Chapter 20 The Banking System and Its Regulation Introduction to Economics (Combined Version) 5th Edition

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. Introduction to Economics (Combined Version) 5th Edition

What is a 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 Introduction to Economics (Combined Version) 5th Edition

Balance Sheet of U.S. Banks  The principal assets of U.S. commercial banks are loans. The principal liabilities are deposits. Introduction to Economics (Combined Version) 5th Edition

Some 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. Introduction to Economics (Combined Version) 5th Edition The ability to withdraw cash from ATM machines helps to keep bank deposits liquid

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. Introduction to Economics (Combined Version) 5th Edition Homeowners who cannot repay their mortgages are one source of credit risk for banks

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. Introduction to Economics (Combined Version) 5th Edition

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”. Introduction to Economics (Combined Version) 5th Edition ? ?

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. Introduction to Economics (Combined Version) 5th Edition

Securitization  Securitization begins when customers borrow from banks.  The bank sells the loan to an intermediary that issues securities based on a pool of many such loans.  Each security receives a rating from a rating agency.  The resulting securities are then sold to investors. Introduction to Economics (Combined Version) 5th Edition

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 mortgages were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy. Introduction to Economics (Combined Version) 5th Edition

However, Subprime Mortgages Proved 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. Introduction to Economics (Combined Version) 5th Edition

The Golden Age of Finance  Easy availability of credit and changing social attitudes changed the behavior of U.S. consumers during the late 1990s and early 2000s.  Household debt—including mortgage debt, credit card debt, and other forms of debt—rose to 98 percent of GDP.  With credit so cheap and easy to get, saving almost disappeared. Introduction to Economics (Combined Version) 5th Edition

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. Introduction to Economics (Combined Version) 5th Edition

Do Banks Take Excessive Risks? Gambling with Other People’s Money  Conflicts of interest can arise 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. Introduction to Economics (Combined Version) 5th Edition

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 and  don’t win often, but have a huge payoff when they do win.  These are called positively skewed risks. Introduction to Economics (Combined Version) 5th Edition When gambling with other people’s money, the best games are ones that...  win a moderate amount most of the time, or  rarely lose but may have really huge losses when they do.  Once a big loss comes, the game is over; the gambler, however, keeps past winnings and someone else bears the cost.

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. Introduction to Economics (Combined Version) 5th Edition  Executive compensation plans are often misaligned with fiduciary duties.  Bonuses for short-term performance  Lack of “clawback”  Golden parachutes  Such bonus-based compensation plans cause managers to seek excessively risky strategies.

Example of Misaligned Incentives: Strategy A  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  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 Introduction to Economics (Combined Version) 5th Edition 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

 Safety and Soundness: Bank Examinations  Bank examinations are the oldest tool for ensuring the safety and soundness of the banking system.  These examinations, conducted by state or federal officials, are intended to ensure that banks do not make unduly risky loans, that they value their assets honestly, that they maintain adequate levels of net worth and liquid reserves, and that they have competent management. The “CAMELS” Checklist for bank examiners: Is there adequate capital? Are assets of high quality? Is management competent? Are earnings reliable? Is there adequate liquidity? Is there too much sensitivity to market risk? Introduction to Economics (Combined Version) 5th Edition

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. 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. Introduction to Economics (Combined Version) 5th Edition

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?  Capital injection?  Carve-out? Introduction to Economics (Combined Version) 5th Edition Bailouts of big banks have been a source of great political controversy.

Additional Slideshows Introduction to Economics (Combined Version) 5th Edition More classroom-ready slideshows on banking and bank regulation: Tutorial on Bank Failures and Bank Rescues defines the terms and illustrates the concepts needed to understand banking crisis like Cyprus, Ireland, Iceland, etc. What Is Basel III and Why Should We Regulate Bank Capital? explains the importance of the Basel III rules and uses simple balance sheets to illustrate the importance of regulating bank capital. Updated in March 2013, this classic has been the most viewed of all my slideshows.What Is Basel III and Why Should We Regulate Bank Capital? More on Basel III: Regulating Bank Liquidity is a companion to the preceding slideshow and was also updated in March 2013.More on Basel III: Regulating Bank Liquidity If you have trouble with the links on this slide, check the index of slideshows on Ed Dolan’s Econ Blog, (dolanecon.blogspot.com)