economics combined version edwin g. dolan best value textbooks 4 th edition chapter 20 the banking...

Dolan, Economics Combined Version 4e, Ch. 20

EconomicsCombined Version

Edwin G. DolanBest Value Textbooks

4th edition

Chapter 20The Banking Systemand Its Regulation


The U.S. Banking System

Banks 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


The 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

The accounting equation:

Assets = Liabilities + Net Worth


Balance Sheet of U.S. Banks

The principal assets of U.S. commercial banks are loans. The principal liabilities are deposits.


Risks of Banking

Types 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

Other 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


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-Hold

Traditionally, 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


Simple Pass-Through Bonds

Earliest mortgage-backed securities were simple pass-through bonds

Each bond received an equal share of all principal and interest payments on a pool of loans

Each bond shared an equal part of the loss from any default

Senior-subordinate structure In important innovation was introduction

of tiers of bonds with different risk (tranch)

Senior bonds have first priority to receive interest and principal payments, last to bear losses

Subordinate bonds bear the first risk of losses from defaults, stand last in line for income

Mezzanine bonds stand in between Investors select safe, low-yield senior

bonds or riskier, high-yield subordinate bonds according to their appetite for risk


Growing ComplexityOver time securitization became more complex. First households and firms

borrow from originating banks. The banks then sell the loans to GSEs and other specialized intermediaries, who issue securities divided in "tranches" according to risk Each type of security is rated and then sold to investors, often hedge funds or other institutions, who buy the type of security that best fits their appetite for risk. Investors can further protect themselves against risk by means of credit default swaps which are a form of insurance purchased by the investor.


Perceived BenefitsFor originating banks New sources of fee income No additional capital needed Reduced credit riskFor the economy Banks can make many more loans because they do not have to

hold the loans to maturity on their own books Credit risk borne by hedge funds, insurance companies, and other

investors thought best positioned to bear it Wide distribution of credit risk makes financial system more

stable Cost of credit reduced for everyone


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 loans were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy www.pdclipart.org.


Standard vs. Subprime Mortgages

Standard (prime) mortgages: Borrowers are expected to

repay loan from current income

Lenders profit primarily from interest payments

Borrowers get full benefit of increase in home value or bear full loss from decrease

Subprime mortgages Banks rely on appreciation of

home value, not borrowers’ income, for repayment

Lenders profit primarily from fees for origination, servicing, and refinancing

Lenders share benefit from appreciation of home value and risk of loss if value decreases


Standard vs. Subprime Mortgage terms

Standard (prime) mortgage terms:

Loan to value ratio usually 80%-90%

Constant fixed rate for full 30-year life of mortgage

No prepayment penalty Require careful

documentation of income and assets of borrower

Subprime mortgage terms: Loan to value ratio up to

100% or even more Low teaser rate for 2 or 3

years followed by high step-up rate

Large prepayment penalty May not require

documentation of income or assets


Profitable in a Rising Market Subprime mortgages are

profitable to both lender and borrower in a rising market

Borrowers accumulate equity in homes they could not otherwise afford to buy

Lenders extract profit at end of initial 2 or 3 year period in one of three ways Through prepayment penalties if

property is sold or refinanced Through high step-up interest

rates if not refinanced Through foreclosure in case of

default www.pdclipart.org.


. . . but Risky in a Falling MarketIn 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

www.pdclipart.org.


But house prices never fall, do they? From 1975 to 2006 house prices never had a nationwide down

year From 2000 on, prices rose far above the historical trend based on

gradually rising household incomes


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 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’ money

When 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 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 rarely lose, but may have really

huge losses when they do Once a big loss comes, the

game is over, but the gambler 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


Fiduciary Duties of Managers Executive compensation plans

are often misaligned with fiduciary dutiesBonuses for short-term

performanceLack of “clawback” (money

taken back in case of extraordinary circumstances)

Golden parachutes Such bonus-based

compensation plans cause managers to seek excessively risky strategies


Example of misaligned incentives

Strategy A – Prudent, moderate risk

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 – Aggressive, high risk

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


Tools to Ensure Safety and Soundness

Lender of last resort During 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

– That is the FED in the US System

Deposit insurance

During 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 – That is the FDIC in the US System


Sources of the Crisis

The housing bubble, financed by subprime lending

Ratings failures and disappearance of liquidity

Regulatory failures


Rehabilitating Failed Banks

Three 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?Carve-out?Capital injection?

www.pdclipart.org.


How a Carve-out Works The government first creates a

bank assistance agency (example: TARP)

The bank assistance agency exchanges good government bonds for low-quality financial instruments (“toxic waste”)

If the value of the low-quality instruments turns out to be less than that of the good bonds, the bank assistance agency loses net worth and the financial institutions gain.


How a Capital Injection Works The bank assistance agency

exchanges good government bonds for equity (common or preferred stock) in financial institutions.

Low quality assets stay with the financial institutions

The value of the government’s stock rises or falls depending on what happens to the value of the low-quality assets

economics combined version edwin g. dolan best value textbooks 4 th edition chapter 20 the banking...

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