Econ exam 2

Standard and Poor's 500 index (S&P 500(

includes 500 large US corporations: much broader index than the dow -stocks in this index account for about 70% of market capitalization of all US stocks. Market capitalization is the number of shares outstanding times the price of each share -it is a weighted index; it weights the individual stocks by their market capitalization. If microsoft has 5 times the market capitalization as cisco systems, it is given 5 times the weight in the s&p 500; a 1% increase in the price of Microsoft stock would have 5 times the effect on the index as a once percent increase in the price of Cisco

if a bank is suspected of facing severe financial problems, the bank must be prepared for a "run" on the bank by large depositors with funds in the bank in excess of $250,000 (the FDIC insurance limit).

if the bank is forced to sell off long-term bonds at prices significantly below prices originally paid for the bonds, the run can be the last straw that renders a bank insolvent

The predominant cause of bank failures is bad loans

loans that appeared sound when they were granted are sometimes rendered "bad loans" by changes in economic conditions

Adverse selection occurs when resources and funds are allocated to areas that are least deserving

-a high-roller, irresponsible people opened S&Ls due to lax regulations -funds were systematically transferred to the most risky S&Ls because they paid the highest rates

Financial institutions Reform, Recovery, and Enforcement Act of 1989

-abolished the federal savings and loan insurance corporation (FSLIC) and federal home loan bank board (FHLBB -created office of thrift supervision (OTS) to regulate thrifts -created the resolution trust corporation (to resolve insolvent thrifts) -provided funding to resolve insolvent thrifts -re-imposed restrictions on S&Ls -increased insurance premiums for depository institutions

Bank Capital

-bank capital is the net worth of the bank. it is the residual arrived at by subtracting total bank liabilities from total assets. Bank capital is the equity held by the owners of the bank. An individual bank short on capital can increase its capital by issuing new shares of stock, reducing dividends paid to stock holders, and other means. -regulations specify that a bank must abide by specific minimum capital requirements--that is, requirements that each bank must maintain a ratio of capital to total assets at or able a specific percentage. The capital/total assets ratio can be viewed as a cushion to protect a bank from possible insolvency. -the principal source of declining bank capital is bad loans. A certain portion of bank loans typically become bad loans and must be written down by the bank, thus reducing total assets and capital. When a bank borrower defaults on a loan, bank capital declines on a dollar-for-dollar basis. This happens as total assets decline by the amount of the loan default while total bank liabilities remain unaffected -when a bank writes off band loans (asset side) the bank's loans and oral assets decrease by that amount of the write-off. The bank's capital account decreases by the amount of the write-off; if the bank is insolvent, the regulatory agencies will either close the bank or sell it to new owners. -a banks capital become significantly negative by the time regulatory authorities take action. The authorities will likely have to compensate an existing bank to take over a failed bank. Hence, capital is a cushion that protects the FDIC against losses, thus protecting taxpayers. Bank capital is also a cushion protecting deposits who have more than $250,000 in a bank (the deposit insurance ceiling) -banks financial problems are heavily influence by the business cycle. In severe recessions as unemployment rises sharply, hundreds of thousands of individuals and small businesses default on bank loans, impairing bank capital. In the period from 1930-1933, the nation experienced severe price level deflation (30%) and massive employment. An enormous number of loans defaulted, taking down 9,700 banks (1/4 of the nation's banks at the time). In the most recent recession of 2007-09, about 300 banks failed -adverse shocks to particular economic sectors in a otherwise strong economy also reduce bank capital and expose the system to bank failures. the 70% drop in oil prices in the past year or two has exposed many banks in north dakota, texas, oklahoma, and other oil producing states to bad loans and declining bank capital. if oil prices stay under $40 another year or two, we are likely to see a large number of bank failures -when total liabilities > total assets, the bank is insolvent, it has negative capital, and will likely be closed down, sold to a healthier bank, or bailed out by the government if the bank is "too big to fail"; the fact that the largest banks in the nation are considered "too big to fail" creates a significant moral hazard problem, as such banks have incentive to make excessive risk. -the capital/total assets ratio is an important metric indicating the overall health of the banking system. Note hat in January 2016, the aggregate bank balance sheet indicates total U.S. bank capital of $1,712 billion, which represents a capital/assets ratio of just under 11%; this suggests that overall, the U.S. banking system is in relatively robust condition.

on the liability side: financial innovations hurt banks

-the advent and popularity of money market mutual funds forced banks to pay higher rates to depositors; competition -innovation of repurchase agreements and sweep accounts meant that banks were essentially paying interest to corporate depositors. (explicit payment of interest to corporate depositors is prohibited by law.) -threat of disintermediation increased as interest rates rose in the late 1970s and early 1980s in response to the double digit inflation

In the 1990s a bogus view became widespread that the US had entered a "New Economy." To see why this happened recall that in the 1990s, aided by globalization and the build-out of the internet we entered a golden period of surging productivity, rapid GDP growth, falling unemployment, falling inflation, strongly appreciating US dollar in foreign exchange markets, and booming business profits

