Module 11: Banking and the Federal Reserve System

Assets for Commercial Banks

Vault cash/reserves, government bonds, loans to public. A bank's assets are someone else's liabilities. // A & P National's interest-earning assets are government bonds and loans to the public.

The real rate of interest is

the nominal rate of interest minus the expected rate of inflation or the actual rate of inflation.

The nominal rate of interest is

the rate of interest actually charged, without any correction for inflation.

The Fed uses the money supply and interest rates to affect

to affect: output, employment, and the price level.

Primary Functions of a Bank

to be an intermediary in the lending business

If the price level is rising, the dollars repaid on a loan will be

worth less and less with each successive payment.

Borrowing from the Fed by banks is called

"using the discount window." // The Fed may deny use of the discount window to banks that have made unwise loans.

Three Functions of the Federal Reserve

(1) *Sets monetary policy* through decisions that affect the *flow of money and credit*. (2) Contributes to the safety and soundness of the financial system by *supervising and regulating banks*. (3) Serves as *the bank for depository institutions and the government* and makes sure the payment system works efficiently.

ER

*Excess Reserves*.

Reasons why banks fail

*Liquidity*: a lack of ready cash to meet large withdrawals by the public. Deposit insurance and having the Fed as a lender of last resort have largely resolved that problem. *Insolvency*: having assets whose value is not enough to cover liabilities, such as deposits. A bank becomes insolvent if it has too many assets in loans that may never be repaid. An insolvent bank will go out of business or be taken over by another bank in a merger, often forced by the insuring agency. Insolvency has been the dominant bank problem in more recent history.

Ways the Fed can influence the money supply

*Open market operations / purchases* (preferred) involve buying and selling bonds to affect banks' reserves. // Changes in the *discount rate aka federal funds rate* affects the level of bank borrowing from the Fed. // Changes in the *reserve ratio* affect excess reserves.

rr (lower case)

*Reserve Ratio*. Aka the liquidity ratio. Banks' required reserves are rr x D, where D = checkable deposits. // The reciprocal is the money multiplier.

Banking History

1930's: policies to prevent bank failures. 1980's: eliminated a lot of those. // 1970's banks couldn't fail due to legislation but their rates were so high and there were interest rate ceilings so they were losing business to credit unions and savings associations. So they deregulated the banking industry in 1980's and brought credit unions and savings associations under the Fed. Consumers got better products now that banks were allowed to fail. // In the early 1980s, market interest rates dropped sharply, causing the average interest rate on banks' loan portfolios to fall very quickly. Interest paid on deposits didn't keep up so the spread got smaller and profits. Some made risky investments as last-ditch effort to become solvent. Many banks failed and the FDIC paid out $124B then taxed the remaining banks $30B.

Great Recession

1990's: Government pursued getting low income families into homes. Banks had to lower standards to follow these rules. 2000-2006: Housing boom. 2004-2006: Fed raised interest rates from 1% to 5.25%. Many subprime were ARM's so their payments went up. Loan default rate got up to 5.2%, bank failures raised in kind. 2007-2009: 168 depository institutions failed. $540B of failed bank assets. Total: Less banks failed but dollars involved were 1.5x the great depression or the 1980's. // Changes: First, all accounts that do not earn interest are insured in full, regardless of the balance. Those accounts that earn interest are still covered under the standard regulations for bank accounts. In 2010, Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which permanently raises the current standard maximum deposit insurance amount (SMDIA) to $250,000. // Fed worked hard to make sure the financial system did not freeze after the bankruptcy of Lehman Brothers. // During the great recession the Fed arranged for the Bank of America to buy Countrywide Mortgage and for Bears Stearns to be bought by JP Morgan. Both Countrywide and Bears Stearns were going bankrupt and the Fed pushed Bank of America and JP Morgan to acquire them.

Bank Reserves (BR)

Bank assets that can be used to pay depositors when funds are requested. Consist of currency on hand (vault cash) and deposits at the central bank. // One is currency and coins, or vault cash. The second, and larger, consists of funds the bank has on deposit with its district Reserve Bank.

