1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich

2 Lecture 10: October 15 Ch. 10

3 Creation of Eurocurrencies Bombardier sells US$46 M CRJ-900 to Jet Airways – Jet pays initial deposit of US$10 M by check drawn on U.S. bank branch in Mumbai (Citibank) Options for Bombardier –Convert to C$ at current spot rate (E) –Keep US $ (required for purchases of engines, avionics, consulting services, etc.) Buy US TBs Buy CD from US bank Buy Euro-US dollar deposit from Royal Bank branch in Montreal –Only this option leads to creation of Eurodollar deposit – no change in US money supply

4 Creation of Euro-US Dollars Bombardier –Asset: US$ Deposit with RB (Montreal) –Liability: US$ customer advances Jet Airways –Asset: US$ customer advance –Liability: US$ loan from Citi Citi (Mumbai) –Asset: US$ Loan to Jet Airways –Liability: US$ Loan from Citi (NY) Citi (NY) –Asset: +US$ Loan to Citi (Mumbai) –Asset: -US$ Deposits with Fed Royal Bank (Montreal) –Asset: US$ Deposit with DB (Frankfurt) –Liability: US$ Deposit of Bombardier Deutsche Bank (Frankfurt) –Asset: US$ Deposit with JPMorgan Chase (NY) –Liability: US$ Deposit of RB JPMorgan Chase (NY) –Asset: US$ deposits with Fed –Liability: US$ Deposit of DB

5 Vulnerabilities Absence of regulatory oversight Inter-bank lending (as in preceding example) – hierarchy of banks –“Offshore” bank in turn lends to another bank – interest rate on Eurodollar deposits increases as the money moves up the hierarchy of banks Potential for money laundering –At top of the hierarchy, much greater default risk than at bottom –If bank or ultimate borrower at top defaults, default could create domino effect – Royal’s exposure may be much different because of interbank lending Consider structure of CDOs, credit default swaps

6 Counter-Party Risks Derivatives –Exchange traded – rules, collateral –Private transactions – no rules (other than contracts), no collateral (other than specified in contracts) –CDS –Other risks related to assumptions entered into black boxes

7 Domestic Safeguards Deposit insurance Reserve requirements Capital requirements and asset restrictions Bank examination Lender of last resort facilities – central bank Government-organized bailout Difficulties in regulating international banking

8 Interdependence of Financial Markets Bubbles and collapses Herd effects – equilibrium and overshooting/undershooting Diversification – geographic, industry, asset class: purpose of diversification Contagion effects – spreading of economic shocks: open vs. closed financial markets –Is geographic diversification possible?

9 Interdependence of Financial Markets “We have more complexity today because of the sheer size of the capital markets and the presence of new and unpredictable players” (Robert Bruner, Dean of the business school at the U. of Virginia in Charlottesville) –Complex financial instruments: new generations of derivatives –Increasing use of leverage –New institutions: hedge funds –Globalization –Ineffective regulations –Rapid movement of capital

10 Financial Crisis 1 Rocket scientists, derivatives and a free lunch Banks: more money in fees than direct lending Investors: searching for higher returns without more risk –Money for nothing and the ….. for free Leverage Shadow banking system Greed, trust, uncertainty Absence of regulatory oversight Central banks did not appreciate degree of interdependence between Lehman and all major financial institutions

11 Financial Crisis 1 Fed: –Widespread declines in underwriting standards –Breakdowns in lending oversight by investors and rating agencies –Increased reliance on complex and opaque credit instruments that proved fragile under stress –Unusually low compensation for risk-taking

12 St. Bernanke: Time Magazine Person of the Year Innovations – quantitative easing –Provision of short-term liquidity to banks and other depository institutions and other financial institutions –Provision of liquidity directly to borrowers and investors in key credit markets –Expanded traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities –Interest on reserve balances with Fed

13 Traditional Balance Sheet Assets Aug/07) U.S Treasury securities: $791 B Gold, SDRs, other: $83 B Total: $874 B Liabilities Aug/07) Currency in circulation: $814 B Bank deposits: $17 B Treasury balance: $5B

14 Changes in Fed Balance Sheet: August 1, 2007 to December 17, 2008 Assets Treasury securities: +$340B Mortgage-backed securities: +$18B Lending to banks: +$538B Credit extended to AIG: +$82 B Lending to primary dealers: +$47B Lending for purchase of Commercial Paper: +$346B Assets purchased from Bear Stearns: +$27B Swaps with central banks: +$572B Total: +$1.4 T Liabilities Currency in circulation: +$64B Bank deposits: +$785B Treasury cash deposits: +$475B

15 Current Balance Sheet Assets 08/12/15 US Treasury securities: $2,461 B Mortgage-backed securities: $1,735 B Federal agency debt securities: $35 B Gold: $11 B Foreign currency denominated assets: $20 B Total: $4.5 T 08/12/15 Currency in circulation: $1,375 B Reverse repurchase agreements: $244B Bank deposits: $2,559 B

16 Financial Crisis 1 US Treasury allocated US$700 B to buy troubled assets from banks US$250 B used instead to invest in capital of banks –Earned profit on investments –“Bailout of Wall Street” needed to prevent collapse of Main Street US$85 B used to bailout AIG and counter-parties to about US$400B in CDS sold by AIG Investments in GM and Chrysler