chapter 20 the banking system and its regulation introduction to economics (combined version) 5th...

Chapter 20The Banking

Systemand Its Regulation

Introduction to Economics (Combined Version) 5th Edition

The U.S. Banking SystemBanks are financial

institutions that accept deposits and make loans.

Types of banks:Commercial banksThrift institutions (savings

and loans; mutual savings banks; credit unions)

The Federal Reserve System (Fed) is the central bank of the United States.


What is a Balance Sheet? A balance sheet is a financial statement showing what a firm owns

and what it owes. Assets are all the things that the firm or household owns or to

which it holds a legal claim. Liabilities are all the legal claims against a firm by non-owners or

against a household by nonmembers. Net worth, also listed on the right-hand side of the balance sheet, is

equal to the firm’s or household’s assets minus its liabilities. In banking, net worth is called capital.

Assets = Liabilities + Net Worth


Balance Sheet of U.S. BanksThe principal assets of U.S. commercial banks are

loans. The principal liabilities are deposits.


Some Important Terms An asset is said to be liquid

if it can be used as a means of payment or quickly and easily converted to a means of payment without loss of nominal value.

A bank is said to be insolvent if its liabilities exceed its assets.

Reserves are cash or deposits held at the Fed that a bank can draw on to meet liquidity needs.


The ability to withdraw cash from ATM machines helps to keep bank deposits liquid

Risks of BankingTypes of risk: Credit risk is the risk that

loans will not be repaid on time and in full.

Market risk is the risk that changes in market conditions will cause a decrease in the value of assets relative to that of liabilities.

Liquidity risk is the risk that a bank will have to sell illiquid assets below the value listed on the balance sheet, resulting in a loss.


Homeowners who cannot repay their mortgages are one source of credit risk for banks

Traditional BankingTraditional banking earned

profits with an originate-to-hold strategy.

Use funds from deposits to make loans.

Hold the loans until they are paid in full.

Earn a profit from the difference between interest rates on loans and interest rates on deposits.

Hold cash reserves and capital for safety.


Traditional Banking: Originate-to-HoldTraditionally, banks rarely sold loans to other investors.No two loans were exactly alike.Bankers needed personal knowledge of their customers.Buyers feared that any loan a bank wanted to sell must be a “lemon”.


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The Beginnings of Securitization Starting in the 1930s,

Government Sponsored Entities (GSEs) were created to buy loans from banks.

Banks used the funds to make new loans.

The GSEs bundled the loans into securities and sold them to investors—a process called securitization.


Securitization Securitization begins when customers borrow from banks. The bank sells the loan to an intermediary that issues securities

based on a pool of many such loans. Each security receives a rating from a rating agency. The resulting securities are then sold to investors.


Housing and Social Policy In the 1990s, affordable housing

received increased attention as a social issue.

Why should only the middle class be able buy a home? Why were low-income families excluded?

Banks’ answer: Because loans to low-income households are too risky!

Subprime mortgages were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy.


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However, Subprime Mortgages Proved Risky in a Falling Market.

In a falling market, subprime mortgages are more likely than prime mortgages to produce losses.Negative equity is more likely because of high initial loan-to-value ratio.Low income borrowers are more likely to default when equity becomes negative.Recovery rates on forced sales of low-quality housing may be low.


The Golden Age of Finance Easy availability of credit

and changing social attitudes changed the behavior of U.S. consumers during the late 1990s and early 2000s.

Household debt—including mortgage debt, credit card debt, and other forms of debt—rose to 98 percent of GDP.

With credit so cheap and easy to get, saving almost disappeared.


Do Banks Take Excessive Risks?Spillover Effects

Failure of one bank may trigger runs on other banks.

Failure of one bank may causes losses for counterparties (other financial firms who do business with the bank).

Failure of the banking system damages the nonfinancial economy by interfering with normal flows of credit.


Do Banks Take Excessive Risks?Gambling with Other People’s Money

Conflicts of interest can arise when one party gets the gains and the other party is stuck with the losses. Managers vs. shareholders Managers vs. traders Shareholders vs.

bondholders In economic terminology,

these are called principal-agent problems.


