Econ 121

8 Basic Facts
1. Stocks are not the most important sources of external financing for a
business
2. Issuing marketable debt and equity securities are not the primary way
businesses finance their operations
3. Indirect finance is many times more important than direct finance
4. Financial intermediaries (such as banks) are the most important source of
external funds used to finance businesses
5. The financial sector is among the most heavily regulated sectors of the
economy
6. Only large, well-established companies have easy access to securities market
to finance their activities
7. Collateral is a prevalent feature of debt contracts for both businesses and
households.
8. Debt contracts are extremely complicated legal documents that place
substantially restrictive covenants on borrowers
Transaction Costs
-

Financial intermediaries have evolved to reduce transaction costs through

economies of scale and expertise

Asymmetric information: adverse selection

-

Occurs before transaction

Moral hazard arises after transaction
Agency theory assesses how these affect economic behavior

Tools to help adverse selection

-

Private production and sale of information

o Free rider problem
Government regulation to increase information
o Not always works, explains 5
Financial intermediation
o Explains 3, 4, 6
Collateral and net worth
o Explains 7 and 8

How moral hazard affects choice between debt and equity contract
-

Principal-Agent problem
o Principal: less info/stockholder
o Agent: more info/manager
Separation of ownership and control of frim
o Managers pursue power and benefits and not profitability of firm

Tools to help
-

Monitoring
o Fact 1, free-rider problem
Government regulation
o Fact 5
Financial Intermediation
o Fact 3
Debt Contracts
o Fact 1

How moral hazard influence financial structures in debt market

-

Borrowers have incentive to take on projects that are riskier than lenders
would like
o Prevents them from paying back loan

Tools to solve
-

Net worth and collateral

o Incentive compatible
Monitoring and enforcement of restrictive covenants
o Discourages undesirable behavior, keeps collateral valuable, provides
info
Financial intermediation

Ass info in transition and developing countries

-

Financial repression created by an institution characterized by:

o Poor system of property rights (unable to use collateral efficiently)
o Poor legal system (difficult to enforce strict covenants)
o Weak accounting standards (less access to good info)

Government intervention through directed credit programs and state

owned banks (less incentive to properly channel funds to its most
productive use)

Application: Fin dev and econ growth

-

Fin systems in developing and transition countries face difficulties that keep
them from operating efficiently
o System of property rights functions poorly and makes it hard to use
tools effectively

Financial Crises
-

Occurs when there is a large disruption in the information flows of a financial

market
Results in financial friction increasing sharply and financial markets stop
functioning
Balance sheet:
o Stock market decline: Decrease net worth of corps
o Unanticipated decline in price level: liability increases in real terms, net
worth decreases
o Unanticipated decline in value of domestic currency: increase debt
denominated in foreign currency, decrease net worth
o Asset write-downs

Factors causing these:

-

Deterioration in financial institutions balance sheet decrease in lending

Banking crisis loss of information production and disintermediation
Increases in uncertainty decrease lending
Increase in interest rates increase adverse selection, increase need for
external funds and thus, increase adverse selection and moral hazard
Government fiscal imbalances creates fear of default of government debt,
investors might pull money out of country

Dynamics of Financial Crises in Advanced Economies

-

Stage
o
o
o
o
Stage
Stage

One: Initiation of Financial Crisis

Mismanagement of financial liberalization/innovation
Asset price boom or bust
Spikes in interest rate
Increase in uncertainty
Two: Banking Crisis
Three: Debt Deflation

