Copyright 2010 Pearson Addison-Wesley. All rights reserved. Chapter 1 Why Study Money, Banking, and...

Chapter 1

Why Study Money, Banking, and Financial Markets?

Why Study Money, Banking, and Financial Markets• To examine how financial markets such as bond and

stock markets work

• To examine how banks, other financial institutions and financial regulation work

• To examine the role of monetary policy in the economy

Financial Markets

• Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds

The Bond Market and Interest Rates• A security (financial instrument) is a claim on the

issuer’s future income or assets

• A bond is a debt security that promises to make payments periodically for a specified period of time (that is, IOU)

• An interest rate is the cost of borrowing or the price paid for the rental of funds

FIGURE 1 Interest Rates on Selected Bonds, 1950–2008

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

The Stock Market

• Common stock represents a share of ownership in a corporation (IOBU)

• A share of stock is a claim on the earnings and assets of the corporation

• Common stock holders are residual claimants.

FIGURE 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2008

Source: Dow Jones Indexes: http://finance.yahoo.com/?u.

Financial Institutions and Banking• Financial Intermediaries: institutions that borrow

funds from people who have saved and make loans to other people:– Banks: accept deposits and make loans

– Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks

Financial Crises

• Financial crises are major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms.

• Severe financial crises typically spill over into the real economy.

Function of Financial Markets1. Allows transfers of funds from person or business without investment opportunities to one who has them2.Improves economic efficiency3.Transfer funds over life horizon

Direct and Indirect Finance

• Direct finance: lenders hold direct claims on borrowers’ assets or future income.

• Indirect finance: Lenders hold claims on financial intermediary, which in turn hold claims on borrowers. (q)

Classifications of Financial Markets I

By Financial Instruments1. Debt Markets

Short-term (maturity < 1 year)Long-term (maturity > 10 year)

2. Equity MarketsCommon stocks (owner a residual claimant)

Securities are assets for holders, but liabilities for issuers. (q)

The value of debt instruments was $20 trillion in 2002 while the value of equity was $11 trillion.

Classifications of Financial Markets II

• 1. Primary Market (often behind closed doors)New security issues sold to initial buyers

• 2. Secondary Market Securities previously issued are bought and

sold • Investment Bank.• Role of Brokers and Dealers. (q)• Liquidity and Valuation Provided by the

Secondary Market.

Classifications of Financial Markets III

By Organization of Secondary Market

• 1. ExchangesTrades conducted in central locations (NYSE,ASE)

• 2. Over-the-Counter (OTC) MarketsDealers at different locations buy and sell

• U.S. Gov’t Bond Market Organized as an OTC market with 40 or so dealers.

Classifications of Financial Markets IV

By Maturity

1. Money Market (< 1 year debt instruments)

2. Capital Market (longer term debt and equity).

Chapter 4

UnderstandingInterest Rates

Four Types of Credit Instruments1. Simple loan2. Fixed-payment loan3. Coupon bond4. Discount (zero coupon) bond

Concept of Present ValueSimple loan of $1 at 10% interestYear 1 2 3 n

$1.10 $1.21 $1.33 $1x(1 + i)n

$1PV of future $1 =

(1 + i)n

Present Value

Yield to Maturity: LoansYield to maturity = interest rate that equates today’s value with present value of all future payments1. Simple Loan (i = 10%)

$100 = $110/(1 + i)

$110 – $100 $10i = = = 0.10 = 10%

$100 $100

2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126$1000 = + + + ... +

(1+i) (1+i)2 (1+i)3 (1+i)25

FP FP FP FPLV = + + + ... +

(1+i) (1+i)2 (1+i)3 (1+i)n

Yield to Maturity: Bonds

4. Discount Bond (P = $900, F = $1000), one year

$1000$900 =

$1000 – $900i = = 0.111 = 11.1%

F – Pi =

3. Coupon Bond (Coupon rate = 10% = C/F)

$100 $100 $100 $100 $1000P = + + + ... + +(1+i) (1+i)2 (1+i)3 (1+i)10 (1+i)10

C C C C FP = + + + ... + +

(1+i) (1+i)2 (1+i)3 (1+i)n (1+i)n

Consol: Fixed coupon payments of $C forever

C CP = i =

Relationship Between Price and Yield to Maturity

Three Interesting Facts in Table 11. When bond is at par, yield equals coupon rate2. Price and yield are negatively related3. Yield greater than coupon rate when bond price is below par value

