Financial Institutions and Markets Test 1
The Federal Reserve and Its Powers 2 Some weaknesses of operating without a central bank:
-Unstable money supply -No standard currency, mostly private banknotes -"Hard currency" (gold/silver) hoarded, unevenly distributed -No coordinated payments system -No supervision of lending or accounting practices -Frequent bank failures -Disruptions of business credit from bank failures prolonged and intensified economic downturns -Exaggerated business cycle-"boom & bust"
The Federal Reserve and Its Powers 1 1) What is the fundamental role of money (2)? 2) Historically, many types of money had what type of value? 3) Most money in circulation today (USD, euro, yen) is fiat money, which is what (3)?
1) -1) To facilitate efficient (lowest cost) exchange between economically specialized persons. -2) Technology that helps people to trade goods and services. 2) had intrinsic value, or were explicitly backed by some commodity with intrinsic value 3) -1) Fiat money has value solely by virtue of government decree -2) The government decrees that the coinage is "legal tender" that can legally be used to make payments and discharge debts -3) The fin. system relies on the credibility of money and the government
The Federal Reserve and Its Powers 3 1) Who owns the Federal Reserve and what percent is in? 2) How do they 'own' the FRB?
1) -Member banks represent "dual banking" in the US -All National Banks must be members of the Fed -About 17% of state banks choose to join -Some 36% of all US banks are in, representing about 76% of deposits 2) -Member banks buy stock in the FRB for their district -Collect dividends but do not otherwise share profits -Elect 6 of 9 FRB directors but have no other vote or say -As of 1980 Fed services are available to any depository institution for a fee (not just members) -Reserve requirements apply to all U.S. depository institutions
The Federal Reserve and Its Powers 4 1) FOMC stands for what? It oversees what? 2) How many members does it have? How many are permanent and rotating? 3) Who are permanent members and who is rotating?
1) The Federal Open Market Committee (FOMC) oversees the Federal Reserves monetary policy: actions it takes to attempt to influence the money supply and interest rates 2) -FOMC has 12 members - 8 permanent, 4 rotating 3) Permanent -7 Governors are permanent members -President of FRB of New York has permanent seat -New York Fed operationally executes FOMC directives Rotating -Presidents of 4 other FRBs rotate through 1-year terms -Nonvoting Reserve Bank presidents attend the meetings of the Committee and participate in discussions
The Federal Reserve and Its Powers 3 1) Main organizational elements of the Fed: 2) Each FRB provides basic services in its district:
1) -The 12 Federal Reserve Banks -Several thousand member commercial banks -The Board of Governors -The Federal Open Market Committee (FOMC) 2) -Processing checks and electronic payments -Issuing Federal Reserve Notes (Factoid: notes actually printed by Bureau of Engraving and Printing) -Holding reserves of banks and other depository institutions -Monitoring regional economic conditions -Advising the Board of Governors -Helping make monetary policy *The Federal Reserve Banks are part of a coordinated national monetary policy
The Federal Reserve and Its Powers 1 1) Taxonomy is: 2) Properties and functions of money (3):
1) Study of money. "Monteta" is the temple of Goddess Junow were first coins were struck. 2) -1) Medium of Exchange: money is used to trade real assets (goods and services) -2) Store of Value: money serves as a means of storing purchasing power; allows you to postpone consumption -3) Unit of Account: Prices denominated in terms of a monetary unit
The Federal Reserve and Its Powers 7 A) Monetary policy refers to what? B) By conducting monetary policy, a central bank attempts to manipulate which key macros economic variables (4)?
A) Monetary policy refers to government actions intended to affect the money supply in an economy B) By influencing the money supply, a central bank attempts to manipulate macro economic variables: 1) Interest rates 2) Unemployment 3) Inflation 4) Economic Growth (change in GDP)
Financial Institutions and Markets 4 A) How do transaction costs affect the choice of financing channel?
A) Most transactions costs related to financing have a significant fixed component -Fixed costs: do not increase with scale of production/output *Main points: -Individual and small business financing needs are almost always served by financial intermediaries -Large, established firms may find it more cost effective to transact in direct credit markets
Financial Institutions and Markets 6 A) What are 4 examples of contractual savings institutions?
A) Obtain funds under long-term contractual arrangements; invest in capital markets (stock/bonds) 1) Life insurance companies 2) Casualty insurance companies 3) Private pension funds 4) State and local government pension funds *Example: Life insurance companies issue life insurance policies (liabilities sold to public) and invest the proceeds in a portfolio of corporate bonds/stocks (assets)
The Federal Reserve and Its Powers 5 A) How is the Fed public-like (5)? B) How is the Fed private-like (3)? C) Is independence beneficial?
A) On the public side: 1) Congress created it, and Congress could strip it of powers; 2) The president appoints, and the Senate confirms, 7 members of its Board of Governors; 3) After expenses, the Fed hands off its earnings to the Treasury. 4) Details of its responsibilities are subject to oversight 5) Subject to US laws, some of these explicitly specify Fed goals B) On the private side: 1) Owned by member banks 2) Operates as a (profitable!) bank, does not rely on Congress for funding 3) Long (14 year) terms of Governors promotes independence C) Countries with independent central banks have lower rates of inflation than countries with less independent central banks.
The Federal Reserve and Its Powers 9 A) Open market operations affect what? B) Buying government securities does what? C) Selling securities does what?
A) Open market operations affect the level of member bank reserves and the monetary base. B) Buying government securities from the private sector, the Fed eventually credits member bank deposits, increasing the level of bank reserves and the banks' ability to make loans and expand the money supply C) Selling securities (could be any asset) to private security dealers or banks, the Fed is paid with a bank check which reduces the level of member bank actual reserves
Quantitative Easing 1 A) ECB's new QE program plans to purchase how much of what by when? B) How much per month? Objective is to?
A) Plans to purchase over € 1 trillion in public and private sector bonds by Fall 2016 B) Purchasing pace of € 60B/month, open-ended with objective to push inflation toward 2% target
Financial Institutions and Markets 3 A) Direct finance requires that DSUs and SSUs be "well matched" along which 4 dimensions?
