economists argue that the public interest view doesn't appear to apply with regard to price stability (ex: persistent inflation since World War 2) - other economists argue otherwise - there are similar debates over the Fed's contributions to the stability of other economic indicators
open market operations
- the Fed's purchases and sales of US Treasury securities in the financial market
1913
- the Federal Reserve Act passed 1. the Act established the Federal Reserve System as the central bank of the United States
1912
- the Glass-Willis proposal
1908
- the National Monetary Commission was created
1836
- the Second Bank of the US closed
1897
- the Wall Street Panic
Explaining the Explosion in the Monetary Base
- the monetary base increased sharply in the fall of 2008 and stayed at high levels through 2016 - Most of the increase occurred because of an increase in the bank reserves component, not the currency in circulation component - the Fed's holdings of Treasury securities actually fell while the base was exploding - as the Fed began to purchase assets connected with Bear Stearns and AIG, the asset side of its balance sheet expanded, and so did the monetary base - Key point: Whenever the Fed purchases assets of any kind, the monetary base increases
monetary base (B)
- the non borrowed monetary base (Bnon) and borrowed reserves (BR) (same as discount loans) - MB = Bnon +BR - the Fed has control over the nonborrowed monetary base
required reserve ratio
- the percentage of checkable deposits that the Fed specifies that banks must hold as reserves
Argument Against Fed Independence
- the public could hold elected officials responsible for perceived monetary policy problems - monetary policy could be coordinated and integrated with government taxing and spending of the early 1930's - the Fed policies were too inflationary in the 1960's and 1970's - the Fed ignored the housing market bubble in the early 200's and then moved too slowly to contain the effects when the bubble burst in 2006
currency to deposit ratio (C/D)
- the ratio of currency held by the nonbank public, C, to checkable deposits, D
simple deposit multiplier
- the ratio of the amount of deposits created by banks to the amount of new reserves
The Principal-Agent View
- this view predicts that the Fed acts to increase its power, influence, and prestige as an organization - the view also suggests that the Fed would fight to maintain its autonomy - the Fed successfully lobbied Congress to strip most of the provisions in the Dodd-Frank Act that would have reduced its independence - the Fed could manage monetary policy to assist the reelection efforts of presidential incumbents who are unlikely to limit its power - the result would be a political business cycle: 1. the Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection - the facts for the United States don't support the political business cycle theory - but the president's desires may subtly influence Fed policy - one study found a close correlation between changes in monetary policy and signals from the administration that they desired a policy change
the money supply process
- three actors: 1. the Federal Reserve: responsible for controlling the money supply and regulating the banking system 2. the banking system: created the checking accounts that are major component of M1 3. the nonbank public (all households and firms): decides the form in which they wish to hold money (ex: currency vs checking deposits)
how collateral and net worth reduce adverse selection problems
- to deal with firms' information advantage, lenders often require borrowers to have collateral and high net worth
lemons problem
- used car market with only individual sellers and buyers; no car dealers - the seller of a used car has more information on the true condition of a car than does a potential buyer - the prices that potential buyers are willing to pay reflect the buyers' lack of complete information on the true condition of the car - because of asymmetric information, the used car adversely selects the cars that will be offered for sale
collateral
- used to reduce adverse selection - assets pledge to the bank in the event that the borrower defaults - a compensating balance is a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank
Federal Reserve Banks
- when banks join the Federal Reserve System, they are required to buy stock in their District Bank - to prevent on constituency from exploiting the central bank's power at the expense of another, Congress restricted the composition of the boards of directors of the District Banks - the directors represent the interests of 3 groups 1. Banks 2. Businesses 3. the general public - member banks elected three banks (Class A directors) and three leaders in industry, commerce and agriculture (Class B directors) - the Fed's Board of Governors appoints three public interest directors (Class C directors) - the Federal Reserve District Banks engage in monetary policy both directly and indirectly - in recent decades, the discount rate has been set by the Board of Governors in Washington DC, not by the District Banks - the District Banks also influence policy through their representatives on the FOMC and on the Federal Advisory Council, a consultative body composed of district bankers