Distinction Between Interest Rates and Returns

Rate of Return

C + Pt+1 – PtRET = = ic + gPt

Cwhere: ic = = current yield

Pt+1 – Ptg = = capital gainPt

Key Facts about RelationshipBetween Interest Rates and Returns

Maturity and the Volatility of Bond ReturnsKey Findings from Table 21. Only bond whose return = yield is one with maturity = holding

period2. For bonds with maturity > holding period, i P implying capital loss3. Longer is maturity, greater is % price change associated with

interest rate change4. Longer is maturity, more return changes with change in interest rate5. Bond with high initial interest rate can still have negative return if i Conclusion from Table 2 Analysis1. Prices and returns more volatile for long-term bonds because have

higher interest-rate risk2. No interest-rate risk for any bond whose maturity equals holding

period

Chapter 5 The Behavior of Interest Rates

The Behavior of Interest Rates

Determinants of Asset Demand

Supply and Demand Analysis ofthe Bond MarketMarket Equilibrium

1. Occurs when Bd = B

s, at P* =

$850, i* = 17.6%

2. When P = $950, i = 5.3%, Bs >

Bd (excess supply): P to P*, i

3. When P = $750, i = 33.0, Bd >

Bs (excess demand): P to P*,

i to i*

Shifts in the Bond Demand Curve

Factors that Shift the Bond Demand Curve1. Wealth

A. Economy grows, wealth , Bd , Bd shifts out to right2. Expected Return

A. i in future, Re for long-term bonds , Bd shifts out to rightB. e , Relative Re , Bd shifts out to rightC. Expected return relative to other assests , Bd , Bd shifts out to

right3. Risk

A. Risk of bonds , Bd , Bd shifts out to rightB. Risk of other assets , Bd , Bd shifts out to right

4. LiquidityA. Liquidity of Bonds , Bd , Bd shifts out to rightB. Liquidity of other assets , Bd , Bd shifts out to right

Factors that Shift Demand Curve for Bonds

Shifts in the Bond Supply Curve

1.Profitability of Investment OpportunitiesBusiness cycle expansion, investment opportunities , Bs , Bs shifts out to right

2.Expected Inflatione , Bs , Bs shifts out to right

3.Government ActivitiesDeficits , Bs , Bs shifts out to right

Factors that Shift Supply Curve for Bonds

Changes in e: the Fisher Effect

If e 1. Relative RETe

, Bd shifts in to left

2. Bs , Bs shifts out to right

3. P , i

Evidence on the Fisher Effect in the United States

Business Cycle Expansion

1. Wealth , Bd , Bd shifts out to right

2. Investment , Bs , Bs shifts out to right

3. If Bs shifts more than Bd then P , i

Evidence on Business Cycles and Interest Rates

Relation of Liquidity PreferenceFramework to Loanable FundsKeynes’s Major AssumptionTwo Categories of Assets in Wealth

MoneyBonds

1. Thus: Ms + Bs = Wealth2. Budget Constraint: Bd + Md = Wealth3. Therefore: Ms + Bs = Bd + Md

4. Subtracting Md and Bs from both sides:Ms – Md = Bd – Bs

Money Market Equilibrium5. Occurs when Md = Ms

6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd = Bs and bond market is also in equilibrium

1. Equating supply and demand for bonds as in loanable funds framework is equivalent to equating supply and demand for money as in liquidity preference framework

2. Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects on interest rates from changes in expected returns on real assets

Liquidity Preference AnalysisDerivation of Demand Curve1. Keynes assumed money has i = 02. As i , relative RETe on money (equivalently, opportunity cost of

money ) Md 3. Demand curve for money has usual downward slopeDerivation of Supply curve1. Assume that central bank controls Ms and it is a fixed amount2. Ms curve is vertical lineMarket Equilibrium1. Occurs when Md = Ms, at i* = 15%2. If i = 25%, Ms > Md (excess supply): Price of bonds , i to i* =

15%3. If i =5%, Md > Ms (excess demand): Price of bonds , i to

i* = 15%

Money Market Equilibrium

Rise in Income or the Price Level

1. Income , Md , Md shifts out to right

2. Ms unchanged3. i* rises from i1 to i2

Rise in Money Supply

1. Ms , Ms shifts out to right2. Md unchanged3. i* falls from i

1 to i

Money and Interest RatesEffects of money on interest rates1. Liquidity Effect

Ms , Ms shifts right, i 2. Income Effect

Ms , Income , Md , Md shifts right, i 3. Price Level Effect

Ms , Price level , Md , Md shifts right, i 4. Expected Inflation Effect

Ms , e , Bd , Bs , Fisher effect, i Effect of higher rate of money growth on interest rates is ambiguous1. Because income, price level and expected inflation effects work in opposite direction of liquidity effect

Does Higher Money Growth Lower Interest Rates?