A) Preferences of both must match as to 1) Amount (size of issue) 2) Maturity (e.g., 5 year versus 10 year bond) 3) Risk (high growth firms often require VC / 'angel' financing) 4) Liquidity (what if SSU needs cash earlier?)
Financial Institutions and Markets 1 A) The financial system provides for B) The financial system includes (3):
A) Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions. B) Financial system includes: 1) Markets for financial assets 2) Financial institutions and financial intermediaries 3) Regulatory bodies
Interest Rates 1 A) Realized real rates of return reflect what? B) equation for realized real rate is: C) Why were interest rates so high around 1980?
A) Realized real rates of return reflect the impact of realized inflation on past investments B) realized real rate of interest = nominal interest rate - actual rate of inflation (slide 18) C) Because inflation and hence expected inflation, were very high at this time.
Monetary Policy and the Macro Economy 1 A) What is the Fed Funds rate? B) Give a simple model of the Fed Funds rate. C) How do Fed actions affect the Fed Funds rate?
A) Recall: Fed Funds rate is the rate at which banks lend each other reserves (interbank lending rate) B) Simple model of Fed Funds Rate -Bank reserves trade in a competitive market -The Fed Funds Rate is simply the price in this market -Supply and demand determine price --There is a downward sloping demand curve for bank reserves --There is an upward sloping supply curve for bank reserves C) Key point: Fed actions shift supply/demand curves in this market -> affect price (rate)
Monetary Policy and the Macro Economy 2 A) Why is price stability so important (2)?
A) Rising inflation: 1) Creates uncertainty in the economy -Information in prices difficult to interpret -Complicates decisions made by businesses, households, and govt. -Creates inefficiencies 2) Effects potentially undesirable wealth transfers -Defined benefits (pensions, etc.) often in nominal terms -Debt: wealth transfer from lenders to borrowers -Rising inflation erodes value -Potential for social conflict
Financial Institutions and Markets 6 A) What are 3 examples of Investment funds?
A) Sell "shares" to investors and use funds to purchase direct financial claims 1) Mutual Funds 2) Money Market Mutual Funds 3) Exchange Traded Funds (ETFs)
Monetary Policy and the Macro Economy 1 A) What is contractual monetary policy? B) What is the most common operation the Fed uses?
A) Selling treasury bills is contractual monetary policy. Fed sells bonds, other institutions buy them, sucking money out of the financial system. B) Most common operation the Fed uses is open market purchases.
Economics of Financial Crises and the 2007-2008 Crisis 1 A) What is stage 2 of a financial crisis? B) what does insolvent mean? C) If sufficiently severe, what occurs?
A) Stage 2: bank panic B) Due to deteriorating balance sheets, some banks become insolvent (negative net worth) -Unable to pay off depositors and creditors, some banks fail C) If sufficiently severe, this sets off a wave of bank failures, known as a bank run or bank panic -Banks sell assets and cease making loans to increase reserves -Asset prices decline, making some previously solvent banks insolvent -The "bank" run phenomenon may occur for other intermediaries, as in 2007-2008 crisis (run on 'shadow-banking system')
Economics of Financial Crises and the 2007-2008 Crisis 1 A) What is Stage 3 of a financial crisis? B) What is the definition of the term that is the answer to (A)? C) What happens because of the answer to (A)?
A) Stage 3: Debt deflation B) Deflation (a drop in the overall price level) occurs C) This further deteriorates firms' net worth because of the increased burden of indebtedness -Debt is the most sticky of prices! -Debt contracts typically fixed in nominal terms, often for long maturities -Surprise deflation increases firms' real liabilities but does not increase real value of assets -Real net worth of firm declines -Firms are perceived as greater credit risks by lenders -Drop in lending and economic activity
The Federal Reserve and Its Powers 3 1) Who runs the Federal Reserve System? 2) How are these people chosen and how long is their term? 3) Who heads the board currently and what is the position called? How long is the term?
1) The Board of Governnors 2) -7 Governors appointed by President, confirmed by Senate -No 2 Governors from same Federal Reserve District -Governors have 14-year terms, expiring every 2 years. -Governors' terms are nonrenewable 3) -One Governor serves as Chairman -Chairman has 4-year term and may be reappointed -When new Chairman is named, old one traditionally leaves (regardless of time left in underlying appointment as Governor) -Current Chairman of the Board: Janet Yellen
The Federal Reserve and Its Powers 1 1) What does a Central bank do (4)?
1) Acts as national government's "fiscal agent" (i.e. depository bank) 2) Regulates other financial institutions, especially depository institutions 3) Supervises nation's money supply and payments system 4) Acts as "lender of last resort" when financial system has liquidity problems
Interest Rates 1 A) the 3 key determinants of the real interest rate include: B) How can we model the real interest?
1) The (real) return on investment / capital -Affected by technological changes and innovation -Varies with expected future conditions in product markets 2) Consumers' impatience / time preferences -All other things equal, consumers prefer to consume now rather than defer consumption to the future -Consumers also generally prefer a smooth consumption profile (over time) to one that is 'feast or famine' 3) Government policy -Tax rates influence consumer wealth and willingness to lend -Fiscal policy (expansion creates demand for capital) B) At an abstract level, we can model the real interest in a competitive market for 'loanable purchasing power' (slide 8)
The Federal Reserve and Its Powers 2 1) Federal Reserve Act of 1913 established what? 2) Main objectives of this act were what (4)?
1) The Federal Reserve System 2) -Provide an "elastic" currency— --Federal Reserve Notes—standardized currency --Ability to adjust money supply to changes in economy --12 regionally autonomous Federal Reserve Banks -Serve lender of last resort to keep banks liquid -Improve payments system (check clearing) -Supervise banks more vigorously
Quantitative Easing 1 1) How did Quantitative Easing come about?
