Exam 2

other forms of government safety nets

-lending from central bank to troubled institutions as a lender of last resort. -providing funds to troubled institutions from Treasury and others -government nationalization of institutions

How do banks manage liquidity?

-maintain excess reserves to eliminate shortfall. excess reserves are an insurance against costs of deposit outflows. - selling securities: cost is brokerage and other transaction costs -borrow from fed: incurs

How financial institutions have responded to innovation

1. Response to changes in demand 2. responses to changes in supply 3. securitizing illiquid assets

function of FAC

12 bankers, one from each district

function of fed banks

12 exist. each have 9 directors, 6 of them appoint a president and other FRB (fed reseve bank) officers. 1. establishes discount rate 2. selects FAC clears checks, issues new curency, withdraw damaged currency, administer and makes discount loans to banks within districts, evaluates proposed mergers and expansion. liason with businesses and fed, examines state chartered banks and bank holding companies, data collection on business deicisions, economists to research conduct of military policy

function of member commercial banks

2,000 member commerical banks 1. elects 6 directors to each FRB -all national banks must be members of the fed system. Commercial banks chartered by states are not required but may choose to be members. Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities

function of board of governors

7 members, including chairman, appointed by POTUS and confirmed by the senate 1. reviews and determines discount rate 2. sets reserve requirements 3. appoints 3 directors to each FRB HQ in DC votes on open market ops, sets reserve req, controls discount rate in a review and determination process, sets margin requirements, sets salries of fed officers and reviews bank's budgets. approves mergers, new activies, supervises activities. chairman advises president on ec policy, testifies in congress, speaks for fed to media, reps US in foreign negotiaions

Bank balance sheet

=sources of bank funds + uses to which theyre put basic operations - lists assets and liabilities assets = liabilities + capital CHECKABLE DEPOSITS are NOT ASSETS on a bank's balance sheet

If insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazards might result? Explain.

Adverse selection=> Risk taking individuals are more likely to actively seek insurance to exploit for personal gain. Moral Hazard=> people with fire insurance take less measures to prevent fire.

securitization

Securitization=> process of bundling small and illiquid financial assets(residential mortgages, auto loans etc) into capital market securities. Shadow banking system involved. Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s.

What happens when there is a deposit?

bank must pay depositor immediately. if presents check must pay funds. is an asset for depositor but is a liability for a bank because is obligated to pay it back.

Bank panics and need for deposit insurance

before FDIC bank failures meant depositors had to wait until bank was liquidated(assets turned into cash) to get deposits back and only some deposits were repaid bank panic = where lack of info about bank assets occurs, and with no deposit insurance, there is a shock in the economy. lending falls. -Asymmetric information here=> depositors do not know which one is a "good" bank or one of the 5% banks. -Depositors assume all banks fail! Withdraw deposits. -First-come, first-serve basis=> depositors line up at bank, want to be the first ones served. Why? -This incentive to line up and "run" to withdraw is a "bank run" -Uncertainty about health of banking system lead to bank runs (for both good and bad banks). One bank fails, others follow=> contagion effect. FDIC is a safety ned: short circuits bank failures and the contagion affect. guarantees payments in first 250,000 in a bank for current depositors

costs and benefits of banking consolidation

benefits: -Increased competition, driving inefficient banks out of business -Also, increased efficiency from economies of scale and scope -Lower probability of bank failure from more diversified portfolios. Eg. Commercial banks may make loans in both oil-rich Texas as well as in service sector in New England area. Banks will do well with diversified portfolios. costs: -Elimination of community banks may lead to less lending to small business=> close community ties disrupted. -Banks expanding into new areas may take increased risks and fail

Why are banks important?

channels funds to borrowers -> with productive investment opps --> ensures financial system and economy runs smoothly provides credit important for welfare -> gives loans to help businesses, college ed, new cars and houses, checking and savings accounts, debit cards, ATMs

what are the borrowing sources for a commercial bank?

comm banks borrow from fed - aka discount loans - and fed home loan banks. get funds through overnight fed funds market to meet required deposit amount. also borrow from parent companies, agreements with other corps, eurodollars. is a liability.

