Chapter 2

Banks and Other

Financial Intermediaries

© 2008 John Wiley and Sons

 Chapter Outcomes
 Describe the major financial
intermediaries & their roles in the
financial system
 Describe the differences between
commercial banking & investment
banking
 Identify the functions of banks & of
the banking system

2
 Chapter Outcomes
(Continued)

 Discuss general regulation of the

banking system & how depositors’
funds are protected
 Describe the structure of banks in
terms of bank charters, branch
banking, & bank holding companies
 Briefly describe the structure of the
Federal Reserve System
3
 Chapter Outcomes
(Continued)
 Discuss how the Federal Reserve
uses reserve requirements, the
discount rate, & open market
operations to carry out monetary
policy
 Explain the meaning of a fractional
reserve system

4
 Chapter Outcomes
(Continued)

 Explain the meaning of the monetary

base and the money multiplier
 Discuss structural characteristics of
central banks located in selected
foreign countries

5
 Types of Financial Intermediaries

Financial Intermediation:
 Process by which individual savings are
accumulated in financial institutions and, in
turn, lent or invested

Four Basic Categories:

 DEPOSITORY INSTITUTIONS
 CONTRACTUAL SAVINGS ORGANIZATIONS
 SECURITIES FIRMS
 FINANCE FIRMS

6
 Types of Depository Institutions
 Commercial Banks
Accept deposits, issue check-writing
accounts, and make loans to businesses
and individuals

Thrift Institutions:
Depository institutions (savings banks,
savings and loan associations, and credit
unions) called thrift institutions that
accumulate individual savings and lend
primarily to other individuals

7
 Thrift Depository Institutions

 Savings Banks
Accept the savings of individuals and lend pooled
savings to individuals primarily in the form of
mortgage loans
 Savings & Loan Associations
Accept individual savings and lend pooled
savings to individuals, primarily in the form of
mortgage loans, and businesses
 Credit Unions
Cooperative nonprofit organizations that exist
primarily to provide member depositors with
consumer credit
8
 Contractual Savings Organizations

 Insurance Companies
Provide financial protection to individuals
and businesses for life, property, liability,
and health uncertainties
 Pension Funds
Receive contributions from employees
and/or their employers and invest the
proceeds on behalf of the employees for
use during their retirement years

9
 Securities Firms
 Investment Companies
Sell shares in their firms to individuals
and others and invest the pooled proceeds
in corporate and government securities
 Mutual Fund
Open-end investment company that can
issue an unlimited number of its shares to
its investors and use the pooled proceeds
to purchase corporate and government
securities

10
 Securities Firms (Continued)

 Investment Banking Firms

Sell or market new securities
issued by businesses to individual
and institutional investors
 Brokerage Firms
Assist individuals to purchase new or
existing securities issues or to sell
previously purchased securities
11
 Finance Firms

 Finance Companies
Provide loans directly to consumers and
businesses or aid individuals in obtaining
financing of durable goods and homes
 Mortgage Banking Firms
Originate mortgage loans on
homes and other real property by bringing
together borrowers and institutional
investors
12
 Primary Sources of Funds for
Financial Intermediaries
 Depository Institutions & Mutual Funds
Primary source:
individual savings
 Insurance Companies
Primary source: policy premiums
 Pension Funds Primary
source: employee/employer contributions
 Investment Banking, Brokerage, Mortgage
Banking, & Finance Firms
Primary source: receive funds from other
institutions 13
 Role of Financial Intermediaries in
Directing Savings to Business Firms

 Commercial Banks
Make loans to and purchase debt
securities issued by business firms
Intermediaries that purchase both debt and
equity securities issued by businesses:
 Mutual Funds
 Insurance Companies
 Pension Funds
 Investment Banks & Brokerage Firms
14
Role of Individual Savers & Investors

 Make deposits in commercial banks

 Purchase shares in mutual funds
 Purchase securities from/through
investment banks and brokerages
 Pay premiums to insurance
companies
 Make contributions to pension funds
15
 Overview of the Banking System