1) US situation in early 2009: -financial markets stabilized, but very high unemployment rates and little economic growth -Short term interest rates (Fed funds rate) plunged from near 4% at beginning of 2008 to 0.15% by end of that year -Short term rates consequently near "zero bound" -The Fed unable to rely on conventional monetary policy to stimulate the economy (why?) What's left? -Fiscal policy: political infeasible at the time -Unconventional monetary policy (aka quantitative easing)
Economics of Financial Crises and the 2007-2008 Crisis 3 A) Bernanke Vs. Taylor in causes of the housing bubble:
A) -John Taylor: Low interest rate policies of the Fed caused the housing bubble. -Bernanke: Problem not policy, but practice (mortgage practices) + influx of foreign capital (China)
The Federal Reserve and Its Powers 4 A) Who is very powerful within the modern Federal Reserve System? B) What important tasks does this powerful committee do (4)?
A) -The Board of Governors is very powerful within the modern Federal Reserve System -Governors outnumber FRB presidents 7 to 5 on FOMC B) 1) The Board sets reserve requirements 2) Board can review and disapprove of regional banks' discount rates: effective control of discount rates 3) Board appoints top officers at regional banks 4) The Board directs the Fed's economic research
The Federal Reserve and Its Powers 4 A) FOMC holds how many meetings per year? B) What does it do at these meetings (1-3)?
A) -The FOMC holds eight regularly scheduled meetings per year. B) -At these meetings, the Committee: 1) Reviews economic and financial conditions, 2) Determines the appropriate stance of monetary policy 3) Assesses the risks to its long-run goals of price stability and sustainable economic growth.
Economics of Financial Crises and the 2007-2008 Crisis 2 A) compare the great depression to the great recession... -output? -unemployment? -M2? -prices? -sector collapses?
A) -output: 25%, 1% fall -unemployment: 25%, 10% -M2: 33% fall, 10% rise -prices: 25% fall, 5% rise -sector collapses: --stock collapse, then bank collapse, then bailouts --housing collapse, then bank collapse, then bigger bailouts
Financial Institutions and Markets 7 A) What are 6 types of risks faced by financial institutions?
A) 1) Credit risk -Default risk; the other party will fail to honor their obligations. 2) Interest rate risk -Interest rates move in a way that devalues the asset held by the institution 3) Liquidity risk 4) Foreign exchange risk 5) Political risk 6) Operational/legal risk
Economics of Financial Crises and the 2007-2008 Crisis 3 A) What are the last 2 origins of the financial crisis?
A) 1) "Originate-to-distribute" model exacerbated agency problems -Mortgage brokers (agents) had little incentive to have home buyers' best interests at heart -Lax regulation of originators: predatory lending 2) Commercial/Investment banks quietly became heavily exposed to housing market risk -Underwrote MBOs, CDOs, etc. and had little interest in ensuring holders of these securities would ultimately be paid -Underwrote many credit default swaps -insurance contracts providing payoff to holder in event of default Held chunks of these contracts on books - big exposure to housing sector
The Federal Reserve and Its Powers 8 A) The discount rate: Institutions (banks) may borrow from their district's Federal Reserve Bank (at the "discount window") for (3):
A) 1) Adjustment credit, to cover short-term liquidity shortages 2) Seasonal credit, to help them through seasonal fluctuations 3) Extended credit, to support institutions in exceptional circumstances *The discount rate is the rate the Fed charges on these loans
Bond Pricing 1 A) three rules of bond pricing relations are:
A) 1) Bond prices are inversely related to bond yields 2) Price volatility of a long term bond is greater than that of a short term bond, holding constant coupon rate 3) Price volatility of a low-coupon bond is greater than that of a high-coupon bond -Bond 1 pays coupon of 10% = $100 -Bond 2 pays coupon of 20% = $200 --Price volatility for bond 1 will be greater --Why? ---Same reason as before: payoffs further in the future are more sensitive to the discount rate ---bond 1 has a greater duration than bond 2
Financial Institutions and Markets 5 A) 5 basic types of services provided by FIs:
A) 1) Denomination divisibility 2) Currency transformation 3) Maturity flexibility 4) Credit risk diversification 5) Liquidity
Financial Institutions and Markets 6 A) What are the 4 classifications of FIs?
A) 1) Deposit-type or "depository" institutions -Financial intermediaries source their funds from deposits 2) Contractual savings institutions -Insurance companies 3) Investment funds 4) Other institutions
The Federal Reserve and Its Powers 5 A) Why is the Federal Reserve Bank of New York so important?
A) 1) Holds day-to-day responsibility for implementing monetary policy for the Federal Reserve -Takes direction from the FOMC 2) Located in Wall Street financial district 3) Vast holdings of gold bullion -10% of world's official gold reserves -5,000 metric tons of gold bullion, worth $270 billion as of 2010 4) Houses Foreign Exchange Desk: conducts foreign exchange interventions on behalf of Fed and Treasury
Economics of Financial Crises and the 2007-2008 Crisis 3 A) What are the first 2 origins of the 2007-2008 crisis?
A) 1) Low interest rates in the early 2000s (partially attributable to Fed policy) fueled a boom in housing market 2) Financial innovation (securitization) led to a credit boom in the mortgage market -Boom particularly strong in "subprime" sector (relatively poor credit risks) -"NINJA" loans: No Income No Job (no) Assets !?! -Explosion in new financial products --Mortgage backed securities (MBS) --Collateralized debt obligations (CDOs): strips/tranches of MBS pools, CDO2s, etc. -Ratings agencies (Moody's, S&P) gave these strong ratings
The Federal Reserve and Its Powers 7 A) What are the Fed's 3 tools of monetary policy?
A) 1) Reserve requirements 2) Discount rate 3) Open market operations *In practice: open market operations are the Fed's primary tool for conducting monetary policy.
The Federal Reserve and Its Powers 5 A) What aspects of banking and finance does the Federal Reserve regulate (5)?
A) 1) Securities Credit Regulation -Fed establishes borrowing (margin) limits for buyers of securities on margin. 2) Regulation of the Payment System 3) Truth-in-lending Act: Fed regulates disclosure of interest rates on consumer credit offered by banks, savings institutions, etc. 4) Control of International Banking Activities 5) Bank Regulation -Regulation of Bank Holding Companies (BHCs) -BHC is the dominant comm. bank org. structure -Supervision and Examination of State Member Banks
Interest Rates 1 A) nominal interest rates are determined by? B) What are some examples of what nominal interest rates are determined by?