What is financial innovation? How did it emerge?

driven by desire to earn profits search for new profitable activities. it emerged with change in environment in 60's with high inflation, high interest rates. fin regulation increased. to make profits new services had to be offered

function of FOMC

federal open market committee = board of governors + FRB presidents of NY and 4 others 1. advises reserve requirements 2. directs open market operations 3. advises discount rate decides on conduct of open market ops, sets federal funds rate (aka interest rate on overnight loans) decides tightening monetary policy (rise in fed funds rate), or easing of monetary policy

What are the options to maintain liquidity and increase reserves?

if want to maintain liquid assets they will make less loans bc loans are less liquid than other types of assets since the cash can't be attained until loan maturity occurs a. Borrowing from other banks - cost is interest rate paid on borrowed funds b. sell securities: to cover deposit outflow. - cost is brokerage and other transaction costs c. borrow from fed: interest rate payments is based on the discount rate d. reduce loans: and deposit difference with the fed. most costly way of getting reserves, because angers customers

response to changes in supply

information technology - lowered costs of financial transactions so is profitable for institutions, easier for firms to issue securities and acquire information credit and debit cardss: earns income from loans to CC holders, payments made through credit. firm costs are loan defaults, stolen card, expense in processing transaction. but lowers transaction costs. ebanking: ATM, virtual banking. is cheap, low cost. but won't replace completely because worried about electionic footprint, confidentiality, want to know savings are secure junk bonds: option to buy bonds from less well known places with low credit ratings, not with inv. grade status commercial paper market: SR debt securities issued by banks and corporations. raises SR funds in commercial paper market.

response to changes in demand

interest rate volatility : led to financial innovations. fluctuations led to big capital gains and losses, and uncertainty about returns adjustable rate mortgages: lending is more attractive if interest fluctuates less. Mortgage loan with 10% interest is a loss when two months later interest could have been 12% instead. -1975=> adjustable rate mortgages (ARMs) when market interest rates change, interest rates also change. -Flexible interest rates keep profits high when rates rise -Lower initial interest rates make them attractive to home buyers. -When market interest rates rise, interest rates on ARMs go up=> profits high. financial derivations: -Ability to hedge interest rate risk -Payoffs are linked to previously issued (i.e. derived from) securities. -Chicago Board of Trade devised future contracts in financial instruments where commodity sold at a future date at an agreed price.

Financial consolidation and government safety net

large FI's challenge regulation: -Increased size of institutions through financial consolidation results in "too big to fail" problem=> financial system susceptible to system-wide risk. These institutions take on greater risks (moral hazard). -Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the global financial crisis). -When a bank and a financial service firm merges, safety net may be extended to new activities such as underwriting securities, insurance, real estate activities and so on. Greater risk taking.

What are the sources of assets?

liabilities and capital

options for liability management and capital adequacy management

liability management: = acquiring funds at low costs -expansion of overnight loan markets -new fin instruments like CD's -checkable deposits decreased as a source of bank funds --> more options to secure liabilities and more scope to increase assets capital adequacy management: = deciding on amount of capital to maintain and acquiring it -is needed to prevent bank failure, affects return for owners or equity holders of bank, and fills a regulatory requirement.

Principles of bank management

liquidity management: keep cash on hank, acquire more liquid assets to meet obligations asset management: pursue low risk assets which have low default risk and diversify liability management: acquiring funds at a low cost capital adequacy management: ensures sufficient capital credit risk: borrowers may default interest rate risk: asset returns and riskiness of earnings may change

How do banks manage assets?

through three goals: 1. seek highest possible returns on loans and securities 2. reduce risk 3. hold liquid assets for adequate liquidity

true or false: Decisions about "easing" or "tightening" monetary policy made by the Federal Open Market Committee

true

Tradeoff between returns to equity holder and safety

-Benefits the owners of a bank by making their investment safe -Costly to owners of a bank because the higher the bank capital, the lower the return on equity -Choice depends on the state of the economy and levels of confidence -Uncertain times=> hold more capital to protect equity holders because higher probability of default. -Good times=> hold less capital, increase return on equity, enjoy.

why was the US so late to adopt a central banking authority?

-Fear of centralized power - esp. from constitution, checks and balances -Distrust of moneyed interests - the symbol of which = central bank wrote checks and balances into 1913 fed reserve act - resolved hostility to idea of central banks

13 origins of fed system

-primary resistance to a central bank bc fear of centralization, distrust of money interets. the first experiment of the first bank of the US failed in 1811, the second expired in 1836 and nor renewed. -did not function as a lender of last resort. there were regular banks so eventually in 1907 people were convinced a central bank was needed -Fed Act of 1913: opposition to authority continued, arguments over it being government or private owned. wrote in checks and balances, made it decentralized. are spread throughout the country, and all involved in monetary policy decisions.

10 Why do we need regulation?

-to address assymetric information problems - that lead to adverse selection and moral hazardt -to avoid bank panics

Four options to manage assets

1. find borrowers who will pay high interest rates and have low chance of defaulting. -can advertise borrowing rates to get loans -screen for adverse selection reduction -are conservative withdefault rates < 1 2. buy securities with high returns and low risk --> can assess securities that provide both 3. lower risk by diversifying: buy different assets (SR, LR, T) and approve loans to many customers -shouldn't put all eggs in one basket - if one sector isn't or won't do well 4. balance need for liquidity against increased returns from less liquid assets : need to meet deposit outflows, reserve requirements and get a profit -means need to hold less liquid securities -can't be too conservative because needs profits, lots of excess reserves have low interest --> so need to make loans

policy tools of fed

1. reserve requirements 2. open market operations = purchase and sale of government securities that affect banking systems' interest rate and reserves. directed by FOMC 3. discount rate: the int rate the Fed loans to the banks. can only be obtained by certain banks.

