Money and Banking Flashcards

Defining Money by Its Functions

Money is defined as whatever serves society in the following four specific functions:

• Medium of exchange: This refers to whatever is widely accepted as a method of payment for goods and services.
• Store of value: This is something that serves as a way of preserving economic value so that an individual can spend or consume it in the future.
• Unit of account: This is the common way in which market values are measured within an economy; it provides a consistent standard for pricing.
• Standard of deferred payment: Money must be acceptable to make purchases today that will be paid for at a future date.

The Absence of Money

In a world without money, trade relies on barter, which is the direct trading of one good or service for another. Barter depends on a double coincidence of wants, a situation where two people each possess a good or service that the other person desires.

Commodity versus Fiat Money

• Commodity money: This is an item used as money that also possesses intrinsic value from its use as something other than money (e.g., gold or silver used in jewelry or industry).
• Commodity-backed currencies: These are dollar bills or other currencies with values specifically backed up by gold or another commodity. Historically, gold and silver backed the money supply in the United States.
• Fiat money: This type of money has no intrinsic value but is declared by a government to be the country's legal tender.
• Current U.S. Standing: By government decree, U.S. currency is legal tender for all debts, even though it is no longer backed by a commodity. Its only backing is the universal faith and trust that the currency has value.

Measuring Money: Currency, M1, and M2

Money can be defined narrowly (M1) or broadly (M2).

The M1 Money Supply

M1 is a narrow definition of the money supply. As of April 24, 2020, the Federal Reserve Board loosened regulations on savings deposits, effectively shifting them into the M1 category.

M1 Components (May 2021 Data):

General Note: Total M1 was approximately $\$19$ trillion in 2021.

The M2 Money Supply

M2 is a broader definition that includes everything in M1 plus other types of deposits.

M2 Components (May 2021 Data):

General Note: Total M2 was approximately $\$20$ trillion in 2021. The money supply has grown tremendously over time as the economy has grown.

The Status of "Plastic Money"

Credit cards, debit cards, and smart cards provide ways to move money but are not money in their own right:

• Debit card: An instruction to the user's bank to transfer money directly and immediately from the user's account to the seller.
• Credit card: Immediately transfers money from the credit card company's checking account to the seller. This is considered a short-term loan; the user owes the money to the company at the end of the month.
• Smart card: Stores a specific value of money on a card for purchases (e.g., a RamCard used for food or parking).

The Role of Banks as Financial Intermediaries

Banks are financial intermediaries that link savers (depositors) and borrowers. They facilitate the flow of capital and lower transaction costs significantly, which would otherwise be high if individuals had to find and negotiate with borrowers directly.

The Profit Mechanism

Banks make a profit by borrowing from depositors and lending to individuals and businesses. They pay a lower interest rate on deposits than the interest rate they charge on loans.

The Bank Balance Sheet

A balance sheet is an accounting tool that lists assets and liabilities:

• Asset: An item of value owned by the firm or individual (e.g., loans made to others, government bonds, reserves).
• Liability: An amount or debt that the firm or individual owes (e.g., deposits made by customers).
• Net Worth (Bank Capital): The excess of asset value over liabilities. It is calculated as: $\text{Total Assets} - \text{Total Liabilities}$.     * A healthy bank maintains positive net worth.     * Negative net worth means a bank cannot fulfill all depositor withdrawals.
• Reserves: Funds a bank keeps on hand that are not loaned out or invested in bonds.
• Reserve Requirement: The specific fraction of deposits that a bank is legally required to keep as reserves.

Banking Risks and Failures: Silicon Valley Bank (SVB)

Types of Risk

Banks are exposed to two primary types of risk:

1. Default Risk: The risk that borrowers will not repay loans, which lowers a bank's assets and net worth.
2. Liquidity Risk: Deposits are liquid (can be withdrawn anytime), but loans are illiquid (cannot be called for immediate repayment). This is known as asset-liability time mismatch.

Risk Management Strategies:

• Diversification of loans across various firms and individuals.
• Selling loans in the secondary loan market.
• Holding a larger share of assets in reserves or government bonds.

Case Study: Silicon Valley Bank (SVB) Collapse

SVB failed on Friday, March 10, 2023, representing the second-biggest commercial bank collapse in U.S. history.

Context and Vulnerabilities:

• SVB served many venture capital (VC) firms and startup tech firms.
• The bank's deposits were highly concentrated: bulk of deposits were held in only $37,000$ accounts, and over $90\%$ of deposits exceeded the $\$250,000$ FDIC insurance limit.
• SVB held many assets in long-term loans like government bonds.

The Catalyst:

• In March 2022, the Federal Reserve began raising interest rates to combat inflation.
• As market interest rates rise, the selling price of existing bonds falls.
• While banks can keep bonds at a constant value on balance sheets if held, selling them to meet withdrawals forces the bank to reflect those losses.
• On Wednesday, March 8, 2023, SVB announced it sold billions in bonds at a loss to raise funds.
• The Run: Spooked depositors attempted to withdraw $\$42$ billion by the close of March 9. The FDIC took control on March 10.

Government Response and Signature Bank

• Signature Bank: Failed on Sunday, March 12, 2023. It was based in New York, heavy in VC and cryptocurrency, and was the 3rd largest commercial bank failure in U.S. history.
• Response Options:     * Option 1: FDIC pays only under $\$250,000$. Risk: Systemic risk to the entire financial system.     * Option 2: Pay all depositors. Risk: Moral Hazard—bailing out bad behavior may encourage other banks to take more risk in the future.

Conclusion

Banks are essential for connecting borrowers and lenders, but they do not operate without oversight. The government intervenes in financial markets through The Federal Reserve.