Evidence on Money Growth and Interest Rates

Chapter 6

The Risk and Term Structure of Interest Rates

FIGURE 1 Long-Term Bond Yields, 1919–2008

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.

Risk Structure of Interest Rates• Bonds with the same maturity have different

interest rates due to:– Default risk– Liquidity – Tax considerations

Risk Structure of Interest Rates• Default risk: probability that the issuer of

the bond is unable or unwilling to make interest payments or pay off the face value– U.S. Treasury bonds are considered default free

(government can raise taxes). – Risk premium: the spread between the interest

rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds

FIGURE 2 Response to an Increase in Default Risk on Corporate Bonds

Table 1 Bond Ratings by Moody’s, Standard and Poor’s, and Fitch

Risk Structure of Interest Rates• Liquidity: the relative ease with which an

asset can be converted into cash– Cost of selling a bond– Number of buyers/sellers in a bond market

• Income tax considerations– Interest payments on municipal bonds are

exempt from federal income taxes.

FIGURE 3 Interest Rates on Municipal and Treasury Bonds

Term Structure of Interest Rates• Bonds with identical risk, liquidity, and tax

characteristics may have different interest rates because the time remaining to maturity is different

Term Structure of Interest Rates• Yield curve: a plot of the yield on bonds with

differing terms to maturity but the same risk, liquidity and tax considerations– Upward-sloping: long-term rates are above

short-term rates– Flat: short- and long-term rates are the same– Inverted: long-term rates are below short-term

Facts Theory of the Term Structure of Interest Rates Must Explain

1. Interest rates on bonds of different maturities move together over time

2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted

3. Yield curves almost always slope upward

Three Theories to Explain the Three Facts1. Expectations theory explains the first two

facts but not the third2. Segmented markets theory explains fact

three but not the first two3. Liquidity premium theory combines the

two theories to explain all three facts

FIGURE 4 Movements over Time of Interest Rates on U.S. Government Bonds with Different Maturities

Sources: Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.

Expectations Theory

• The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond

• Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity

• Bond holders consider bonds with different maturities to be perfect substitutes

Expectations Theory: Example• Let the current rate on one-year bond be

6%.• You expect the interest rate on a one-year

bond to be 8% next year.• Then the expected return for buying two

one-year bonds averages (6% + 8%)/2 = 7%.

• The interest rate on a two-year bond must be 7% for you to be willing to purchase it.

Expectations Theory

For an investment of $1= today's interest rate on a one-period bond

= interest rate on a one-period bond expected for next period= today's interest rate on the two-period bond

Expectations Theory (cont’d)

Expected return over the two periods from investing $1 in thetwo-period bond and holding it for the two periods

(1 + )(1 + ) 1

1 2 ( ) 1

Since ( ) is very smallthe expected re

turn for holding the two-period bond for two periods is2 ti

If two one-period bonds are bought with the $1 investment

(1 )(1 ) 1

1 ( ) 1

( ) is extremely smallSimplifying we get

e et t t t

i i i i

Both bonds will be held only if the expected returns are equal

2The two-period rate must equal the average of the two one-period rates

For bonds with longer maturities

et t t

1 2 ( 1)...

The -period interest rate equals the average of the one-periodinterest rates expected to occur over the -period life of the bond

e e et t ni i

Expectations Theory

• Explains why the term structure of interest rates changes at different times

• Explains why interest rates on bonds with different maturities move together over time (fact 1)

• Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2)

• Cannot explain why yield curves usually slope upward (fact 3)

Segmented Markets Theory

• Bonds of different maturities are not substitutes at all

• The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond

• Investors have preferences for bonds of one maturity over another

• If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)