A) 1) Supply of loanable funds -All sources of funds available to invest in financial claims 2) Demand for loanable funds -All uses of funds raised from issuing financial claims *Supply and demand determine the equil. interest rate B) 1) Supply of loanable funds: -Consumer savings -Business savings -Government budget surpluses -Central Bank actions 2) Demand for loanable funds: -Consumer credit purchases -Business investment -Government budget deficits *In open economies, supply and demand for funds are international in nature (slides 11-12
Bond Pricing 1 A) What are the names of short, medium, and long term bonds? B) Essence of bond pricing is?
A) 1) US Treasury Bills (short term) 2) US Treasury Notes (medium term) 3) US Treasury Bonds (long term) B) the bond price equals the discounted value of all bond cash flows
Monetary Policy and the Macro Economy 3 A) How do increases in the money supply affect the long run? What is the theory called?
A) -In the LR, changes in the money supply just affect prices -The "quantity theory of money" delivers this implication: --Factors of production and technology determine (real) output Y --Money supply determines nominal value of output PY % change in M = % change in P *Long run "neutrality of money" -Intuition: changing the nominal value of every existing dollar into two dollars just leads to a doubling of all prices (including wages)
Monetary Policy and the Macro Economy 2 A) Can monetary policy actually influence the inflation rate and unemployment rate? B) Are there implicit tradeoffs between the two primary goals of monetary policy? What is it called?
A) -Inflation rate: Most economists believe so -Unemployment rate/GDP growth: More contentious B) The so-called "Phillips curve" from macroeconomics suggests there is a tradeoff
Financial Institutions and Markets 4 A) What are the 2 leading examples of financial intermediaries? B) What is the case for financial intermediaries?
A) 1) Commercial banks -Take deposits and make loans -Depositors are SSUs Borrowers are DSUs 2) Insurance companies -Issue policies, collect premiums, and invest in stocks and bonds -Policyholders are SSUs -Businesses or governments are DSUs B) In working to offer services at lower cost (to lure business from competitors), fin. intermediaries reduce financing costs
Economics of Financial Crises and the 2007-2008 Crisis 2 A) What are 3 things that economists learned from the Great Depression?
A) 1) Don't let the money supply fall by 1/3 -By "money" we mean cash + checking + savings accounts 2) Don't let average prices and wages fall dramatically -Too hard to repay old debts when you earn less & sell less --Irving Fisher, "Debt-Deflation Theory of Great Depressions," 1935 -Workers resist wage cuts—get laid off instead 3) Loose money helps private sector heal itself -Different from government spending approach = taking up slack
Financial Institutions and Markets 6 A) What are 2 examples of 'Other Intermediaries?'
A) 1) Finance Companies -Make consumer and business loans -Main difference from depository institutions: don't take deposits -How do they raise cash? Selling equity (stock), issuing short term debt called "commercial paper" --Example: financing arm associated with Toyota 2) Government -Government institutions are important intermediaries -Fannie Mae and Freddie Mac: provided government guarantees on qualifying home mortgage loans
Monetary Policy and the Macro Economy 2 A) Why is high employment a sensible policy goal (2)? B) What is frictional and structural unemployment? And what is the natural rate of unemployment
A) 1) High unemployment causes human misery and social unrest 2) High unemployment implies 'economic slack:' idle workers and resources; unrealized potential GDP B) 1) Frictional unemployment: some acceptable unemployment related to appropriately matching works with firms 2) Structural unemployment: mismatch b/w job requirements and worker skills. Undesirable, but not something monetary policy can address. Hopefully temporary. 3) Natural rate of unemployment: theoretical target for policy
The Federal Reserve and Its Powers 9 A) Why are open market operations preferred tool (2)?
A) 1) Money supply changes quickly 2) Open market operations are flexible and precise *Open market operations conducted nearly every weekday by Fed Example: suppose Fed wants to decrease the money supply slightly -Increasing reserve requirements is too draconian a measure and can't be used frequently -Increasing the discount rate may move the money supply in the correct direction, but hard to forecast the ultimate change (must predict bank discount borrowing behavior) -Easy to do using open market operations
The Federal Reserve and Its Powers 8 A) The Fed actually has several discount rates (4): B) Historically, the Fed focused directly on managing what? Now, the Fed typically targets interest rates (which one in particular?)
A) 1) Primary credit (.75%): overnight loans for essentially sound banks 2) Secondary credit (1.25%): longer term loans for 'short term liquidity needs or to resolve severe financial difficulties" 3) Seasonal credit (.15%): example: midwestern bank with fluctuations around agric. cycle 4) Fed Funds Target rate (0-.25%): rate banks charge each other for overnight loans of reserves -This rate is a market rate (responds to market forces related to supply and demand of reserves) -The Fed can influence (but not directly control) Fed Funds rate B) Historically, the Fed focused directly on managing the money supply (money growth). Now, the Fed typically targets interest rates, in particular the "Fed funds rate"
Financial Institutions and Markets 3 A) What are the 3 sources of transaction costs?
A) 1) Search costs (getting in contact with SSUs) -Significant "time and hassle" 2) Contract/legal costs 3) Due diligence / evaluation costs (evaluation of DSU) -Asymmetric information: buyers and sellers do not possess same information --DSUs (issuers) more knowledgeable than SSUs (investors) -Moral hazard: incentive problems after transaction --Banks must monitor behavior of borrowers -Mitigating problems related to asym. info. can be costly --Example: To address adverse selection problems, commercial banks rely on sophisticated mathematical models of credit risk
Monetary Policy and the Macro Economy 3 A) Keynesian macro theories states that monetary policy can influence the real economy how?
A) 1) Unexpected increases in the money supply lower interest rates -There is a temporary excess of funds available for lending 2) Lower interest rates stimulate aggregate demand -Households more willing to borrow for consumption (new car, boat, or home) -Firms more willing to borrow for investment projects* 3) Output and employment increase: firms produce more and hire more to satisfy higher aggregate demand
Quantitative Easing 1 A) In Dec. 2012, the Fed said it would keep the Federal Funds Rate around 0% so long as (3):
A) 1) unemployment rate remains above 6-1/2 percent, 2) inflation between one and two years ahead is projected to be no more than 1/2 percentage point above the Committee's 2 percent longer-run goal, 3) longer-term inflation expectations continue to be well anchored.
