Dolan, Economics Combined Version 4e, Ch. 20 Economics Combined Version Edwin G. Dolan Best Value Textbooks 4 th edition Chapter 20 The Banking System and Its Regulation

Dolan, Economics Combined Version 4e, Ch. 20 The U.S. Banking System  Banks are financial institutions that accept deposits and make loans  Types of banks:  Commercial banks  Thrift institutions (savings and loans; mutual savings banks; credit unions)  The Federal Reserve System (Fed) is the central bank of the United States

Dolan, Economics Combined Version 4e, Ch. 20 The Balance Sheet  A balance sheet is a financial statement showing what a firm owns and what it owes  Assets are all the things that the firm or household owns or to which it holds a legal claim  Liabilities are all the legal claims against a firm by non-owners or against a household by nonmembers  Net worth, also listed on the right- hand side of the balance sheet, is equal to the firm’s or household’s assets minus its liabilities. In banking, net worth is called capital. Assets Liabilities Net worth The accounting equation: Assets = Liabilities + Net Worth

Dolan, Economics Combined Version 4e, Ch. 20 Balance Sheet of U.S. Banks The principal assets of U.S. commercial banks are loans. The principal liabilities are deposits.

Dolan, Economics Combined Version 4e, Ch. 20 Risks of Banking Types of risk  Credit risk is the risk that loans will not be repaid on time and in full  Market risk is the risk that changes in market conditions will cause a decrease in the value of assets relative to that of liabilities  Liquidity risk is the risk that a bank will have to sell illiquid assets below the value listed on the balance sheet, resulting in a loss Other important terms:  An asset is said to be liquid if it can be used as a means of payment, or quickly and easily converted to a means of payment without loss of nominal value  A bank is said to be insolvent if its liabilities exceed its assets  Reserves are cash or deposits held at the Fed that a bank can draw on to meet liquidity needs

Dolan, Economics Combined Version 4e, Ch. 20 Traditional Banking Traditional banking earned profits with an originate-to- hold strategy  Use funds from deposits to make loans  Hold the loans until they are paid in full  Earn a profit from the difference between interest rates on loans and interest rates on deposits  Hold cash reserves and capital for safety

Dolan, Economics Combined Version 4e, Ch. 20 Traditional Banking: Originate-to-Hold Traditionally, banks rarely sold loans to other investors  No two loans were exactly alike  Bankers needed personal knowledge of their customers  Buyers feared that any loan a bank wanted to sell must be a “lemon” ? ?

Dolan, Economics Combined Version 4e, Ch. 20 The Beginnings of Securitization  Starting in the 1930s, Government Sponsored Entities (GSEs) were created to buy loans from banks  Banks used the funds to make new loans  The GSEs bundled the loans into securities and sold them to investors—a process called securitization

Dolan, Economics Combined Version 4e, Ch. 20 Simple Pass-Through Bonds  Earliest mortgage-backed securities were simple pass- through bonds  Each bond received an equal share of all principal and interest payments on a pool of loans  Each bond shared an equal part of the loss from any default

Senior-subordinate structure  In important innovation was introduction of tiers of bonds with different risk (tranch)  Senior bonds have first priority to receive interest and principal payments, last to bear losses  Subordinate bonds bear the first risk of losses from defaults, stand last in line for income  Mezzanine bonds stand in between  Investors select safe, low-yield senior bonds or riskier, high-yield subordinate bonds according to their appetite for risk

Dolan, Economics Combined Version 4e, Ch. 20 Growing Complexity Over time securitization became more complex. First households and firms borrow from originating banks. The banks then sell the loans to GSEs and other specialized intermediaries, who issue securities divided in "tranches" according to risk Each type of security is rated and then sold to investors, often hedge funds or other institutions, who buy the type of security that best fits their appetite for risk. Investors can further protect themselves against risk by means of credit default swaps which are a form of insurance purchased by the investor.

Dolan, Economics Combined Version 4e, Ch. 20 Perceived Benefits For originating banks  New sources of fee income  No additional capital needed  Reduced credit risk For the economy  Banks can make many more loans because they do not have to hold the loans to maturity on their own books  Credit risk borne by hedge funds, insurance companies, and other investors thought best positioned to bear it  Wide distribution of credit risk makes financial system more stable  Cost of credit reduced for everyone

Dolan, Economics Combined Version 4e, Ch. 20 Housing and Social Policy  In the 1990s, affordable housing received increased attention as a social issue  Why should only the middle class be able buy a home? Why were low-income families excluded?  Banks’ answer: Because loans to low-income households are too risky!  Subprime loans were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy

Dolan, Economics Combined Version 4e, Ch. 20 Standard vs. Subprime Mortgages Standard (prime) mortgages:  Borrowers are expected to repay loan from current income  Lenders profit primarily from interest payments  Borrowers get full benefit of increase in home value or bear full loss from decrease Subprime mortgages  Banks rely on appreciation of home value, not borrowers’ income, for repayment  Lenders profit primarily from fees for origination, servicing, and refinancing  Lenders share benefit from appreciation of home value and risk of loss if value decreases