The Great Depression

-

Brought by:
o Stock market crash

o
o
o

Bank panics
Debt deflation
Continuing decline of stock prices

Global Financial Crisis

-

Causes:
o Financial innovations emerge in mortgage markets
Subprime, alt-A mortgages
Mortgage-backed securities
Collateral debt obligations (CDOs)
o Housing bubble forms
Increase in liquidity from cash flows surging to USA
Innovations increased demand for housing and increased the
prices
o Agency Problems arise
originate to distribute model is subject to principal/investor
and agent/broker problem
Borrowers had little incentive to disclose info about ability to pay
Commercial and investment banks had weak incentive to assess
quality of securities
o Information problems surface
o Bubble bursts
o Crisis spreads globally
Sign of globalization of financial markets
TED spread (3 month interest rate of Eurodollar minus 3 months
treasury bills rate) increased from 40 basis points to almost 240.
o Banks balance sheet deteriorates
Write downs and selling of assets/credit restriction
o High profile firms fall (Bear Sterns, Fannie Mae, Freddie Mac, Lehman
Brothers, Merrill Lynch, AIG, Reserve Primary Fund and Washington
Mutual)
o Bailout package debated
o Stimulus plan

Collateral debt obligations

-

Creation requires SPV or special purpose vehicle that buys a collection of

assets such as corp bonds and loans, mortgage backed-securities etc
SPV separates payment streams into buckets called tranches
Highest rated tranches called super senior tranches are paid off first and
have least risk
Lowest is the equity tranche not paid out if underlying assets default and stop
making payments. Highest risk and not traded

Some argue low interest rate policies by the Fed from 03-06 caused the house
pricing bubble

Taylor argues low rate meant low mortgage rate which cause issuing of subprime
mortgages and bubble
Fed argued that proliferation of innovation that relaxed lending standards that
brought more buyers
Dynamics of Financial Crises in Emerging Market Economies
Stage 1: initiation of financial crisis
-

Path One: Mismanagement of financial liberalization/globalization

o Weak supervision and lack of expertise leads to boom
o Domestic banks borrow from foreign
o Fixed exchange rates gives lower sense of risk
o Banks play big role in emerging markets economies because securities
market is not yet developed
Path Two: severe fiscal imbalances
o Governments in need of funds force banks to buy government debt
o When government debt loses value, banks lose and net worth
decreases
o Additional factors: increase in int rate from abroad, asset price
decrease, uncertainty from politics

Stage 2: Current Crisis

-

Deterioration of bank balance sheets trigger crisis

o Govt cannot raise interest rates and speculators expect devaluation
Severe fiscal imbalances trigger crisis by foreign and domestic investors sell
the domestic currency

Stage 3: Full-fledged financial crisis

-

Debt burden in domestic currency increases/net worth decreases

Increase in expected cash flow and actual inflation reduces firms cash flows
Banks are more likely to fail: individuals cant pay off debt (value of assets
fall) and debt denominated in foreign currency increases (liability increases)

Review application
Banking and Management of Financial Institutions

Basic Banking: Cash Deposit

Assets: vault cash + or reserves +
Liabilities: Checkable deposits +
Check deposit
Reserves + , checkable deposits +
How it makes profit:
Assets: required reserves +, loans/excess reserves +
Liabilities: checkable deposits +
General Principles of Bank Management: Liquidity, Asset, Liability and Capital
Adequacy Mgt, Credit and interest rate risk
Ample Excess Reserves
Assets

Liab

Reserves 20m
deposits 90m

Deposits 100m

Loans 80m

Bank Capital 10m

Securities 10m

Assets

Liab
Reserves 10m

Loans 80m

bank capital 10m

securities 10m

If required reserves are 10% and has ample reserves, outflow does not necessitate
change in other parts of balance sheet
Shortfall in Reserves
Assets

Liab

Assets

Liab

Reserves 10m
deposits 90m
Loans 90m

Deposits 100m

Bank Capital 10m

Securities 10m
-

Reserves 0m
Loans 90m

bank capital 10m

securities 10m

Reserves are a legal requirement, shortfall must be eliminated

Excess reserves are insurance against cost associated with deposit outflows

Liquidity management: borrowing

Assets

Liab

Reserves 9mdeposits 90m

Loans 90m

Borrowing 9m

Securities 10m
-

Bank Capital 10m

Cost incurred is interest rate paid on the borrowed funds

Securities Sale
Reserves 9mdeposits 90m
Loans 90m

bank capital 10m

Securities 1m
-

Cost of selling securities is the brokerage and other transaction costs

Federal Reserve
-

Borrowing from the fed is also a liability similar to borrowing

Reducing loans
-

Subtract loans
Antagonizes customers, most costly way, other banks may agree to purchase
loans at a substantial amount