Liquidity Premium & Preferred Habitat Theories• The interest rate on a long-term bond will

equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond

• Bonds of different maturities are partial (not perfect) substitutes

Liquidity Premium Theory

int it it1

e it2e ... it(n 1)

where lnt is the liquidity premium for the n-period bond at time t

lnt is always positive

Rises with the term to maturity

Preferred Habitat Theory

• Investors have a preference for bonds of one maturity over another

• They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return

• Investors are likely to prefer short-term bonds over longer-term bonds

FIGURE 5 The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory

Liquidity Premium and Preferred Habitat Theories• Interest rates on different maturity bonds move

together over time; explained by the first term in the equation

• Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case

• Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens

FIGURE 6 Yield Curves and the Market’s Expectations of Future Short-Term Interest Rates According to the Liquidity Premium (Preferred Habitat) Theory

FIGURE 7 Yield Curves for U.S. Government Bonds

Sources: Federal Reserve Bank of St. Louis; U.S. Financial Data, various issues; Wall Street Journal, various dates.

Application: The Subprime Collapse and the Baa-Treasury Spread

Corporate Bond Risk Premium and Flight to Quality

Mar-07

May-07

Sep-07

Nov-07

Mar-08

May-08

Sep-08

Nov-08

Corporate bonds, monthly data Aaa-RateCorporate bonds, monthly data Baa-Rate10-year maturity Treasury bonds, monthly data

Chapter 7

The Stock Market, The Theory of Rational Expectations, and the Efficient Market Hypothesis

1 10 (1 ) (1 )e e

Div PP

Computing the Price of Common Stock

• Basic Principle of FinanceValue of Investment = Present Value of Future Cash Flows

• One-Period Valuation Model

Generalized Dividend Valuation Model

• Since last term of the equation is small, Equation 2 can be written as

1 20 1 2(1 ) (1 ) (1 ) (1 )

n nn n

e e e e

D PD DP

k k k k

01 (1 )

Gordon Growth Model

• Assuming dividend growth is constant, Equation 3 can be written as

• Assuming the growth rate is less than the required return on equity, Equation 4 can be written as

1 20 0 0

(1 ) (1 ) (1 )(1 ) (1 ) (1 )e e e

D g D g D gP

(1 )( ) ( )e e

D g DP

k g k g

How the Market Sets Prices

• The price is set by the buyer willing to pay the highest price

• The market price will be set by the buyer who can take best advantage of the asset

• Superior information about an asset can increase its value by reducing its perceived risk

How the Market Sets Prices

• Information is important for individuals to value each asset.

• When new information is released about a firm, expectations and prices change.

• Market participants constantly receive information and revise their expectations, so stock prices change frequently.

Adaptive Expectations

• Expectations are formed from past experience only.

• Changes in expectations will occur slowly over time as data changes.

• However, people use more than just past data to form their expectations and sometimes change their expectations quickly.

Theory of Rational Expectations• Expectations will be identical to optimal forecasts

using all available information• Even though a rational expectation equals the

optimal forecast using all available information, a prediction based on it may not always be perfectly accurate– It takes too much effort to make the expectation the best

guess possible– Best guess will not be accurate because predictor is

unaware of some relevant information

Implications

• If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well– Changes in the conduct of monetary policy (e.g.

target the federal funds rate)• The forecast errors of expectations will, on

average, be zero and cannot be predicted ahead of time.

Efficient Markets

• Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return

• In an efficient market, a security’s price fully reflects all available information

Evidence on Efficient Markets Hypothesis

Favorable Evidence1. Stock prices reflect publicly available information: anticipated

announcements don’t affect stock price2. Stock prices and exchange rates close to random walk

If predictions of P big, Rof > R* predictions of P smallUnfavorable Evidence1. Small-firm effect: small firms have abnormally high returns2. January effect: high returns in January3. Market overreaction4. New information is not always immediately incorporated into

stock pricesOverviewReasonable starting point but not whole story

Application Investing in the Stock Market• Recommendations from investment advisors

cannot help us outperform the market• A hot tip is probably information already

contained in the price of the stock• Stock prices respond to announcements

only when the information is new and unexpected

• A “buy and hold” strategy is the most sensible strategy for the small investor

Behavioral Finance

• The lack of short selling (causing over-priced stocks) may be explained by loss aversion

• The large trading volume may be explained by investor overconfidence

• Stock market bubbles may be explained by overconfidence and social contagion

Chapter 8

An Economic Analysis of Financial Structure

Main Street - Wall Street

What this chapter is about

• Facts about financial structure• Function of financial intermediaries• Asymmetric information

