Chapter 2: Banks and Money In the equity market:

2-1 Why Banks Exist  Directors know potential future profits,

shareholders do not
Asymmetric Information
 The price of the stock reflects the
When information is not equal/even discounted future profitability of the
corporation
May lead to inefficient outcomes; resources may
 The directors of a corporation may know
be wasted or misallocated
more about the future potential
Adverse Selection profitability of the firm than would any
outside stockholder.
When undesirable results occur due to the lack of
 The outside stockholders may only be
information between a buyer and seller
willing to offer the average price of high-
Leads to a situation wherein the market is quality and low-quality stocks thus high-
dominated by subpar products thus driving out quality stock is never brought to the
better alternatives market

The solution to this problem is a better flow of 2-2 Overcoming Adverse Selection in Financial
information. Consult experts or other reputable Markets
organizations to verify the quality and price of a
Information Collection
product
Gathering information to know the capabilities
Adverse Selection in Financial Markets
of a bond issuer to repay
In bank lending:
Free-rider problem: A situation where some
 Bad borrowers know who they are, but members of society benefit from the
lenders do not consumption of a good or service without paying
 Low-quality borrowers would gladly for the good or service
accept the average interest rate of “bad” Government-Required Disclosures
borrowers and “good” borrowers
 High-quality borrowers would not Public companies are required to submit
accept this higher rate, and would refuse quarterly and annual reports as well as submit
to pay for such Management Discussion and Analysis that
explains how a company has done over the past
In the bond market: year
 Issuers know if they can repay, bond Securities and Exchange Commission:
buyers do not responsible for enforcing rules and regulations
 If bond buyers are uncertain about the surrounding the disclosure of information to
ability of the bond issuer to repay, low- investors
quality bond issuers will dominate the
market Screening
 High-quality bond issuers will no longer Private information the bank gathers to get a
offer their bonds for sale better idea of your ability to repay your debts.
2-3 Moral Hazard Corporate Board of Directors: a group of people
who are legally responsible to govern a
One entity takes on an excessive amount to risk
company. These people watch over the actions
because it knows another entity will bear the
of the executive branch of the corporation
burden of those risks
2-4 What Banks Do
Moral Hazard in Corporate Governance
Provide Liquidity
Principle-agent Problem: the problem of having
one party (the agent) who has been hired by Liquidity: The ease and expense at which one
another company (the principle) to act in the asset can be converted into another asset
best interests of the hiring party
Liquidity Mismatch: a situation in which there is
Moral Hazard in Financial Markets a lack of unity between the contractual amounts
and dates of cash inflows and outflows
Moral Hazard in Insurance: people become
reckless as they rely on an insurance that has no Reduce Transaction Costs
penalties
Search Costs: The implicit and explicit costs
Moral Hazard in Lending: otherwise frugal involved in savers and borrowers looking for
people mishandle their money since it “isn’t each other
their money but the bank’s money”
Economies of Scale: As output increases the cost
Moral Hazard in Debt and Equity Markets: firms per unit of output declines
mishandle the capital gained from stocks and
Block Lending
bonds as it “isn’t the firm’s money but the money
of the stockholders and bondholders” A bunch of small savings gathered into one big
bundle to then lend out to a borrower
Overcoming the Moral Hazard Problem in
Financial Markets Diversification: A means of reducing risk by
holding a variety of assets
Deductibles and Adjustable Premium: A
deductible is the amount of damage that the 2-5 Simple Deposit Multiplier
insured must pay. A premium is the regular
payment of the insurance; it may be increased Assets = Liabilities + Net worth (or Bank Capital)
after a claim for damage has occurred Required Reserve Ratio: The proportion of
Restrictive Covenants: legally binding promises deposits banks must hold in the form of cash or
made by the issuer to the bondholder. Financial reserves
covenants may limit the amount of debt the firm Total Reserves = Required Reserves + Excess Reserves
can issue; Non-financial covenants may require
1
the management to provide information to ∆𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠 = ∆𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 × ( )
𝑅𝑅𝑅
shareholders and bondholders.