Asset Management: 3 goals

-

Seek highest possible return on loans and securities, reduce risk and have
adequate liquidity

Asset Management: 4 tools

1. Find borrowers who will pay high interest rates and low possibility of
defaulting
2. Purchase securities with high returns and low risk
3. Lower risk by diversifying
4. Balance need for liquidity against increased returns from less liquid assets
Liability Management
-

Recent phenomenon due to rise of money center banks

Expansion of overnight loan markets and new fin instruments such as
negotiable CDs
Checkable deposits have decreased in importance as source of bank funds

Capital adequacy mgt

-

Bank capital helps prevent market failures

Regulatory requirement
Amount of capital affects return for owners of bank

Returns to Equity Holders

Return on Asset ROA = net profit after taxes over assets
Return on Equity ROE = net profit after taxes over equity capital
Equity multiplier expresses relationship of ROA and ROE, asset/equity capital,
amount of assets per dollar of equity capital
ROE = ROA x EM
Safety
-

Benefits the owner of bank by making safe investments

Costly to the owners of a bank because higher the capital lower ROE
Choice depends on state of economy and levels of confidence

How a capital crunch caused a credit crunch in the GFC

-

Shortfall of bank capital led to slower credit growth: huge losses from
mortgages resulted into reduced bank capital
Banks couldnt raise capital in weak economy, tightened lending standards
and reduced lending

Managing Credit Risk

Screening and monitoring: specialization in lending and monitoring and

enforcement of restrictive covenants
Long term customer relationships, loan commitments, collateral and
compensating balances, credit rationing

Managing Interest rate risk

-

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates
will reduce bank profits and a decline in interest rates will raise bank profits

Gap and Duration Analysis

-

Gap analysis: (rate-sensitive assets minus rate sensitive liabilities)x delta

interest rates = delta in bank profit
Maturity bucked approach: measures gap for several maturity sub intervals
Standardized gap analysis: accounts for different degrees of rate sensitivity
o % change in market value of security H percentage point change in
interest rate x duration in years
Uses weighted average duration of assets and liabilities to see
how net worth responds to change in interest rate

Off balance sheet activities

-

Loan sales (secondary loan participation)

Generation of free income
o Servicing mortgage backed securities
o Creating structured investment vehicles or SIVs which can expose
banks to risk
Trading activities and risk management techniques
o Principal agent problem arises
Internal controls to reduce principal agent problem
o Value-at-risk
o Stress testing
o Limits on exposure
o Separation of trading activities and bookkeeping

Asymmetric Information and Financial Regulation

Bank panics and the need for deposit insurance:
-

FDIC : short circuits bank failures and contagion effects

Payoff method
Purchase and assumption method (more costly for FDIC)

Other form of government safety net

-

Lending from the central bank to troubled institutions/ lender of last resort

Govt safety net

Moral hazard: depositors do not impose discipline of market place and

institutions have greater incentive to take risk
Adverse selection: risk lovers find banking attractive, depositors have little
incentive to monitor financial institutions

Safety Net: Too big to fail

-

Provides guarantees of repayment to large uninsured creditors of the largest

financial institutions even when they are not entitled to a guarantee
Uses purchase and assumption method
Increases moral hazard incentives for big banks

Safety Net: Financial Consolidation

-

Larger and more complex financial organizations challenge regulation

o Increased too big to fail problem
o Extends safety net to new activities and increases risk incentives in
these areas

Restrictions on Asset Holdings

-

Attempts to restrict financial institutions from too much risk taking

o Bank regulations: promote diversification and prevents holding of
common stock
o Capital requirements: minimum leverage ratio, Basel Accord (risk
based capital requirements) and regulatory arbitrage
Government imposed, minimizes moral hazard
First form: based on leverage ratio (capital divided by assets).
Ratio must be greater than 5%. Increased regulatory restrictions
for those below 3%.
Second form: risk based capital requirements