-This virtuous cycle came at the end of a lengthy period extending from 1983 into the late 1990s in which we experienced only one recession--and that was the mildest and shortest of the 10 or so post WWII recessions -With Alan Greenspan at the helm of the federal reserve, people began to think we had conquered the business cycle--that with brilliant people in chard a the Fed, recessions were a thing of the past--they had become obsolete. A book appeared name "The Maestro," idolizing the genius in charge--Greenspan -Given this kind of thinking which was becoming increasingly prevalent the numerators of the able equation were revised upward, and the downward revision of perceived risk in shticks sharply lowered ke. These factors triggered the stock market bubble, and by 1999 the S&P 500 PE ratio of nearly 45 exceed that even of the famous bubble of the late 1920s bubble

liability management techniques

-borrowing in the federal funds market--"buying federal funds," issuing negotiable CDs, issuing commercial paper, and engaging in reverse repurchase agreements. -large banks organized as bank holding companies can borrow by issuing commercial paper. Mid-sized and smaller banks can bid on "brokered deposits"--pieces of large negotiable CDs that have been broken down into fully insurable $250,000 blocks. Liability management has become pervasive among banks, both large and small -dangers are inherent in bank liability management. Bank assets typically have longer matures than bank liabilities. That is banks facilitate maturity transformation--issuing short-term deposits to make longer-term loans and purchase securities that have longer matures than the deposit liabilities, most of which are essentially withdraw able on demand. -in periods in which interest rates rise sharply and in periods in which yield cure becomes inverted, this maturity transformation function of banks makes them vulnerable. Also, bank profitability depends on the slope of the yield curve--that is the amount by which long-term yields exceed short-term interest rates. Bank profits increase when this yield spread increases -also in periods of rising interest rates, because banks are slow to raise rates they pay depositors but quickly reap higher yields on their assets, bank profitability increases. That is the prospect as of early 2016--- expectations are that bank profit margins will increase as interest rates move up closer to normal levels. Due to expectation, stocks in large US banks like JP morgan chase and Wells fargo have rallied in recent weeks. -Liability management sometimes makes the federal reserve's job more difficult. If aggregate demand becomes excessive in an economic boom and threatens to bring rising inflation, the fed withdraws funds from the banking system in an effort to reduce bank lending. however if banks aggressively resort to liability management to obtain funds with which to accommodate loan demand, the Fed's effort may be partially negated by bank liability management.

The euphoria connected with the development of information technology and the internet in the 1990s led to a dramatic run-up in prices of hundred of little-known tech stocks

-by early spring of 2000 market capitalization of some internet stocks reached preposterous levels, the bottom fell out in the ensuing two years as it became increasingly evident that hoped for profits were not going to materialize -note in the list of tech stocks that Amazon, Cisco, EMC, Hewlett Packard, and Motorola dropped by more than 85% in price. The Dow and S&P 500, and NASDAQ indexes dropped by 38%, 49%, and %78 respectively. Thousands of investors were wiped out by the collapse of this huge bubble

Commercial banking

-commercial banks play a key role in channeling funds from surplus units (savers) to deficit-spending units (borrowers). Bank obtain funds primarily by issuing checking, savings, and time deposits and use the funds to mainly grant loans to home buyers, businesses and consumers and to purchase treasury securities -commercial banks are the dominant player among depository institutions. They are the oldest and most diversified of the depository institutions (which also include savings and loans, mutual savings banks, and credit unions). Total assets of all US commercial banks today total more than $15,000 billion or $15 trillion -our interest in banks stems from their dominant role among depository institutions and their special role in the money supply process. An important portion of the claims banks issue (demand deposits and savings deposits) count in our money (m1 and m2). Banks create money by lending and buying securities -commercial banks are the primary conduit through which the federal reserve influences the nation's money supply, credit conditions, and interest rates. For these reasons, commercial banking warrants special attention. -a healthy banking system is essential to the nation's economic well being. In the past 40 years, banks have been challenged by financial innovations, competition from non-banks, deregulation, globalization, and the Great financial crisis of 2007-2009. For these reasons, bank profitability has fluctuated substantially over the years. Banks in the US and many other nations (especially Europe) were severely impaired by the Great financial crisis. US banks have recovered strongly in recent years, while banks in many European nations, Japan and elsewhere remain in less-robust condition that US banks.

dodd-frank wall street reform and consumer protection act of 2010

-created consumer financial protection bureau to regulate mortgage and other financial products in the interest of the public -required most derivatives to be traded through exchanges and clearinghouses -banned banks from proprietary trading and limited banks ownership of hedge funds -created financial stability oversight council to regulated systematically important financial institutions -authorized government taker of financial holding companies

Federal reserve act

-created the federal reserve system -major objective was to create a lender of last resort to stem panics

macroeconomic conditions also contributed powerfully to bank problems in the late 1980s

-declining interest-rate spreads on assets relative to liabilities occurred as interest rates surged in late 1970s and corporate loan demand dropped. this decking spread resulting falling rate of return on total assets induced banks to seek out higher-paying loans (to energy sector, less developed countries and agriculture). All of these sectors experienced problems in the 1980s so bank loan write-offs surged, impairing bank balance sheets -banks deliberately reduced their capital/total assets ratio (increased their equity multiplier or leverage) to try to prevent decline in the rate of return on capital or equity -the severe world wide recession of 1981-82 caused a large decrease in commodity prices and LDC exports. several of these LDCs could not make payments on their loans from large USbanks. Midwest banks were hit had by the severely depressed crop and land prices, as well as overvaluation of the US dollar due to the massive appreciation of the dollar during 81-85. this dollar overvaluation hammered the US auto industry and other import competing sectors -price of oil fall sharply in late 1985 impairing bank loans to the energy sector in Texas, Louisiana, Oklahoma, etc. -real estate prices fell in certain US cities in the late 1980s and early 1990s, bankrupting many real estate developers -several huge US money-center banks had loans outstanding to LDC's that exceed their capital ratios. US announced "too big to fail" policy to prevent a run on the banks by depositors with huge deposits above the FDIC insurance ceilings -altogether, more than 1300 commercial banks failed in the period from 1983-1992