Compensating Balances: minimum balance to

ensure that the borrower has some secondary
means to make payments. Compensating
balances may also be used to monitor the
financial status of the borrower
2-6 What the Simple Deposit Multiplier Tells Us term deposits into long-term assets such as
and Its Problems loans)

Banks Create and Destroy Money The Big Picture

A large portion of our money supply is created Community banks: provide banking services to
through the banking system; banks play a major local communities and focus on providing
role in the creation and reduction of the money services to consumers and local businesses
supply
Money center banks: located in large cities
Banks are Subject to Bank Runs (money centers). The customer base can range
from across the country to around the world.
A bank run is when a large number of depositors
The failure of a megabank may result in a
suddenly want their deposits back; if people
collapse of the entire financial or economic
believe their money is safe, they leave their
system (systemic risk)
money in the banks. However if they don’t, they
withdraw their money 3-2 Bank Deposits and Other Liabilities

If Banks Don’t Lend Transaction Deposits

Credit Crunch: A reduction in the general Transaction deposit accounts: A liquid bank
availability of credit most often seen as an account most often used by depositors for
irrational increase in risk aversion transferring funds to another person

If Banks Don’t Lend Required notice: the legal notice a depositor

gives to a financial institution that states a plan
If the economic system has no banks, money
of withdrawing funds in the future
supply does not increase; the level of economic
activity also does not increase. A lack of banks Demand deposit accounts: accounts that are
can result in economic stagnation payable on demand of deposit; deposit issued
with an original maturity or notice period of less
Problems with the Simple Deposit Multiplier
than 7 days
Zero Excess Reserves: In reality, banks may not
Characteristics:
be able to lend out all of its excess reserves;
excess reserves are retained in the bank  No maturity period or an original
maturity period of less than seven days
Nonbank Public Holding Cash: Money held by
 Payable on demand (or less than seven
nonbanking institutions or individuals is
days’ notice)
excluded from the money supply
 No limit on the number of transactions
Chapter 3: Bank Management  No eligibility requirements
3-1 Balance Sheets NOW (Negotiable Order of Withdrawal)
Accounts: Checking accounts that pay interest
Asset Transformation
Characteristics:
The process by which a financial institution
creates a new asset from existing liabilities with  No maturity date
different characteristics (ex. Converting short-
  Institution may reserve the right to Securities
request at any time written notice at
Bank management usually leans toward safety
least seven days before a withdrawal
and hold securities with low default risk and high
 Unlimited transactions
level of liquidity
 May be accessed by check, draft,
telephone, or electronic order to pay a Bank Loans
third party or transfer funds to an
Short-term Business Loans
account from the same institution
 May be held by individuals, government  Self-liquidating Inventory Loans
units, and non-profits  Seasonal Borrowing
 Interim Construction Loans
Money Market Deposit Accounts
 Securities Dealer Financing
Came about in response to money market  Retail and Equipment Financing
mutual funds. It pays a higher rate of interest
because its amount of withdrawals per month Long-term Business Loans
are limited. It is a savings account that is not as  Fixed Asset or Blind-spot Loans
illiquid as a certificate of deposit  Project Loans
Non-transaction Accounts  Leveraged Buyouts (LBOs)
 Agricultural Loans
Savings or Passbook Accounts: oldest type of
non-transaction account. A passbook was proof Short-term Consumer Loans
of the account that the depositor could keep
 Credit Cards
Certificates of Deposit: a time deposit; early  Unsecured Personal Loans
withdrawals would incur heavy penalties;  Unsecured Personal Lines of Credit
virtually risk-free. Jumbo CDs interest rate is
Long-term Consumer Loans
negotiable and there is a secondary market for it
 Home Mortgages: first mortgage
Other Liabilities
 Home Mortgages: second mortgage and
 Federal Funds Purchases equity lines of credit
 Repurchase Agreements  Automobile Loans
 Eurodollar Accounts  Other vehicle Loans
 Subordinated Risk
3-4 Off Balance Sheet Activities
 Other borrowing and other liabilities
Commercial Letters of Credit
3-3 Banks Loans and Other Assets
Promise of repayment; tied to a specific
Cash
transaction
Held as either vault cash or on deposit. Cash is
Standby Letters of Credit
the most liquid of assets however it does not pay
very high returns. Promise of repayment in general; not tied to a
specific transaction
Financial Derivatives Holding of Equities: two arguments; banks
should hold a lot of equities since equities
Agreement between a customer of the bank and
generally outperform bonds in the long run or
the bank to exchange currencies or interest
banks shouldn’t hold a large amount of equities
payment at an agreed-upon price at some date
since the asset side of a bank’s balance sheet
in the future
would contract if stock prices fall dramatically
Credit Default Swap Contracts (CDC)
Liabilities: Regulation Q
Investors are repaid if the issuer of a financial
Regulation Q: A strict amount of regulation over
contract defaults; basically an insurance policy
what banks could pay in terms of interest on
Chapter 4: Bank Regulation deposits