Quantitative Easing 1 A) What is the basic idea of quantitative easing? B) What are risks associated with this policy (2)?
A) Central bank (Fed or ECB) purchases longer duration (no longer t-bills) financial assets (bonds/mortgage-backed securities issued by Fannie/Freddie) in order to inject a certain quantity of money into the economy How does it work? Buy longer maturity assets with electronically created reserves -Push up price of these assets -> decrease yield (interest rate) -This amounts to pushing down long end of the 'yield curve' (at this time, the money rate (beginning of yield curve) was extremely low, but long end of the yield curve was high, leading to a steeply sloped yield curve). B) Risks: 1) Inflation: just as with conventional monetary expansion, repeated QE may lead to significant inflation 2) Ineffectiveness: Banks must ultimately lend out reserves in a way that spurs economy
Quantitative Easing 1 A) What is Operation Twist? When did it occur? B) What was the goal of operation twist?
A) After two rounds of QE, the Fed announced in late 2011 that it planned to buy $400B of bonds with long maturities (6-30 years) and sell $400B of bonds with short maturities -Effectively, this is a shift in the maturity of the assets held by the Fed (toward longer maturity) B) Goal: To 'flatten the yield curve' and reduce long term interest rates believed to be more closely related to investment and consumer purchases -Program extended/expanded in June 2012.
The Federal Reserve and Its Powers 6 A) How did the Fed's balance sheet on the assets side change pre- and post-recession? B) How did the Fed's balance sheet on the liabilities side change pre- and post-recession?
A) Assets almost tripled in size, from 879,784,000,000 to 2,335,533,000,000. Biggest changes were: its purchase of mortgage backed securities. B) Liabilities also almost tripled in size (same exact numbers as assets because no owner's equity). The biggest change was the massive expansion in depository institution reserves post-crisis (banks stopped lending).
The Federal Reserve and Its Powers 6 A) Bank reserves are? B) The monetary base is? And formula?
A) Bank reserves: cash or deposits held at other banks that may be used to satisfy depositor demands B) The monetary base is one definition of an economy's money supply. -It is the sum of currency (C) and total reserves (TR) in the banking system: MB = C + TR -Alternative definitions include increasingly less liquid items --M1: C + checking deposits --M2: M1 + savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, etc.
The Federal Reserve and Its Powers 8 A) Reserve requirements as a monetary tool:
A) Changes to reserve requirements are not typically used as a monetary policy tool -Changes in reserve requirements can have dramatic effects -Very difficult to 'fine-tune' money supply -Requirements infrequently changed since 1980:
Financial Institutions and Markets 5 A) What is credit risk diversification? B) What is liquidity?
A) Credit risk diversification: FIs typically hold large portfolios of credit risks -- benefit from diversification -In direct markets claims holders (SSUs) often exposed to large, "idiosyncratic" credit risks --Example: Suppose Boeing issues a large corporate bond through a private placement: holder of this bond is heavily exposed to credit risk related to Boeing B) Liquidity: FIs tend to produce securities that are highly liquid; makes SSUs more willing to provide funds -Example: Money market funds allow households very liquid access to interest-bearing wealth
The Federal Reserve and Its Powers 7 A) Reserve requirements are: -Where are they held? B) What Act deals with reserve requirements?
A) Depository institutions must reserve set percentage of certain types of deposits (required reserves) -Most reserves are held at FRB for that district -Reserves may also be held as vault cash B) Monetary Control Act of 1980 -Subjects all US depository institutions to uniform reserve requirements -Sets limits within which Fed is to specify required reserve ratio
Economics of Financial Crises and the 2007-2008 Crisis 4 A) What did Congress do to avoil a full financial collapse? B) What did TARP allow for? C) What did the US government ge in return? D) What restrictions were in place on the organizations (3)?
A) Desperate to avoid a full financial collapse, Congress passed a massive bailout measure (TARP) B) TARP allows the US Treasury to purchase or insure up to $700 billion of "troubled assets," specifically: -Residential or commercial mortgages and any securities, obligations, or other instruments based on these -Purchase of promotes 'financial market stability' C) Participating institutions issue US gov. preferred shares* and/or warrants (option to buy shares at agreed price) -Allows taxpayers to recoup funds through increases in share prices of institutions D) Restrictions on (1) executive compensation, (2) bonuses, (3) 'golden parachutes' for participating institutions
Economics of Financial Crises and the 2007-2008 Crisis 1 A) What is stage 1 of a financial crisis? What causes stage 1? B) What does deleveraging involve? What occurs because of deleveraging?
A) Deterioration of financial intermediaries balance sheets and deleveraging due to: -Mismanagement of financial liberalization or globalization -Asset price declines (bursting of a "bubble") -Sudden increase in interest rates -Increase in uncertainty B) Deleveraging involves a contraction in credit (fewer loans) as financial institutions reduce leverage following asset price declines and/or loan underperformance -As credit provision weakens, economic activity wanes
Financial Institutions and Markets 3 A) The first of 2 main channels through which SSUs pair with DSUs is: B) provide 3 examples: C) 3 key characteristics are:
A) Direct Financing -SSUs and DSUs directly interact -SSUs transfer funds directly to DSU -DSU issues claims directly to SSU(s) B) Examples 1) Corporate bond issuance 2) IPO (initial public offering of equity securities) 3) 'Private placement' of corporate bonds/equity C) Key characteristics: 1) Large, "wholesale" transactions 2) Minimum transaction size $1 million (often much larger) 3) Sophisticated parties involved in transactions: Commercial banks, Governments, Hedge funds, etc.
Monetary Policy and the Macro Economy 4 A) Economists opposed to discretionary policy prefer what? B) What are the two types of the answer to (A) C) Taylor rule is an explicit interest rate rule proposed by John Taylor that adjusts the interest rate upward in which 2 scenarios?
