1. Capital Adequacy In addition to reserve requirements,
Reserves/Deposits ≥ “15.5/115.1” calculation
a bank must satisfy a capital adequacy ratio
Capital/“Loans” ≥ h%
where h is from 6 to 12, depending on bank.
A new regulation is that people who start a bank have to buy stock in the bank.
That is, can’t start a bank with completely other people’s money, must now have skin in the game.

2. Loan Multiplier
Example. Assume banking system “fully loaned up”, simplistic k = 20%, and money supply is increased by 5,000.
If banking system proceeds to again become “fully loaned up,” total loans will increase by how much?
Reserves in banking system will increase by how much?
answer 20,000
answer ,000

3. Multiplier Effect (assume “simplistic” k = 20%)
week = 0
5,000 deposit (say, money
from abroad)
Assets Liabilities
loans ,000
reserves 1,000
5,000 deposits
week= 1: new loans create
4,000 more in deposits
Assets Liabilities
loans ,200
reserves 1,800
9,000 deposits
week=2: new loans create
3,200 more in deposits
Assets Liabilities
loans ,760
reserves 2,440
12,200 deposits

4. Banking System Getting Fully “Loaned Up”
week=3: new loans create
2,560 more in deposits
Assets Liabilities
loans ,808
reserves 2,952
14,760 deposits
week=4: new loans create
2,048 more in deposits
Assets Liabilities
loans ,446
reserves 3,362
16,808 deposits
week=5: new loans create
1,638 more in deposits
Assets Liabilities
loans ,757
reserves 3,689
18,446 deposits

5. Banking System Getting “Fully Loaned Up”
week=6: new loans create
_____ more in deposits
Assets Liabilities
loans
reserves
deposits
week=7: new loans create
_____ more in deposits
Assets Liabilities
loans
reserves
deposits . .
week = infinity
Assets Liabilities
loans ,000
reserves 5,000
25,000 deposits

6. Securitization
Securitization is the financial engineering practice of repackaging pools of relatively illiquid assets into much more liquid securities (that are easier to market)

7. Mortgage & Asset Backed Securities
MBSs (mortgage backed securities) are created by a securitization process. They are securities whose cash flows are derived from a pool of mortgages.
Two types of MBSs:
mortgage bonds (created from a pool of mortgages)
CDOs (created from a pool of mortgage bonds)
MBSs can get extremely complicated.
ABSs (asset backed securities) are same as MBSs but cash flows are from a pool of home equity loans, auto loans, student loans, credit card receivables, . . .
Now $1.4 trillion in student loans (but not all have been securitized, i.e., made into ABSs).

8. A Securitization Example
A bank creates a trust, ie, special purpose vehicle (SPV).
Then lends SPV money to buy many loans of a particular type. Go into a pool. SPV then sells bonds, structured into tranches, to investors to pay back bank with proceeds.
Loans in pool pay interest and make principal repayments, which flow through to service the bonds and pay them off.
Bank makes money in several ways including: (1) fees for setting up the SPV, (2) annual fees for operating the SPV, (3) by owning bottommost tranche to claim all residual profit after all higher level tranches have been paid off.

9. Target Rate vs. Actual Sep07 to Sep08
9/22

10. Peak Financial Crisis
03/17/08 Bear Stearns (taken over by JP Morgan Chase and government guarantees)
09/07/08 Fannie Mae / Freddie Mac (conservatorship)
09/15/08 Lehman Brothers (bankruptcy)
09/16/08 AIG (kept alive by US government and Federal Reserve)
09/21/08 Goldman Sachs & Morgan Stanley become bank holding companies
09/25/08 Washington Mutual (receivership by FDIC and then bankruptcy, an S&L that was 6th largest US bank)
12/31/08 Wachovia (at time 4th largest US bank, taken over by Wells Fargo)
01/01/09 Merrill Lynch (saved from failure by being purchased by Bank of America)

11. More Realism to Commercial Bank Bal Sheets
Simplistic
Assets
Liabilities & Capital
Reserves
Loans
DEP
Capital
Less simplistic
Assets
Liabilities & Capital
Reserves
Investments
Loans
DEP
Other borrowings
Capital
9/27

12. Fed Balance Sheet (millions), April 2009
Assets
Liabilities & Capital
Gold & Coin ,107
Loans to depository institutions
Repurchase agreements
US treasury securities ,969
Agency securities ,511
MBS ,590
Term Auction Facility (TAF) ,799
CP Facility ,431
Maiden Lane & related ,163
Other loans ,988
Other ,711
2,198,269
Federal Reserve Notes ,960
Rev Repurchase agreements ,681
Deposits
Depository inst balances ,773
US Treasury ,399
Other ,456
Capital ,000
2,198,269

13. MBS (Mortgage Backed Securities)
MBSs (mortgage backed securities) are created by a securitization process. They are securities whose cash flows are derived from a pool of mortgages.
Two types of MBSs:
Mortgage Bonds (created from a pool of mortgages)
CDOs (created from a pool of mortgage bonds)
MBSs can get extremely complicated.

