Money and Banking - EXAM#2

standard of living influences/factors

1. ability of businesses to accumulate machinery, computers, robots and other physical capital
2. ability of businesses to adopt latest technology
3. ability of government to provide a legal framework that protects property rights nad enforces contracts

\
strong financial system → economic growth → higher standard of living

real GDP/capita

best measure of how successful a firm’s country is in providing a high standard of living to its residents

finanical development

total amount of credit banks and financial markets extend to households and firms as % of GDP

\-higher financial development = higher GDP/capita

obstacle for flow of funds from savers to borrowers (small investors)

1. transaction costs


1. information costs

reducing transaction and info costs

financial intermediaries…

\-take advantage of economics of scale:


1. fees are spread across larger investments (pooling funds)
2. contract writing frees spread over many loans
3. software is used to evaluate creditworthiness

\-develop expertise

\-provide customers with liquidity services that make trasactions easier

asymmetric information

situation in which 1 party to an economic transaction has better/more information than other party

\-typically borrower has more info than lender

\-seller has more info than buyer

\-information problems reduce economic efficieny in a market

2 problems/information costs from asymmetric information

1. adverse selction


1. moral hazard

adverse selection

problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment

\-occurs **before transaction**

\-sometimes bad credit risk most actively seek out loans

*explains facts #1-7*

moral hazard

risk that people will take actions after they have entered into a transaction that will make the other party worse off

\-occurs **after transaction**

\-borrowers may engage in activities that are undesirable from lender’s perspective

*explains facts #1, 3, 4, 5 &* 8

credit rationing

the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate

reducing adverse selection

1. material information disclosure

\-SEC: reduces info costs through info disclosure

\-generally accepted accounting principles (GAAP)

how financial intermediaries can reduce AS:


2. investing in firms with high net worth’s and requiring collateral


1. relationship banking

debentures

bonds without collateral

relationship banking

\-the ability of banks to assess credit risks on the basis of private information about borrowers

\-reduces the costs of adverse selection and explains the key role banks play in providing external financing to firms

free riders

those who gain benefit without having to face costs

principal-agent problem

moral hazard problem of managers (agents) pursuing their own interests rather than those of shareholders (principals)

8 facts/puzzles about financial structure (1970-2000)

**1.** Stocks are **not** the most important sources of external financing for businesses (11% of financing)

**2.** Marketable debt and equity securities (43%) are **not** the primary way in which businesses finance their operations (Bonds 32% in US)

**3.** Indirect finance is much more important than direct finance (indirect = 56%)

**4.** Bank loans **are** the **most important** source of external funds

**5.** The financial system is among the **most heavily regulated** sectors of the economy (help promote financial stability and symmetric info)

**6.** Only large, well-established corporations have access to securities markets to finance their activities

**7.** Most debt contracts (loans) for households and businesses are **collaterized**

**8.** Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on behavior of borrowers

transaction costs

freeze out small savers/borrowers out of financial market

\-ex. small borrower faces high legal costs and small saver faces high brokerage fees, bond denominations and risk

adverse selection and financial structure: **lemons problem (used car market)**

\-buyers are often unable to assess quality of car

\-price reflects average quality of used cars in market

\-owner generally knows more about quality of car → lemon owns are happy to sell at overvalues average price

\-peach owners don’t want to sell at undervalued average price → good cars will be taken off market → average quality decreases

\-market functions poorly since average quality has decreased and few people want to buy lemons

lemons problem: stock and bond market

\-investors often can’t distinguish between good firms (high expected profits and low risk) and bad firms

\-price for stocks and bonds reflect average quality of firms issuing securities

\-owners/managers of good firms are unwilling to sell securities are avgerage undervalued price

\-securities market doesn’t function well b/c bad firms are left and use it to raise capital and investors do not want to hold bad securities