A) Economists opposed to discretionary policy prefer policy rules -"Program in" policy responses. Enables commitment. -Important issue: what form should a rule take? B) Many proposed monetary policy rules involve either inflation targeting and/or interest rate targeting 1) Inflation targeting -Central bank (Fed) makes a public announcement of target inflation rate, then steers actual rate toward target 2) Interest rate targeting -Central bank (Fed) frames monetary policy in terms of targets for benchmark interest rate; "observable and immediate" --Example: Fed has focused on targets for the Fed funds rate C) 1.) inflation is above target 2.) output is above target
Financial Institutions and Markets 5 A) What is denomination divisibility? B) What is currency transformation? C) What is maturity flexibility?
A) FIs produce a wide range of denominations ($1-millions of $) in providing their services -Many households are able to fund only modest deposits and are consequently unable to transact in direct financial markets B) Currency transformation: FIs buy securities in one currency and sell in another C) Maturity flexibility: FIs create securities with a wide range of maturity lengths -Home loans with maturities of 15 or 30 years -Overnight loans to other banks and institutions
The Federal Reserve and Its Powers 9 A) Execution of Open Market Operations: Who decides what? B) Execution of Open Market Operations: what securities are involved? C) Execution of Open Market Operations: how many times do they meet? D) Execution of Open Market Operations: Who issues policy directives and to whom are they issued to?
A) FOMC decides whether, when, and how much to buy or sell B) Usually the securities involved in open market operations are US Treasuries (but could be other assets) C) FOMC meets 8 times a year D) The FOMC issues policy directives to Open Market Desk at FRB of New York
Financial Institutions and Markets 1 A) Financial claims are? Examples are? They are also called what? B) Financial markets are? C) Financial institutions do what? Examples are? Financial institutions are also called what?
A) Financial claims are financial assets and liabilities; financial contracts -Leading examples: shares of stock, bonds -Also called financial instruments or securities B) Financial markets are markets for financial claims: Stock markets, Bond markets, Foreign exchange markets C) Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers -Banks, mutual funds, pension funds, insurers, ...
Financial Institutions and Markets 2 A) Financial claims arise as what happens? B) Financial claims are an asset to who and a liability to who?
A) Financial claims arise as SSUs provide resources to DSUs -SSU provides cash that is spent by DSU now -DSU provides SSU with some form of "IOU" -This IOU becomes the SSUs "financial claim" B) Financial claims: -Asset to the SSU involved in the claim -Liability to the DSU involved in the claim *The financial system balances: total financial assets equal total liabilities
Financial Institutions and Markets 4 A) Why do financial intermediaries exist?
A) Financial intermediaries exist because they succeed in reducing transactions costs -Exploit economies of scale; invest in expertise (e.g., credit scoring models, monitoring of loans) *Financial intermediaries "transform" claims: -Raise funds by issuing claims to SSUs -Use funds to buy claims issued by DSUs *Claims can have unmatched characteristics: -SSU has claim against intermediary -Intermediary has claim against DSU
Financial Institutions and Markets 2 A) Financial markets provide SSUs with 3 valuable options:
A) Financial markets provide SSUs with valuable options: 1) Match maturity of claim to planned investment period 2) Buy claim with longer maturity, but sell at end of period 3) Buy claim with shorter maturity, then reinvest
Financial Institutions and Markets 8 A) What is the Glass-Steagall Act? B) What is the Truth-in-Lending Act? C) What is the Regulatory Reform act of 2010?
A) Glass-Steagall Act (1933): separated investment banking from commercial banking; gradually weakened, particularly in early 2000s B) Truth-in-Lending Act (1968): requires lenders to provide borrowers with the APR (annual percentage rate) when they apply for a loan C) Regulatory Reform Act of 2010: -Creates "Consumer Protection Agency" -Creates "Financial Stability Oversight Council" -Lots of additional regulatory power for Fed
Monetary Policy and the Macro Economy 1 A) The higher the interest rate that the bank reserves offer, what? B) How does the Fed conduct expansionary monetary policy? What happens to the Fed Funds Rate?
A) Higher the interest rate that bank reserves offer, the more supply that will be offered. B) When the Fed buys t-bills it pushes out money into the money (expansionary open market operation), it pushes down the federal funds rate.
Quantitative Easing 1 A) In late 2012, the Fed's strategy evolved from the "twist," in which purchases of longer maturity assets were sterilized via sales of T-bills, to what? B) What was the timetable for this strategy? C) When did QE3 end?
A) In late 2012, the Fed's strategy evolved from the "twist," in which purchases of longer maturity assets were sterilized via sales of T-bills, to 'naked' purchases of long-term assets ($40B/mo MBS and $45B/mo of Treasury bonds) B) This program was "open ended," with the Fed to continue the program until the unemployment rate hit a target of 6.5% (as long as inflation was at/under target) In Dec. 2013, Fed announced a "tapering" program: reduce purchases by $10B/mo. QE3 ended 10/2014
Financial Institutions and Markets 3 A) The second of 2 main channels through which SSUs pair with DSUs is:
A) Indirect Financing -Financial intermediaries serve as a conduit between SSUs and DSUs -DSUs issue financial claims to FI -FI issues separate financial claims to SSUs -Fund flows are similar: --SSUs transfer funds to FIs --FIs then transfer funds to DSUs
Financial Institutions and Markets 7 A) What is interest rate risk? B) What is an example of interest rate risk from history?
A) Interest rate risk: risk associated with fluctuations in the price of securities or reinvestment income caused by fluctuations in market interest rates B) Example: Savings & Long (S&L) crisis -In late 1970s and early 1980s, interest rates were very volatile -Many S&Ls failed as short term market interest rates paid on deposits rose faster than long term interest rates earned on mortgage portfolios
Duration/Interest Rate Risk 1 A) Interest rate risk is? What are its 2 components?