 COMMERCIAL BANK
Accepts deposits, makes loans, and
issues check-writing accounts
 INVESTMENT BANK
Helps businesses sell their securities to
raise financial capital
 UNIVERSAL BANK
Bank that engages in both commercial
banking and investment banking activities
16
 Overview of the Banking System
(Continued)
 Glass-Steagall Act of 1933:
Provided for separation of commercial
banking and investment banking activities
in the U.S.
 Gramm-Leach-Bliley Act of 1999:
Repealed the separation of
commercial banking and investment
banking activities provided for in the
Glass-Steagall Act
17
 Functions of Banks and the Banking
System
 Accepting deposits
 Issuing checkable deposit accounts
 Granting loans
 Clearing checks
 Creating deposit money
 Raising financial capital for
businesses (investment banking)
18
 Early Development of the U.S.
Banking System
 Early Chartered Banks
 First Bank of the United States
 Second Bank of the United States
 State Banks from 1836 to the Civil
War
 Entry of Thrift Institutions:
Accumulate individual savings and lend primarily
to other individuals
19
Regulation of the Banking System
General Banking Legislation:
 National Banking Act of 1864
 Federal Reserve Act of 1913
 Depository Institutions Deregulation
and Monetary Control Act of 1980
 Garn-St. Germain Depository
Institutions Act of 1982
 Gramm-Leach-Bliley Act of 1999

20
 Savings and Loan Crisis

 What Happened?
Mid-1980s to Mid-1990s: Over 2,000 S&Ls
were closed or merged into other
institutions
 Why did it Happen?
S&Ls failed due to (1) mismanagement
and (2) greed that led to fraudulent
activities on the part of some officers and
managers

21
Nature of S&L Business Activities

 S&Ls borrow short-term by accepting the

deposits of savers and paying interest on
the savings
 S&Ls, in turn, provide long-term mortgage
loans to help finance homes
 The result is loan illiquidity and financing
cost risk associated with rising short-term
interest rates
22
Changing S&L Business Activities
 Deregulation caused additional S&L
operating difficulties
 In early 1980s, S&Ls were permitted to
invest in a range of high-yielding
investments including speculative
office/commercial buildings and “junk”
(high yield, low quality) bonds issued by
businesses
 S&L managements were ill prepared for
deregulation resulting in mismanagement
 Greed also resulted in fraudulent behavior
on the part of some officers and managers
23
 Legislative Changes to Address
S&L Crisis
 Federal Savings and Loan Insurance
Corporation (FSLIC), the insurer of most
S&L depositors since early 1930s, went
bankrupt in early 1988 because of the
number and size of S&L failures
 The Financial Institutions Reform,
Recovery, and Enforcement Act was
passed in 1989. FIRREA provided for the
termination of the FSLIC and formed the
Savings Association Insurance Fund
(SAID)
24
 Legislative Changes to Address
S&L Crisis (continued)
 FIRREA required S&Ls to commit more of
their assets to home loans, restricted
S&Ls from holding junk bonds, and
allowed commercial banks to purchase
S&Ls
 Congress created the Resolution Trust
Corporation (RTC) in 1988 to take over and
dispose of the assets of failed S&Ls by
finding acquirers or through liquidations
 Congress shut down the RTC in 1995
25
 Protection of Depositors’ Funds

 The Federal Deposit Insurance

Corporation (FDIC) was created in 1933 to
protect deposits in banks
 The Federal Savings and Loan Insurance
Corporation (FSLIC) was created to
protect deposits in S&Ls [replaced by
SAIF in 1989]
 The National Credit Union Share Insurance
Fund (NCUSIF) was created to protect
deposits in credit unions
26
 Protection of Depositors’ Funds
(continued)
 Deposit account insurance was increased
on time until it reached $100,000 in 1980
and remains at that level today
 Bank Insurance Fund: Collects annual
insurance premiums from commercial
banks to create the pool of funds available
to FDIC for covering insured depositors
 Federal Deposit Insurance Corporation
Improvement Act of 1991: Provides for
differences in deposit premiums based on
the relative riskiness of banks
27
 Structure of Banks:
Bank Charters
 DUAL BANKING SYSTEM:
Commercial banks can obtain charters
either from the federal government or
a state government
 FEDERALLY CHARTERED BANKS:
Must have “national” in their titles and
be members of the Federal Reserve
System and the Federal Deposit
Insurance Corporation 28
 Structure of Banks:
Branch Banking
 UNIT BANKING: Exists
when a bank can have only one full-
service office
 LIMITED BRANCH BANKING:
Allows additional banking offices
within a defined distance of a bank’s
main office
 STATEWIDE BRANCH BANKING:
Allows banks to operate offices
throughout a state 29
 Structure of Banks:
Bank Holding Companies
 HOLDING COMPANY:
A firm that owns and controls other
organizations or firms
 ONE BANK HOLDING COMPANY:
Permits a firm (OBHC) to own and
control only one bank
 MULTIBANK HOLDING COMPANY:
Permits a firm (MBHC) to own and
control two or more banks 30
 International Banking and
Foreign Systems
 INTERNATIONAL BANKING:
Exists when banks operate in more
than one country
 INTERNATIONAL BANKING ACT OF
1978:
Provided more consistent regulation
of banks across countries