on the asset side banks were also hurt by financial innovation

-development of commercial paper market reduced bank loan demand by large corporations who circumvented banks by issuing the paper. And emergence of MMFs vastly stimulated growth of the commercial paper market. -development of Junk bond market allowed more risky corporations to also circumvent banks as source of funds by issuing junk bonds (high-yield bonds) -so corporate loan demand from banks dropped precipitously impairing bank profitability

banking act of 1935

-increased the power of the board of governors in washington relive to the 12 regional bank presidents -removed secretary of treasury and the comptroller of currency from board of governors (this increased political independence of fed from execute branch of government) -gave bd of governors authority to set reserve requirements and gave them 7 of 12 votes on the federal open market committee -gave federal open market committee power to direct open market operations 2. depository institutions deregulation and monetary act of 1980 -imposed uniform reserve requirements on all banks -opened fed's "discount window" to all banks--all banks could now borrow reserves from the fed -started check clearing for all banks -phased out interest-rate ceilings on deposits

Indicators of Aggregate Bank Liquidity

-indicators of bank liquidity include the ratio of bank loans to total assets and the corresponding ratio of bank security holdings to total assets. -loans are less liquid than security; another indicator is the ratio of cash assets to total assets--a higher ratio indicates a more liquid banking system -bank liquidity has declined over the past 60 years. The ratio of bank loans to total bank assets has increased from 35% in the 1950s to almost 60% today. The treasury securities holdings made up 40% of bank assets in the 1950s but approximately 20% today. -on the other hand, the need for bank liquidity has also declined. The share of total bank deposits made up by the DO has dropped from 60% in the 1960s to less than 15% today. With a larger share of bank deposits coming from savings and time deposits, which have lower withdrawal rates than DDO, the typical bank needs liquidity in its asset structure than formerly -in recent decades, banks increasingly turned to the liability side of their balance sheet to obtain funds when needed.

the stock market and why its important

-it provides a barometer of sentiment: provides an indicator realign people's expectations about the future economy -stock market behavior influences aggregate expenditures and therefore economic activity: when stock market prices rise, wealth increases and this boost consumption spending -companies often issue new shares of stock to finance investment expenditures on plant and equipment: when stock market prices are high, firms tend to issue new shares of stock to finance investment

The current favorable tax treatment of capital gains and dividends will likely be ended if democrats win the White House and U.S. Senate in 2016

-large budget deficits loom and the nation needs more tax revenue due to the demographics. Current tax law is arguably unfair in going preferential tax treatment to dividends and capital gains relative to earned income.

Depository institutions and deregulation and monetary act of 1980 (DIDMCA)

-phased out the interest rate-ceilings on savings and time deposits (by 1986) -authorized NOW and ATS accounts for commercial banks and thrifts -broadened somewhat the permissible activities of thrift institutions -imposed uniform reserve requirements on all depository institutions -increased FDIC insurance deposits from $40,000 to $100,000

Federal Deposit Insurance corporation improvement act of 1991

-recapitalized the FDIC (it was broke -mandated that the FDIC establish risk-based insurance premiums -increased capital requirements, reporting requirements, and examinations -set provisions for prompt correct actions for troubled institutions -limited brokered deposits

Meeting Reserve requirements

-reserves: cash in the bank + deposits at the federal reserve -reserve requirements: a percentage requirement which specifies that each bank must maintain reserves in an amount no less than a certain percentage of demand deposits and other checkable accounts (DDO); like the personal income tax, there is a progressive structure of reserve requirements, in which larger banks must hold a slightly larger percentage of their DDO in reserves than small banks, the top bracket is 10%. -the purpose of reserve requirements is to enable the central bank (the Fed) to control lending and the nation's money supply -required reserves: the dollar amount of reserves a bank must hold, expressed as a percentage of DDO -excess reserves: the amount of reserves a bank is holding able and beyond the required reserves amount

Banking Acts of 1933 (Glass Steagall) and 1935

-separated commercial banking from investing banking -created the Federal Deposit Insurance Corporation (FDIC) -prohibited payment of interest on checking accounts -restricted issuing checking accounts to commercial banks -placed interest-rate ceilings on savings and time deposits

Depository Institutions act of 1982 (Garn-St. Germain Act)

-sharply deregulated thrift institutions (broader range of permissible activities include business and consumer loans as well as mortgages)

firms have a choice in deciding whether to finance new investment by issuing debt (bonds), or issuing equity (shares of stocks)

-the disadvantage of issuing new shares of stock is that the portion of the company owned by already existing owners is diluted -the decision often boils down to how high is the cost of issuing debt (the interest rate) and how high are stocks prices 1. when stock prices are high the decision is often tilted toward issuing shares of stock 2. investment spending is likely positively related to stock prices: that is, higher stock prices tend to boost investment spending on plant and equipment

politics of chairman of board of governor

1. 1972-- president nixon and arthur burns (fed chair) 2. 1980 election---jimmy carter and paul volcker 3. 1992 bush 41 (elder) and alan greenspan