Monetary Base vs Money Supply

It is worthwhile to point out the difference between the *monetary base*, which is *the total amount of reserves and currency available for circulation*, and the *money supply*, which is *the monetary base times the money multiplier*.

T-Account

A partial balance sheet. Shows changes in assets or liabilities resulting from one or more transactions. The only items listed on a T-account are those that change.

Open Market Operations

Buying and selling bonds to affect banks' reserves. The impact on reserves can be precisely determined. Can be reversed without any fanfare. Fed buys government bonds from the bank, so they have more assets to lend. These are expansionary actions for the money supply.

D aka Deposits aka Checking Accounts

Checkable Deposits accounts.

Liabilities for Commercial Banks

Checkable deposits, other deposits, loans from the Fed. // Savings deposits and loans that the Fed has made to this bank make up the rest of the bank's liabilities. // A bank's *biggest* liability are *checkable deposit* accounts.

FDIC

Federal Deposit Insurance Corporation // This is an insurance corporation designed to protect bank depositors from insolvency, not banks or bank stockholders. // Supervise member banks for safety and compliance with banking regulations. // Created in 1935 after the Fed didn't receive a very good grade as a guarantor of bank safety. Expanded to ALL banks after problems in the 1980's. Shifted the burden of protecting depositors to the federal government. // Used to be the FDIC and FSLIC but they combined. Federal Savings and Loan Insurance Corporation.

What does a 'bank of last resort' do?

If a financial institution needs money and no one will lend to them, the Fed will lend. If it happens regularly the Fed will work to find out why and if necessary arrange a merger or takeover.

Loans between banks are made in the -- market.

In the *federal funds* market.

Government Bonds

Liabilities of the U.S. Treasury. Range from T-bills (short-term obligations) to notes (medium term) to bonds (long term).

The Fed sets which interest rates

Many people are under the impression that the Fed sets market interest rates, but *the discount rate is the only rate the Fed sets directly*, although they have very good control over other interest rates.

Comptroller of the Currency

The FDIC and the Comptroller of the Currency regulate the kinds of investments that banks can make.

Contracting the Money Supply

The Fed pays for Open Market Purchase by increasing member banks' reserves. If the Fed wishes to contract the money supply or prevent banks from expanding the money supply, it will offer to sell bonds to the banks. If banks do not wish to buy the bonds, their customers will, and the effect on reserves will be the same. When the Fed sells bonds, it accepts payment by decreasing the bank's reserve account. // Sales of government bonds by the Fed reduce bank reserves.

Fed Districts

The United States is divided into *12 Federal Reserve districts*, each with its own Reserve Bank (see Figure 11.1). The purpose of districts was to keep management in closer touch with the people, instead of concentrating power in Washington, DC, or New York City. // The Board of Governors is the governing body of the Federal Reserve System. *Seven members* are *appointed by the president* for *14-year staggered terms*, with no more than one governor from any of the 12 districts. The chair of the Fed is chosen by the president from among the sitting governors for a four-year, renewable term.

Money Multiplier

The amount of money generated in the banking system for every additional dollar of reserves. It equals the *reciprocal of the reserve ratio*. /// Since the multiplier has the potential to change over the course of the business cycle, it is important to recognize that the actions of the Fed may be weakened or strengthened by these changes in the multiplier.

Fractional Reserve Banking

The bank can loan all deposited funds except for a reserve equal to a fraction / percentage of their checkable deposits so that cash is available for withdrawals. // When a bank lends out a portion of its customers' deposits. // The practice of holding a fraction of money deposited as reserves and lending the rest. // New loans earn interest where reserve funds do not earn interest. // Developed by goldsmiths.

Required Reserve Ratio

The fraction of the deposits that banks are required to hold in reserves.

Discount Rate

The interest rate the Fed charges a bank // The higher the rate, the less eager banks are to borrow. // Each Federal Reserve Bank sets a discount rate for the depository institutions of its district, but the rates are usually the same in all 12 districts. // Historically the discount rate was lower than the federal funds rate but banks abused it by borrowing low and loaning it out at higher rates. In 2003 the Fed began a penalty discount policy that sets the discount rate around 1% higher than the effective Fed fund rate. This was to more directly force banks to borrow first from the private sector. The Fed truly become a "lender of last resort."