*explains why securities/stocks/direct finance are not primary sources of funds* (facts #1 & 2)

getting rid of lemons problem

\-lemons problem vanish **without** asymmetric info b/c investors would be willing to pay full value and owners of goods firms would get fair price → markets would function well and channel funds to good firms

solutions to adverse selection problems

1. **private production and sale of info to saver/lenders**


1. ex. Moody’s and S&P gather and sell info to investors
2. doesn’t solve lemons problem entirely due to **free-rider problem** (firms won’t make as much problem and will be reluctant to produce info
2. **government regulation to encourage spenders/borrowers to reveal info about themselves**


1. ex. SEC requires firms to disclose info about themselves
2. lesss difficult politically than gov production of info
3. doesn’t eliminate lemons problem completely bc firms still have more info than investors and bad firms have incentive to distort info to be presented in favorable light
4. this solution explains why financial market are so heavily regulated (fact 5)
3. **financial intermediation**


1. most used-cars are sold to dealers who produce info in market by becoming experts in determining quality of cars


1. people will be more likely to buy with dealers gurantee on quality
2. dealer can make profit on production of info b/c they can sell car at higher price and avoid free-rider problem
2. most funds are channeled from savers to spenders through financial intermediaries who produce info and differentiate between good/bad credit risks
3. banks avoid free-rider problems through primarily private, nontraded loans
4. **collateral and net worth**


1. consequences of adverse selection are reduced by collateral and net worth
2. collateral can be sold to make up for loan losses (explains why debt is collateralized)
3. net worth plays similar role → lender can take title to firm’s net worth and sell to make up for loan losses
4. firms with high net worth are less likely to default in first place

\
\*\* **adverse selection problem explains facts 1-7** \*\*

moral hazard: choice between debt and equity contracts

**equity contracts** are subject to moral hazard due to principal-agent problem → firms shareholders/owners (principals) long-term interest are separate from managers (agents) short-term interests

\-managers have incentive to act in own best interest rather than shareholders since there is less incentive to max profits

\-managers pursue own benefits/corp. strategies that enhance personal power/bonuses

\-principal-agent problem is worse if managers engage in fraud

solutions to/principal-agent problem vanishes if….

\-owners has complete info about manager’s action

\-ownership and control are **not** separate (same goals)

\
solutions:


1. monitoring/production of info (fact #1)
2. governent regulation to increase info about managers


1. ex. standard accounting principals, criminal penalties for fraud


3. financial intermediation - intermediaries can avoid free-rider problem through…


1. venture captial firms: info in only available to investors


1. help with development of start-ups
2. private equity firms → improves efficiency of existing firms
4. debt contracts


1. reduce need for monitoring of managers and cost of state verification
2. explains why debt contracts are more important than equity in raising funds/captial (fact #1)


1. lenders receieve payments of debts/bonds regardless of firms profitability

financial structure in debt markets

\-debt contracts are subject to moral hazard b/c borrowers havce incentive to take on riskier investment projects

\-borrowers have less to lose and lender has a lot to lose

solutions to moral hazard in debt contracts

1. networth and collateral


1. moral hazard is smaller with higher net worth (only people who don’t need money can borrow)
2. high net worth makes debt contracts incentive compatible
2. monitoring and enforcing restrictive covenants


1. explains why debt contracts are complex documents (provides info to lenders)
2. can’t elimate moral hazard problem b/c it’s impossible to rule out every risk-taking activity with covenants and borrowers can find loopholes
3. covenants discourage undeseriable behavior by borrowers
3. financial intermediation


1. free-rider problems arise in debt/bond markets b/c monitoring of restrictive covenants is costly


1. financial intermediaries can make private non-tradable loan

operations of commerical banks and other depository institutions are seen…

on bank’s balance sheet

bank’s assets

used of bank funds


1. **reserves (required and excess (15%))**


1. **highly liquid**
2. **cash items in process of collection (5%)**


1. ex. checks from Bank A deposited in Bank B
2. deposits at other banks
3. **securities (debt only (20%)**


1. U.S. gov and agency bonds→secondary reserves (**more liquid**)
2. state +local gov bond (**less liquid**)
4. **loans (52%)**