The Saving and Loan crisis of the 1980s

1. The US government has long fostered home ownership via subsidies and other means, such as the creation of Fannie Mae and Freddie mac and tax deductibility of mortgage interest payments 2. In the 1930s it created the federal home bank board to regulate and supervise the S&L and the Federal Savings and Loan Insurance Corporation (FLSIC) to insure S&L deposits 3. S&Ls traditionally have borrowed funds from masses of individual households via savings accounts, and used these funds to grant fixed-rate mortgages to home buyers. Like banks S&Ls borrow short term and lend long term. They rely on savings deposits rather than DDO. To remain competitive, they must pay depositors interest rates approximately in line with those on Treasury bills and faits paid by money market mutual funds. 4. If an S&L can borrow at 3% and grant fixed-rate mortgages at 6% this spread makes life easy for S&L managers (the "3-6-3" rule) and this was roughly the scenario from the 1930s through the mid 70s 5. as long as yield curve is upward sloping and as long as short-term interest rates do not increase rapidly, S&Ls do well financially. This was the case tom the 1930s until inflation surged in the late 1970s, and the Fisher effect and the federal reserve pushed interest rates up sharply. 6. S&Ls are heavily regulated are required to put 80-85% of their assets in mortgages. before the 1980s almost all of these mortgages were fixed-rate mortgages. Adjustable-rate mortgages came on later--in fact, they came on as the result of the crisis 7. the treasury bill rate may be considered a proxy for the rate that S&Ls must pay to their depositors to prevent hem from fleeing to T bills or money market mutual funds. 8. The figure shows that the 90-day T bill yield and lagged average 30-year died rate per the previous 5 ears( life of the average mortgage on an S&Ls books is 5-7 years). Note that in the late 1970s the T bill yield shot above the mortgage rate and stayed above it for about 3 1/2 years 9. The average spread between the mortgage rate and T bill yield, which averaged about 4% points from 1985 to 2015 was negative 1.5 % points between january 1979 to june 1982 10. this negative spread, along with the fall out from the back-to back recessions of 1980 and 1981-82 resulted in enormous losses for the S&Ls, with 85% of all S&Ls losing money in 1981. By the end of 1982, it estimated that 60% of the nations S&Ls were insolvent. The collective net worth or capital of the S&Ls dropped form $30 billion in 1979 to $5 billion in 1982.

financial innovations that benefit average Americans

1. advent of discount brokerages: prior to the 1980s, investors were charged large minimum fees by brokerage firms to make transactions in stocks (typically $35 to $50 brokerage fee even to buy $500 worth of stock) today, we have discount brokerages such as Fidelity, Scott Trade, etc. In which fees per transaction average as little as $4. Fidelity, one of the largest discount brokerages, charges a fixed fee of $7.95 per transaction 2. Advent of stocks that track major indexes such as the S&P 500 stock index. This enables a small investor who has only a few thousand dollars to gain broad diversification which would otherwise be impossible 3. advent of exchange traded funds (ETFs) that allow an investor to purchase a pro-rata share of a diversified set of stocks in a particular industry or sector that an investor might expect to do well (pharmaceuticals, solar power, electric cars, etc) -one can argue that advent of ETFs, which have extremely low annual fees, have virtually made mutual funds obsolete

Key units of the federal reserve system

1. board of governors:7 members, appointed by president of the united states for one 14 year term, presidential appointment of board member is subject to approval by the US senate (peter diamond story) -one member of board of governors is chosen by US president to be chairman for a 4-yr term. The term of chair is potentially renewable within the limits of overall 14-year term on board of governors 2. federal open market committee (FOMC): key committee that meets 8 times annually for the purpose of setting short term interest rates (federal funds rate) in order to influence economic activity -fomc consists of 7 "governors" (members of the bd of governors) + 5 of the 12 presidents of the regional federal reserve banks a. president of the federal reserve bank of new york is a permanent member of the FOMC b . the other 11 regional fed bank presidents alternate on the fomc, 4 at a time (all 12 presidents attend the meetings and voice their opinions on the proper course of action, but only 5 are voting members of FOMC. congress's intent in establishing the FOMC was to grant most of the power to the board of governors in Washington, DC -the federal reserve was deliberately established by congress to make the institution relatively free of political influence by the executive and legislative branches of government

responsibility for supervision and examination of banks is divided among 3 agencies or entities

1. comptroller of currency: national banks (chartered by fed gov't) 2. federal reserve: state banks that are members of the federal reserve 3.FDIC: insured state banks that are not members of the federal res CAMELS evaluation system -c: capital adequacy -a: asset quality -m: management quailty -e: earnings level and stability -l: liquidity -s: sensitivity to risk banks are rated 1-5 on each criterion, and a relatively low overall rating brings on increased scrutiny and frequency evaluations 4. perform certain chores -issue and withdraw currency -hold reserves for banks (bank deposits at fed) -clear checks among bank -serve as banker for US government

functions of the federal reserve system

1. control short-term interest rates, credit availability and the nations money supply 2. serve as a lender of last resort to the banking system 3. supervise and examine banks

Possible forces driving bank mergers and consolidation

1. economies of scale--this would mean average cost of providing banking services declines as bank size increases 2. economies of scope 3. desire to gain diversification 4. desire to increase executive compensation (Greed) 5. desire to increase market power (monopoly power)

limitations on actual federal reserve independence

1. fed must report twice annually to congress with an in-depth report on economic conditions and the fed's recent and prospective policy 2. there are frequent proposals coming before congress on issues other than monetary policy that have implications for the federal reserve; for this reason the fed is motivated to keep congress and the president happy. 3. the federal reserve is ultimately accountable to congress, which created the fed in 1913 and could abolish the fed or materially alter the fed (proposal to force the fed to turn over all of its revenues to the treasury and come before congress to request a budget each year)

