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ECON 304 Money and Banking Instructor: Bernard Malamud Office: BEH 502 Phone (702) 895 3294 Fax: 895 1354 Email: bernard.malamud@unlv.edu Website: www.unlv.edu/faculty/bmalamudwww.unlv.edu/faculty/bmalamud Office hours: MW 11:30 - 12:30 pm; 2:30 3:30 pm; and by appointment

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Money, Banking, Financial Markets and Crisis The role of money and monetary policy in the economy TRUST How financial markets such as bond, stock and foreign exchange markets work TRUST How financial institutions such as banks and insurance companies work TRUST

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Course Objectives Roles played by banks and other intermediaries Determination of asset prices in financial markets How financial institutions operate Asymmetric information Adverse selection/Moral hazard/Principal Agent Problems Innovations Regulation The conduct and impacts of monetary policy. How policies can promote macroeconomic stability Understand and explain the roots, responses and consequences of the subprime-triggered financial crisis.

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Texts Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets, 10 th edition. Earlier editions workbut read Ch 9 of 9 th & 10 th ed. Financial Crisis Inquiry Commission Report Supplemental Books and Articles (see course outline): Frank Partnoy. Infectious Greed: How Deceit and Risk Corrupted the Financial Market, 2003 Gillian Tett, Fools Gold. 2009. David Wessel, In Fed We Trust: Ben Bernankes War on the Great Panic, 2009. Andrew Ross Sorkin, Too Big to Fail. 2009. Simon Johnson and James Kwak, 13 Bankers : The Wall Street Takeover and the Next Financial Meltdown. 2010 Henry Paulson, On the Brink, 2010. Raghuram G. Rajan, Fault Lines. 2010. Joseph Stiglitz, Freefall. 2010. Perry Mehrling, The New Lombard Street. 2011. Gretchen Morgenson and Joshua Rosner, Reckless Endangerment. 2011. Neil Barofsky, Bailout. 2012. Articles in Journal of Economic Perspectives (JEP) and Federal Reserve System publications cited in this outline and as added as the semester proceeds. These can be accessed from the JEP and Federal Reserve Bank websites.

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M & B Talk Some Terms Liquidity/solvency Shadow banking system Structured Investment Vehicles (SIVs) This time is different Irrational exuberance Systemically important financial institutions (SIFI) Too Big to Fail Too Big to Bail Discount window stigma Term Auction Facility (TAF)/Term Security Lending Program (TSLP) Primary Dealer Credit Facility (PDCF)/Money Market Investor Funding Facility (MMIFF) Asset Backed Securities (ABS/MBS)/Credit Default Swaps (CDS) Troubled Asset Relief Program (TARP) Lender of Last Resort Stress test Large negative tail Black swan

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Development and Recent Past of the Financial System http://ineteconomics.org/video/full-video/recent-past-finance-adair-turner

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Some Basics of Money, Banking and Financial Markets A security (financial instrument) is a claim on the issuers future income or assets A bond is a debt security that promises to make specified payments over time An interest rate is the cost of borrowing or the price paid for the rental of funds Common stock represents a share of ownership in a corporation A share of stock is a claim on the earnings and assets of the corporation

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M & B Pictures Interest Rates on Selected Bonds, 19532011 Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

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Stock Prices as Measured by the Dow Jones Industrial Average, 19502011 Source: Based on Dow Jones Indexes: http://nance.yahoo.com/?u.