4-1 Bank Regulation Bank Capital

Banks Are Special Acts as a cushion for the bank whenever there is
a decline in its assets
Banks exist primarily to solve the asymmetric
information problem Bank Management Incentives and Bank Capital:
bank executive’s compensation is closely tied
Bank Regulation in the United States with a bank’s stock price. Bank executives have
Bank Charter: Permission issued to establish and an incentive to hold the lowest possible level of
operate a depository institution bank capital because that means high levels of
compensation for them.
Dual Banking System: A banking system where
bank charters are granted by the national Basel Accords
government as well as state or provincial Basel I: An international agreement among the
governments central banks and bank regulators that for the
Government-sponsored Deposit Insurance: first time created standard definitions of bank
Protection offered by a government agency that capital and established risk-weighted bank
protects the depositors from losses that may capital level. Basel I was issued in 1988
occur if the depository institution becomes Basel II: The second of the international banking
insolvent or fails regulation accords that was issued in 2004 and
Geography: with geographical diversification, was designed to be implemented in 2008. More
bank loans made in other states are unaffected flexible minimum bank capital levels; changed
by local problems and they continue to be repaid supervisory review; increased dependence on
as promised market discipline via increased bank disclosures

4-2 Bank Balance Sheet and Bank Capital Basel II: The third and most recent international
banking regulation accords, which were created
Balance Sheet Regulations in 2010 in the wake of the global financial crisis
Loan and Credit Extension Amounts: single 4-3 Bank Regulation: How It’s Done
borrower’s limit is 15% of the bank’s combined
capital. Can be extended by 10% if secured by Call reports: Detailed quarterly reports of the
readily marketable collateral operations and financial condition of a
depository institution
On-site examination: A periodic physical Truth in Lending Act of 1968
inspection of a bank’s operations, including the
Formerly known as Regulation Z; the act requires
quality of the bank’s management, assets,
full disclosure of the terms and costs involved in
lending policies, and compliance with banking
the loan
regulations
The Community Reinvestment Act of 1977
Cease and desist order: Legal notice given to a
financial institution by one of its regulators; or by Redlining: The act of denying financial services
courts, requiring the financial institution to take to people living in a particular area
actions or follow proscriptions in the order to
stop unlawful, unsafe, or unsound financial Fair Credit Reporting Act of 1970
practices Designed to regulate the collections and use of
CAMELS Ratings consumer credit information; to ensure that only
accurate information is reported
 Capital
Dodd-Frank Wall Street Reform and Consumer
 Asset quality
Protection Act of 2010
 Management
 Earnings Dodd-Frank Act; Increases the amount of
 Liquidity consumer protection in financial markets
 Sensitivity to market conditions
Why Has the US Bank Regulatory System
Dealing with a Failed Financial Institution Failed?

Pay off and liquidate: A policy used by bank Regulatory Shopping: When banks and other
regulators to deal with failed or failing financial institutions are allowed to choose their
institutions whereby the depositors are paid regulator, they may pit the regulators against
their deposit balances for the liquidation of the each other and then choose the regulator that
institution’s assets offers the most favorable regulations

Purchase and assume: A policy used by bank Intellectual Capture: The widely held belief that
regulators to deal with failed or failing whatever benefits the financial industry must
institutions whereby the regulator finds a also be beneficial to society
solvent institution to purchase the performing
assets of the failed or failing institution and the
regulator assumes or takes over the non-
performing assets

Too Big to Fail (TBTF)

A policy followed by bank regulators whereby

some financial institutions are so important to
the entire financial and economic system that
these institutions will not be allowed to fail. That
is, regulators will take action to ensure that these
systemically important institutions continue in
operation