Fed aka Federal Reserve System

The major source of bank reserves, including cash in the form of Federal Reserve notes. Has the power to create reserves and set the required reserve ratio. // They are in charge of the monetary system.

Federal Funds Rate

The rate that banks pay or receive when using government bonds. The rate in the federal funds market. They purposely make this a bit high so that banks are more encouraged to borrow for each other. The rate changes with the market. When the rate is to *high* the Feb *buys* bonds, too *low* and the Fed *sells* bonds, and these actions push the rate back toward the target rate. Cushions the fall of a recession. The Fed typically lowers the target rate if the economy is experiencing higher than normal unemployment. Almost zero in 2009 to encourage banks to borrow and loan. /// When the rate is high the desire for funds is high so the Fed buys to inject cash and bring the demand in balance and the rate into the target range.

RR (capitals)

The sum of *Required Reserves*. Banks' required reserves are rr x D, where D = checkable deposits.

Money Supply

The total of all funds available in the nation. New loans increase the money supply but making a deposit into a checkable deposits account does NOT affect it. // When all the excess reserves in the banking system have been used up, the money supply stops expanding.

BR

Total *Bank Reserves*.

Primary Functions on Federal Reserve System

WHEN ESTABLISHED: *Regulate banks* to keep them from making risky loans that threatened the safety of deposits. To be a *"lender of last resort"* to rescue basically sound banks that were threatened with failure and bankruptcy because of temporary economic conditions. NOW: *managing the size of the money supply* so as to promote economic growth, high employment, and a stable price level. This is now the Fed's most important function. // It would also serve as a banker to the treasury, clear checks, and issue currency. // A congressional creation *not a constitutional one*. // The first two attempts at central banks were also private banks, but concerns about corruption led Congress to seek a different structure for the U.S. central bank. // Bank safety was a primary reason for establishing the Federal Reserve System.

The banking system / an individual bank is fully loaned up when

When RR equals BR (i.e., ER = 0)

Federal Open Market Committee (FOMC)

Within the Fed, the most powerful group is the Federal Open Market Committee (FOMC), which *supervises the conduct of monetary policy*. The FOMC consists of the Board of Governors plus the presidents of five district banks, always including the president of the New York Federal Reserve Bank. When the FOMC meets regularly to decide changes in bank reserves and the money supply, all district bank presidents attend.

The interest rate on a loan depends on

how risky the borrower is as well as the length of the repayment period.

A change in the reserve ratio changes the

maximum size of the money supply, not by changing bank reserves (BR), but by changing the money multiplier (1/rr). The money multiplier is the reciprocal of the reserve ratio. ///// A change in the reserve ratio is more complex than open market operations because of this double impact. Because it is such a powerful tool, changes in the reserve ratio are made rarely and in small amounts. Even a change of a fraction of a percent can have a very large (and somewhat uncertain) impact on the economy and can be very unsettling to banks.

When the Fed sells bonds to a bank, the bank's reserves are

reduced, so bank loans must fall. /// When the government BUYS bonds they pay the bank for the bond so the bank has more money and more reserves and more money to loan out, aka the monetary base goes up. / When the government SELLS bonds they have others pay the government which takes cash out of circulation. The monetary base goes down, bank loans fall. / Buying and selling bonds does the same thing whether they are bought / sold to a bank or a private individual.

The Fed changes the discount rate to

signal the direction of monetary policy rather than as a direct tool for changing the money supply.

The interest rate the Fed charges a bank is called

the discount rate. // The higher the rate, the less eager banks are to borrow. // The Fed may deny use of the discount window to banks that have made unwise loans.

The market for loanable funds is

the market in which transactions between borrowers and lenders determine an equilibrium that ensures that the quantity of loanable funds offered is equal to the quantity demanded. The interest rate is the price of loanable funds. The interest rate is an important policy concern because it influences lending and borrowing decisions and thus affects the level of output and employment.