14. Term Auction Facility (TAF)
As mortgage default problems arose in late 2007, banks began to encounter liquidity problems. Overwhelmed discount window.
In Dec 2007, Fed suspended traditional discount window operations in favor of Term Auction Facility (TAF):
rather than just overnight, made 28 and 84-day loans
accepted other securities, rather than just Treasuries and agency securities, as collateral.
originally for depository institutions, extended to non-bank financial institutions.
no new loans after March 2010

15. CP (Commercial Paper) Facility
Unsecured promissory notes that mature before nine months (270 days).
Proceeds to be used only for operating purposes (inventories, receivables) and not for fixed assets (land, buildings, machinery).
Issued by 600 to 800 corporations.
Sold at discount, mature at par.
Some sold by direct placement, but most sold through dealers .
Dealers charge something like one-tenth to one-eighth of a percent of face value to underwrite an issue for a firm.

16. CP Backup Lines of Credit
Except for a few highly-rated firms, usually not possible for an issuer to sell CP without a backup line of credit.
Backup line of credit is agreement by which a bank will lend an issuer, if needed, the money necessary to redeem maturing paper.
Makes purchasers feel more secure in the event issuer is not able to “roll over” maturing CP (i.e., sell new CP to pay off old CP).
Banks charge 10 to 12.5 basis points (on an annual basis) of par amount for backup lines of credit, then market interest rate if money is actually borrowed.
Average CP maturity is about 30 days
In financial crises, difficult to roll over

17. CP
Rated: prime, desirable, satisfactory. P-1, P-2, P-3 (Moody’s) A-1, A-2, A-3 (S&P’s)
Virtually impossible to sell unrated commercial paper
Advantage of CP: low interest rates
About 30 commercial paper dealers.
There is a secondary market and issuers sometimes buy back their commercial paper. Transaction costs in range of about one-eighth of one percent.
Normal for $1 trillion in CP to be outstanding at any moment.

18. Fed Balance Sheet, September 13, 2017
Assets
Liabilities & Capital
Gold & Coin ,066
Loans to depository institutions
Repurchase agreements
US Treasury securities ,465,458
Agency securities ,757
MBS ,782,346
Term Auction Facility (TAF)
CP Facility
Maiden Lane & related ,708
Other loans Other ,829
4,471,174
Federal Reserve Notes ,533,584
Rev Repurchase agreements ,719
Deposits
Depository inst balances ,360,190
US Treasury ,220
Other ,352
Capital ,109
4,471,174
9/29

19. Open Market Injection of $30 Billion
10/3

20. Technical Factors
Cash drains – increased cash holdings by public decrease banking system reserves. Example:
Suppose system in equilibrium
But people take more money out of their checking accounts than anticipated in advance of a big weekend.
Reduces vault cash
Banks have harder time meeting RRs
Makes Fed Funds rate go up
Fed does repurchase agreements to increase temporarily depository institution reserves
Causes Fed Funds rate to drop
US Treasury transactions can cause shifts in reserves. Fed can offset with calibrated open market transactions (typically ith repos and reverse repos)

21. Velocity of Money Velocity is annual money supply turnover rate.
Velocity * Money supply = GDP
Velocity is difficult to predict.
For given change in money supply, the Fed can expect direction of change in economy, but cannot ensure the degree.

22. Subprime Lending
Although definition varies, subprime lending is to people with a FICO score of less than 640.

23. Subprime Mortgages teaser rates pick-a-pay interest only
no down payment
When rates would reset, told can either sell at profit (because housing prices would go up) or refinance to get another low rate.
But prices went down starting in Couldn’t pay mortgage, couldn’t refinance. Mortgage servicers foreclosed. Mortgage bond holders (many of which were financial institutions) suffered huge losses.
Mortgage bonds became toxic securities (nobody would buy them).

24. Asset-Backed Commercial Paper
In addition to normal commercial paper, there is asset-backed commercial paper (ABCP).
Typical maturities of ABCP a little longer: 90 to 180 days
In run up to financial crisis, issued by up to 1,000 special purpose vehicles to help buy pools of mortgages, car loans, student loans, credit card receivables, etc., but mostly mortgages.
Before financial crisis struck, up to $1 trillion of US ABCP outstanding.
Then couldn’t roll over, so Fed had to step in.

25. A Securitization Example
A bank creates a trust, ie, special purpose vehicle (SPV).
Then lends SPV money to buy many loans of a particular type. Go into a pool. SPV then sells bonds, structured into tranches, to investors to pay back bank with proceeds.
Loans in pool pay interest and make principal repayments, which flow through to service the bonds and pay them off.
Bank makes money in several ways including: (1) fees for setting up the SPV, (2) annual fees for operating the SPV, (3) by owning bottommost tranche to claim all residual profit after all higher level tranches have been paid off.