– Adverse Selection– Moral Hazard

Sources of External Finance for Nonfinancial Business

• Bank loans: 18%• Nonbank loans: 38%• Bonds: 32%• Stock: 11%

Facts of Financial Structure1. Issuing marketable securities not primary

funding source for businesses, banks are. 2. Only large, well established firms have

access to securities markets3. Collateral is prevalent feature of debt

contracts4. Debt contracts are typically extremely

complicated legal documents with restrictive covenants

5. Financial system is among most heavily regulated sectors of economy

Transaction Costs and Financial Structure

Transaction costs hinder flow of funds to people with productive investment opportunitiesFinancial intermediaries make profits by reducing transaction costs1. Take advantage of economies of scale

Example: Mutual Funds2. Develop expertise to lower transaction costs

Adverse Selection and Moral Hazard: DefinitionsAdverse Selection:1.Before transaction occurs2.Potential borrowers most likely to produce

adverse outcomes are ones most likely to seek loans and be selected

Moral Hazard:1.After transaction occurs2.Hazard that borrower has incentives to engage in

undesirable (immoral) activities making it more likely that won’t pay loan back

Adverse Selection and Financial StructureLemons Problem in Securities Markets1. If investors can’t distinguish between good and bad

securities, they are only willing to pay only average of good and bad securities’ values.

2. Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued.

3. Investors won’t want to buy bad securities, so market won’t function well.Explains Less asymmetric information for well known firms, so smaller lemons problem

Tools to Help Solve Adverse Selection (Lemons) Problem1.Private Production and Sale of Information

Free-rider problem interferes with this solution2.Government Regulation to Increase Information

Explains Fact 53.Financial Intermediation

A. Analogy to solution to lemons problem provided by used-car dealers

B. Avoid free-rider problem by making private loansExplains dominance of banks

4.Collateral and Net Worth

Moral Hazard: Debt versus EquityMoral Hazard in Equity:Principal-Agent Problem1. Result of separation of ownership by stockholders

(principals) from control by managers (agents)2. Managers act in own rather than stockholders’ interestTools to Help Solve the Principal-Agent Problem1. Monitoring: production of information2. Government regulation to increase information3. Financial intermediation4. Debt contractsExplains Why debt used more than equity

Moral Hazard and Debt MarketsMoral hazard: borrower wants to take on too much risk

Tools to Help Solve Moral Hazard1. Net worth2. Monitoring and enforcement of restrictive covenants3. Financial intermediation

Banks and other intermediaries have special advantages in monitoring

Conflicts of Interest

• Underwriting and Research in Investment Banking• Auditing and Consulting in Accounting Firms• Credit Assessment and Consulting in Credit-Rating

Agencies• Political Beneficiary and Representing Public Interest in

Government Agencies

Chapter 10

Banking and the Management of Financial Institutions

Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, December 2008)

Bank OperationT-account Analysis:Deposit of $100 cash into First National BankAssets LiabilitiesVault Cash + $100 Checkable Deposits + $100(=Reserves)Deposit of $100 check into First National BankAssets LiabilitiesCash items in process Checkable Deposits + $100of collection + $100First National Bank Second National BankAssets Liabilities Assets Liabilities

Checkable CheckableReserves Deposits Reserves Deposits+ $100 + $100 – $100 – $100Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount

Principles of Bank Management

1. Liquidity Management2. Asset Management

Managing Credit RiskManaging Interest-rate Risk

3. Liability Management4. Capital Adequacy Management

Principles of Bank ManagementLiquidity ManagementReserve requirement = 10%, Excess reserves = $10 millionAssets LiabilitiesReserves $20 million Deposits $100 millionLoans $80 million Bank Capital $ 10 millionSecurities $10 millionDeposit outflow of $10 millionAssets LiabilitiesReserves $10 million Deposits $ 90 millionLoans $80 million Bank Capital $ 10 millionSecurities $10 millionWith 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Liquidity Management

No excess reservesAssets LiabilitiesReserves $10 million Deposits $100 millionLoans $90 million Bank Capital $ 10 millionSecurities $10 millionDeposit outflow of $ 10 millionAssets LiabilitiesReserves $ 0 million Deposits $ 90 millionLoans $90 million Bank Capital $ 10 millionSecurities $10 million

Liquidity Management

1. Borrow from other banks or corporationsAssets LiabilitiesReserves $ 9 million Deposits $ 90 millionLoans $90 million Borrowings $ 9 millionSecurities $10 million Bank Capital $ 10 million