shadow banking system
-consists of 1. investment banks 2. hedge funds 3. money market mutual funds - on the eve of the financial crisis, the size of the shadow banking system was greater than the size of the commercial banking system
Economic power within the Federal Reserve System is divided in 3 ways:
1. Among bankers and business interests 2. Among states and regions 3. Between government and the private sector
The 12 Federal Reserve Banks
1. Boston 2. New York 3. Philadelphia 4. Cleveland 5. Richmond 6. Atlanta 7. Chicago 8. St. Louis 9. Minneapolis 10. Kansas City 11. Dallas 12. San Antonio * Board in Washington DC
Four groups within the Federal Reserve system were empowered to perform separate duties:
1. The Federal; Reserve Banks 2. Private commercial member banks 3. the Board of Governors 4. the Federal Open Market Committee (FOMC) - all national banks (chartered by the federal government) were required to join the system - state banks (chartered by state governments) were given the option to join
conclusion about the structure of the US financial system
1. loans from financial intermediaries are the most important external source of funds for small- to medium-sized firms - smaller firms can't borrow directly from savers because transactions costs are too high - they cannot sell bonds or stocks because of the adverse selection and moral hazard problems that arise from asymmetric information 2. the stock market is a less important source of external funds to corporations that is the bond market - most of the trading on the stock market involves existing shares, not new shares of stock - in recent years, corporations have actually bought back from investors more stock that they have issued - moral hazard is less of a problem with debt contracts than with equity contracts 3. debt contracts usually require collateral or restrictive covenants - large household loans use the good being purchased as collateral - many corporate bonds also specify collateral - to reduce moral hazard, both loans and bonds typically contain restrictive covenants 4. by reducing transactions and information costs, financial intermediaries can offer higher interest rates for savers and lower interest rates for borrowers 5. commercial banks, investment banks, and other financial firms are continually searching for ways to earn profit by expediting the flow of funds from savers to borrowers
Money Supply Process for M1
1. money supply will change in the same direction of a change in the monetary base or the money multiplier 2. an increase in C/D causes the value of the money multiplier and the money supply to decline 3. an increase in rD causes the value of the money multiplier and the money supply to decline 4. an increase in ER/D causes the value of the money multiplier and the money supply to decline
Expected Value
= (Probability car is peach) × (Value if peach) + (Probability car is a lemon) × (Value if lemon)
A bank that expects interest rates to fall will want to have:
A positive gap and a positive duration gap
securitized loans must now be insured
All of the following are new rules affecting the shadow banking system as a result of the Dodd-Frank Act EXCEPT:
float, increase
An increase in ________ temporarily leads to an equal ________ in the monetary base.
manage liquidity risk
Banks make use of the federal funds market in part to:
decrease;decrease
Everything else held constant, an increase in the capital required reserve ratio cause the M1 money multiplier to ________ and the money supply to ________
to reduce transaction costs for small savers and borrowers
Financial intermediaries emerged:
it reduces the interest-rate risk of lenders
How does the use of adjustable-rate mortgages affect interest-rate risk?
decrease bank capital
If the duration of a bank's assets is greater than the duration of a bank's liabilities, an increase in market interest rate will:
decrease bank's profits
If the value of a bank's variable-rate assets is less than the value of its variable-rate liabilities, an increase in market interest rate will
A $50 increase in reserves and a $50 increase in checkable deposits
If you deposit a $50 check in the bank, the immediate impact on your bank's balance sheet will be a
appointed by the President of the United States, subject to confirmation by the Senate
Members of the Board of Governors are:
Money Supply Process Equation
Monetary Base (determined by the Fed) x Money Multiplier (determined by the Fed, the Banking System, and the Nonbank Public) = Money Supply
assets for depository institutions, but liabilities for the Fed
Reserve deposits are:
adverse selection, moral hazard, and transaction costs
Smaller firms tend to rely on financial intermediaries instead of financial markets for external financing due to
Increase; Remain Unchanged
Suppose Sasha deposits $1 million into her checking account. Sasha's action, everything else held constant, will cause total reserves in the banking system to ________ and the monetary base to ________.
