Money, Banks, and the Federal Reserve

Money, Banks, and the Federal Reserve
CHAPTER Money, Banks, and the Federal Reserve © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Money Money Means of payment Money supply
An asset widely accepted as a means of payment Means of payment Anything acceptable as payment for goods and services Money supply The total amount of money held by the public © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Money Supply Money supply, M1 Cash in the hands of the public
Checking account deposits Travelers checks Currency and coins held by the nonbank public © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Money Supply Checkable deposits Travelers checks
Accounts held by households and business firms at commercial banks Demand deposits Automatic transfers from savings accounts Travelers checks Specially printed checks that you can buy from banks or other private companies © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The U.S. Money Supply The most basic definition of the U.S. money supply consists of cash in the hands of the public, checkable deposits, and travelers checks. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Money Supply Money supply, M2 M1 Savings deposits
Money market deposits Money market funds Certificates of deposit under $100,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Functions of Money Functions of money Means of payment Store of value
Unit of account A form in which wealth can held A common unit for measuring how much something is worth © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Brief History of the Dollar
Prior to 1790 Each colony had its own currency, the “pound” Different purchasing power 1790, Congress created a new currency, the dollar Merchants and businesses switched immediately to the new dollar The dollar rapidly became the standard unit of account © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Primary means of payment Until the Civil War Paper currency issued by private banks During the Civil War Government issued the first federal paper currency, the greenback Until 1879 1913, the Federal Reserve System © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Federal Reserve System Monetary authority of the United States Creating and regulating the nation’s supply of money Commodity money Precious metals and other valuable commodities Important uses other than means of payment The non-money use is what gave commodity money its ultimate value © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Paper currency Initially - a certificate representing a certain amount of gold or silver held by a bank People were willing to accept paper money: Currency could be exchanged for a valuable commodity such as gold or silver The issuer—either a government or a bank—could print new money only when it acquired additional gold or silver © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Paper currency Today - it is no longer backed by gold or any other physical commodity Fiat money Something that serves as a means of payment by government declaration © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Financial intermediary
A business firm that specializes in brokering between savers and borrowers Commercial banks Savings and loan associations Mutual savings banks Credit unions Insurance companies Some government agencies © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Depository institutions Financial intermediaries
Accept deposits from the general public Lend the deposits to borrowers Largest group: commercial banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Commercial banks
A private corporation, owned by its stockholders, that provides services to the public Largest group of depository institutions Obtain funds mainly by accepting checkable deposits, savings deposits, and time deposits Use the funds to make business, mortgage, and consumer loans © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Balance sheet Bank’s assets Bank’s liabilities
Financial statement showing assets, liabilities, and shareholders’ equity at a point in time Bank’s assets Everything of value that it owns Bonds, loans, reserves Bank’s liabilities The amounts that the bank owes Checking account deposits, bank borrowing © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Balance Sheet of Mid-Size National Bank
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Bond Loan A promise to pay back borrowed funds
Issued by a corporation or government agency Loan An agreement to pay back borrowed funds Signed by a household or non-corporate business © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Reserves Required reserves
Vault cash plus balances held at the Fed Required reserves Minimum amount of reserves a bank must hold Depends on the amount of its deposit liabilities Required reserve ratio, RRR The minimum fraction of checking account balances that banks must hold as reserves © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Banking System Excess reserves Shareholders’ equity
Reserves in excess of required reserves Shareholders’ equity The difference between total assets and total liabilities A balance sheet always balances © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Federal Reserve System
Central bank A nation’s principal monetary authority responsible for controlling the money supply England: 1694 France: 1800 The United States: 1913 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12 Federal Reserve districts It is not part of any branch of government Was created by Congress Could be eliminated by Congress if it so desired President and Congress Appoint key officials in the system © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 The Geography of the Federal Reserve System
The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Board of Governors Seven members Appointed by the president Confirmed by the Senate For a 14-year term Chairman One of the seven governors Approved by the with Senate 4-year term © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12 Federal Reserve Banks Each - supervised by nine directors Three - appointed by the Board of Governors Six - elected by private commercial banks Each – a president Chosen by the directors © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 The Structure of the Federal Reserve System
Principal decision-making power at the Fed is vested in the Board of Governors, who are appointed by the president and confirmed by the Senate. Monetary policy is set by the Federal Open Market Committee, which consists of the seven governors plus five of the presidents of Federal Reserve Banks. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Federal Open Market Committee (FOMC) A committee of Federal Reserve officials that establishes U.S. monetary policy All seven governors of the Fed Five of the twelve bank presidents Discount rate The interest rate the Fed charges on loans to banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The functions of the Fed Supervising and regulating banks Acting as a “bank for banks” Issuing paper currency Check clearing Guiding the macroeconomy Dealing with financial crises © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Fed and the Money Supply
Open market operations Purchases or sales of bonds by the Federal Reserve System The primary way the Fed increases or decreases the money supply Open market purchase Fed buys government bonds Money supply increases © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assumptions Banks never hold excess reserves Households and businesses do not withdraw or deposit cash Required reserve ratio is 0.1 For each $1,000 increase in deposits at a bank, its reserves must rise by $100 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Fed purchases government bonds The Fed buys $100,000 worth of bonds from Acme Bond Company Has its own checking account with Mid-Size National Bank Result: The Fed injected $100,000 in reserves into the banking system The money supply already increased by $100,000 (checking accounts) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in Mid-Size’s balance sheet: Mid-Size National Bank $10,000 required reserves $90,000 excess reserves Lends $90,000 to Paula She deposits the check in her checking account at Second-Bank © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

