Money and Banking
Money and Banking ECON 3115
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This 11 page Class Notes was uploaded by Abraham Schoen on Sunday October 25, 2015. The Class Notes belongs to ECON 3115 at University of North Carolina - Charlotte taught by Benjamin Russo in Fall. Since its upload, it has received 23 views. For similar materials see /class/229021/econ-3115-university-of-north-carolina-charlotte in Economcs at University of North Carolina - Charlotte.
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Date Created: 10/25/15
ECONTest 3 Study 1252010 30600 PM Chapter 9 1 Commercial Bank Balance Sheets Leverage and Risk Assets bank reserves government securities bank loans Liabilities bank deposits funds borrowed from commercial banks and other financial institutions including but not limited to the Federal Reserve Bank BCA L Must be positive for the bank to continue operating if negative bank is insolvent The amount of BC relative to A determines bank leverage everage is the use of borrowed funds to increase the amount of funds invested It increases the return on assets and increases the risk that a bank will become insolvent BC has 2 main sources equity shares outstanding and retained earnings In the US if the BC falls below 2 the FDIC closes down the bank CFPl The fundamental activity of banks in borrowing Short term funds from savers and lending those funds long term This transfer is My because the bank requires leverage Bank borrowing is short term and lending is long term Bank deposits can dissipate quickly g Interest Rate Risk which increases with maturity and 4 Borrowers may default A measure of leverage is the equity multiplier The larger EM the larger the return on bank capital the larger the risk the bank will become insolvent EM A A L II A Definition of Selective History of Financial Crisis Financial CrisisA major disruption in the financial system characterized by sharp declines in asset prices and the failures of many financial and non financial firms Influence of Wealth in Imperial Rome AD33 A number of large trading enterprises failed causing a run on banks Tiberius ended the panic by ordering funds to be withdrawn from the treasury and distributed to bankers Tulip Mania 1637 People started buying tulips for their investment value Mackay said that tulips sold for more than 20x39s the annual income of a skilled craftsman The bubble busted and ruined many investors because of the fall in prices and Dutch commerce declined severely The South Sea Bubble 17111717 The South Sea company had trading rights for goods imported to England from South America in order to fund the English Governments Debt Many of the holders exchanged their debt for a new issue of stock that no one knew what it was asymmetric information and the prices rose and then dropped dramatically US debt to cover the Revolutionary War1791 18 million of debt which was attractive to investors Rumors spread about the solvency of NY banks in attempt to drive down banks value Prices of Government bond dropped 25 Hamilton ended the panic by ordering the treasury to borrow from commercial banks and buy back government bonds Bankers Panic of New York 1907 Retraction of liquidity by a number of banks in NYC lost confidence among depositors and the Stock Market declined greatly Local banks and business went bankrupt Morgan convinced banks to pool capital which restored confidence and the Fed was created in 1913 The Great Depression 19291933 Most sever depression to record Real GDP declined by more than 25 in 5 years Prices on the stock market doubled Stock Market crashed on Oct 291929 The Fed raised interest rates to protect the value of the dollar There was a run on banks and the Fed allowed the banks to fail Price level declined creating debtdeflation and more defaults The price of real assets declined along with everything else and unemployment increased The congress created the Federal Home Loan Bank System which created liquidity Also created the Reconstruction Finance Corporation which lend funds to banks The Home Owners Loan Corporation bought defaulted mortgages The Great Depression saw 1 Creation of FDIC 2 Creation of SEC 3 The GlassStegall Act which put limits on bank interest rates precluded banks from owning corporate bonds and common stock and prevented commercial banks from investment banking apanese Liberalization 1980 Yen appreciated greatly accelerating increases in real estate and stock prices Banks granted risky loans and the real estate bubble burst Many banks became insolvent and the regulators allowed the banks to continue operating regulatory forbearance The collapse was going on for more than a decade One of the worst yet US Savings and Loan Crisis 19801990 DIDMCA permitted SampL39s greatly increased loans for small business and commercial real estate all which increased risk SampL officers weren39t qualified to evaluate risk so the legislation reduced government financing of SampL regulation There was a huge moral hazard with regulatory forbearance here The Economic Recovery and Tax Act of 1982 reduced personal income tax and liberalized asset depreciation So SampL lending leverage and risktaking increased rapidly Regulators chose regulatory forbearance SampL39s losses were nearly 40billion The industry never fully recovered Southeast Asian Financial Crisis 1997 Thailand borrowed from abroad to finance real estate boom Loan contract had to be paid back in dollars Thailand devalued its currency which lead to an wholesale run which led to the crisis The decline in currency increased the real value of debt repayment debtdeflation III Causes of Financial Crisis Financial Crises can lead to high interest rates low national production and high