31
 The Federal Reserve System

Two Important Definitions:

 CENTRAL BANK:

Federal government agency that facilitates

operation of the financial system and
regulates money supply growth
 FEDERAL RESERVE SYSTEM (Fed): U.S.

central bank that sets monetary policy and

regulates banking system

32
 Structure of the Federal
Reserve System
The Fed System consists of five
components:
 Member Banks
 Federal Reserve District Banks
 Board of Governors
 Federal Open Market Committee
 Advisory Committees
33
 Member Banks
 All national banks must be members of
the Fed
 State-chartered banks are permitted to
join the Fed system
 All member banks must purchase capital
stock of the Reserve Bank of their district
up to a maximum of 6%
 About one-third (3,500) of commercial
banks are members of the Fed
 Member banks hold about three-fourths of
the deposits of all commercial banks
34
Member Banks and Other Depository
Institutions
Monetary Control Act of 1980:
 Increased the importance of the Fed in the
nation’s financial system
 Generally eliminated distinctions between
member banks of the Fed and other
depository institutions (savings banks,
S&Ls, & credit unions)
 Applies Fed-comparable reserve and
reporting requirements to these other
depository institutions
35
 Federal Reserve District Banks

 The Federal Reserve Act of 1913 provided

for establishment of twelve Federal
Reserve districts with each district served
by a Federal Reserve Bank
 In addition to the twelve Reserve Banks,
twenty-five branch banks have been
established
 The geographically large western Federal
Reserve districts have most of the
Reserve Branch Banks
36
 Federal Reserve District Banks
(continued)
District banks:
 Hold reserve balances for depository
institutions
 Lend to depository institutions located in
their districts at the prevailing discount
(interest) rate
 Issue new currency and withdraw
damaged currency from circulation
 Collect and clear checks and transfer
funds for depository institutions
37
 Federal Reserve District Banks
(continued)
 Each Reserve Bank has corporate
officers and a board of nine directors
 Directors serve terms of three years
 Three directors are appointed each
year so that appointments are
staggered
 Directors are divided into three
groups: Class A, Class B, & Class C
38
 Federal Reserve District Banks:
Directors and Officers

 CLASS A DIRECTORS:
Represent member banks of the district
 CLASS B DIRECTORS:
Represent nonbanking interests
(commerce, agriculture, & industry)
 CLASS C DIRECTORS:
Appointed by the Fed Board of Governors
(may not be in banking)
39
 Fed Board of Governors (BOG)
 Sets reserve requirements and
approves discount rates as part of
monetary policy
 Supervises and regulates member
banks and bank holding companies
 Establishes and administers
protective regulations and consumer
finance
 Oversees Federal Reserve Banks 40
Federal Open Market Committee

 Comprised of the Fed Board of

Governors and Five Reserve Bank
Presidents
 Directs open market operations
(buying and selling of U.S. government
securities), which are the primary
instruments of monetary policy

41
 Advisory Committees
 Federal Advisory Council: provides
advice and general information on
ban king-related issues to the BOG
 Consumer Advisory Council:
provides advice relating to consumer
matters
 Thrift Institutions Advisory Council:
provides advice on issues that
directly affect thrift institutions
42
Monetary Policy and Instruments

Monetary Policy:
 Formulated by the Fed to regulate

money supply growth (as well as the

cost and availability of money)
Basic Policy Instruments:
 Changing Reserve Requirements

and/or the Discount Rate, and

conducting Open-Market Operations
43
 Monetary Policy Instruments

 Reserve Requirements
-Fed sets reserve requirements for
depository institutions
 Discount Rate Policy
-Fed sets interest rate at which it will
lend to depository institutions
 Open-Market Operations
-Fed buys/sells government
securities to change bank reserves
44
 Reserve Requirements:
Basic Concepts
 FRACTIONAL RESERVE SYSTEM:
Reserves held with Fed that equal a
certain percentage of bank deposits
 BANK RESERVES:
Vault cash and deposits held at Federal
Reserve Banks
 REQUIRED RESERVES:
Minimum amount of total reserves a
depository institution must hold
45
 Reserve Requirements:
Basic Concepts (Continued)

