Class Note for ECON 311 at UMass(3)
Class Note for ECON 311 at UMass(3)
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Date Created: 02/06/15
1 January 14 Banks U 39 Copynght 2007 Peavson Addwsoeres ey AH thts vesevved 91 Episodes of Speculative Manias Kindleberger pp 5051 Copyngm 2007 Peavson Addwsoeres ey AH ngms vesevved 94 Kindleberger39s Crisis Model l 1 Displacement exogenous shock end of war new technology etc that changes expectations of future profitability 2 BoomExpansion banks and others endogenously create money chasing after new opportunities aided by financial innovation 3 Positive feedback also selffulfilling prophecy bubble inflates 4 Euphoria overconfidenceoverestimate of profit potential expansion potential draws in outsiders Copyright 2007 Pearson Addisoanesley All rights reserved 95 Kindleberger39s Crisis Model ll 1 Distress a insiders bail b broader community starts to realize the end is near can39t meet liabilities may not be able to exit market 2 Revulsion stampede to exit the market for safe money prices drop bankruptcy counterparty risk 3 Resolution Prices go so low as to bring people back into the mrkt Trading stopped price floors Lender of last resort provides liquidity try to calm panic Copyright 2007 Pearson Addisoanesley All rights reserved 96 Minsky Why a new model Keynes vs Bastard Keynesianism a K 39ist economy with sophisticated financial institutions is capable of a number of modes of behavior and the mode that actually rules at any time depends upon institutional relations the structure of financial linkages ows of debt and income streams and the history of the economy theory is historically and institutionally contingent need to model theorize K assets and money as it is endogenously created by banks to finance production and investment need to incorporate obvious instability in model a normal function of K39ist economy Copynght 2007 Pearson Addrsoanesley AH thts reserved 97 Minsky The model I price of current assets fcurrent est of future profit ows current subjective liquidity preference depends on subjective expectations about uncertain future AD and uncertainty determine current investment what determines AD Expectations of demand for I goods Legacy of financial residue Consumption from wage bill Time inconsistency Markup pricing market power in equilibrium Copynght 2007 Peavson Addisoanesley AH thts vesevved 98 Minsky The model II Econ Activity generates cash ows Debts future cash out ow commitments finance present K purchases present K yields future cash in ow Wall Stfinanciersrentiers exchange present cash ow for promised future cash ow incl 139 and principal Cash ows maymay not validate debt and price of K asset cash ows to individual asset function of AD Leverage cash in ows expected cash out ow commitments Hedge speculative Ponzi Cash ows securitized leveraged for other investments e g mortgage backed securities Copynght 2007 Peavson Addisoanesley AH thts vesevve 99 Minsky The model III Expectations affect new commitments ST and LT interest rates ST and LT profitability Acceptable safe level of leverage Business cycle expansion gt increasing leverage Overconfidence gt too much leverage spec and Ponzi Financial fragility Collapse cooked spaghetti oopyngm 2007 Peavson Addisoanesley AH ngms vesevved 910 Minsky Conclusion I Comparison Kindleberger exogenous shock Minsky cyclical expansion begets collapse Financial instability is endemic to K39ism no one policyinstitutional fix but institutions and regulations to deter bad things Copynght 2007 Peavson Addisoanesley AH ngms vesevved 911 TAB L E 1 Balance Sheet of All Commercial Banks items as a percentage of the total January 2006 Assets Uses of Funds Liabilities Sources of Funds Reserves and cash items 4 Checkable deposits 7 Securities Nontransaction deposits US government and agency 13 Smalldenomination time deposits State and local government and lt 100000 savings deposits 43 other securities 10 Largedenomination time deposits 16 Loans Borrowings 26 Commercial and industrial 12 Bank capital 8 Real estate 34 Consumer 8 Interbank 3 Other 9 Other assets for example physical capital 7 Total 100 Total 100 ln order of decreasing liquidity Source wwwfederalreserve