unemployment They harm the economy as a whole Triggers of Financial Crises Increase in Interest Rates increase AS savers and banks lend less asset prices decline interest rates increase again creating a vicious cycle Increases in uncertainty increase in the probability of loan defaults which causes AS and causes interest rates to rise Asset price declines lower security prices causes net worth to decline which is debtdeflation Real DebtDP Defaults make loans worthless Deterioration in financial institutions balance sheets which reduces bank lending turmoil reduces BC Banks borrow short and lend long IRR Decline in security prices increases MH Government fiscal imbalances banks buy very large amounts of government securities Financial Liberalization result of deregulation Bursting of an Asset Price Bubble Factors that trigger financial crises are interwoven See P 6 D Debtdeflation does not require an actual decline in prices to damage It can occur if actual inflation declines even in general level of prices increases Interest rates can rise without damaging the economy IV The Financial Crisis of 0708Chronology 20022006inflation in US house prices 2006 Nominal house prices declined 2007 AprilNew Century Financial declared bankruptcy June Bear Stearns collateralized a loan of up to 32 bilion to bailout a hedge fund it owned which prompted a markdown of similar assets July Bear Stearns disclosed 2 subprime hedge funds had lost all of their value House price increase in the US triggered in the mortgage market everywhere 2007August BNP in France announced large losses on subprime mortgages causing a loss of confidence in the US and the FFR spiked up well above the Feds 525 target 2007September Run on Northern Rock Bank in the US and Fed reduced its target FFR by January it was down to 3 Term Auction Facility made bank reserves available through auctions as opposed to the open market Bear Sterns near death experience the investment bank borrowed in the short term markets to invest in subprime securities They had taken on great amounts of leverage investors lost confidence in his ability to keep operating in March of 08 There was a run on the bank and rumors spread about Bear being a selffulfilling advisor The Fed stepped in and gave a long to JP Morgan Chase to buy Bear Stern In July of 08 IndyMac Bank the largest mortgage lender in the US collapsed It39s assets were seized by the FDIC Fanny Mae and Freddie Mac required 250 billion in loan guarantees from the Fed government September 7th government placed Fannie Mae and Freddie Mac in conservatorship which means that the government effectively took control In early September there was also a run on Lehman Brother and they declared bankruptcy on Sept 15th On Sept 16th the Fed provided with an 85 billion dollar loan The public lost confidence in the money market mutual funds The Reserve Primary mutual fund fell below 1 in share value And a run began in the money market On September 17th the money market mutual funds lost 200 billion dollars And that led to withdrawals from Washington Mutual and Wachovia Bank which were both heavily involved in the subprime mortgage market Bank of America purchased Merrill Lynch The biggest bank failure in US history occurred on September 2th when JPMorgan Chase agreed to purchase the banking assets of Washington Mutual In danger of failure on October 2nd Wachovia sold itself to M Fargo Bank V The Financial Crisis of 0708Contributing Factors The Bursting of the US House Price Bubble in 2006 Lower house prices reduced bank capital and the banks attempted to restore capital by issuing new equity or reducing relatively risky loans This decline in prices increased uncertainty making investors less willing to provide equity Then there was falling asset prices and uncertainty and then that just repeated The the 198039s the Fed denied bank merger applications of banks deemed not to have conformed to the 1977 Community Reinvestment Act This may have reduced lending standards The 1986 basel Accord tends to increase risk in the banking system The Basel Accord is an international banking regulatory agreement that creates risk adjusted capital requirements designed to reduce the risk of bankruptcy So some banks might of removed risky assets off their balance sheet and reduce banks risk causing external risk which is much harder to evaluate than internal risk The emergence of credit default swipes a contract that a bond owner buys to protect against default on a bond bond insurance which leads to moral hazard Fannie Mae and Freddie Mac mandates to increase purchases of mortgages with lower qualities for affordable homes Which was risktaking when they could of avoided risk which reduced lending standards Securitization of Mortgages decreased the risk to the individual mortgage provider Although the providers could increase profits by reducing lending standards and passing off the risk to FMFM Gary Gorton attributes to crisis to policy makers desire to increase subprime lending and bankers innovations designed to satisfy policy makers Here are his THREE arguments The riskiness of subprimes was not evaluated properly This led to collateral calls and fear of lending Securitization process banks bought subprime mortgages which they then bundled into CDO39s then bundled into Collateralized Debt securities Which caused information loss and unknown risk This led to a run on offbalance sheet vehicles and hedge funds which has purchased the securities Economic Theory basis of Moral Hazard banks issued riskier mortgages and made large fees by securitizing subprimes and didn39t think they would suffer directly from the risk SampP and Moody39s assigned high ratings to securitized mortgages and loans that