ECON 252 Module 10: The Financial Sector

The trinity

banks, bond market, stock market

What is a bank?

when you deposit money, banks pool deposits and lend them out; a profit maximizing business

How banks maximize their profits

receive more interest from loans then paying interest to deposits

What banks do

pool savings, spread risk, mitigate information problems, provide payment services, maturity transformation, create money

Assess on “5 C’s”

character/credit history, capacity (debt to income ratio), collateral, capital (wealth), conditions

Maturity transformation

long term loans from short-term deposits

When you deposit money, the bank owes you that money (demand deposits)

to the bank, your deposit is a liability

When a bank loans money out, the bank is owed money

to the bank, a loan is an asset

Fractional reserve lending

banks make profit off lending, banks keep just enough cash on hand to meet the typical withdrawal, upside is profit opportunity

Downside of fractional reserves

bank runs

Bank runs

when a lot of depositors pull their money out of the bank at the same time

Causes of bank runs

concerns about bank solvency and contagion

Banks are vulnerable to self-fulfilling failures

their assets are usually longer term and conditional, while their liabilities are shorter term and unconditional

Bank failure

bank cannot meet its obligations to depositors or any other creditors (liabilities > assets, FAIL)

Causes of bank failures

bank runs and decline in value of assets

Assets

physical assets (non-earning asset), cash and cash equivalents (non-earning and highly liquid), loans, trading assets

Liabilities

deposits, trading liabilities, money owed to others, owner’s equity

Deposit insurance

makes bank runs much less likely, guarantee that you won’t lose the money you deposit in the bank, covers up to $250,000 per account, breaks interdependence that leads to self-fulfilling panics

Commercial banks

stock corporations (primary obligation is to shareholders), mostly specialize in short-term business credit but also make consumer loans and mortgages, are chartered by state/federal government, FDIC

Savings and Loans Banks (aka “thrifts”)

specialize in real estate lending, can be owned by shareholders or by depositors and creditors, chartered by comptroller of the currency or state regulations, insured by FDIC, must pass “qualified thrift lender” test

Credit unions

cooperative financial institution formed by group with a “common bond”, non-profit institutions, goals are to encourage savings and provide lower interest rate loans, exempt from federal taxation, federally or state chartered, variety of accounts, mostly insured by NCUA

Shadow banks (non-bank financial intermediaries)

act like banks but don’t follow bank rules, take funds from investors to make longer-term investments, engaged in high risk activities, no deposit insurance, unknown interdependencies can make small problems balloon into big ones

Federal Reserve System

central bank of the US, created by Federal Reserve Act of 1913, Federal Reserve Board + 12 regional banks, dual mandate, keeps financial system working, acts as the banks’ bank, key role in payments system and research

Dual mandate of Federal Reserve System

low, steady, predictable inflation and full employment; uses monetary policy to achieve

M0

monetary base: currency in circulation + bank reserves

Money supply

M1 and M2

M1

most liquid, currency outside of banks + demand deposits + other liquid deposits (like savings accounts)

M2

broader, M1 + small time deposits + retail and Keogh MMF

Money multiplier

theoretical expansion of money supply, banks must fully loan out money and all money kept in banks

Bonds

IOU’s, it’s a market (buyers are savers, suppliers are borrowers)

Secondary bond market

demand wants bonds, suppliers have existing bonds

Issuer of bonds

seller/supplier

Principle of bond

amount to be repaid

Maturity date of bond

due date for repayment

Coupons

payments made along the way

Yield

annual percentage rate of return earned on a security, a function of a bond’s purchase price and coupon interest rate

What does the bond market do?

channel funds from savers to borrowers, funds government debt, spreads risk, creates liquidity

Bond prices and interest rates are inversely related

if interest rates go up, demand for bonds decreases, price decreases

Risk of bonds

credit risk (bond ratings), market risk, interest rate risk (term risk), inflation risk

Firms want to do more borrowing because they are optimistic about the future

supply of bonds increase, bond prices decrease, bond returns increase

Borrowers think interest rates will go up

bond demand decreases, prices decrease, returns increase

Money multiplier equation

money multiplier = 1/(required reserves)

Stock

partial ownership in a firm

Share

stock sometimes called a share, owners of stock are stockholders

Dividends

share of profits the company pays shareholders

Share price

if price goes up, you can sell for a profit

What do stocks do?

coordinate savings and investment, spread risk, reallocates control, creates liquidity

Drivers of the stock market

expectations largely drive the stock market