 REQUIRED RESERVES RATIO:

Percentage of deposits that must be held
as reserves
 EXCESS RESERVES:
Amount of that total reserves are greater
than required reserves

46
 Discount Rate Policy
 DISCOUNT RATE:
Interest rate that a bank must pay to
borrow from its regional Federal Reserve
Bank
 FORMS OF BORROWING:
Borrowing institution may receive an
“advance” (loan) or may “discount” (sell)
to the Reserve Bank its “eligible paper”

47
 Open-market Operations

 OPEN-MARKET OPERATIONS:
Buying and selling of securities in the
“open market” by the Fed to alter bank
reserves
 FED’S ASSETS:
Primarily held as U.S. government and
government agency securities

48
 Fractional Reserve System
Definitions:
 FRACTIONAL RESERVE SYSTEM:

Reserves held with the Fed that are equal

to a certain percentage of bank deposits
 PRIMARY DEPOSIT:

Deposit that adds new reserves to a bank

 DERIVATIVE DEPOSIT:

Occurs when reserves created from a

primary deposit are made available to
borrowers through bank loans
49
 Checkable Deposit Expansion
[Assume: reserve requirement is 20%]
Bank A receives a $10,000 primary
deposit and makes a loan of $8,000.
The “books” would show:
BANK A
Assets: Liabilities:
Reserves $10,000 Deposits $10,000
Loans $8,000
50
 Checkable Deposit Expansion
[Continued]
[Assume: a check is drawn against Bank A
and is deposited in Bank B (representing
all other banks)]
BANK A
Assets: Liabilities:
Reserves $2,000 Deposits $10,000
Loans $8,000
BANK B
Assets: Liabilities:
Reserves $8,000 Deposits $8,000 51
 Multiple Expansion of Checkable
Deposits
BASIC EQUATION APPROACH:
Change in Checkable Deposits =
(Increase in Excess Reserves)/(Required
Reserves Ratio)

Assume Excess Reserves increase by

$1,000 and the Reserve Ratio is 20%, then
the Change in Checkable Deposits would
be:
$1,000/.20 = $5,000 52
 Monetary Base and Money
Multiplier
 EQUATION: MB x m = M1
 MONETARY BASE (MB):
Banking system reserves plus
currency held by the public
 MONEY MULTIPLIER (m): In
a simple monetary system, the ratio of
1 divided by the reserve ratio
 MONEY SUPPLY (M1):
Basic definition of the money supply
53
 Complex Money Multiplier (m)
 EQUATION:
m = (1 + k)/[r(1 + t + g) + k]
 DEFINITIONS:

r = ratio of reserves to total reserves

k = ratio of currency held by nonbank
public to checkable deposits
t = ratio of noncheckable deposits to
checkable deposits
g = ratio of government deposits to
checkable deposits 54
 Complex Money Multiplier (m)
Example
 Basic Information: r = 20%; k = 40%;
t = 15%; & g = 10%. What is the
money multiplier (m)?
 m = (1 + k)/[r(1 + t + g) + k]
 m = (1 + .40)/[.20(1 + .15 + .10) + .40]
= (1.40)/[.20(1.25) + .40]
= 1.40/.65 = 2.15

55
 Link Between Money Supply and
Gross Domestic Product
 Velocity of money (M1V) is the rate of
circulation of money supply
 Money supply (M1) is linked to gross
domestic product (GDP) via velocity
 Nominal GDP is real GDP (RGDP) +
Inflation (I)
 In terms of growth rates (g) we have:
M1g + M1Vg = RGDPg + Ig
56
 Example of Link Between Money
Supply and Real GDP
 Assume inflation is expected to be
3% next year
 M1 is expected to grow by 4% and
M1 velocity is expected to increase
by 1% next year
 What is real GDP expected to
increase by?
 RGDP growth = 4% + 1% - 3% = 2%
57
Central Banks in Other Countries
 UNITED KINGDOM:
Bank of England (BOE)--created well prior
to the Fed
 JAPAN:
Bank of Japan (BOJ)--created in 1947
 EUROPEAN MONETARY UNION:
European Central Bank
(ECB)--created in 1999
Conducts monetary policy for the twelve
European countries that adopted the euro
as their common currency
58
 Web Links
 www.citibank.com
 www.chase.com
 www.federalreserve.gov
 www.sba.gov
 www.stls.frb.org
 www.frbsf.org
 www.minneapolisfed.org
 www.ecb.int
59