1. 17 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Money, Banking, and Financial Institutions 9

2. 9-2 Functions of Money Medium of exchange Used to buy/sell goods Unit of account Goods valued in dollars Store of value Hold some wealth in money form Liquid LO1

3. 9-3 Money Definition M1 M1 Currency Checkable deposits Institutions offering checkable deposits Commercial banks Savings and loan associations Mutual savings banks Credit unions LO1

4. 9-4 Money Definition M2 M2 M1 plus near-monies Savings deposits including money market deposit accounts (MMDA) Small-denominated time deposits Money market mutual funds (MMMF) LO1

5. 9-5 Money Definitions Source: Federal Reserve System LO1 Savings deposits, including money market deposit accounts 61% Money market mutual funds 8% Small time deposits 9% M1 22% Currency 50% Checkable deposits 50% Money supply, M1 $1935 billion Money supply, M2 $9001 billion

6. 9-6 What “Backs” the Money Supply? Guaranteed by government’s ability to keep value stable Money as debt Why is money valuable? Acceptability Legal tender Relative scarcity LO2

7. 9-7 What “Backs” the Money Supply? Prices affect purchasing power of money Hyperinflation renders money unacceptable Stabilizing money’s purchasing power Intelligent management of the money supply—monetary policy Appropriate fiscal policy LO2

8. 9-8 Federal Reserve — Banking System Historical background Board of Governors 12 Federal Reserve Banks Serve as the central bank Quasi-public banks Banker’s bank LO3

9. 9-9 Federal Reserve — Banking System Commercial banks Thrift institutions (savings and loan associations, mutual savings banks, credit unions) The public (households and businesses) 12 Federal Reserve Banks Board of Governors Federal Open Market Committee LO3

10. 9-10 Federal Reserve — Banking System LO3 The 12 Federal Reserve Banks

11. 9-11 Federal Reserve — Banking System Federal Open Market Committee Aids Board of Governors in setting monetary policy Conducts open market operations Commercial banks and thrifts 6,800 commercial banks 8,700 thrifts LO3

12. 9-12 Federal Reserve Functions Issue currency Set reserve requirements Lend money to banks Collect checks Act as a fiscal agent for U.S. government Supervise banks Control the money supply LO4

13. 9-13 Federal Reserve Independence Established by Congress as an independent agency Protects the Fed from political pressures Enables the Fed to take actions to increase interest rates in order to stem inflation as needed LO4

14. 9-14 Global Snapshot World’s 12 Largest Financial Institutions, 2011 Source: Forbes Global 2000, www.forbes.comwww.forbes.com LO4 Assets (billions of U.S. dollars) BNP Paribas (France)2,681 Deutsche Bank (Germany)2,557 HSBC Holdings (U.K.)2,468 Barclays (U.K.)2,328 Royal Bank of Scotland (U.K.)2,266 Bank of America (U.S.)2,265 Mitsubishi UFJ (Japan)2,177 Crédit Agricole (France)2,131 JP Morgan Chase (U.S.)2,118 Citigroup (U.S.)1,914 ICBC (China)1,724 Mizuho Financial (Japan)1,667

15. 9-15 The Financial Crisis of 2007 and 2008 Mortgage default crisis Many causes Government programs that encouraged home ownership Declining real estate values Bad incentives provided by mortgage-backed bonds LO5

16. 9-16 The Financial Crisis of 2007 and 2008 Securitization— the process of slicing up and bundling groups of loans into new securities As loans defaulted, the system collapsed “Underwater” homeowners abandoned homes and mortgages LO5

17. 9-17 The Financial Crisis of 2007 and 2008 Failures and near-failures of financial firms Countrywide: second largest lender Washington Mutual: largest lender Wachovia Other firms came close LO5

18. 9-18 The Financial Crisis of 2007 and 2008 Troubled Asset Relief Program (TARP) Allocated $700 billion to make emergency loans Saved several institutions from failure LO6

19. 9-19 Postcrisis U.S. Financial Services Major categories of financial institutions Commercial banks Thrifts Insurance companies Mutual Fund companies Pension funds Securities firms Investment banks LO7

20. 9-20 InstitutionDescriptionExamples Commercial banks State and national banks that provide checking and savings accounts and make loans JPMorgan Chase, Bank of America, Citibank, Wells Fargo Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans Charter One, New York Community Bank Insurance companies Firms that offer policies through which individuals pay premiums to insure against loss Prudential, New York Life, Northwestern Mutual, Hartford Mutual Fund companies Firms that pool customer deposits to purchase stocks or bonds Fidelity, Vanguard, Putnam, Janus, T. Rowe Price Pension funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits TIAA-CREF, Teamsters’ Union, CalPERs Securities firms Firms that offer security advice and buy and sell stocks and bonds for clients Merrill Lynch, Smith Barney, Charles Schwab Investment banks Firms that help corporations and governments raise money by selling stocks and bonds Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura Securities Major Categories of Financial Institutions LO7