A) Interest rate risk: risk related to changes in interest rates that cause a bond's total return to differ from promised yield or YTM. Two components: 1) Price risk: variability in bond prices caused by their inverse relationship with interest rates 2) Reinvestment risk: variability in realized yield caused by changing market rates at which coupons are reinvested *Price risk and reinvestment risk work against each other: -When interest rates fall Bond prices rise BUT -Coupons are reinvested at lower return
The Federal Reserve and Its Powers 4 A) Who is the Fed Chair? B) What are 3 aspects of the Fed Chair?
A) Janet Yellen B) 1) Sets agenda and chairs meetings of both Board of Governors and FOMC 2) Public face and voice of the Fed: All remarks scrutinized by world financial markets 3) Many FOMC votes are unanimous, but this is not always the case: -Sometimes voting members break with chairman to voice disagreement on policy -Split votes more common when chairman is expected to step down: posturing for position as next chairman
Financial Institutions and Markets 1 A) Financial system's main roles (2): B) Other imporant functions (3):
A) Main Roles: 1) Allocation of scarce resources -Some economic units (households, firms, etc.) possess excess financial resources -Other economic units wish to utilize these resources 2) Facilitates risk sharing -Uncertainty is a fact of life for households and firms -Risk aversion: desire to share and/or trade risks -Classic example: insurance industry B) Other important functions: 1) clear and settle payments 2) aggregate funds 3) generate and disseminate info
The Federal Reserve and Its Powers 6 A) Fed's balance sheet: main operating assets (4): B) Fed's balance sheet: main operating liabilities (4):
A) Main operating assets: 1) Loans at Discount Window 2) Gold certificates 3) US Government Securities 4) "CIPC:" Cash Items in Process of Collection B) Main operating liabilities: 1) Federal Reserve Notes in Circulation 2) Depository Institution Reserves 3) Treasury Deposits 4) "DACI:" Deferred Availability Cash Items *CIPC - DACI = "float:" net ext. of credit related to payments
Financial Institutions and Markets 2 A) Major players in an economic system include: -Households: -Businesses: -Governments: -Foreign Investors:
A) Major players in an economic system: -Households supply labor, demand products, and save for the future. -Businesses demand labor, supply products, and invest in productive assets. -Governments collect taxes and provide "public goods" (e.g. education, defense). -Foreign investors: nondomestic households, businesses, govts
Financial Institutions and Markets 7 A) How do financial institutions manage credit risk (3)?
A) Manage through: 1) Credit screening 2) diversification 3) monitoring *Example of a large credit risk event: sub-prime mortgage crisis
Financial Institutions and Markets 2 A) Surplus spending units (SSUs) have what? B) Deficit spending units (DSUs) have what? C) One of the primary functions of the financial system is to what?
A) Surplus spending units (SSUs) have income for the period that exceeds spending, resulting in savings. -SSU = "saver", "lender," or "investor" -Many SSUs are households B) Deficit spending units (DSUs) have spending for the period that exceeds income. -Another term for DSU is "borrower" -Most DSUs are businesses or governments C) One of the primary functions of the financial system is to match SSUs with DSUs.
Monetary Policy and the Macro Economy 3 A) Which model depicts the hypothesized tradeoff between inflation and what? B) How well does US economic history support this model? C) What is the Resolution to this dilemma? The Phillips curve shifts when there are (2)?
A) The "Phillips curve" captures the hypothesized tradeoff between inflation and (un)employment: B) Relationship held quite tightly in 1960s -BUT 1970s brought stagflation: combination of high unemployment and high inflation -Stagflation is inconsistent with the 'basic' Phillips curve C) Resolution: Phillips curve shifts when there are: 1) Changes in expectations of future inflation 2) Supply/cost shocks (world oil price shock) *"Short run Phillips curve" valid only so long as inflation expectations remain constant
The Federal Reserve and Its Powers 5 A) What recent act widened the regulatory powers of the Fed? What powers did this act give to the Fed? B) 3 specific powers are:
A) The 2010 "Restoring American Financial Stability Act" widens the regulatory powers of the Fed -Summary: provides Fed with authority to monitor and, when necessary, intervene in business affairs of large complex bank and nonbank holding companies posing risk to economy. Focuses Fed regulatory powers on large banks B) 1) Fed can preempt other primary regulators of any financial institution if such institution poses threat to economy 2) Can even break up firms or require divestments of certain assets 3) Attempts to address "Too Big to Fail" problem through: -Preventive oversight of large financial institutions -Corrective action before taxpayers have to bail out institutions
The Federal Reserve and Its Powers 9 A) Fed control: Monetary base versus money supply: Fed directly controls which? B) But the Fed has substantial influence over what? C) What is another lever the Fed has to influence bank behavior?
A) The Fed directly controls the monetary base B) Because changes in money supply generally respond to changes in monetary base (see previous slide), the Fed has substantial influence over the money supply -Cannot control money supply perfectly -Other influences: --Bank behavior (rr factor in money multiplier) --Consumer behavior (cr factor in money multiplier) C) Fed can now pay interest on reserves -This gives Fed another lever to influence bank behavior -Example: Fed wants banks to hold more than required reserves: increase interest rate paid on reserves
Economics of Financial Crises and the 2007-2008 Crisis 4 A) How did the crisis kick into gear? B) The crisis was exacerbated by a run on the what? What is the definition of the answer to the question above?
A) The crisis kicked into gear in 2006-2007 as subprime mortgages began to default and housing prices fell -Value of many MBS and CDO securities collapsed as default rates became apparent -Deterioration in financial institutions' balance sheets and deleveraging B) The crisis was exacerbated by a run on the shadow banking system -Shadow banking system: long term positions financed via short term instruments (repos, commercial paper) -"Haircuts" on repos rose rapidly, forcing "fire sales" of assets -Vicious cycle ensued --Fire sales further depressed prices, raising haircuts again, leading to more fire sales...
Economics of Financial Crises and the 2007-2008 Crisis 4 A) When did the crisis peak? B) What happened to large investment banks and insurers at the peak? C) What happened to Merrill Lynch, Lehman Bros, and AIG and during what time span?