New changes in Mid-Size’s balance sheet: From beginning to end, net changes on Mid-Size’s balance sheet: © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Second Bank $90,000 checking account $9,000 required reserve $81,000 excess reserves Lends out the excess reserves Changes in Second Bank’s balance sheet: © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Effects of a $100,000 Open Market Purchase

Money multiplier =1/RRR The number by which we multiply the injection of reserves to get the total change in the money supply Where RRR is the required reserve ratio Δ Money Supply = Δ Checking Deposits = [1/RRR] ˣ Δ Reserves © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Open market sale Fed sells government bonds Money supply decreases The Fed sells government bonds The Fed now sells $100,000 in government bonds to Acme bond dealers Acme will pay with a $100,000 check drawn on its account at Mid-Size © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in Mid-Size National Bank’s balance sheet Mid-Size National Bank Total reserves decreased by $100,000 Required reserves decreased by $10,000 Deficient reserves $90,000 Calling in loans: $90,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in Mid-Size’s balance sheet A withdrawal of reserves Is a negative change in reserves Provisos about the money multiplier Changes in the public’s cash holdings Increased reserve holdings © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Fed actions that change the money supply Changes in the required reserve ratio Changes in the discount rate Changes in the interest rate on reserves © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the required reserve ratio Lower the required reserve ratio Increase in money supply Increase the required reserve ratio Decrease in money supply The Fed cannot count on the effectiveness of this tool © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the discount rate Lower discount rate Encourages banks to borrow more Increase the money supply Increase the discount rate Decrease the money supply Banks are hesitant to borrow from the Fed Little effect on bank borrowing, bank reserves, or the money supply © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the interest rate on reserves The Fed began paying interest on reserves (IOR) in 2008 Reduced bank’s opportunity cost of holding reserves If the Fed lowers the IOR rate The opportunity cost of holding excess reserves rises Encourage bank lending Increase the money supply © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banking Panics Fractional reserve system Bank becomes insolvent
A system in which banks hold only a fraction of their deposit liabilities as reserves Bank becomes insolvent When its total assets are less than its total liabilities Bank failure When an insolvent bank goes out of business © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Bad Loans Cause Mid-Size Bank to Become Insolvent

Banking Panics Run on the bank Banking panic
An attempt by many of a bank’s depositors to withdraw their funds Banking panic A situation in which depositors attempt to withdraw funds from many banks simultaneously © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Bank Failures in the United States, 1921–2011
The bank failure rate was high even after the Fed was created in It peaked when a major banking panic struck during the Great Depression and a large number of banks failed. The creation of the Federal Deposit Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the financial crisis of 2008–2009, bank failures were far fewer than in the 1930s. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banking Panics Banking panics
Would force many banks to “close their doors” (be unable to honor their depositors’ requests for funds) Even if they were solvent Were largely eliminated after 1933 Federal Reserve - ready to inject reserves into the system more quickly in a crisis Federal Deposit Insurance Corporation: reimburse those who lose their deposits Increased government regulation of banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banking Panics Bank regulation
Continuous monitoring of their financial condition Focus on the shareholders’ equity Legal capital requirements: Banks must hold a significant percentage of their assets as bank capital Encourages banks to lend responsibly © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banking Panics Bank capital Capital ratio
Another name for shareholders’ equity in a bank Capital ratio A bank’s capital (shareholders’ equity) as a percentage of its total assets © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banking Panics Higher capital ratios
Greater incentives to avoid risky loans Reduces the likelihood of bank failures that pass losses onto non-owners Reduce the amount of interest-earning assets a bank can hold for each dollar of capital that the owners have invested Reduces the rate of return to the bank’s owners Discourages people from forming or investing in banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Shadow Banking System
Non-bank A financial intermediary less strictly regulated than a bank And with no government-guaranteed deposits Shadow banking system The entire collection of non-bank financial intermediaries © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Non-banks share four characteristics: 1. Short-term liabilities 2. Long-term assets 3. Liabilities do not include government-insured deposits 4. Not closely regulated by government © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