Equity Multiplier

EM = assets / (equity capital) aka the amount of assets per dollar of equity capital

11 Historical trends

Structure and operation of banks in the US unique. Most countries, limited number of banks. USA=> 5700 commercial banks, 800 savings and loan associations, 7000 credit unions. Bank of North America chartered in 1782 => other banks opened up. Controversy over the chartering of banks=> states wanted more control, lobbied by agricultural interests National Bank Act of 1863 creates a new banking system of federally chartered banks Federal Reserve System created in 1913 to create safe banking system. All national banks required to become members. Great Depression 1930-1933=> 9000 bank failures wiped out savings at commercial banks. To prevent future loses, legislation led to the Federal Deposit Insurance Corporation (FDIC)=> federal insurance on deposits.

how can deposit insurance reduce bank runs?

The FDIC scheme guarantees that current depositors will be paid off in full on the first $250,000 they have as deposits in a bank. Depositors don't need to "run" to make withdrawals if their deposits are insured.

why does the fed of NY play a special role?

The New York district contains the largest banks in the country. The New York Fed supervises and examines these banks to insure their soundness and the safety of the nation's financial system. The New York Fed conducts open market operations and foreign exchange transactions for the Fed and Treasury. The New York Fed belongs to the Bank for International Settlements, so its president and the chairman of the Board of Governors represent the U.S. at the monthly meetings of the world's central banks.

shadow banking

The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal financial regulations. bank lending replaced by lending through securities market. lending via securities markets with involvement of FI. NBFI involvement

theory of bureaucratic behavior

Theory of bureaucratic behavior: objective is to maximize its own welfare which is related to power and prestige the fed WILL: -fight vigorously to preserve autonomy -Avoid conflict with more powerful groups=> may compromise. -May be slow to increase interest rates if it chooses to avoid conflicts with Congress. -Does not rule out altruism public interest view: One view of government bureaucratic behavior is that bureaucracies serve the public interest. The theory of bureaucratic behavior may be a useful guide to predicting what motivates the Fed and other central banks.

Strategies to manage bank capital -- how to increase and decrease capital

lower the capital, higher the returns for owners of the bank. needs to maintain a level of capital to reduce chances of insolvency or bank failure. must compare benefit of higher capital (safety) with cost of higher capital (lower return for bank owners) to lower bank capital and raise equity multiplier, can buy back bank stock, pay out higher dividends to stockholders to reduce retained earnings, or keep capital constant but increase assets by acquiring new funds and getting more loans/securities to raise capital relative to assets: can issue equity (common stock), cam reduce dividends to stockholders, or keep at same level but reduce assets by making less loans, sell securities, and using proceeds to lower liabilities (this 3rd option shrinks bank size).

Consider a bank facing a shortfall in capital. If capital falls to dangerously low levels, the bank will be declared insolvent. As a bank manager, how will you address the situation? What three options do you have to manage your bank capital?

make one of 3 choices: a. Increase capital by issuing more equities/common stock b. Increase capital by reducing dividends and increasing earnings that become capital c. Reduce bank assets by reducing amount of loans and selling securities, where amount of capital can be kept the same amount. but it is harder to raise capital at this time because of low stock prices, or shareholders recieving less dividends. option 3 is best

Drawbacks of government safety net

moral hazard: One party engages in detrimental activities. Financial institutions have an incentive to take on greater risk=> taxpayers will foot the bill if bank fails. adverse selection: Risk-lovers find banking attractive=> engage in risky activities. Easy for them to get away with fraud and embezzlement. too big to fail: -Regulators grapple with moral hazard created by safety net and desire to prevent financial failures. -If there is no safety net, then financial crisis has worse impact. But with safety net, you have moral hazard and adverse selection! Risky ventures "rewarded" -Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee=> Too Big to Fail -FDIC uses the purchase and assumption method=> insolvent bank given capital, find a willing partner to take over. -TBTF increases moral hazard incentives for big banks: if TBTF, large depositors won't monitor bank activities and pull out when it takes on risk. no matter what bank does, creditors won't suffer losses bc there will be payouts regardless. in this case failure is likely. -also NBFI's do not monitor activities bc of safety net --> excessive risk --> financial crisis

FDIC 2 approaches

payoff method: lets bank fail, pays off depositors. after assets are sold off, FDIC gets a share of proceeds from liquidated assets. purchase and assumption method: more costly for FDIC. Reorganizes bank, finds a willing merger partner who takes over liabilities. -No depositor or creditor loses money. -FDIC also offers subsidized loans or buys back some loans.