A) The crisis peaked in September/October 2008. B) Large investment banks and insurers became insolvent or nearly insolvent C) In the span of 3 days (Sept. 14 - Sept. 16): -Merrill Lynch (3rd largest I-bank) sold to BofA for 60% of its value one year prior -Lehman Bros. (4th largest I-bank) declared bankruptcy -AIG suffered liquidity crisis after credit downgrade and accepted Fed loan to stay afloat
Bond Pricing 1 A) The expected yield is? B) zero coupon bonds trade at?
A) The expected yield on a bond is the predicted yield for a given holding period B) Since zero coupons do not make interest payments, they trade at a discount. US treasury bills are zero coupon bonds.
Financial Institutions and Markets 3 A) The key principle governing whether financing is direct or indirect is the what?
A) The key principle governing whether financing is direct or indirect is the size/significance of transactions costs -Transactions costs refer to the economic costs of doing business or conducting a transaction -When transactions cost are low/insignificant, it is often better to "cut out the middleman" use direct financing
Bond Pricing 1 A) The realized yield on a bond is what? And assumes what? B) How to compute?
A) The realized yield on a bond is the ex post (after the fact) yield from holding a bond -Assumes coupon payments are reinvested at realized yield rate B) Determine the yield/rate that equates the purchase price of the bond with the PV of the sum of coupons and sale value actually received.
Monetary Policy and the Macro Economy 3 A) Why does the 'classical' neutrality of money story not hold in the short run? B) In the short run, money supply growth that stimulates the economy is often accompanied by what?
A) The standard reason offered is "price stickiness" -Some prices do not adjust quickly to changes in economic conditions -Example: the Fed unexpectedly prints a bunch of currency and drops bundles of it overnight in the yards of households --Is it reasonable that Starbucks coffee prices will be higher the very next morning? --Will wages go up the very next day? -With sticky prices, the money supply can affect the real economy in the short run (IS-LM model from macro) . B) growth that stimulates the economy is often accompanied by inflation
Bond Pricing 1 A) What is total return on a bond? B) How to compute total return?
A) The total return on a bond considers capital gains/losses and changes in the reinvestment rate B) 1) Make an assumption (or look back historically) to determine the actual reinvestment rate on coupon payments 2) Using this reinvestment rate, determine the future value of the coupon payments, i.e., the value at the time of sale of the bond, accounting for the effects of interest 3) Add this future value to bond sale price, and compute the discount rate equating this to the purchase price of the bond
Financial Institutions and Markets 6 A) What are 3 types of depository institutions?
A) These institutions / intermediaries take deposits and make loans 1) Commercial Banks -Checkable/savings deposits; -Business, consumer loans + mortgages -Large: $7.8 trillion in assets in 2003 2) Thrift Institutions -Checking/savings deposits -Specialize in residential mortgage loans to consumers 3) Credit Unions -Non-profit, cooperative, consumer organized, "common bond" -Primarily short-term installment consumer loans ** Deposits generally insured by FDIC up to $250,000
Monetary Policy and the Macro Economy 1 A) When the Fed controls the Fed Funds Rate, what is this best viewed as? B) The Yield Curve describes interest rates as a function of what? C) What new Fed tool is geared at the long end of the curve?
A) This control is best viewed as "short-run" *Fed funds rate is the rate on very short maturity interbank lending - "front end of curve" -In long run, market forces will determine interest rates B) Yield curve: interest rates as a function of maturity C) We'll talk soon about "QE" - new Fed tools geared at long end of curve
The Federal Reserve and Its Powers 7 A) Formula for total reserves: B) Formula for required reserves: C) 2 options for what to do with excess reserves:
A) Total Reserves = Required Reserves + Excess Reserves B) Required Reserves = required reserve ratio x total bank deposits C) What to do with excess reserves? -Option 1: lend out to earn interest -Option 2: hold for liquidity/safety (or for Fed interest. Historically, the Fed did not pay interest on reserves, but this policy was changed recently. See pp. 70-71 of the Ch. 2 in the text.)
Interest Rates 1 A) Unanticipated inflation benefits who? B) Who does what to offset anticipated decreases in purchasing power? C) Expected inflation is embodied in nominal interest rates. What is this called? Equation?
A) Unanticipated inflation benefits borrowers at expense of lenders. B) Lenders charge added interest to offset anticipated decreases in purchasing power. C) Expected inflation is embodied in nominal interest rates. This is called the Fisher effect. (1+realinterest)(1+inflation) = (1+nominal)
The Federal Reserve and Its Powers 8 A) Discount Rate Lending and the Monetary Supply: When the Fed lends at the discount window, the money supply does what? B) Why don't banks rely as much on the discount window (relative to past) (2 reasons)?
A) When the Fed lends at the discount window, the money supply increases: -Example: Bank borrows $5 mil. from discount window: Some of these funds may be lent out, increasing money supply -Indirect channel: decreases in discount rates incentivize greater risk taking (lending) by banks "on the margin" B) 1) Variety of alternative funding options (interbank loans, etc.) 2) Wary of increased Fed "scrutiny" that sometimes accompanies borrowing at discount window *Discount rates now serve more of a 'signaling' role
Monetary Policy and the Macro Economy 4 A) Austrian school perspective:
A) loose money policy creates credit booms with mal-investment -Recession occurs as money supply suddenly contracts and resources diverted back to more efficient uses -Austrian: monetary policy is ill-advised—it would be better to not dabble with this stuff.
Monetary Policy and the Macro Economy 2 A) Act specifies the 6 mian goals for the Fed's monetary policy? B) What are these 6 main goals? And which are the most important?
A)Humphrey-Hawkins act (1978) B) 1) Price stability 2) Full employment Most important ^^^^ 3) Economic growth 4) Interest rate stability 5) Stable financial system 6) Stable foreign exchange markets
The Federal Reserve and Its Powers 2 1) History of Central banks in the US:
There have been 2 "eras" of central banking in the US -Early era: 1791-early 1830s --First National Bank of the United States (1791-1811) --Second National Bank of the United States (1816-1832) --Both ultimately failed to survive political winds of the time -Modern era: 1913-onward --Banking act of 1913 established the Federal Reserve System Between these two eras (1832-1914) the US operated without a central banking system -Banks were state-chartered and unregulated -No deposit insurance or minimum capital requirements -Little supervision of lending or accounting practices