Financial Supervision
Chartering screening of proposals to open new financial institutions to prevent
adverse selection
Examinations scheduled and unscheduled monitoring of capital requirements and
restrictions on asset holding to prevent moral hazard. Capital adequacy, asset
quality, management, earnings, liquidity, sensitivity to market risk
Filing periodic call reports
Assessment of Risk Management
-

Greater emphasis on evaluating soundness of management processes for

controlling risk

Trading Activities Manual of 1994 for risk management rating based on

Quality of oversight provided, a dequacy of policies and limits for all risky
activities, quality of the risk measurement and monitoring systems, adequacy
of internal controls,
Interest-rate risk limits: internal policies and procedures, internal
management and monitoring, implementation of stress testing and Value-at
risk (VAR)

Disclosure requirements: adhere to standard accounting principles and disclose

wide range of info with fair value accounting
Consumer protection
Restrictions on competition: increased competition increases moral hazard
incentives and takes on more risk. Higher consumer charges and inefficiency though

Microprudential vs Macroprudential
-

microprudential supervision is focused on the safety and soundness of

individual financial institutions. Post crisis, macroprudential supervision,
which focuses on the safety and soundness of the financial system in the
aggregate.

1980s Savings and Loan Bank Crisis

-

Financial innovation and new financial instruments increased risk taking.

Increased deposit insurance led to increased moral hazard. Deregulation

Crises throughout the world

-

Dj vu all over again

o Deposit insurance is not to blame for some of these banking crises
o The common feature of these crises is the existence of a government
safety net, where the government stands ready to bail out troubled
financial institutions.

Dodd-Frank Bill and Future Regulation

-

Most comprehensive financial reform legislation

Consumer protection, resolution authority, systemic risk regulation, Volcker
rule, derivatives
There are several areas where regulation may be heading in the future:
capital requirements, compensation, government-sponsored enterprises,
credit rating agencies, danger of overregulation

Historical Development of the Bank System

-

Bank of America chartered in 1782

Controversy regarding chartering
Natl bank act of 1863 creates new banking system of federally chartered
banks
o Dual banking system and office of the comptroller of currency
Federal Reserve System created in 1913
Glass-Steagall Banking Act of 1933 creates FDIC and separates banking and
securities industries

Primary Supervisory Responsibilities of Bank Regulatory Agencies

-

Fed and state banking authorities: state banks part of the Fed regulates bank
holding companies
FDIC: insured state banks not part of Fed
State banking authorities: state banks without FDIC insurance

Shadow Banking System Financial innovation is driven by the desire to earn profit
Financial Engineering change in the financial environment will stimulate a search
by financial institutions for innovations that are likely to be profitable

Interest Rate Volatility

-

Adjustable rate mortgages: flexible interest rates keep profits high when rates
rise and lower initial rates make it attractive
Financial derivatives: ability to hedge interest pay risk. Payoffs are linked to
previously issued or derived from previous securities

Information Technology
-

Bank debit and credit cards: improved tech lowers transaction costs
Electronic banking
Junk bonds and commercial paper market
Securitization: transform illiquid assets to marketable capital market
securities.
o Important role in the development of the subprime mortgages

Loophole mining Reserve requirements act as a tax on deposits. Restrictions on

interest paid on deposits led to disintermediation. Money market mutual funds and
sweep accounts
Financial innovation and the decline of traditional banking

Market share has fallen. Commercial banks share of total financial

intermediary assets has fallen. No decline in overall profitability. Increase in
income from off-balance sheet activity
Decline in cost advantages of acquiring funds (liabilities)
o Rising inflation led to rise in interest rates and disintermediation
o Low-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)
o Information technology has decreased need for banks to finance shortterm credit needs or to issue loans
o Information technology has lowered transaction costs for other
financial institutions, increasing competition