2. Sell SecuritiesAssets LiabilitiesReserves $ 9 million Deposits $ 90 millionLoans $90 million Bank Capital $ 10 millionSecurities $ 1 million

Liquidity Management3. Borrow from FedAssets LiabilitiesSecurities $10 million Bank Capital $ 10 millionReserves $ 9 million Deposits $ 90 millionLoans $90 million Discount Loans $ 9 million

4. Call in or sell off loansAssets LiabilitiesReserves $ 9 million Deposits $ 90 millionLoans $81 million Bank Capital $ 10 millionSecurities $10 millionConclusion: excess reserves are insurance against above 4 costs from deposit outflows

Asset and Liability ManagementAsset Management1. Get borrowers with low default risk, paying high

interest rates2. Buy securities with high return, low risk3. Diversify4. Manage liquidityLiability Management1. Important since 1960s2. Banks no longer primarily depend on deposits3. When see loan opportunities, borrow or issue CDs to

acquire funds

Capital Adequacy Management1. Bank capital is a cushion that helps prevent bank failure2. Higher is bank capital, lower is return on equity

ROA = Net Profits/AssetsROE = Net Profits/Equity CapitalEM = Assets/Equity CapitalROE = ROA EMCapital , EM , ROE

3. Tradeoff between safety (high capital) and ROE4. Banks also hold capital to meet capital requirements5. Managing Capital:

A. Sell or retire stockB. Change dividends to change retained earningsC. Change asset growth

Application: How a Capital Crunch Caused a Credit Crunch in 2008

• Shortfalls of bank capital led to slower credit growth– Huge losses for banks from their holdings of

securities backed by residential mortgages.– Losses reduced bank capital

• Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending.

Managing Credit Risk

Solving Asymmetric Information Problems1.Screening2.Monitoring and Enforcement of Restrictive

Covenants3.Specialize in Lending4.Establish Long-Term Customer Relationships5.Loan Commitment Arrangements6.Collateral and Compensating Balances7.Credit Rationing

Managing Interest Rate RiskFirst National BankAssets LiabilitiesRate-sensitive assets $20 m Rate-sensitive liabilities $50

mVariable-rate loans Variable-rate CDsShort-term securities MMDAs

Fixed-rate assets $80 m Fixed-rate liabilities $50 mReserves Checkable depositsLong-term bonds Savings depositsLong-term securities Long-term CDs

Equity capital

Managing Interest-Rate RiskGap AnalysisGAP = rate-sensitive assets – rate-sensitive liabilities

= $20 – $50 = –$30 millionWhen i 5%:1. Income on assets = + $1 million

(= 5% $20m)2. Costs of liabilities = +$2.5 million

(= 5% $50m)3. Profits = $1m – $2.5m = –$1.5m

= 5% ($20m – $50m) = 5% (GAP)Profits = i GAP

Duration AnalysisDuration Analysis

% value –(% pointi) (DUR)Example: i 5%, duration of bank assets = 3 years, duration of liabilities = 2 years;

% assets = –5% 3 = –15%% liabilities = –5% 2 = –10%

If total assets = $100 million and total liabilities = $90 million, then assets $15 million, liabilities$9 million, and bank’s net worth by $6 millionStrategies to Manage Interest-rate Risk1. Rearrange balance-sheet2. Interest-rate swap3. Hedge with financial futures

Off-Balance-Sheet Activities1.Loan sales2.Fee income from

A. Foreign exchange trades for customersB. Servicing mortgage-backed securitiesC. Guarantees of debtD. Backup lines of credit

3.Trading ActivitiesA. Financial futuresB. Financial optionsC. Foreign exchangeD. Swaps

Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)• Generation of fee income. Examples:

– Servicing mortgage-backed securities.– Creating SIVs (structured investment vehicles)

which can potentially expose banks to risk, as it happened in the subprime financial crisis of 2007-2008.

• Trading activities and risk management techniques – Financial futures, options for debt instruments,

interest rate swaps, transactions in the foreign exchange market and speculation.