21. 9-21 Postcrisis U.S. Financial Services Wall Street Reform and Consumer Protection Act Passed to help prevent many of the practices that led to the crisis Critics say it adds heavy regulatory costs LO7

22. 9-22 Fractional Reserve System The goldsmiths Stored gold and gave a receipt Receipts used as money by public Made loans by issuing receipts Characteristics: Banks create money through lending Banks are subject to “panics” LO8

23. 9-23 Fractional Reserve System Balance sheet Assets = Liabilities + Net worth Both sides balance Necessary transactions Create a bank Accept deposits Lend excess reserves LO8

24. 9-24 A Single Commercial Bank Transaction #1 Vault cash: cash held by the bank AssetsLiabilities and Net Worth Creating a Bank Balance Sheet 1: Wahoo Bank Cash$250,000Stock shares$250,000 LO8

25. 9-25 A Single Commercial Bank Transaction #2 Acquiring property and equipment AssetsLiabilities and Net Worth Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash$ 10,000Stock shares$250,000 Property240,000 LO8

26. 9-26 A Single Commercial Bank Transaction #3 Commercial bank functions Accepting deposits Making loans Assets Liabilities and Net Worth Accepting Deposits Balance Sheet 3: Wahoo Bank Cash $110,000 Checkable deposits $100,000 Property 240,000 Stock shares 250,000 LO8

27. 9-27 A Single Commercial Bank Transaction #4 Depositing reserves in a Federal Reserve Bank Required reserves Reserve ratio Reserve ratio = Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities LO8

28. 9-28 A Single Commercial Bank AssetsLiabilities and Net Worth Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash$ 0Checkable Deposits $100,000 Property240,000Stock Shares250,000 Reserves110,000 Transaction #4 Assume the bank deposits all cash on reserve at the Fed LO8

29. 9-29 A Single Commercial Bank Excess reserves Actual reserves - Required reserves Required reserves Checkable deposits × Reserve ratio Example: Checkable deposits: $100,000 Reserve ratio: 20 percent LO8

30. 9-30 A Single Commercial Bank Transaction #5 Clearing a check $50,000 check reduces reserves and checkable deposits AssetsLiabilities and Net Worth Clearing a Check Balance Sheet 5: Wahoo Bank Checkable deposits $ 50,000 Property 240,000 Stock shares250,000 Reserves $ 60,000 LO8

31. 9-31 Money-Creating Transactions Transaction #6a Granting a loan $50,000 loan deposited to checking AssetsLiabilities and Net Worth When a Loan Is Negotiated Balance Sheet 6a: Wahoo Bank Checkable deposits $100,000 Property240,000 Stock shares250,000 Reserves$ 60,000 Loans50,000 LO8

32. 9-32 Money-Creating Transactions Transaction #6b Using the loan $50,000 loan cashed AssetsLiabilities and Net Worth After a Check Is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Checkable deposits $ 50,000 Property240,000 Stock shares250,000 Reserves$ 10,000 Loans50,000 A single bank can only lend an amount equal to its preloan excess reserves LO8

33. 9-33 The Banking System Multiple-deposit expansion Assumptions: 20 percent required reserves All banks “loaned up” Banks lend all of their excess reserves A $100 bill is found and deposited Multiple deposits can be created LO8

34. 9-34 The Banking System The Banking System’s Lending Potential LO8 AssetsLiabilities and Net Worth Multiple-Deposit Expansion Process Checkable deposits $+100 (a 1 ) Loans+80 (a 2 ) Reserves$+100 (a 1 ) -80 (a 3 ) Balance Sheet: Commercial Bank A

35. 9-35 The Banking System The Banking System’s Lending Potential AssetsLiabilities and Net Worth Multiple-Deposit Expansion Process Balance Sheet: Commercial Bank B Checkable Deposits $ +80 (b 1 ) Loans+64 (b 2 ) Reserves$+80 (b 1 ) -64 (b 3 ) LO8

36. 9-36 Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks Bank (1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio =.2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 The Banking System LO8

37. 9-37 The Monetary Multiplier Monetary multiplier = 1 Required reserve ratio = 1 R LO8

38. 9-38 The Monetary Multiplier Maximum amount of new money created by a single dollar of excess reserves Higher R, lower m Reversibility Making loans creates money Loan repayment destroys money LO8

39. 9-39 Bank Panics of 1930–1933 Before deposit insurance Bank failure led to mass withdrawals Forced loan reduction 25-33 percent decline in money supply 1933 national bank holiday to evaluate all banks Contributed to the Great Depression Regulation protects the system today LO8