1. \
> 50% of bank revenues
2. commerical, industrial, real estate, consumer, interbank (overnight)
3. **low liquidity**
5. **other assets (physical assets) (13%)**


1. least liquid

bank’s primary source of funds

deposits

bank’s primary use of funds

funds

bank’s capital

\-aka. shareholder’s equity/networth

\-difference between bank’s assets and liabilites

\-equity & retained earnings

\-acts as cushion from going insolvent

bank's liabilities

1. checkable deposits (14%)


1. demand deposits: no interest paid
2. NOW, SuperNOw, MMDA: interest paid
2. Non-transactions deposits (63%)


1. saving deposits
2. small-time deposits (CD

discount rate

what Fed charges to banks for loans

secondary reserves

short term U.S. treasury securities

\-highly liquid, hence being called secondary reserves

reserves

bank assets consisting of vault cash plus bank deposits with the Federal Reserve

vault cash

cash on hand in a bank: currency in ATMs and deposits in other banks

required reserves

reserves the Fed requires banks to hold against demand deposit and NOW account balances

excess reserves

reserves banks hold above those necessary to meet reserve requirements

\-important source of liquidity to banks

cash items in process of collection

claims banks have on other bamks for uncollected funds

rules about corporate bonds and common stock

commercial banks cannot invest checkable deposits in corp. bonds or common stock

bank loans

-largest category of bank assets.

-loans are illiquid relative to marketable securities and have greater default risk and higher information costs

\-3 categories:


1. loans to businesses
2. consumer loans


1. real estate loans

t-account

an accounting tool used to show changes in balance sheet items

primary commercial banking activities

1. take in deposits from savers (loans)


1. make loans to houses and firms (assets)

shareholder’s equity aka. bank capital

represents the $ amount the owners of the firm would be left with if the firm closed, sold assets and paid of liabilities

\-funds contributed by shareholders through their purchases of bank’s stock and bank’s retained earnings

demand deposits

banks must exchange depositor’s check for cash immediately

\-aka. checkable deposit: allows owner to write check to 3rd party

\-aka. transaction deposits

time deposits

large denomination CD’s can be bought/sold in secondary markets prior to maturity

\-can result in profit or loss for bank

bank’s profit equation

bank’s profit = interest earned - interest paid

banks assets are acquired by funds they…

1\. receive from depositors

2\. borrow from other institutions

3\. acquire initially from shareholders

4\. retain as profits from operations

leverage

a measure of how much debt an investor assumes in making an investment

bank leverage

the ratio of the value of a bank’s **assets** to the value of its **capital**

\-**Managers of banks and other financial firms may have an incentive to hold a high ratio of assets to capital**

\-a high ratio of assets to capital (high leverage) can magnify ROE but it can do the same for losses

\-moral hazard can contribute to high bank leverage

\-high leverage → increases degree of risk for banks as it means there is inadequate captial relative to assets

moral hazard and bank leverage (A/C)

moral hazard can contribute to high bank leverage

\-if managers are compensated for a high ROE, they may take on more risk than shareholders would prefer

\-Federal deposit insurance has increased moral hazard by reducing the incentive depositors have to monitor the behavior of bank managers

setting leverage maxmium to deal with risk of moral hazard/risk banks face

government regulations called **capital requirements** have placed limits on the value of the assets commercial banks can acquire relative to their capital

liquidity risk

possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost

liquidity risk reduction strategies

1. hold more in reserves
2. asset management: lend funds in federal funds market overnight
3. reverse repurchases agreements
4. liquidity management


