money, banking, and financial institutions

17

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Money, Banking, and Financial Institutions

17

17-2

Functions of Money

• Medium of exchange

• Used to buy/sell goods

• Unit of account

• Goods valued in dollars

• Store of value

• Hold some wealth in money form

• Liquid

LO1

17-3

Money Definition M1

• M1

• Currency

• Checkable deposits

• Institutions offering checkable deposits

• Commercial banks

• Savings and loan associations

• Mutual savings banks

• Credit unions

LO1

17-4

Money Definition M2

• M2

•M1 plus near-monies

• Savings deposits including money market deposit accounts (MMDA)

• Small-denominated time deposits

• Money market mutual funds (MMMF)

LO1

17-5

Money Definitions

Source: Federal Reserve System

LO1

Savings deposits, including money market deposit accounts

61%

Money market mutual funds

8%Small time deposits

9%

M122%

Currency50%

Checkable deposits

50%

Money supply, M1$1935 billion

Money supply, M2$9001 billion

17-6

What “Backs” the Money Supply?

• Guaranteed by government’s ability to keep value stable

• Money as debt

• Why is money valuable?

• Acceptability

• Legal tender

• Relative scarcity

LO2

17-7

What “Backs” the Money Supply?

• Prices affect purchasing power of money

• Hyperinflation renders money unacceptable

• Stabilizing money’s purchasing power• Intelligent management of the money

supply—monetary policy• Appropriate fiscal policy

LO2

17-8

Federal Reserve — Banking System

• Historical background

• Board of Governors

• 12 Federal Reserve Banks

• Serve as the central bank

• Quasi-public banks

• Banker’s bank

LO3

17-9


Commercial banksThrift institutions

(savings and loan associations,mutual savings banks,

credit unions)

The public(households and

businesses)

12 Federal Reserve Banks

Board of Governors

Federal Open Market Committee

LO3

17-10


LO3

The 12 Federal Reserve Banks

17-11


• Federal Open Market Committee

• Aids Board of Governors in setting monetary policy

• Conducts open market operations

• Commercial banks and thrifts

• 6,800 commercial banks

• 8,700 thrifts

LO3

17-12

Federal Reserve Functions

• Issue currency

• Set reserve requirements

• Lend money to banks

• Collect checks

• Act as a fiscal agent for U.S. government

• Supervise banks

• Control the money supply

LO4

17-13

Federal Reserve Independence

• Established by Congress as an independent agency

• Protects the Fed from political pressures

• Enables the Fed to take actions to increase interest rates in order to stem inflation as needed

LO4

17-14

Global Snapshot

World’s 12 Largest Financial Institutions, 2011

Source: Forbes Global 2000, www.forbes.com

LO4

Assets (billions of U.S. dollars)

BNP Paribas (France) 2,681

Deutsche Bank (Germany) 2,557

HSBC Holdings (U.K.) 2,468

Barclays (U.K.) 2,328

Royal Bank of Scotland (U.K.) 2,266

Bank of America (U.S.) 2,265

Mitsubishi UFJ (Japan) 2,177

Crédit Agricole (France) 2,131

JP Morgan Chase (U.S.) 2,118

Citigroup (U.S.) 1,914

ICBC (China) 1,724

Mizuho Financial (Japan) 1,667

17-15

The Financial Crisis of 2007 and 2008

• Mortgage default crisis

• Many causes

• Government programs that encouraged home ownership

• Declining real estate values

• Bad incentives provided by mortgage-backed bonds

LO5

17-16


• Securitization— the process of slicing up and bundling groups of loans into new securities

• As loans defaulted, the system collapsed

• “Underwater” homeowners abandoned homes and mortgages

LO5

17-17


• Failures and near-failures of financial firms

• Countrywide: second largest lender

• Washington Mutual: largest lender

• Wachovia

• Other firms came close

LO5

17-18


• Troubled Asset Relief Program (TARP)

• Allocated $700 billion to make emergency loans

• Saved several institutions from failure

LO6

17-19

Postcrisis U.S. Financial Services

• Major categories of financial institutions

• Commercial banks

• Thrifts

• Insurance companies

• Mutual Fund companies

• Pension funds

• Securities firms

• Investment banks

LO7

17-20

Institution Description Examples

Commercial banks State and national banks that provide checking and savings accounts and make loans

JPMorgan Chase, Bank of America, Citibank, Wells Fargo

Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans

Charter One, New York Community Bank

Insurance companies

Firms that offer policies through which individuals pay premiums to insure against loss

Prudential, New York Life, Northwestern Mutual, Hartford

Mutual Fund companies

Firms that pool customer deposits to purchase stocks or bonds

Fidelity, Vanguard, Putnam, Janus, T. Rowe Price

Pension funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits

TIAA-CREF, Teamsters’ Union, CalPERs

Securities firms Firms that offer security advice and buy and sell stocks and bonds for clients