Banks responses: expand into new and

riskier areas of lending (commercial
real estate loans and corporate takeovers and leveraged buyouts) and pursue off
balance sheet activities (non-interest income and concerns about risk)
Structure of banking industry: restrictions on branching and this caused bank
holding companies and ATMS
Bank consolidation and nationwide banking: banks have declined over the years
-

Bank failures and consolidation. Deregulation and economies of scale and

scope from IT
Results may not be only a smaller number of banks but a shift of assets to
larger banks

Benefits of Consolidation: increased competition, efficiency from economies of scale

and scope and lower probability of from more diversified portfolios
Costs: less lending to small business because of elimination of community banks,
take increased risks
Separation of Banking and Other Financial Services Industries Throughout the World
-

Universal banking: No separation between banking and securities industries

British-style universal banking: May engage in security underwriting
o Separate legal subsidiaries are common
o Bank equity holdings of commercial firms are less common
o Few combinations of banking and insurance firms
Some legal separation: Allowed to hold substantial equity stakes in
commercial firms but holding companies are illegal

Thrift industry regulation and structure

Savings and Loans associations: Chartered by Federal govt or states. Member of
FHLBS

Mutual Savings Bank: Half are chartered by states, regulated by state where they
are located and FDIC or state insurance
Credit unions: Tax exempt, chartered by fed gov or state
International banking: rapid growth. Eurodollar market and global investment
banking is profitable. Growth in intl trade and multinational corporations
Eurodollar market: Dollar-denominated deposits held in banks outside of the U.S.
Most widely used currency in foreign trade. Offshore deposits not subject to
regulation. Important source of funds for US banks
Structure of US Banking Overseas : shell operations, edge act corps, international
banking facilities
-

IBFs have no regulation and cant loan out to domestic residents

Foreign banks in the US:

-

Agency office of the foreign bank. Can lend and transfer fund in the U.S.
Cannot accept deposits from domestic residents. Not subject to regulations
Subsidiary U.S. bank is subject to U.S. regulations. Owned by a foreign bank.
Branch of foreign bank: limited service maybe allowed in any other state,
branches only in designated home state or in state that allows entry of out of
state banks
Subject to International Banking Act of 1979

Basel Accord 1988: sets minimum capital requirements

The Market For Reserves and the Federal Funds Rate
-

Demand and Supply for Market Reserves

Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could have been earned
minus the interest rate that is paid on these reserves, ier

Demand
-

When the federal funds rate is above the rate paid on excess reserves, ier, as
the federal funds rate decreases, the opportunity cost of holding excess
reserves falls and the quantity of reserves demanded rises. Downward
sloping demand curve that becomes flat (infinitely elastic) at ier

Supply
-

Two components: non-borrowed and borrowed reserves. Cost of borrowing

from the Fed is the discount rate. If if < id, then banks will not borrow from
the Fed and borrowed reserves are zero. Curve will be vertical. As if rises

above id, banks will borrow more and more at id, and re-lend at if. The supply
curve is horizontal (perfectly elastic) at id.
With excess demand, federal funds rate rises. Opposite for excess supply.

Effects of open an market operation depends on whether the supply curve

initially intersects the demand curve in its downward sloped section versus its
flat section.

An open market purchase causes the federal funds rate to fall whereas an
open market sale causes the federal funds rate to rise (when intersection
occurs at the downward sloped section).

Open market operations have no effect on the federal funds rate when
intersection occurs at the flat section of the demand curve.

If the intersection of supply and demand occurs on the vertical section of the
supply curve, a change in the discount rate will have no effect on the federal
funds rate.

If the intersection of supply and demand occurs on the horizontal section of

the supply curve, a change in the discount rate shifts that portion of the
supply curve and the federal funds rate may either rise or fall depending on
the change in the discount rate

When the Fed raises reserve requirement, the federal funds rate rises and
when the Fed decreases reserve requirement, the federal funds rate falls.