decrease; remain unchanged
Suppose a branch of Bank of America in Texas deposits $1 million of currency into its account at the Federal Reserve Bank of Dallas. The branch's action, everything else held constant, will cause vault cash to ________ and Federal Reserve liabilities to ________
5
Suppose an investment bank is buying $50 million in long-term mortgage-backed securities and finances the investment by borrowing 80% and paying for the other 20% out of equity. What is the bank's leverage?
asymmetric information
Suppose some members of Enron's board of directors are aware of the company's true financial condition, information that is not available to most investors. This is an example of:
an increase of $1,000
Suppose the Federal Reserve Bank of Atlanta buys a painting from a local art store for $1,000. This painting is used to grace the walls of its conference room. This purchase will cause ________ in the monetary base, everything else held constant.
Remain Unchanged; Increase
Suppose the First National Bank of Bangor, Maine deposits $2 million of currency into its account at the Federal Reserve Bank of Boston. First National's action. everything else held constant, will cause its vault cash to ________ and the monetary base to ________.
have an ambiguous effect on
Suppose the currency-to-checkable deposit ratio decreases while, at the same time, the excess reserve-to-checkable deposit ratio also decreases. Everything else held constant, these changes would ________ the money supply.
an decrease of $24.95
Suppose while cleaning out its closets, a worker at the Federal Reserve Bank of Atlanta discovers a painting of Elvis (medium oil on velvet) that used to grace the walls of the conference room. Suppose further that, at a public auction, the bank sells the painting for $24.95. This sale will cause______in the monetary base, everything else held constant.
A decrease in the market interest rate will increase the present value of a bank's assets and liabilities. True or False?
True
Banks make use of the federal funds market in part to manage liquidity risk. True or False?
True
leverage ratio
The sensitivity of bank capital to market interest rates is measured by
its excess reserves
What is the maximum amount the bank can lend?
adverse selection problems increase
When interest rates in the bond market rise:
US government securities
Which asset is sometimes referred to as a bank's secondary reserve?
an increase in the nonbank public's preference for non-transaction accounts relative to checkable deposits
Which of the following increases the M2 multiplier?
They were more heavily regulated than commercial banks, making them less able to adjust to changing market conditions
Which of the following is NOT a reason that firms in the shadow banking system were more vulnerable than commercial banks during the financial crisis of 2007-2009?
open market operations
Which of the following is NOT an activity carried out by Federal Reserve district banks?
your sister borrows $30,000 from you to open a restaurant, but spends it gambling instead
Which of the following is NOT an example of adverse selection?
Federal Deposit Insurance Corporation
Which of the following is NOT considered one of the four groups in the Federal Reserve System?