How do banks make a profit?

profit is gained from funds gained from earning interest on their asset holdings (including securities and loans) which is higher than expenses on liabilities (deposits) = asset transformation, aka when banks sell liabilities (with a combo of liquidity, risk, size, return) and using proceeds to buy assets with other characteristics

Types of financial regulation

restrictions on asset holdings: to prevent from risk taking. bank regulations occur to promote diversification (limit amount of loans in certain categories) and prohibiting stock holdings capital requirement: minimize moral hazard with more equity capital so would be less likely to pursue risky activities. acts as a cusion. leverage ration = capital/assets (must exceed 5%) prompt corrective action: FDIC can intervene when bank gets in trouble. banks are now classified based on bank capital. FDIC can take action against undercap. banks like requiring to submit restoration plans, restrict asset growth, approval for new branches fin sup: chartering: (screening of proposals to open new financial institutions) to prevent adverse selection=> designed to prevent undesirable people from controlling them. evaluates earnings, amount of initial capital fin sup: examinations: Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard assessing risk management processes: Implementation of stress testing and Value-at risk (VAR)=> calculates potential losses and need for capital under fictional adverse scenarios. disclosure requirements: Requirements to adhere to standard accounting principles and to disclose wide range of information consumer protection: -Consumer Protection Act of 1969 (Truth-in-lending Act)=> lenders provide information on cost of borrowing, disclosure of standardized interest rate (APR) -Equal Credit Opportunity Act of 1974, extended in 1976=> no discrimination based on race, gender, marital status, age -Community Reinvestment Act=> banks will lend in all areas in which they take deposits. -The subprime mortgage crisis illustrated the need for greater consumer protection=> borrowers took loans well beyond their means. competition restrictions: competition can increase moral hazard incentives for more risks. but is less efficient and leads to higher consumer charges

What is the relationship between return on equity and return on assets?

return on assets (ROA) = net profit after taxes / (assets) return on equity (ROE) = net profit after taxes / (equity capital) ROE = ROA x EM IS expressed by equity multiplier

How to manage credit risk?

screening: -out bad risks from good ones specialization in lending: can specialize in one industry which lessens adverse selection when lending locally bc is easier to get information, and gets smarter about the one industry's behavior monitoring: can monitor and enforce restrictive covenants with provisions in loan contracts LR customer relatoinships: easier to collect information, lower screening and monitoring costs, borrower has easier time obtaining loans at low interest. moral hazard is avoided as long as customer is mindful of future loans loan commitments: banks agree to provide a a firm with loans, is tied to market interest rate. advantage for firm is a supply of credit, for bank is less screening costs collateral and compensating balances: -collateral reduces moral hazard and adverse selection (banks don't lose as much and borrowers don't default if an asset is held as collateral) -compensating balances - firm receiving a loan must keep a min. balance at bank credit rationing: refusing to make loans at an interest rate even if borrower is willing to borrow. this is bc worries about adverse selection (risky individuals defaulting) and moral hazard (larger loans = more incentive to do riskier activities)

What are liabilities?

sources of funds bank uses checkable deposits: are payable on demand, are low cost for banks since there is low interest. nontransaction deposits: can't write checks on them but interest is high. -includes savings accounts -and time deposit accounts (COD, CD with fixed maturity, penalties for withdrawl). small denomination is less than 100k, less liquid and higher interest so costs more for banks. large denom greater than 100k, bought by corps and other banks, alternative to T-bills and short-term bonds borrowings: borrowing from fed, other banks and corporations. -fed = disocunt loans -borrowing overnight from other banks --> federal funds, to maintain deposits -other sources = parent company, repos, foreign banks bank capital: net work, from selling stock or retained earnings. is a cushion against shocks.

What are assets?

uses to which funds are put reserves: must keep portion of deposits on hand in an account with the Fed (required reserves, because of reserve requirements). excess reserves meet deposit obligations when funds are taken out. is very liquid cash items in process of collection: check written on account at other bank deposited at your bank deposits at other banks: small banks hold deposits in larger banks for other services like foreign exchange securities: buys USGOV and agency, state, local. very liquid. state and local are less marketable and have a higher risk of default but returns are higher. loans: most profit here. less liquid becauase need to wait for loans to mature. have a higher probability of default, higher liquidity, higher return on loans. other assets = physical capital, buildings, computers, equipments

structure of fed system

wanted to diffuse power between private sector, government, bankers, businesses, public owned by private commerical banks in district that are members of the fed system. are quasi-public. largest = NY, Chi, San Fran own > 50% of assets. NY is most prominent bc of large commercial banks in US (FRB of NY examines and supervises banks) and bc of contact with global major central banks and bc of involvement in bond and foreign exchange markets a. fed reserve banks b. board of governors c. FOMC d. federal advisory council e. member commercial banks