The federal reserve's assets

1. gold certificate account and SDR account -the fed's gold certificate accout is of historical interest but is of little current importance because it has been constant for decades at 11.04 billion. for each dollar of gold purchase by the US treasury, the treasury prints a dollar's worth of paper gold certificates and presents them to the federal reserve; whenever the treasury acquired additional gold, it issued an equivalent value of gold certificates to the fed; the fed paid the treasury by crediting the treasury's deposit account at the fed (liability side of the fed's balance sheet) -for more than 40 years there have been two prices of gold; free market price of roughly 1,100 per ounce and the governments official price which is fixed at 42.22 per ounce; the treasury stands ready and willing to purchase all gold offered at this official price; the treasury stands ready and willing to purchase all gold offered at this official price; since the early 1970s the free market gold price exceeded this fixed price; no one is foolish enough to sell gold to the US treasury at this low price; therefore this item on the Fed's balance sheet has remained at its current figure of 11.04 billion for more than 4 decades *special drawing rights (SDRs) are issued by the international monetary fund as a means of expanding international liquidity. When the US is issued additional SDRs by the IMF they are presented to Fed. This item, like gold certificates has remained constant for a lengthy time

appropriate regulatory response depends on forces at work

1. if first two forces are at work, laissez-faire approach is appropriate 2. international competition may also force laissez-faire approach 3. if last two forces at work, laissez faire approach is not appropriate 4. too big to fail problem means laissez faire approach is not appropriate

features that minimize influence of politics on the Fed

1. lengthy non renewable terms of members of board of governors -cannot get second term -cannot be fired because of disagreements about policy viewpoints 2. terms of board members are staggered--with 7 member having 14 year terms, one term comes due every 2years; this was intended to prevent a president from "stacking the board" with members sympathetic to a president's re-election 3.unique financial status of the federal reserve; the fed dos not receive funding from congressional appropriations; it has a very large source of income from interest earned on its huge portfolio of US treasury securities (also in recent years from its holdings of mortgage-backed bonds)

Priorities of bank asset management

1. meet reserve requirements and maintain a cushion of liquid assets 2. accomodate loan demand by creditworthy and responsible borrowers 3. purchase bonds for income and income tax considerations 4. strike a reasonable balance between maintenance of safety and earning a solid rate of return on assets

Should the fed be set up to be independent of political process? two views:

1. no; monetary policy must be accountable and it is not; the let executive branch run the fed and let the electorate evaluate the Fed's performance. If gov't messes up in conducting monetary policy, the public will "throw the rascals out" democratic process will work 2. yes; the electorate is not capable of evaluating the federal reserve and its conduct of monetary policy. If president or congress is influencing monetary policy we are likely to get a "political business cycle" with low interest rates triggering economic boom as elections approach, followed by severe restraint immediately after elections to control inflation triggered by pre election stimulus; this kind of "stop-go" policy is not good for the nation's economic engine -recent proposal to "audit" the fed is an attempted power to grab by congress to control monetary policy; this would be a disaster, the fed is already audited in the accounting sense; we do not need congress meddling in Fed policy decisions, which have been superb in recent years -there is some element of truth in the viewpoint that the federal reserve often willingly serves as a scapegoat for the government -politicians blame the fed when things go wrong, the fed resists fighting back publicly at congressional attacks on the fed...the quid pro quo is that congress agrees to not change the nature of the fed; for example the fed's independence of congress as source of revenue to run the fed. from time to time, congressional leaders have threatened to force the fed to turn over all of its revenues to the treasury and come before congress each year to request a budget; this would not be a good idea

Key role of the federal reserve bank of new york

1. president of NY fed is permanent voting member of FOMC 2. NY fed has more than 50% of total assets of the 12 federal reserve banks 3. NY fed handles dealings with foreign central banks and international institutions 4. open market operations are conducted at the federal reserve bank of New York

U.S. commercial banks prospered from the end of the Great depression (1934) until the mid 1970s. Very few banks failed; in large part, this prosperity was the result of relatively stable economic conditions and regulations that shielded banks from competition; examples of anti-competitive forces artificially protecting banks include:

1. prohibition of branch banking. this protected banks from encroachment on their territory by other banks. 2. regulations that prohibited banks from paying interest on checking accounts, as well as interest-rate ceilings payable on savings and time deposits (regulation Q). also favorable bank profitability, DDO was the main source of bank funds through the 1960s and 1970s BUT these restrictions were removed in the 1980s: 1. restrictions on branch banking was eased, stimulating competition. 2. regulation Q ceilings were phased out by federal legislation. The phase out occurred during 1980-86 3. financial innoation accelerated in the 1970s. this affected banks adversely, both on the asset and liability side of the balance sheet.

what give the chairman of the board of governors so much power (reputably second only to US president)

1. sets agenda and leads the FOMC meetings (8 times each year) 2. influences other members of fomc 3. influences public opinion via speeches, etc. 4. meets with secretary of treasury, US president, and testifies before congress and congressional committees

What determines the price of a stock?