a patient with a terminal illness buys life insurance. this is an example of:
adverse selection
a company in serious financial trouble offers to pay you 30% on a loan. This is an example of:
adverse selection
greater control over open market operations than over discount loans
although open market operations and discount loans both change the monetary base, the Fed has
an decrease in securities held of $10 million and an increase in bank reserves of $10 million
if the Fed purchases securities worth $10 million from a commercial bank, the banking system's balance sheet will show
You want to sell your well-maintained 2010 Toyota Corolla in the used car market. After checking the price other owners of 2010 Toyota Corolla are able to get, you decide to not sell your car. This is an example of:
moral hazard
legally separate investment banking from commercial banking
the Glass-Steagall Act was designed to
nonbank financial institutions such as investment banks and hedge funds
the Shadow Banking system refers to:
the Fed acts to stimulate economic activity before an election
the political business cycle theory predicts that:
During the financial crisis of 2007-2009
- "nonbank" financial institutions (shadow banking systems) 1. acquired funds that had previously been deposited in banks 2. then used these funds to provide credit - commercial banks no longer played the dominant role in routing funds from savers to borrowers
1927
- Congress passed the McFadden Act 1. prohibited national banks from operating branches outside their home states 2. resulting a large number of unit banks: a fragmented banking system
2010
- Dodd-Frank Act 1. limit the underwriting for hedge funds 2. created the Consumer Financial Protection Bureau to protect consumers in their borrowing and investing activities 3. established the Financial Stability Oversight Council, to identify and act on systemic risks to the financial system
1933
- Glass-Steagall Act 1. created FDIC (Federal Deposit Insurance Corporation) which provides insurance to individuals' deposits up to a certain amount 2. separating commercial banks from investment banking: - banks could NOT: dealing in securities, providing insurance, etc. - banks could not take advantage of economics of scale and scope
1999
- Gramm-Leach-Bliley Act or Financial Modernization Act 1. repealed the restriction of Glass-Steagall
1994
- Riegel-Neal Act 1. repealed the McFadden Act by allowing banks to acquire an unlimited number of branches nationwide (except for Texas and Montana) 2. No single bank could more than 10% of the deposits in the country
1980's
- State Compacts 1. states passed legislation to allow banks operate branches
reducing interest-rate risk
- banks with negative gaps can make more adjustable-rate or floating-rate loans - banks can use interest-rate swaps-- agree to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan - banks can use futures contracts and options contracts that can help hedge interest-rate risk
diversification
- by diversifying, banks can reduce the credit risk associated with lending too much to a single borrower
vault cash
- cash on hand in a bank (including currency in ATMs or deposits with other banks)
Bank Liabilities
- checkable deposits - demand deposits - NOW accounts
demand deposits
- checkable deposits on which banks do not pay interest
NOW accounts
- checking accounts that pay interests
loan sales
- financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party
are shadow banks still vulnerable to runs today?
- following the financial crisis of 2007-2009, they were extensive regulations of the shadow banking system - the Dodd-Frank Act contained limited regulations of the shadow banking system: 1. trading of derivatives needed to be carried out on exchanges 2. large hedge funds needed to be registered with the SEC 3. firms selling mortgage-backed securities were required to hold 5% of the credit risk - a basic problem was still not addressed: some shadow banks borrow short term to make highly leveraged long-term investments
prime rate
- formerly the interest rate banks charged on six-month loans to high-quality borrowers (now an interest rate bank charge primarily to smaller borrowers)
Regulation and the Shadow Banking System
- in 1934, congress gave the sec broad authority to regulate the stock and bond market - in 1974, congress established the Commodity Futures Trading Commission to regulate futures markets - securities that were not traded in exchanges were not subject to regulation - when derivatives are traded on exchanges, the exchange serves as the counterparty, which reduces the default risk to buyers and sellers - in 20120, congress enacted regulatory changes that would push more trading in derivatives onto exchanges
collateral
- includes assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan
net worth
- is the difference between the value of a firm's assets and the value of its liabilities
high ratio of assets to capital (high leverage) is a two-edged sword
- leverage can magnify relatively small ROAs into large ROEs, but it can do the same for losses
managing bank risk
- liquidity risk - credit risk - interest-rate risk
the fragility of the shadow banking system
- many firms in the shadow banking system were borrowing short term send lending long term - investors providing funds to investment banks were not protected by deposit insurance - due in part to lack of regulation, investment banks could invest in risky assets and became highly leveraged - many investment banks suffered heavy losses due to investments in mortgage-backed securities