1. liability management: determin best mix of borrows using repos and discount loans

credit risk

risk that borrowers might default on their loans

\-source of credit risk → asymmetric info

prrime rate

rate charges to high-quality borrowes

methods to manage credit risk

1. diversification
2. credit-risk analysis
3. collateral
4. credit rationing
5. monitoring and restrictive covenants
6. long-term business relationships

credit-risk anaylsis

process that bank loan officers use to screen loan applicants

\-banks often use credit-scoring systems to predict whether a borrower is likely to default

collateral

assets pledged to the bank in the event that the borrower defaults

\-used to reduce adverse selection & credit risk

\-a compensating balance is a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank

credit rationing

the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate

\-ex. credit limit (helps reduce moral hazard)

restrictive covenants

explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities

relationship banking

ability of banks to assess credit risks on the basis of private information on borrowers

\-can reduce problems of asymmetric information

interest-rate risk

-the effect of a change in market interest rates on a bank’s profit or capital

\-risk that price of financial asset iwll cahnge in response to changes in market interest rates

\-a rise (fall) in the market interest rate will lower (increase) the present value of a bank’s assets and liabilities

measuring sensitivity of bank’s profits by change in interest rates

gap analysis

duration analysis

an analysis of how sensitive a bank’s capital is to changes in market interest rates

\-longer the duration of asset or liability, the more the value of it will change as a result of market interest rate changes

\-p**ositive duration gap** (most banks):


1. increasing market rate = value of assets will decrease more than value of liabilites and bank’s capital will decrease
2. falling market rate = good → increased profits and increases bank capital value

\

gap analysis

analysis of the gap between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities

\-used to caluculate vunerability of bank’s profits to changes in market interest rates

\-most banks have negative gaps → liabilities (deposits) are more likely to have variable ates than assets (loans and securities

banks and common gaps…

most banks have

\-negative gap

\-positive duration gap

reducing interest-rate risk

1. adjustable/floating-rate loans (if market rate increases and banks have to pay higher rates, they will also receive higher interest rates on loans)
2. interest-rate swaps
3. future/option contracts: allows hedging against interest rate risk (swap variable interest rate to fixed rate for a period of time)

interest-rate swaps

agree to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan

national bank

federally chartered bank

dual-banking system

current U.S. system in which banks are chartered by either state gov or federal gov

off-balance-sheet activitites

activities that do not affect a bank’s balance sheet

\-important for increasing profits

\-profit is made from fees


1. loan sales (secondary loan participation)
2. provision of specialized services for fees


1. ex. foreign exchange
2. guarantee debt securitites
3. backup/standby lines of credits
3. trading activities


1. trading financial futures, options and interest-rate swaps for debt instruments
2. creates severe principal-agent problem
3. usually occurs to reduce risk and facilitate bank business
4. can lead to bank insolvency

banks and debt/income ratio loan requirements

banks will **not** loan to person with more than a **40%** debt to income ratio

banks make profit from…

borrowing short and lending long

\-aka. asset transformation

proprietary trading

when a bank trades with their own funds

principal-agent problem with trading activities

\-trader (agent) has incentive to take on excessive risk → high profit = large bonus/salary AND large losses are covered by financial institutions (principals)

\-managers must set up internal controls


1. separtion of those in charge of trading and bookkeeping
2. limit on traders’ transactions and institution’s risk exposure


1. use of risk assessment procedures

financial innovation is…

driven by desire of individual firms to maxmize profit:


1. responses to change in demand conditions
2. responses to change in supply conditions


1. improvements in computer/telecommunications
3. avoid government regulations


1. regulations restrict profits
2. ex. with deposit insurance, banks may take on more risk as depositors will monitor investments less

asset transformation

\-how banks provide service to public

\-the process when banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristic

banks evaluate borrowers uses 5 C’s

*done in effort to decrease adverse selection and moral hazard*


1. character: credit score
2. capacity: ability to pay
3. collateral
4. conditions: economic (local/national) conditions
5. capital: networth

general principles of bank management

4 goals:


1. acquire sufficiently liquid assets to meet deposit outflows (liquidity management)
2. acquire assets with low default rates and diversify to minimize risk (asset management)
3. acquire funds at low cost (liability management)
4. decide and acquire need capitial (bank capital manangement)

liquidity management

the acquisition of assets that are liquid enough to meet the bank’s obligations to depositors

asset management

acquire assets will low default rates and by diversifying asset holdings

liability management

aqcuire funds at low cost

\-used to have little emphasize on it

\-used to be no bank competition from interest paid on checkable deposits and used to be little interbank borrowing