1.the present value (and price) of any asset is the present value of the stream of expected payments from the asset. Hence, the price of a bond is the sum of the present value of each of the coupons payable over the life of the bond plus the present value of the face value to be paid at maturity of the bond. The rate used to "discount" these expected future payments to arrive at the present value of the bond is the existing yield in the market on bonds of comparable maturity and risk. -in the case of bonds, the coupons are constant over time and locked in by bond contract. And the face value is also locked in by the bond contract 2. the present value and price of a share of stock differs in several important ways from bonds, and these differences account for the greater volatility (price fluctuations) of stocks: a. unlike bonds, the expected payments (mainly dividends) or "cash flows" from shares of stock (the numerators) are not constant or locked in--they are revised every day as new info becomes available b. unlike bonds, in the US, stocks are potentially perpetual securities that potentially include an unlimited number of future payments c. unlike bonds, stocks are not obligated to make any payments (dividends) in the future. In fact, many dividends have been reduced or eliminated in recent months. Hence, stocks are riskier than bonds. Also, if a corporation enters bankruptcy, its bondholders must be paid in full before stockholders receive any payments

Moral hazard in financial sector--occurs when there is an incentive to engage in excessive risk akin from the publics viewpoint. Examples:

A. Rogue traders in financial institutions -Nicholas Leeson's speculation in Japanese futures market bankrupted the British bank, Barings bank with 1.3 billion loss in 1995 -JP morgan trader who cost the firm $5 billion in losses 3 years ago

Commercial banks obtain funds by accepting deposits, borrowing from non deposit sources, and issuing equity claims (bank capital).

Banks use the funds mainly to make loans and purchase securities

Ke changes when perceived risk changes; it increases when perceived risk increases. Other things being equal when perceived risk increases, Ke increases and stock prices fall

During the U.S financial crisis of 2007-2009, U.S. stocks fell by 55%. In terms of the above equation, the D's were revised downward as the economy fell into recession and business profits collapsed. And especially in september 2008 when Lehman Brothers took bankruptcy protection and the world economy was on the precipice of an impending catastrophic meltdown, the enormous increase in perceied risk sharply boosted Ke (the discount factor applied to expected future payments.) The dow was falling 300, 300, and 500 points day after day. Stock prices collapsed

Will economy continue to grow next 40 years as it did in the past 80 years?

Robert Gordon says no, other economists say yes -households should thus consider holding a diversified portfolio of stocks of high quality companies in retirement accounts and other accounts to provide for the long-run future -however, stocks are extremely risky from a short-run standpoint. In the past 16 years, we have experienced two episodes in which stock prices fell by more than 50% in about 2 year period (2000-02 and 2007-09)

The tech wreck of 2000-2002

The biggest U.S. stock market bubble in history took place during the virtuous economic cycle of the late 1990s. The bubble is indicated by the magnitude of the crash of technology stocks during 2000-02. Many stocks lost more than 90% of their value and the NASDAQ index collapsed, losing 78% of its value in about two years

Maintaining a cushion of liquid assets

a banks liquid assets include its excess reserves, short term securities (treasury bills) and federal funds "sold"--that is, deposit accounts at the Fed that a bank has loaned out on a very short-term basis (often overnight) -the reasons that a bank needs significant liquidity is that cash is being withdrawn from and (deposited in) the bank every day, checks written by bank customers are being cleared against its reserve deposit (and credited to its reserve deposit) each day. Because these transactions do not even out each day there will be frequent occurrences in which a bank loses a significant amount of reserves. -banks can obtain funds to meet reserve requirements by: borrowing from the fed, borrowing federal funds from a bank with surplus funds at the fed, and selling some of its treasury securities. -similarly, if there is a significant net withdrawal of cash by bank depositors, the bank's reserves fall on a dollar for dollar basis, while required reserves fall by only 10% of the withdrawal from a DDO, and they fall at all if the funds are withdrawn from a savings account. So a large withdrawal of currency from a bank would also put the bank in a position where it needs to have a solid cushion of liquid assets -also, if a good customer requests a loan, the bank needs to either have excess reserves on hand or some liquid assets available to sell off. Reason: when a customer borrows from a bank, the funds are initially made available by the bank by increasing the borrowers DDO. When the borrower writes a check to use these, the bank will witness its deposit at the fed to be deducted by the amount of the check. Once again, reserves fall by the amount of the loan and the bank will likely find itself short on meeting the reserve requirement

A plausible explanation of the enormous stock market bubble of the late 1990s is that stock prices surged because of two factors which gave rise to the euphoria that creates bubbles in asset prices

a. an unwarranted upward revision of the numerators in the above equations b. an unwarranted downward revision of perceived risk in stocks and ke -both of these factors boosted stock price far above their warranted levels

The dow jones industrial

an average of stock prices of 30 large US corporations -an unweighted index: just ad the price of 30 stocks each day and divide by 30; this makes it an inferior index; a company 5 times larger than another should probably have a larger weight in computing the index; continued popularity of this index stems from inertia and habit rather than quality of the index. -was initiated in 1896 with only 12 stocks; expanded to 30 stocks in 1928 -stocks in the Dow account for 20-25% of stock market capitalization -recent additions (apple, nike and goldman sachs, cisco and travelers) -dropped (at&t, bank of america, hewlett packard, general motors, etc)