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Understanding Financial Distress I credit routinely turned over but in crunch Background Concepts Flavors of liquidity Funding liquidity haircut on collateral Market liquidity fire sale in crisis Lending channel (turn to banks) Moral hazard monitoring cost When borrower net worth down dont lend Precautionary hoarding by intermediary Network effects: everyone a borrower & lender/no netting When counterparty credit risk up GRIDLOCK Silent run loans not renewed

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Connectivity and Amplification Reduced Positions Initial Losses Funding Problems Higher Margins Losses on Existing Assets Falling Prices Fire Sale

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Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization MBSs Escalating House Prices Govt Sponsored Enterprises Developer Clout Bank Regulators The best of times A Global Saving Glut

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Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization MBSs Escalating House Prices Govt Sponsored Enterprises Developer Clout Bank Regulators The best of times

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Underlying Innovations Securitization SIVs (Structured Investment Vehicles) Ratings bias ARMs, teaser rates, no-doc loans, NINJA loans Episodes American Home Loan, PNB Paribus hedge fund failures TED rate jump ECB, Fed Injections (TAF) Monoline insurers (of MBSs) downgrade Impact on money market funds Carlyle failure run on Bear (March 2008) Fed backed JP Morgan takeover/TSLF for investmt banks September 2008: Lehman, Merrill, AIG TARP

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Responses Lender of Last Resort / Spender of Last Resort Tax Rebate $124 bil. Fed Fund Rate Cuts Fannie/Freddie $200 bil. Bear-Stearns $29 bil. AIG $174 bil. Fed Facilities Primary Dealer Credit Facility (PDCF) $58 bil. Treasury Security Loan Facility (TSLF) $133 bil. Term Auction Facility (TAF) $416 bil. Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. Money Market Investor Funding Facility (MMIFF) $540 bil. More Fed Fund Rate Cuts Hold At ~0% Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. Term Asset-Backed Securities Loan Facility (TALF) $200 bil. Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP II Stress Tests

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Money Growth (M2 Annual Rate) and the Business Cycle in the United States 19502011 Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level

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Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 19502011 Prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely tied Since then, the relationship is less clear but the rate of money growth is still an important determinant of interest rates

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Aggregate Price Level and the Money Supply in the United States, 19502011

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Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 2000-2010 Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

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Monetary and Fiscal Policies Monetary policy is the management of the money supply and interest rates Conducted by the Federal Reserve Bank (Fed) Fiscal policy is government spending and taxation Any deficit must be financed by borrowing government borrowing affects interest rates

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Macro Facts: Bank Excess Reserves

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M1/Monetary Base=M1/(Currency + Reserves)

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Core Principles of Money and Banking Time has Value Interest rate Risk Requires Compensation Financial decisions are based on Information and TRUST Markets set prices and allocate resources Stability reduces risk and spurs enterprise Uncertainty Fear Enterprise

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Function of Financial Markets Channel funds from economic players that have saved surplus funds to those that have a shortage of funds Promotes economic efficiency by producing an efficient allocation of capital increases production Improves consumer well-being allows them to time purchases better

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Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets Exchanges and Over-the-Counter (OTC) Markets Money and Capital Markets Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and equity instruments

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Principal Capital Market Instruments

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Internationalization of Financial Markets Foreign Bondssold in a foreign country and denominated in that countrys currency Eurobondbond denominated in a currency other than that of the country in which it is sold Perhaps in the future a bond backed by all eurozone countries Eurocurrenciesforeign currencies deposited in banks outside the home country EurodollarsU.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks World Stock Markets

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Function of Financial Intermediaries: Indirect Finance Lower transaction costs Economies of scale Liquidity services Reduce Risk Risk Sharing (Asset Transformation) Diversification Asymmetric Information Adverse Selection (before the transaction)more likely to select risky borrower Moral Hazard (after the transaction)less likely borrower will repay loan

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Banking and Financial Institutions Financial Intermediariesinstitutions that borrow funds from people who have saved and make loans to other people and businesses Banksaccept deposits and make loans Other Financial Institutionsinsurance companies, finance companies, pension funds, mutual funds and investment banks Financial Innovation The information age and e-finance Derivatives bubbles and crisis Securitization bubbles and crisis

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Principal Financial Intermediaries and Value of Their Assets

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Regulation of the Financial System To increase the information available to investors: Reduce adverse selection and moral hazard problems Reduce insider trading To ensure the soundness of financial intermediaries: Restrictions on entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

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