– Principal-agent problem arises

• Internal controls to reduce the principal-agent problem– Separation of trading activities and bookkeeping– Limits on exposure– Value-at-risk– Stress testing

Chapters 11 & 12

Banking Industry: Structure, Competition and Regulation

Financial InnovationInnovation is result of search for profitsResponse to Changes in Demand

Major change is huge increase in interest-rate risk starting in 1960sExample: Adjustable-rate mortgages

Financial DerivativesResponse to Change in Supply

Major change is improvement in computer technology1. Increases ability to collect information2. Lowers transaction costsExamples:1. Bank credit and debit cards2. Electronic banking facilities3. Junk bonds4. Commercial paper market5. Securitization

Avoidance of Existing Regulations

Regulations Behind Financial Innovation1.Reserve requirements

Tax on deposits = i r2.Deposit-rate ceilings (Reg Q till 1980)

As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings

Examples1. Money market mutual funds (Bruce Bent)2. Sweep accounts

The Decline in Banks as a Source of Finance

Decline in Traditional BankingLoss of Cost Advantages in Acquiring Funds

(Liabilities) i then disintermediation because

1. Deposit rate ceilings and regulation Q2. Money market mutual funds3. Foreign banks have cheaper source of funds:

Japanese banks can tap large savings poolLoss of Income Advantages on Uses of Funds

(Assets)1. Easier to use securities markets to raise funds:

commercial paper, junk bonds, securitization2. Finance companies more important because easier

for them to raise funds

Banks’ Response

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking1. Expand lending into riskier areas: e.g., real estate2. Expand into off-balance sheet activities3. Creates problems for U.S. regulatory systemSimilar problems for banking industry in other countries

Structure of the Commercial Banking Industry

Table 1 Size Distribution of Insured Commercial Banks, September 30, 2008

Ten Largest U.S. Banks

Branching RegulationsBranching Restrictions: McFadden Act and

Douglas AmendmentVery anticompetitive

Response to Branching Restrictions1. Bank Holding Companies

A. Allowed purchases of banks outside stateB. BHCs allowed wider scope of activities by FedC. BHCs dominant form of corporate structure for

banks2. Automated Teller Machines

Not considered to be branch of bank, so networks allowed

Bank Consolidation and Number of Banks

Bank Consolidation and Nationwide Banking• The number of banks has declined over

the last 25 years– Bank failures and consolidation.– Deregulation: Riegle-Neal Interstate Banking

and Branching Efficiency Act f 1994.– Economies of scale and scope from

information technology.• Results may be not only a smaller

number of banks but a shift in assets to much larger banks.

Benefits and Costs of Bank Consolidation• Benefits

– Increased competition, driving inefficient banks out of business

– Increased efficiency also from economies of scale and scope

– Lower probability of bank failure from more diversified portfolios

• Costs– Elimination of community banks may lead to less

lending to small business– Banks expanding into new areas may take increased

risks and fail

Separation of Banking andOther Financial Service IndustriesErosion of Glass-SteagallFed, OCC, FDIC, allow banks to engage in underwriting

activitiesGramm-Leach-Bliley Financial Modernisation

Services Act of 1999: Repeal of Glass-Steagall1. Allows securities firms and insurance companies to purchase

banks2. Banks allowed to underwrite insurance and engage in real

estate activities3. OCC regulates bank subsidiaries engaged in securities

underwriting4. Fed oversee bank holding companies under which all real

estate, insurance and large securities operations are housedImplications: Banking institutions become larger and more

complex

How Asymmetric InformationExplains Banking Regulation

1.Government Safety Net and Deposit InsuranceA. Prevents bank runs due to asymmetric information:

depositors can’t tell good from bad banksB. Creates moral hazard incentives for banks to take

on too much riskC. Creates adverse selection problem of crooks and

risk-takers wanting to control banksD. Too-Big-to-Fail increases moral hazard incentives for

big banks2.Restrictions on Asset Holdings

A. Reduces moral hazard of too much risk taking

3.Bank Capital RequirementsA. Reduces moral hazard: banks have more to lose when

have higher capitalB. Higher capital means more collateral for FDIC

4.Bank Supervision: Chartering and ExaminationA. Reduces adverse selection problem of risk takers or

crooks owning banksB. Reduces moral hazard by preventing risky activities

5.New Trend: Assessment of Risk Management6.Disclosure Requirements

A. Better information reduces asymmetric information problem

7.Consumer ProtectionA. Standardized interest rates (APR)B. Prevent discrimination: e.g., CRA