govreleasesh8current Copyright 2007 Pearson AddisonWesley All rights reserved 912 Basic Banking Cash Deposit First National Bank First National Bank Assets Liabilities Assets Liabilities Vault 100 Checkable 100 Reserves 100 Checkable 100 Cash deposits deposits Copyright 2007 Pearson Addisoanesiey Aii rights reserved 39 Opening of a checking account leads to an increase in the bank s reserves equal to the increase in checkable deposits 913 Basic Banking Check Deposit First National Bank When a bank receives Assets Liabilities additional deposits it Cash items 100 Checkable 100 gains an equal amoum Offeservesi in process deposits when it loses deposits of collection 1t loses an equal amount of reserves First National Bank Second National Bank Assets Liabilities Assets Liabilities Reserves 100 Checkable 100 Reserves 100 Checkable 100 deposits deposits Copyright 2007 Pearson Addisoanesley All rights reserved 914 Basic Banking Making a Profit First National Bank Second National Bank Assets Liabilities Assets Liabilities Required 100 Checkable 100 Required 100 Checkable 100 reserves deposits reserves deposits Excess 90 Loans 90 reserves Asset transformationselling liabilities with one set of characteristics and using he proceeds to buy assets with a different set of characteristics The bank borrows short and lends long 915 Copyright 2007 Pearson Addisoanesley All rights reserved Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interestrate Risk 916 Liquidity Management Ample Excess Reserves Assets Liabilities Assets Liabilities Reserves 20M Deposits 100M Reserves 10M Deposits 90M Loans 80M Bank 10M Loans 80M Bank 10M Securities 10M capital Securities 10M capital 39 If a bank was ample excess reserves a deposit outflow does not necessitate changes in other parts of its balance sheet 917 Copyright 2007 Pearson Addisoanesley All rights reserved LIqUIdity Vlanagement Shortfall n Reserves Assets Liabilities Assets Liabilities Reserves 10M Deposits 100M Reserves 0 Deposits 90M Loans 90M Bank 10M Loans 90M Bank 10M Securities 10M capltal Securities 10M capltal 39 Reserves are a legal requirement and the shortfall must be eliminated 39 Excess reserves are insurance against the costs associated with deposit outflows Copyright 2007 Pearson Addisoanesley All rights reserved 918 Liquidity Management Borrowing Assets Liabilities Resenes 9M Deposits 90M Loans 90M Borrowing 9M Securities 10M BankCapital 10M 39 Cost incurred is the interest rate paid on the borrowed funds 919 Copyrrgm 2007 Pearson Addisoanesiey AH rrgme reserved Liquidity Management Securities Sale Assets Liabilities Resenes 9M Deposits 90M Loans 90M BankCapital 10M Securities 1 M 39 The cost of selling securities is the brokerage and other transaction costs 920 Copyright 2007 Pearson Addisoanesiey All rights reserved Liquidity Management Federal Reserve Assets Liabilities Resenes 9M Deposits 90M Loans 90M Borrow from Fed 9M Securities 10M BankCapital 10M 39 Borrowing from the Fed also incurs interest payments based on the discount rate Copyrrgm 2007 Pearson Addisoanesley All rrgme reserved 921 Liquidity Management Reduce Loans Assets Liabilities Resenes 9M Deposits 90M Loans 81M BankCapital 10M Securities 1 OM Reduction of loans is the most costly way of acquiring resenes Calling in loans antagonizes customers 39 Other banks may only agree to purchase loans at a substantial discount Copyright 2007 Pearson Addisoanesley All rights reserved 922 Asset Management Three Goals Seek the highest possible returns on loans and securities Reduce risk Have adequate liquidity 2007 Pearson Addisoanesley All rights reserved 923 Asset Management Four Tools Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets 2007 Pearson Addisoanesley All rights reserved 924 Liability Management Money center banks found new ways to squeeze better liquidity properties from reserves Expansion of overnight loan markets and new financial instruments such as negotiable CDs Checkable deposits have decreased in importance as source of bank funds 2007 Pearson Addisoanesley All rights reserved 925 Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners equity holders of the bank Regulatory requirement 2007 Pearson Addisoanesley All rights reserved 926 Capital