Merrill Lynch, Smith Barney, Charles Schwab

Investment banks Firms that help corporations and governments raise money by selling stocks and bonds

Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura Securities

Major Categories of Financial Institutions

LO7

17-21

Postcrisis U.S. Financial Services

• Wall Street Reform and Consumer Protection Act

• Passed to help prevent many of the practices that led to the crisis

• Critics say it adds heavy regulatory costs

LO7

17-22

Fractional Reserve System

• The goldsmiths

• Stored gold and gave a receipt

• Receipts used as money by public

• Made loans by issuing receipts

• Characteristics:

• Banks create money through lending

• Banks are subject to “panics”

LO8

17-23

Fractional Reserve System

• Balance sheet

• Assets = Liabilities + Net worth

• Both sides balance

• Necessary transactions

• Create a bank

• Accept deposits

• Lend excess reserves

LO8

17-24

A Single Commercial Bank

Transaction #1Vault cash: cash held by the bank

Assets Liabilities and Net Worth

Creating a BankBalance Sheet 1: Wahoo Bank

Cash $250,000 Stock shares $250,000

LO8

17-25


Transaction #2Acquiring property and equipment


Acquiring Property and EquipmentBalance Sheet 2: Wahoo Bank

Cash $ 10,000 Stock shares $250,000Property 240,000

LO8

17-26


Transaction #3Commercial bank functions

• Accepting deposits

• Making loans


Accepting DepositsBalance Sheet 3: Wahoo Bank

Cash $110,000 Checkable deposits $100,000Property 240,000Stock shares 250,000

LO8

17-27


Transaction #4Depositing reserves in a Federal

Reserve Bank

• Required reserves

• Reserve ratio

Reserveratio =

Commercial bank’srequired reserves

Commercial bank’scheckable-deposit liabilities

LO8

17-28



Depositing Reserves at the FedBalance Sheet 4: Wahoo Bank

Cash $ 0 Checkable Deposits $100,000

Property 240,000 Stock Shares 250,000

Reserves 110,000

Transaction #4Assume the bank deposits all cash

on reserve at the Fed

LO8

17-29


• Excess reserves

• Actual reserves - Required reserves

• Required reserves

• Checkable deposits × Reserve ratio

• Example:

• Checkable deposits: $100,000

• Reserve ratio: 20 percent

LO8

17-30


Transaction #5

Clearing a check

• $50,000 check reduces reserves and checkable deposits


Clearing a CheckBalance Sheet 5: Wahoo Bank

Checkable deposits $ 50,000

Property 240,000 Stock shares 250,000

Reserves $ 60,000

LO8

17-31

Money-Creating Transactions

Transaction #6a

Granting a loan

• $50,000 loan deposited to checking


When a Loan Is NegotiatedBalance Sheet 6a: Wahoo Bank

Checkable deposits $100,000


Reserves $ 60,000

Loans 50,000

LO8

17-32

Money-Creating Transactions

Transaction #6b

Using the loan

• $50,000 loan cashed


After a Check Is Drawn on the Loan Balance Sheet 6b: Wahoo Bank

Checkable deposits $ 50,000


Reserves $ 10,000

Loans 50,000

A single bank can only lend an amountequal to its preloan excess reserves

LO8

17-33

The Banking System

• Multiple-deposit expansion

• Assumptions:

• 20 percent required reserves

• All banks “loaned up”

• Banks lend all of their excess reserves

• A $100 bill is found and deposited

• Multiple deposits can be created

LO8

17-34

The Banking System

The Banking System’s Lending Potential

LO8


Multiple-Deposit Expansion Process

Checkable deposits $+100 (a1)

Loans +80 (a2) +80 (a2)

Reserves $+100 (a1)

-80 (a3)

-80 (a3)

Balance Sheet: Commercial Bank A

17-35

The Banking System

The Banking System’s Lending Potential


Multiple-Deposit Expansion ProcessBalance Sheet: Commercial Bank B

Checkable Deposits $ +80 (b1)

Loans +64 (b2) +64 (b2)

Reserves $+80 (b1)

-64 (b3)

-64 (b3)

LO8

17-36

Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves(Reserve

Ratio = .2)

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.50

21.99

$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59$400.00

The Banking System

LO8

17-37

The Monetary Multiplier

Monetarymultiplier =

1

Required reserve ratio=

1

R

LO8

17-38

The Monetary Multiplier

• Maximum amount of new money created by a single dollar of excess reserves

• Higher R, lower m

• Reversibility

• Making loans creates money

• Loan repayment destroys money

LO8

17-39

Bank Panics of 1930–1933

• Before deposit insurance

• Bank failure led to mass withdrawals

• Forced loan reduction

• 25-33 percent decline in money supply

• 1933 national bank holiday to evaluate all banks

• Contributed to the Great Depression

• Regulation protects the system today

LO8

money, banking, and financial institutions

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