8.Restrictions on Competition to Reduce Risk-TakingA. Branching restrictionsB. Separation of banking and securities industries in the

past: Glass-SteagallInternational Banking Regulation1.Bank regulation abroad similar to ours2.Particular problem of regulating international

bankinge.g., BCCI scandal

Chapter 14

Multiple Deposit Creation and the Money Supply Process

Meaning and Function of MoneyEconomist’s Meaning of Money1. Anything that is generally accepted in payment for goods and

services2. Not the same as wealth or incomeFunctions of Money1. Medium of exchange2. Unit of account3. Store of valueEvolution of Payments System1. Precious metals like gold and silver2. Paper currency (fiat money)3. Checks4. Electronic means of payment5. Electronic money: Debit cards, Stored-value cards, Smart cards, E-

Four Players in the Money Supply Process

1.Central bank: the Fed2.Banks3.Depositors4.Borrowers from banksFederal Reserve System1.Conducts monetary policy2.Clears checks3.Regulates banks

The Fed’s Balance Sheet

Federal Reserve System

Government securities

Discount loans

Currency in circulation

Reserves

Assets Liabilities

Monetary Base, MB = C + R

Control of the Monetary Base

Open Market Purchase from Bank The Banking System The FedAssets Liabilities Assets LiabilitiesSecurities – $100 Securities + $100 Reserves + $100Reserves + $100Open Market Purchase from Public Public The FedAssets Liabilities Assets LiabilitiesSecurities – $100 Securities + $100 Reserves + $100Deposits + $100 Banking SystemAssets LiabilitiesReserves Checkable Deposits+ $100 + $100Result: R $100, MB $100

If Person Cashes Check Public The FedAssets Liabilities Assets LiabilitiesSecurities – $100 Securities + $100 Currency + $100Currency + $100Result: R unchanged, MB $100Effect on MB certain, on R uncertainShifts From Deposits into Currency Public The FedAssets Liabilities Assets LiabilitiesDeposits – $100 Currency + $100Currency + $100 Reserves – $100 Banking SystemAssets LiabilitiesReserves – $100 Deposits – $100Result: R $100, MB unchanged

Discount Loans

Banking System The FedAssets Liabilities Assets LiabilitiesReserves Discount Discount Reserves + $100 loan + $100 loan + $100

+ $100Result: R $100, MB $100

Conclusion: Fed has better ability to control MB than R

Deposit Creation: Single BankFirst National Bank

Assets LiabilitiesSecurities – $100Reserves + $100

First National BankAssets LiabilitiesSecurities – $100 Deposits + $100Reserves + $100Loans + $100

First National BankAssets LiabilitiesSecurities – $100 Deposits + $100Loans + $100

Deposit Creation: Banking System

Bank AAssets LiabilitiesReserves + $100 Deposits + $100

Bank AAssets LiabilitiesReserves + $10 Deposits + $100Loans + $90

Bank BAssets LiabilitiesReserves + $90 Deposits + $90

Bank BAssets LiabilitiesReserves + $ 9 Deposits + $90Loans + $81

Deposit Creation

If Bank A buys securities with $90 checkBank A

Assets LiabilitiesReserves + $10 Deposits + $100Securities + $90Seller deposits $90 at Bank B and process is same

Whether bank makes loans or buys securities, get same deposit expansion

Deposit Multiplier

Simple Deposit Multiplier1D = R

rDeriving the formulaR = RR = r D

1D = R

Deposit Creation:Banking System as a Whole

Banking SystemAssets LiabilitiesSecurities– $100 Deposits + $1000Reserves+ $100Loans + $1000Critique of Simple ModelDeposit creation stops if:1. Proceeds from loan kept in cash2. Bank holds excess reserves

Money MultiplierM = m MB

Deriving Money MultiplierR = RR + ERRR = r DR = (r D) + ER

Adding C to both sidesR + C = MB = (r D) + ER + C

1. Tells us amount of MB needed support D, ER and C2. $1 of MB in ER, not support D or C

MB = (r D) + (e D) + (c D)= (r + e + c) D

1D = MB

r + e + cM = D + (c D ) = (1 + c) D

1 + cM = MB

r + e + c1 + c

m =r + e + c

m < 1/r because no multiple expansion for currency and because as D ER

Full ModelM = m (MBn + DL)

Excess Reserves Ratio

Determinants of e1. i , relative Re on ER (opportunity cost ), e 2. Expected deposit outflows, ER insurance worth more, e

Factors Determining Money Supply

Deposits at Failed Banks: 1929–33

e, c: 1929–33

Money Supply and Monetary Base: 1929–33

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