Dolan, Economics Combined Version 4e, Ch. 20 Standard vs. Subprime Mortgage terms Standard (prime) mortgage terms:  Loan to value ratio usually 80%-90%  Constant fixed rate for full 30- year life of mortgage  No prepayment penalty  Require careful documentation of income and assets of borrower Subprime mortgage terms:  Loan to value ratio up to 100% or even more  Low teaser rate for 2 or 3 years followed by high step- up rate  Large prepayment penalty  May not require documentation of income or assets

Dolan, Economics Combined Version 4e, Ch. 20 Profitable in a Rising Market  Subprime mortgages are profitable to both lender and borrower in a rising market  Borrowers accumulate equity in homes they could not otherwise afford to buy  Lenders extract profit at end of initial 2 or 3 year period in one of three ways  Through prepayment penalties if property is sold or refinanced  Through high step-up interest rates if not refinanced  Through foreclosure in case of default

Dolan, Economics Combined Version 4e, Ch but Risky in a Falling Market In a falling market, subprime mortgages are more likely than prime mortgages to produce losses  Negative equity is more likely because of high initial loan-to- value ratio  Low income borrowers are more likely to default when equity becomes negative  Recovery rates on forced sales of low-quality housing may be low

Dolan, Economics Combined Version 4e, Ch. 20 But house prices never fall, do they?  From 1975 to 2006 house prices never had a nationwide down year  From 2000 on, prices rose far above the historical trend based on gradually rising household incomes

Dolan, Economics Combined Version 4e, Ch. 20 Do Banks Take Excessive Risks? Spillover effects  Failure of one bank may trigger runs on other banks  Failure of one bank may causes losses for counterparties (other financial firms who do business with the bank)  Failure of the banking system damages the nonfinancial economy by interfering with normal flows of credit

Dolan, Economics Combined Version 4e, Ch. 20 Do Banks Take Excessive Risks? Gambling with other people’s money  Conflicts of interest when one party gets the gains and the other party is stuck with the losses  Managers vs. shareholders  Managers vs. traders  Shareholders vs. bondholders  In economic terminology, these are called principal- agent problems

Dolan, Economics Combined Version 4e, Ch. 20 Gambling with your own or others’ money When gambling with their own money, many people choose games like the lottery that  lose most of the time, but not more than they can afford  don’t win often, but have a huge payoff when they do win  These are called positively skewed risks When gambling with other people’s money, the best games are ones that...  win a moderate amount most of the time  rarely lose, but may have really huge losses when they do  Once a big loss comes, the game is over, but the gambler keeps past winnings and someone else bears the cost

Dolan, Economics Combined Version 4e, Ch. 20 Fiduciary Duties of Managers  Financial managers are paid to gamble with other people’s money  In doing so, they have a fiduciary duty to act in their shareholders’ best interests  They should take prudent risks when there is a good chance of a high return for shareholders... ... but they should not put their personal gain ahead of shareholder interests

Dolan, Economics Combined Version 4e, Ch. 20 Fiduciary Duties of Managers  Executive compensation plans are often misaligned with fiduciary duties  Bonuses for short-term performance  Lack of “clawback” (money taken back in case of extraordinary circumstances)  Golden parachutes  Such bonus-based compensation plans cause managers to seek excessively risky strategies

Dolan, Economics Combined Version 4e, Ch. 20 Example of misaligned incentives Strategy A – Prudent, moderate risk  5 quarters of $100 million profit  5 quarters of $10 million loss  10-quarter net for shareholders: profit of $449.5 million  10-quarter result for executive: total bonuses of $500,000 Strategy B – Aggressive, high risk  9 quarters of $200 million profit  1 quarter of $2,000 million loss  10-quarter net for shareholders: loss of $201.8 million  10-quarter result for executive: total bonuses of $1.8 million Strategy B has higher payoff for the executive but lower payoff for shareholders Assume an executive bonus plan that pays 0.1% of net profit each quarter

Dolan, Economics Combined Version 4e, Ch. 20 Tools to Ensure Safety and Soundness Lender of last resort  During a bank panic, banks may be unwilling to lend to one another  Lack of interbank credit causes failure to spread  Central bank makes emergency loans to protect banks from failure – That is the FED in the US System Deposit insurance  During a bank panic, a run may occur because depositors fear only the first in line will get their money back  Government deposit insurance means there is no need for a run – That is the FDIC in the US System

Dolan, Economics Combined Version 4e, Ch. 20 Sources of the Crisis  The housing bubble, financed by subprime lending  Ratings failures and disappearance of liquidity  Regulatory failures

Dolan, Economics Combined Version 4e, Ch. 20 Rehabilitating Failed Banks Three questions for helping failed banks  Who should be helped?  All banks or only failing banks?  Are some too big to fail?  Who should bear the losses?  Shareholders?  Taxpayers?  How should aid be provided?  Carve-out?  Capital injection?

Dolan, Economics Combined Version 4e, Ch. 20 How a Carve-out Works  The government first creates a bank assistance agency (example: TARP)  The bank assistance agency exchanges good government bonds for low-quality financial instruments (“toxic waste”)  If the value of the low-quality instruments turns out to be less than that of the good bonds, the bank assistance agency loses net worth and the financial institutions gain.

Dolan, Economics Combined Version 4e, Ch. 20 How a Capital Injection Works  The bank assistance agency exchanges good government bonds for equity (common or preferred stock) in financial institutions.  Low quality assets stay with the financial institutions  The value of the government’s stock rises or falls depending on what happens to the value of the low-quality assets