\-since 1960s:


1. there has been expansion of overnight loan market
2. development of new financial instruments


1. negotiable CDs & MMDAs
3. there has been **increase in borrowing** and **loans** and **decrease in checkable deposits**

capital management

decide the amount of capital the bank should maintain and then acquire the needed capital

3 goals of asset management

1. seek highest return on loans and securities
2. minimize risk
3. hold liquid assets to provide adequate liquidity

4 strategies of asset management

1. make loans with highest interest rate and lowest default risk


1. there is tradeoff between low default risk and attractive but risky lendning opportunities with high interest rates
2. buy securities with high returns and low risk
3. diversify portfolio and loans by:


1. buying different types of securities (T-bills (ST), T-bonds (LT))
2. approving different types of loans to many customers
4. manage liquidity of assets to satisfy reserve ratio and deposit outflow with out high costs


1. tradeoff between liquidity and higher returns since there is no interest earned on ER

capital adequacy management

banks must decide how must capital to hold for following reasons:


1. capital helps prevent bank failure
2. the amount of capital affects returns to owners of bank
3. there is a minimum amount of bank capital required by regulatory authorities

bank capital: tradeoff between safety and return on equity

\-bank capital benefits owners by reducing probability of/acting as cushion against bankruptcy/insolvency → protecting their investment → this is costly to owners b/c ROE falls as capital increases and equity multiplier falls

\-in uncertain times when there’s a higher probability of loan defaults, managers might want to hold more capital to protect equity holders

\-equity holders may not want to hold a lot of capital to increase there return per each dollar of capital

*higher capital = lower ROE* *for give ROA*

3 methods to raise bank capital and reduce equity multiplier

1. issue equity/common stock
2. increase retained earnings by reducing dividends
3. reduce assets by selling securities and/or making fewer loans → use proceeds to reduce liabilities

as assets decrease → equity multiplier decreases

credit risk management

1. **screening and monitoring**


1. screening ex → credit score
2. specialization in lending


1. banks have knowledge/relationships with local firms (reduces A.S.)
2. monitoring and enforcing restrictive covenants (helps reduce M.H.)
2. **long-term customer relationships**


1. reduces information costs
2. benefits borrowers b/c they can borrow at lower rates
3. **loan commitments to commercial customers**


1. benefits firms b/c they have source of credit as needed
2. benefits banks b/c it promotes LT relationships
4. **collateral & compensation balances**


1. reduces lender’s loss and A.S.
5. **credit rationing**

rate-sensitive assets

1. variable rate loans


1. short term securities (T-bills)
2. Federal Funds

fixed-rate assets

1. reserves
2. long term loans
3. long term securities (T-bonds)

rate-sensitive liabilities

1. variable rate CDs
2. MMDAs

fixed-rate liabilities

\-checkable deposits/accounts


1. savings deposit
2. long term CDs
3. equity capital

if value of rate-sensitive liabilities>assets

\-profits decrease as i increases

\-profits increase as i decreases

profits & rate sensitive items

profits = change in asset income *-* change in interest payments

(change in i x *value of RS assets) - (change in i x value of RS liabilities)*

financial crisis

a significant disruption in the flow of funds from lenders to borrowers

\-typically leads to recession

mismatch maturity

banks they borrow short term from depositors and lend long term to households and firms

\-creates liquidity risk

bank panic

when many banks simultaneously experience runs

\-feeds on self-fulfilling perception → if depositors believe banks are in trouble, banks are in trouble

\-feedback loop

bank run

process when depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close

\-depositors want to withdrawal as fast as possible to get repaid with bank reserves before they run out

\-can occur when depositors believe banks investments in assets are bad

contagion

the process by which a run on one bank spreads to other banks, resulting in a bank panic