Gambling with Your Own or Others’ MoneyWhen gambling with their own money, many people choose games like the lottery that…

lose most of the time, but not more than they can afford and

don’t win often, but have a huge payoff when they do win.

These are called positively skewed risks.


When gambling with other people’s money, the best games are ones that. . .

win a moderate amount most of the time, or

rarely lose but may have really huge losses when they do.

Once a big loss comes, the game is over; the gambler, however, keeps past winnings and someone else bears the cost.

Fiduciary Duties of Managers Financial managers are

paid to gamble with other people’s money.

In doing so, they have a fiduciary duty to act in their shareholders’ best interests. They should take prudent

risks when there is a good chance of a high return for shareholders. . .

. . . but they should not put their personal gain ahead of shareholder interests.


Executive compensation plans are often misaligned with fiduciary duties.Bonuses for short-term

performanceLack of “clawback” Golden parachutes

Such bonus-based compensation plans cause managers to seek excessively risky strategies.

Example of Misaligned Incentives:

Strategy A 5 quarters of $100 million

profit 5 quarters of $10 million loss 10-quarter net for

shareholders: profit of $449.5 million

10-quarter result for executive: total bonuses of $500,000

Strategy B 9 quarters of $200 million

profit 1 quarter of $2,000 million loss 10-quarter net for

shareholders: loss of $201.8 million

10-quarter result for executive: total bonuses of $1.8 million


Strategy B has higher payoff for the executive but lower payoff for shareholders.

Assume an executive bonus plan that pays 0.1% of net profit each quarter

Safety and Soundness: Bank Examinations Bank examinations are the

oldest tool for ensuring the safety and soundness of the banking system.

These examinations, conducted by state or federal officials, are intended to ensure that banks do not make unduly risky loans, that they value their assets honestly, that they maintain adequate levels of net worth and liquid reserves, and that they have competent management.

The “CAMELS” Checklist for bank examiners:•Is there adequate capital?•Are assets of high quality?•Is management competent?•Are earnings reliable?•Is there adequate liquidity?•Is there too much sensitivity to market risk?


Tools to Ensure Safety and SoundnessLender of last resortDuring a bank panic,

banks may be unwilling to lend to one another.

Lack of interbank credit causes failure to spread.

Central bank makes emergency loans to protect banks from failure.

Deposit insuranceDuring a bank panic, a

run may occur because depositors fear only the first in line will get their money back.

Government deposit insurance means there is no need for a run.


Rehabilitating Failed BanksThree questions for helping failed

banks: Who should be helped?

All banks or only failing banks?Are some too big to fail?

Who should bear the losses? Shareholders? Taxpayers?

How should aid be provided?Capital injection?Carve-out?


Bailouts of big banks have been a source of great political controversy.

Additional Slideshows


More classroom-ready slideshows on banking and bank regulation:

•Tutorial on Bank Failures and Bank Rescues defines the terms and illustrates the concepts needed to understand banking crisis like Cyprus, Ireland, Iceland, etc.•What Is Basel III and Why Should We Regulate Bank Capital? explains the importance of the Basel III rules and uses simple balance sheets to illustrate the importance of regulating bank capital. Updated in March 2013, this classic has been the most viewed of all my slideshows.•More on Basel III: Regulating Bank Liquidity is a companion to the preceding slideshow and was also updated in March 2013.

If you have trouble with the links on this slide, check the index of slideshows on Ed Dolan’s Econ Blog, (dolanecon.blogspot.com)

http://www.slideshare.net/dolaneconslide/what-is-basel-iii-and-why-should-we-regulate-bank-capital

http://www.slideshare.net/dolaneconslide/more-on-basel-iii-regulating-bank-liquidity

chapter 20 the banking system and its regulation introduction to economics (combined version) 5th...

Documents

economics combined version

liquidity risk

market risk

source of credit risk

households assets

principal liabilities

illiquid assets

value of assets relative