During the 1990s and 2000s The shadow banking system grew larger, more complex, and more interconnected with the regular banking system When the financial crisis hit It became clear that bank regulations had not struck the right balance Financial institutions around the world failed Governments had to come to the rescue © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Crisis of 2008
2007 The collapse of housing prices Followed by a recession In 2008 The United States and dozens of other countries experienced a financial crisis Major disruption of the financial system Seriously affected lending and other financial services © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

When the crisis ended Preliminary estimates of total losses in asset values at U.S. banks: well beyond $1 trillion With at least another trillion lost in banks outside the U.S. Banks Invested heavily in mortgages and mortgage-backed securities © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How did these losses come about? With the collapse of housing prices and declining incomes income Millions of homeowners began to default on their mortgages No one wanted to buy mortgage-backed securities at prices even close to their previous value Bank capital declined © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

As bank capital declined, banks had three choices: 1. Acquire more capital by issuing and selling new shares - unappealing 2. Reduce the risk of their assets Sell risky assets and replace them with safer ones Banks tried to do this all at the same time 3. Wait and hope © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Wait-and-hope strategy By many banks (U.S., around the world) Exploited existing leeway in accounting rules Side effect: Reluctance to lend to banks in general Banks would have to sell even more assets to pay back the debts coming due Causing the market value of the assets to fall further FDIC: banks avoided a “banking panic” © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 The Downward Spiral for Banks

Financial crisis of 2008, non-banks Mortgage-backed securities declined in value Causing a drop in capital (shareholders’ equity) Fearing these institutions might fail, lenders would only lend to them for very short periods and at very high interest rates © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial crisis of 2008, non-banks The institutions had to continue paying off short-term debts Pay very high interest rates to roll over their debt Or sell assets at fire-sale prices Either option reduced their capital further © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Non-banks No insured deposits, only short-term debt Cannot use the “wait-and-hope” strategy Not closely regulated Held very little capital relative to their assets Were very highly leveraged September 2008 One of the largest non-bank, Lehman Brothers, declared bankruptcy © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Non-banks The flow of credit to non-banks ceased Only option to pay back debts: sell their assets at fire-sale prices And watch their capital disappear Asset prices Fell further © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 How Non-Banks Contributed to Problems for Banks

Events in the shadow banking system infected the regular banking system Non-banks held many of the same assets as the banks Intensified the fire sales of assets Causing their prices to fall even further Worsened capital at the banks Many banks had extended loans to the non-banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bank Failures and Government Rescue
The Federal Reserve Emergency loans to financial institutions Various policies designed to boost the prices of mortgage-backed securities October 2008, Congress approved the Troubled Asset Relief Program (TARP) Authorized the government to purchase $700 billion in mortgage-backed securities and similar assets Repurposed! © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The government used TARP funds to buy shares of stock Banks A major non-bank (the insurance company AIG) A major automobile company (General Motors) In the end, the government used less than $400 billion of the $700 billion © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

TARP Losses: less than $25 billion Government’s shares rose in value Helped restore confidence in some of the nation’s largest banks and financial institutions Helped to keep the financial system running Prevented the recession from being even worse than it was © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Dodd-Frank Act The Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010 To prevent the need for another TARP-like rescue in the future Extended the regulatory power of the Federal Reserve Enabled the Fed to impose minimum capital ratios on any financial institution Bank or non-bank © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Dodd-Frank Act Created the Financial Stability Oversight Council Collect information from financial institutions Identify threats to the financial system Formulate policies to avert them Focused on regular banks Investments – more closely monitored New restrictions on risky lending and high-risk financial trading © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital and Leverage at Financial Institutions
Simple leverage ratio (for an asset owner) = Value of asset / Equity in asset Financial institutions’ simple leverage ratio = Total assets / Shareholder’s equity Leverage ratio Acts as a “rate-of-return” multiplier © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The greater the leverage ratio The more interest-earning assets the bank can acquire with each dollar of its capital (shareholders’ equity) The greater the return it can earn for its shareholders © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Deleveraging The process of reducing leverage Reducing the risk to your capital from any further declines in asset prices Lower leverage ratios Sell off assets rapidly Increasing capital © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Money, Banks, and the Federal Reserve

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Money, Banks, and the Federal Reserve

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