securities
- marketable securities are liquid assets that banks trade in financial markets - banks are allowed to hold securities issued by the US Treasury and other government agencies and corporate bonds - bank holdings of US Treasury securities are also called secondary reserves due to their liquidity - in the United States, commercial banks cannot invest checkable deposits in corporate bonds or common stock
leverage
- measure of how much debt an investor assumes in making an investment - the inverse of bank leverage is the leverage ratio
factors that determine a country's standard of living include:
- the ability of business to accumulate physical capital -the ability of businesses to adopt the latest technology - the ability of the government to provide a legal framework that protects property rights and enforce contracts - a strong financial system can be essential for robust economic growth required for a rising standard of living
asymmetric information
- the situation in which one party to an economic transaction has better information than does the other party - asymmetric information leads to two major problems in financial markets 1. adverse selection: problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment 2. moral hazard: risk that people will take actions after they have entered into a transaction that will make the other party worse off
1812-1816
- the war of 1812 - there were still stated chartered banks and each bank issued their own currency
your sister borrows $10,000 from you to open a hair salon. once she receives the loan, she uses $10,000 to travel to Europe. this is an example of:
moral hazard
asset
something of value that an individual or a firm owns; in particular, a financial claim
liability
something that an individual or a firm owes; particularly a financial claim on an individual or a firm
bank capital
the difference between the value of a bank's assets and the value of its liabilities; also called shareholders' equity
moral hazard in the stock market
- The organization of large, publicly traded corporations results in a separation of ownership from control. - Firms are owned by shareholders but managed by top management (CEO, CFO, COO, etc.) - Managers have an incentive to underreport profits so that they can reduce dividends and retain the use of the funds. - To reduce this problem, the SEC requires managers to issue financial statements. - Boards of directors meet in frequently and may not be independent of top managers. -Some boards of directors use incentive contracts to align the goals of managers with the goals of shareholders. - Compensation tied to the firm's profits, however, may lead managers to undertake risky investments.
moral hazard in the bond market
- There is less moral hazard in the bond market than in the stock market. - To reduce moral hazard in bond markets, investors insert restrictive covenants into bond contracts.
return on assets (ROA)
- a bank's profits - ratio of the value of a bank's after-tax profit to the value of its assets - ROA = (aftertax profit/ bank assets)
1893
- a banking panic triggered the worst depression in the US
restrictive covenant
- a clause in a bond contract that places limits on the uses of funds that a borrower receives
federal deposit insurance
- a government guarantee of deposit account balances up to $250,000
standby letter of credit
- a promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures
how financial intermediaries reduce moral hazard problems
- a venture capital firm raises equity from investors to invest in start-up firms - a private equity firm (or corporate restructuring firm) raises equity capital to acquire shares in other firms to reduce free-rider and moral hazard problems - a market for corporate control provides a means to remove top management that is failing to carry out the wishes of shareholders
Checkable Deposits
- accounts against which depositors can write checks - demand deposits are checkable deposits on which banks do not pay interest
Bank Assets
- acquired by banks with the funds they: - receive from depositors - borrow from other institutions - acquire initially from shareholders - retain as profits from operations - another important cash asset is csh items in the process of collection- claims banks have on other banks for uncollected funds - banks physical assets (computer equipment and buildings) - collateral received from borrowers who have defaulted on loans
off-balance-sheet activities
- activities that do not affect a bank's balance sheet because they do not increase either the bank's assets or it liabilities 1. standby letters of credit 2. loan commitments 3. loan sales 4. trading activities
lemons problem in financial markets
- adverse selection is presented in the bond market as well - as interest rates on bonds rise, a later fraction of the firms willing to pay the high interest rates are lemon firms - when lenders ration credit, all firms (good firms or lemons) may have difficulty borrowing funds
T-Account
- an accounting tool used to show changes in balances sheet items
loan commitment
- an agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time
duration analysis