Commercial bank assets

assets are things a bank owns and claims the bank has on entities external to the bank. Bank assets are the uses to which bank funds are put. The principal assets of a bank include the following: 1. cash assets, which are composed of reserves (deposits at the Federal Reserve + cash on hand) and accounts receivable or payments about to be received by the bank. This item constitutes 16% of bank assets 2. loans, which are the largest component, comprising 56t% of bank assets in early 2016. These loans include business loans (loans to commerce and industry), real estate loans in the form of residential an nonresidential mortgage loans and home improvement loans, loans to consumers (including auto loans, credit card loans, etc.), interbank loans (loans to other banks), and other loans 3. securities, which primarily consist of US treasury bills, notes and bonds, and securities issued by federal agencies. Banks also hold municipal bonds for tax purposes. Securities made up 20% of aggregate bank assets in early 2016. 4. other assets include the physical plant (buildings) and all the furniture, computers, artwork, and other items in the bank, and accounted for 8% of aggregate assets in early 2016

stock prices over the past 50 and 100 years have outperformed other assets like government and corporate bonds, gold, certificates of deposits, and other assets

average annual rates of return from US stocks over the above periods have averaged 9% annually if one includes both price appreciation and dividend payments

Bank Capital Management

bank capital protects large uninsured depositors and the FDIC insurance fund (hence taxpayers). Capital requirements also protect bank officers from their own mistakes -banks are exposed to various types of risk, including default risk--risk that bank borrower may default on the loan or that a municipal bond may default. -banks are also exposed to interest rate risk--the risk that yields may rise after a bond is purchased , thus reducing the price of the bond. Longer-term bonds have greater interest rate risk. This risk is measured by duration analysis: examines the sensitivity of the market slue of the banks total assets and liabilities to changes in interest rates: -% point change in interest rate * duration in years -other risks incurred by banks include liquidity risk--risk that depositors may withdraw their funds, and foreign exchange risk--risk that exchange rates may move in a direction that harms bank profits. Finally as evidenced buy numerous scandals at some of our largest banks in recent years, banks are subject to management risk. In an ear of highly esoteric and little understood financial instruments, bank managers may engage in activities involving enormous risks. -banks knowingly take legitimate risks in their quest for profits. One of the most fundamental principles of finance is that on average, riskier investments are associated with higher expected rate s of return. A bank that is exceedingly risk averse earns a low rate of return on capital and may alienate customers by denying them legitimate loans

Commercial bank liabilities

bank liabilities are what the bank "owes," or claims that outside entities have on the bank. Bank liabilities are the sources of bank funds. These liabilities and sources of bank funds include: 1. demand deposits and other checkable accounts. These are sometimes referred to as "transactions deposits" the bank "owes" you the funds you have in your checking accounts--an asset of yours and a liability of your bank. You may be surprised that DDO make up a relatively low portion of the sources of bank funds. 2. Non-transaction deposits. This item makes up nearly 2/3 of the sources of bank funds. This item consists of small passbook savings accounts, and small time deposits, also known as consumer certificates of deposit. In addition, large banks often issue large certificates of deposit, known as "negotiable CDs" since these multi-million dollar CDs can be sold prior to maturity thru a network of dealers (hence the term "negotiable"). When credit is tight and large banks need funds to grant large loans to creditworthy borrowers, these large banks often issue negotiable CDs 3. Borrowings. banks borrow from a variety of sources in addition to borrowing from their depositors via saints deposits and checking deposits (DDO). They can borrow from the Federal Reserve, which is known as borrowing from the "discount window," or borrow from other banks in the federal fund market (borrowing a portion of another bank's deposit at the federal reserve) banks also borrow for a short time periods via repurchase agreements--an agreement in which a bank sells some of its treasury securities to a dealer or corporation, with the agreement by the bank to repurchase the securities a short time later -banks that are organized as a bank holding company can borrow by issuing commercial paper on the market to borrow from large corporations, dealers, or others with large blocks of cash on hand to lend for short periods. Note in the aggregate balance sheet, these non-deposit type borrowings add up to an important part of bank liabilities 4. other liabilities include bills payable and other obligations

a higher capital/total assets ratio implies a safer bank (lower risk of insolvency), but also implies a lower rate of return on capital for the bank owners

clearly a bank must grapple with the tradeoff between the risk of bank insolvency versus high tradeoff b/w the risk of bank insolvency versus high rates of return for the owners of the bank.

Federal deposit insurance reform act of 2005

merged bank insurance fund and the savings institutions fund -increased deposit insurance to $250,000 per account

A higher bank capital ratio (capital/total assets) implies a lower risk of bank insolvency

on the other hand, a higher capital ratio implies a lower rate of return on capital or equity for the bank owners. *Earnings capital= (earnings/total assets) * (total assets/capital) -the left hand side of the equation is the rate of return on the capital invested in the bank buh the owners, also known as the rate of return on owner's equity. -the first expression in the right-handed sir of the equation is the rate of return on total bank assets; this is driven in large part buy the spread between the average cost of funds to the banks and the average yield earned on bank assets. It can be viewed as an indicator of efficiency of the bank - the second expression on the right hand side-the ratio of total assets to capital--is known as the equity multiplier. It represents the leverage factor, through which bank earnings on assets are magnified into earnings on bank capital for the bank owners. It is simple the reciprocal of the capital ratio (capital/total assets). A low capital ratio indicates a high equity multiplier. A higher capital ratio indicates a lower equity multiplier (less leverage)

The price of a share of stock is

present value of all future cash flows, the only cash flows that an investor will receive are dividends and a final sales price when the stock is ultimately sold in period n. Po= Dt/(1+ke)^t -because bonds and stocks are substitutes for each other, this ke fluctuates as interest rates change over time; when bond yields rise, Ke rises and bonds become relatively more attractive to purchase, thus reducing stock prices as people sell stocks to buy bonds -one would expect stocks to sell at lower price/earnings ratios she bond yields are high, other things being equal; with bond yields currently very low, it may be reasonable for P/E ratios of US stocks to be currently above longer-term norm.