were downgraded which reduced the perception of risk In the early 200039s productivity was high interest rates were low which leads to increased risk but decreased perception of risk because the cost of capital is reduced The reasons for low interest rates are as follows Decreased risk Increase in availiability of funds and low FFR Perceieved decrease in risk from CDSs increase in securitized mortgages high productivity growth and low long term interest rates encouraged speculative buying of homes The selffullfilling prophecy then set it Lower asset prices shifted attention to a renewed evaluation of risk Bank capital was reduced which caused downward pressure on asset prices This was a vicious cycle Negative cycle is exerbated by the markettomarket accounting rule introduced by SarbanesOxley in 2002 They require firms to adjust asset prices on the books to current market values Part of the problem was contributed to lax regulatory oversite In the Fall of 08 the US faced the results of a quotperfect stormquot it appears that all factors share in the quotcreditquot Chagter 11 Economic Analysis of Financial Regulation 1 Nine Categories of Commercial Bank Regulation o Commercial Bank Safety Net 0 The National Banks have the Fed as their lender of last resort The FDIC guarantees deposits of National Banks if they are failing Deposit insurance is important for the safety net Deposit insurance succeeded until the 0708 financial crisisThe banks safety net creates moral hazard adverse selection and contributes to the quottobigtofailquot syndrome when gov39t is forced to bail out a band bc the FI has become so large that it going out of business will effect other FI39s o Restrictions on Bank Assets 0 To reduce risktaking by commercial banks banks are prohibited from owning corportate bonds and common stock of publicly traded assets o Capital Reguirements 0 BC reduces banks Return on Equity Banks have incentive to keep BC at a minimum BC reduces risk Leverage ratio is a measure of BC Must have 5 Prompt Corrective Action 0 FDIC requires banks to develop and report plans to increase capital Chartering and Examination 0 Charter legal document granting the charter applicants rights to operate a bank Required Bank examiners examine CAMELS capital adequacy asset quality management quality earnings liquidity and sensitivity of bank capital to market risk Assessment of Risk Management 0 Assessment of board of directors risk quality of risk internal controls preventing and detecting fraud Stress tests evaluate whether extreme adverse conditions would cause a bank to become insolvent Disclosure Requirements 0 Disclose information that enables shareholders to assess risk and expected return Consumer Protection 0 Laws and regulations to protect consumers from unscrupulous banking practices CPAannual percentage rate Restrictions on Competition 0 Economic definiton of competition no individual firm or consumer has the ability to influence market prices 0 Finance definition of competition designed to increase market share 0 Both restricted too much risk 0 SUMMARY OF ALL CATEGORIES ON 04 10 11 Banking Crises Around the World PrincipalAgent Problems fall into this pattern 0 Financial Deregulation 0 Increased Competition for market share 0 Increased Adverse Selection and Moral Hazard o Decreased risktaking 0 Banking Crisis 111 Capital Requirements and the Basel Accord Basic requirement is the Lower limit on ratio of common equity to bank assets leverage ratio 1988 Basel Accord 1 introduced quotriskweightedquot capital requirements Which increase with the proportion o risky assets a bank owns Tier 1 and Tier 2 capital ratios Tier 1 the sum of retained earnings and the book value of shareholder equity including preferred stock Must maintain 4 Tier 2Assets that are riskier than tier 1 subordinated debt 8 Basel II altered the definitions of risky assets by adding Core Tier 1 which includes tangible common equity which excludes preferred equity and intangible assets Basel 111 goes into effect after 2012 requires a core tier one of 45 and a conservation buffer of 25 The tier one capital ratio is raised to 6 with the same buffer Tier 2 must be at least 8 with a 25 buffer The conservation buffer is new IV Major Provisions of the DoddFrank Wall Street Reform and Consumer Protection Act of 2010 Possibly the largest financial reform in the US since the great depression Very complicated200 rules will be developed over the next couple of years Major Provisions 1 Creation of the Financial Services Oversight Council to coordinate financial regulation Trying to prevent risk in the banking sector and prevent the too bigtofail syndrome FSOC can increase capital requirements 2 Establish a Federal Insurance Office within the Treasury to monitor the insurance sector to prevent insurance companies from putting banks at risk AIG regulation 3 Broaden Authority of SEC to regulate hedge funds and credit rating agencies 4 Restricts banks ability to invest and trade on their own accounts They can39t operate like hedge funds Volker rule 5 Creates Office of Credit Ratings to monitor the rating agencies and publish performance evaluations 6 Create bureau of Consumer Financial Protectionfinanced by the Fed 7 Others The Office of Thrift Supervision is abolished Financial Holding Companies that own banks cannot sponsor hedge funds glassstegall act Morgtage backed Securities must retain 5 of securities default risk and Finance firms must post collateral for derivatives they sell and permanently increase the FDIC deposit insurance to 250000 for each bank dep0sit0r which decreases the probability of bank runs and increases moral hazard 1252010 30600 PM 1252010 30600 PM
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