- an analysis of how sensitive a bank's capital is to changes in market interest rates 1. positive duration gap: - the duration of the bank's assets is greater than the duration of the bank's liabilities - an increase in market interest rates will reduce the value of the bank's assets more than the value of the bank's liabilities, which will decrease the bank's capital
gap analysis
- an analysis of the gap between the dollar value of a bank's variable-rate assets and the dollar value of its variable-rate liabilities - gap analysis is used to calculate the vulnerability of a bank's profits to changes in market interest rates - most banks have negative gaps because their liabilities (deposits) are more likely to have variable rates than are their assets (loans and securities)
reserves
- bank assets consisting of vault cash plus bank deposits with the federal reserve - reserves= required reserves + excess reserves
Borrowings
- bank borrowings include - short-term loans in the federal funds market - loans from a bank's foreign branches or other subsidiaries or affiliates - repurchase agreements - discount loans from the federal reserve system - the federal funds market involves interbank loans borrowed at the federal funds rate - with repurchase agreements ("repos"), banks sell securities, such as treasury bills, and agree to repurchase them, typically the next day
how financial intermediaries reduce adverse selection problems
- banks and other financial intermediaries specialize in gathering information about borrowers' default risk
trading activities
- banks earn fees from trading in the multibillion-dollar markets for futures, options, and interest-rates swaps - bank losses from trading in securities became a concern during the financial crisis of 2007-2009 - the Dodd-frank act passed in 2010 included a provision that prohibits bank to trade with their own funds, or propriety trading
monitoring and restrictive covenants
- banks keep track of whether borrowers are obeying restrictive covenants- explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities
Bank Capital and Bank Profits
- moral hazard can contribute to high bank leverage - in managers are compensated for a high ROE, they may take on more risk than shareholders would prefer - federal deposit insurance has increased moral hazard by reducing the incentive depositors have to monitor the behavior of bank managers - to deal with this risk, government regulations called capital requirements have placed limits on the value of the assets commercial banks can acquire relative to their capital
1832
- president Andrew Jackson wanted the Second Bank to close
bank leverage
- ratio of assets to capital is one measure - ratio of the value of a bank's assets to the value of its capital
return on equity (ROE)
- ratio of the value of a bank's after-tac profit to the value of its capital - ROE = (aftertax profit/ bank capital) - ROE = (ROA x (bank assets/ bank capital))
excess reserves
- reserve banks hold above those necessary to meet reserve requirements
required reserves
- reserves the Fed requires banks to hold against demand deposit and NOW account balances
system risk
- risk to the entire financial system rather than to individual firms or investors
Bank Capital
- shareholders' equity, or net worth - the difference between the value of a bank's assets and the value of its liabilities - represents the funds contributed by the bank's shareholders through their purchases of stock the bank has issued plus accumulated retained profits - as the value of a bank's assets or liabilities changes, so does the value of the bank's capital
How financial intermediaries reduce transaction costs
- small investors and small- to medium-sized firms turn to financial intermediaries to meet their financial needs - financial intermediaries take advantage of economies of scale to reduce transaction costs
Systemic Risk and the Shadow Banking System
- the FDIC and the SEC were created with the goal to protect depositors from contagion 1. contagion is the likelihood that the failure of one bank would lead depositors to withdraw their money from other banks - Congress was less concerned with the risk to individual depositors than with systemic risk to the entire financial system - in the shadow banking system, short-term loans consist of repurchase agreements, commercial paper and money market mutual funds rather than deposits - there is no equivalent to deposit insurance in the shadow banking system - during the financial crisis of 2007-2009, the shadow banking system was subject to the same type of systemic risk that the commercial baking system experience in the early 1930's
1960's
- the Fed allowed banks to underwrite safe securities as long as income from this is less than 5% of their income. later this limit increased 25%
1863
- the National Banking Act made it possible for a bank to obtain a federal charter - national bank is a federally chartered bank - dual banking system is the system in the US in which banks are chartered by either a state government or the federal government - established the OCC (Office of Comptroller of the Currency)> guaranteed that only nationally chartered banks can issue notes - prohibited banks from using deposits to buy ownership of non-financial firms
attempts to reduce adverse selection