Adequacy Management Preventing Bank Failure When Assets Decline High Bank Capital Low Bank Capital Assets Liabilities Assets Liabilities Reserves 10M Deposits 90M Reserves 10M Deposits 96M Loans 90M BankCapital 10M Loans 90M BankCapital 4M High Bank Capital Low Bank Capital Assets Liabilities Assets Liabilities Reserves 10M Deposits 90M Reserves 10M Deposits 96M Loans 85M BankCapital 5M Loans 85M BankCapital 1M Copyright 2007 Pearson Addisoanesley All rights reserved 927 Capital Adequacy Management Returns to Equity Holders Return on Assets net pro t after taxes per dollar of assets net ro t after taxes ROA P assets Return on Equity net pro t after taxes per dollar of equity capital ROE net pro t after taxes equity capital Relationship between RCA and ROE is expressed by the Equity Multiplier the amount of assets per dollar of equity capital EM 2 Assets Equity Capital net pro t after taxes net pro t after taxes X assets equity capital assets equity capital ROE ROA X EM oopyngm 2007 Pearson Addisoanesley AH ngms vesevved 928 Capital Adequacy Management Safety Tradeoff Benefit safe investment Cost the higher the bank capital the lower the return on equity Choice depends on expectations and level of confidence in said expectations 2007 Pearson Addisoanesley All rights reserved 929 Capital Adequacy Management Regulation Required to hold K reserves by law Basel Accord l 8 mandatory Basel II internal risk mgmt plan VaR 2007 Pearson Addisoanesley All rights reserved 930 Credit Risk Overcoming Adverse Selection and Moral Hazard 39 Screening and information collection 39 Specialization in lending 39 Monitoring and enforcement of restrictive covenants 39 Longterm customer relationships 39 Loan commitments 39 Collateral and compensating balances 39 Credit rationing Copyright 2007 Pearson Addisoanesley All rights reserved 931 InterestRate Risk First National Bank Assets Liabilities Ratesensitive assets 20M Ratesensitive liabilities 50M Variablerate and shortterm loans Variablerate CDs Shortterm securities Money market deposit accounts Fixedrate assets 80M Fixedrate liabilities 50M Reserves Checkable deposits Longterm loans Savings deposits Longterm securities Longterm CDs Equity capital If a bank has more ratesensitive liabilities than assets a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits Copyright 2007 Pearson Addisoanesley All rights reserved 932 Interest Rate Risk Gap Analysis Basic Gap Analysis ratesensitive assets rate sensitive liabilities x A interest rates A in bank pro ts Maturity Bucket Approach measures the gap for several maturity subintervals Standardized Gap Analysis accounts for differing degrees of rate sensitivity Copynght 2007 Peavson Addisoanesley AH ngms vesevved 933 Interest Rate lisk Duration Analysis Duration Analysis A market value of security z percentage point A interest rate gtlt duration in years Uses the weighted average duration of a financial institution39s assets and of its liabilities to see how net worth responds to a change in interest rates Copynght 2007 Peavson Addisoanesley All thts vesevved 934 OffBalanceSheet Activities 39 Loan sales secondary loan participation 39 Generation of fee income Foreign exchange trades on customer s behalf Guaranteeing debt securities Backup lines ofcredit 39 Trading activities and risk management techniques Futures options interestrate swaps foreign exchange Speculation Copyright 2007 Pearson Addisoanesley All rights reserved 935 OffBalanoeSheet Activities oont d Trading activities and risk management techniques cont d Principalagent problem Internal Controls Separation of trading activities and bookkeeping Limits on exposure Valueatrisk Stress testing Copyright 2007 Pearson Addisoanesiey AH rights reserved 936 James Crotty If Financial Market Competition is so Intense Why are Financial Firm Profits so High httpwwwpeopleumasseducrottyWP13 4pdf 2007 Peavson Addisoanesiey Aii tights vesevved 937 Central Bank also has balance sheet Federal Reserve Liabilities billions 2400 2000 Other 1600 Monetary Base BankResewe Balances 1200 800 400 Currency in circulaiion Dec07 Feb08 AprO8 Jun 08 Aug08 Oct 08 Dec 08 Source Federal Reserve Board Dy 9 y g 93933
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