Gramm-leach-billey financial services modernization act of 1999

repealed the Glass Steagall act, allowing commercial banks to engage in investment banking activities

an individual bank can easily gain reserves by selling securities or selling some of its loans, but such reserves are only gained at the expense of another bank's reserves

so aggregate reserves do not increase as banks sell securities or loans

virtuous cycles

strong economic activity, rising stock prices, rising investment spending--even stronger economic growth

the federal reserve balance sheet and the fed's tools of policy

the balance sheet has increased in size about 50fold since late 2007, when the fed began aggressively purchasing treasury securities and mortgage backed bonds; while controversial this balance sheet expansion has helped keep interest rates very low for a period of nearly 8 years; it has thus helped the US economy recover more strongly from the financial crisis than other nations

the aggregate banking system cannot get additional reserves on their own initiate.

the banking system can only gain reserves if a central bank exists to get reserves into the banks, or if the public re-deposits cash into the banks

History of the stock returns in the united states

the following two graphs illustrate the returns from U.S. stocks since 1940; these returns include appreciation in the price of S&P 500 index and the dividend yield. The sum of these two returns is the total return -the first graph shows backward-looking average returns over previous 20 year periods. For example the 1999 observations indicate that average returns over the period from 1979 through 1999 was about 17 % per year, including about 14% per year in price appreciation and about 3% per year in dividends; the low point in 1949 shows that from 1929-1949, the dividend yield averaged about 5%, price appreciation was -3% and total returns averaged about 2% annually. Stock prices collapsed in the Great Depression of the 1930s - in the most recent 20 years (1995-2015), dividends average about 2% per year, stock prices increased about 6% annually, and total returns thus averaged about 8% annually; there has not been a single year in the past 60 year when the average 20-year returns have been negative, this suggests that, as a long-run investment, stocks are not risky. -the next graph looks at backward-looking 10-year average rates of return from stocks. Note in his case that the recent financial crisis period resulted in negate total returns in 10-year period that ended in mid-2009 *if one looked at average return over 5-year periods and especially 2-year periods, there have been a multitude of periods exhibiting negative returns from stocks. Stocks are very risky in the short run but not very risky viewed from a long run perspective. Buy stocks of outstanding companies and hang on for the long run

Because stocks are riskier than bonds, and because most investors are risk averse,

the rate used to discount these expected future payments (mainly dividends) contains a premium for risk, and this risk premium fluctuates over time as perceived risk changes

Measure of overall stock market valuation

there are several indicators that are commonly used to determine (or make "educated guess") whether stock prices in general are over-priced, under-priced, or "just right": 1. Price earnings ratio (P/E): the price per share of the stock divide by earnings or profits per share of the stock -corporations whose earnings are expected to rise rapidly in the near future should tend to exhibit higher P/E ratios than companies that are expected slow or no growth in profits -years ago, when Walmart's growth prospects were extremely strong, it had a P/E ratio of 40. Today because Walmart has exhausted most of its growth potential it sells at a P/E of 14. CVS sells at a higher P/E than Walmart (21) because outlook for its growth is better (aging populations, rising insurance cohort, and increasing use of prescriptions. Starbucks is selling at a P/E of 36. -over the past 80 years, the S&P 500 has had an average P/E of about 16 with a range of roughly 5 to 45 2. Dividend yield: annual dividend/ price of the stock * 100 -lower dividend yield means a higher price of the stock relative to the dividend -analysts traditionally regarded low dividend yields of the overall market as an indication of overpriced stocks, however this conclusion can now be rejected for several reasons; dividend yields today are far lower than in the past -the tax code has increased incentives for corporations to use profits to buy back shares of stock or invest in new equipment and technology rather than pay out profits to stockholders via dividends. Capital gains have traditionally been taxed at attractively low rates, so stockholders may be better off reaping income in the form of capital gains rather than having the firm pay out its profits as dividends (when firms buy back shares with their profits and retire the shares, this boosts profits per share, thus increasing stock prices) 3. Price to book value: book value of a corporation is the residual value of the corporation per share if the company wee to liquidate all assets and pay off all debts. The price to book value of the entire market soared to very high levels in the late 1990s stock market bubble, as did price/earnings ratio of the Dow S&P 500, and especially the NASDAQ 4. Aggregate stock market capitalization/GDP

NASDAQ

these stocks are not traded on an organized stock exchange like the New York stock exchange but rather "over the counter" through a network of dealers -founded in 1971 when its founding boosted information about the over the counter market by acceleration in the dissemination of stock prices. the index includes about 4900 of the 5500 stocks traded over the counter -many newer and smaller companies do not meet the terms of earnings, market capitalization, number of stockholders, and other indicators of financial viability to qualify for listing on the NY stock exchange or other exchanges therefore they are traded on the NASDAQ -many now-established and highly successful companies like microsoft and intel that are now among the DIJA index of 30 huge companies, were once traded on the NASDAQ (microsoft still is); the NASDAQ warrants considerably more attention and respect than 40 years ago

Garn-St. Germain Act of 1982

this act, an implicit recognition that the government had caused the crisis, almost totally deregulated the S&Ls and no longer required them to invest in mortgages.

vicious cycle

weak economic activity, falling stock prices, falling investment spending, weaker economic activity or even recession.