Response to Open Market Operation

a. Supply curve shifts right and intersects downward section of demand curve.
Federal fund rates fall.
b. Same but intersects flat section. Rates dont change as it cant be lower than
that paid on reserves.
Change to Discount Rate
a. Shift supply curve down but does not lower rate.
b. Shift down and lowers rate
Change in Required Reserves
-

Demand to the right. Rate increases.

Change on interest rates to reserve

A. If equilibrium > reserve rate then federal funds rate dont change
B. If equilibrium = reserve rate, rate increases

How the Federal Reserves Operating Procedures Limit Fluctuations in the Federal
Funds Rate
A. Leftward shift of demand makes rate = minimum interest rate of reserve
B. Rightward shift od demand makes rate into a maximum of discount rate
Conventional Monetary Policy Tool
-

3 tools: open market operations, discount lending and reserve requirements

o Control money supply and interest rates

Open market operations: dynamic and defensive market operations, primary

dealers, trading room automated processing system (TRAPS), repurchase
agreement, matched sale-purchase agreements
Advantage of open market ops: Fed has complete volume control, flexible and
precise, easily reverse and quickly implemented.
Discount policy and lender of last resort
-

Discount window, primary credit (standing lending/Lombard facility),

secondary and seasonal credit. Lender of last resort prevents financial panics,
but creates moral hazard problems.

Advantages and disadvantages of discount policy: used to perform role of lender of

last resort, cannot be controlled by Fed; decision by bank, discount facility is used
as a backup facility to prevent the federal funds rate from rising too far above the
target.
Reserve requirements: Depository Institutions Deregulation and Monetary Control
Act of 1980 sets reserve requirement the same for all depository institutions. Fed
can vary 10% requirement to 8-14%.
Disadvantages of RR: no longer binding for most banks. Liquidity problems and
increases bank uncertainty.
Nonconventional Monetary Policy Tools During the Global Financial Crisis
Asset Purchases: During the crisis the Fed started two new asset purchase programs
to lower interest rates for particular types of credit: Government Sponsored Entities
Purchase Program; QE2
Liquidity provision: The Federal Reserve implemented unprecedented increases in
its lending facilities to provide liquidity to the financial markets: Discount Window
Expansion, Term Auction Facility and New Lending Programs.
Monetary policy tools of Euro Central Bank

Open market operations: Main refinancing operations and weekly reverse

transactions. Longer-term refinancing operations
Lending to banks: Marginal lending facility/marginal lending rate and deposit facility
Reserve Requirements: 2% of the total amount of checking deposits and other
short-term deposits and pays interest on those deposits so cost of complying is low
Price Stability Goal and the Nominal Anchor
Nominal Anchor: a nominal variable such as the inflation rate or the money supply,
which ties down the price level to achieve price stability.
Other goals of monetary policy:
1.
2.
3.
4.
5.

High employment and output stability

Economic growth
Stability of financial markets
Interest-rate stability
Stability in foreign exchange markets

Should price stability be the primary goal of monetary policy?

Hierarchal versus dual mandates
-

Hierarchal: price stability first. As long as it is achieved, other goals can be

pursued
Dual: aimed to achieve 2 co-equal objectives: price stability and maximum
employment/output stability

Price stability as the primary, long-run goal of monetary policy

-

Either type of mandate is acceptable as long as it operates to make price

stability the primary goal in the long run, but not the short run.

Inflation targeting: Public announcement of medium term numerical target for

inflation, institutional commitment to price stability as the primary, long-run
goal of monetary policy and a commitment to achieve the inflation goal,
information-inclusive approach in which many variables are used in making
decisions, increased transparency of the strategy, increased accountability of
the central bank

Advantages and Disadvantages of Inflation Targeting

Advantages: does not rely on 1 variable to achieve target, easily understood,
reduces potential of falling in time-inconsistency trap, stresses transparency and
accountability

Disadvantages: delayed signaling, rigidity, potential for increased output

fluctuations, low economic growth in disinflation