- the SEC requires that firms must disclose material information 1. material information is information that would likely affect the price of a firm's stock - this reduces the information costs of adverse selection, but doesn't eliminate them for four reasons: 1. some good firms may be too young to have much information for potential investors to evaluate 2. lemon firms will try to present the information in the best possible light so that investors will overvalue their securities 3. there can be legitimate differences of opinion about how to report some items on income statements and balance sheets 4. interpretation of whether information is material can be tricky -private firms have collected and sold information about firms to investors to reduce adverse selection costs - information is collected from sources such as firms' income statements, balance sheets, and investment decisions - individuals who gain access to the information without paying for it are free riders
1816
- the Second Bank of the US was chartered
relationship banking
- the ability of banks to assess credit risks in the basis of private information about borrowers - reduces the costs of adverse selection and explains the key role banks play in providing external financing to firms
long-term business relationship
- the ability of banks to assess credit risks on the basis of private information on borrowers - by observing the borrower, the bank can reduce problems of asymmetric information - good borrowers can obtain credit at a lower interest rater or with fewer restrictions
1811
- the charter for First Bank of the United States was not renewed
1789
- the constitution came into effect and has served as the basics of the United States
transaction cost
- the costs of a trade or a financial transaction
information costs
- the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired
net interest margin
- the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earnings assets
interest-rate risk
- the effect of a change in market interest rates on a bank's profit or capital - a rise (fall) in the market interest rate will lower (increase) the present value of a bank's assets and liabilities
nonbank had been exempted from restrictions on the assets they can hold and the degree of leverage:
- the firms were not as important to the financial system as were commercial banks - regulators did not believe that the failure of these firms would damage the financial system - these firms deal primarily with other financial firms, institutional investors, or wealthy private investors rather than with unsophisticated investors
The commercial bank's balance sheet
- the key commercial banking activities are taking in deposits from savers and making loans to households and firms - a bank's primary sources of funds are deposits, and primary uses of funds are loans - a balance sheet is a statement is a statement that shows an individual's or a firm's assets and liabilities to indicate its financial position on a particular day - the typical layout of a balance sheet is based on the following accounting equation: Assets = Liabilities + Shareholders' Equity
loans
- the largest category of bank assets - loans are illiquid relative to marketable securities and have greater default risk and higher information costs - 3 categories of loans: 1. loans to businesses: commercial and industrial loans 2. consumer loans: made to households primarily to buy automobiles and other goods 3. real estate loans: residential and commercial mortgages
the principle-agent problem
- the moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals)
Non-transaction Deposits
- the most important types of non-transaction deposits: 1. Savings Accounts 2. Money market deposit accounts (MMDAs) 3. Time deposits, or certificates of deposits (CDs) - CDs of less than $100,000 are called small-denomination time deposits - CDs of $100,000 or more more are called large-denomination time deposits - checkable deposits and small-denomination time deposits are covered by federal deposit insurance
liquidity risk
- the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost - banks reduce liquidity risk through: - lending funds in the federal funds market - engaging in reverse repurchase agreements - liability management - borrowing funds in the federal funds market - engaging in repurchase agreements - obtaining discount loans from the Fed
credit risk analysis
- the process that bank loan officers use to screen loan applicants - banks often use credit-scoring systems to predict whether a borrower is likely to default - historically, the high-quality borrowers paid the prime rate - today, most banks charge rates that reflect changing market interest rates instead of the prime rate
economies of scale
- the reduction in average cost that results from an increase in the volume of a good or service produced
credit rationing
- the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate
credit rationing
- the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate - loan and credit limits reduce moral hazard by increasing the chance a borrower will repay - if a bank cannot distinguish low- from high-risk borrowers, then will run the risk of losing the low-risk borrowers when it raises the interest rate, leaving only the high-risk borrowers-- a case of adverse selection
credit risk
- the risk that borrows might default on their loans - banks can reduce credit risk by these methods: 1. diversification 2. credit-risk analysis 3. collateral and compensating balance 4. credit rationing 5. monitoring and restrictive covenants 6. long-term business relationships