Banking Industry

Features of U.S. Banking Industry

• many banks / many sizes

• Dual banking system

• Three major crises – Great Depression– S&L crisis in the 80s– Housing crisis 2008-9

• Trends: – continual financial innovation– consolidation– more fee generating services– integration of financial services

Some History

• City vs. Country battle – Gold vs. Silver– Wizard of OZ / Cross of Gold

• Fed was not established until 1913– rural states concerned about

econtrol by big city bankers.

– JP Morgan bailed out the U.S.

• McFadden Act (20s) – outlawed cross state banking – limited control of a single bank

More History

• Great Depression – bank failures– stock market crash, lost savings

• FDIC created

• Glass-Steagall Act separated commercial banking from– investment banking– securities brokers– insurance

Glass-Steagall was punishment of big banks.

Bank Consolidation

• Traditional banking in decline– Regulation Q (1970s)– Mutual Funds– Junk bonds

• Consolidation despite McFadden– Holding companies– ATMs

• Riegle-Neale, 1994 finished the job, interstate banking OK

• Pros: – less transactions cost – lower risk

• Cons: – small, local banks may not survive– new huge bank might engage in risky

behavior

Repeal of GS

• Gramm-Leach Bliley Act (1999) repeals Glass-Steagall– State Farm takes deposits– Banks can make investments– Holding companies can have

different financial firms.

• Investment banks (What?)

Financial Innovation

• Always happening - banks try to increase profits

• Old type: foreign bond funds• New type: derivatives / junk

bonds / CDO / SIV• All these fill a market void.

– derivatives allow farmers to hedge against low prices

– junk bonds allow financing for troubled companies

• Potential problems – investors don’t fully understand the

risks – regulators are a step behind (CDS)

Banking Regulation

• FDIC – deposit insurance up to $250,000

• Prevents runs– deals with failed (insolvent) banks

• insurance payoff (dissolution)• finds a new partner, purchase and

assumption method

• Creates incentives for banks to take on more risk– moral hazard– Less depositor vigilance

• More regulation is needed (!?)

Asymmetric information

• Insured banks tend to be riskier - MH

• AS - crooks become bankers

Sometimes FDIC does more:

“Too big to fail” creates similar incentives

MH and AS between regulators and bankers.

Regulations

• Capital requirements– min leverage ratio/max EM

• Disclosure regulations– Show balance sheets– standard accounting practices

• Consumer protection (CRA)– anti-discrimination– standardized contracts

Chartering

Banks chartered by the

• Comptroller of the Currency (Treasury) for national banks

• State agency

• helps w/ AS problem

• Banks also file periodic call reports

Examination

• National Banks– Comptroller

• State banks– Fed– state agency

• CAMELS ratings

• Basel accords– Uniform banking regulation– Asset quality

Dodd – Frank (2009)

• OTS eliminated

• Consumer Protection Agency

• Research & Macro oversight

• Insurance regulation

• Standardized– CDS– MBS etc.

• Many other provisions

Nothing about TBTF

S&L crisis of the 80s

Causes: • lower profits• higher risk• little oversight

Profit squeeze• Regulation Q – hard to attract

funds• Mutual funds• Interest rates rise

More causes

Risky assets

• Junk Bonds

• Derivatives (innovations)

• Real Estate

Oversight

• Depositors didn’t pay attention to risks– Higher deposit insurance– Brokered deposits

• Regulation– S&Ls deregulated (1980)– Regulators had little expertise

assessing risk of new assets

Bank and S&L failures

• Recession of early 80s

• High interest rates– affected liabilities more than

assets– Regulation Q phased out

• Overinvestment in real estate– commercial buildings– High risk typical of large

ventures

• Large number of insolvent banks and S&Ls

Role of Regulators

• Regulators (FSLIC) let S&Ls continue to operate– Effect on S&Ls?

• Huge Moral Hazard Problem – S&L engaged in extremely risky behavior (why not, they’re already dead)

“Zombie S&Ls”

Politics

• S&Ls contribute to politicians who pressure regulators (Keating 5)

• Politicians didn’t give regulators enough money

• Regulators didn’t want to admit mistake

Deal with it

1987 – Congress lends money to FSLIC, not nearly enough – more defaults

1989 – FIRREA,

• eliminates FSLIC

• creates OTS

• restricted S&L asset holdings

• created RTC to take over insolvent S&Ls and sell off assets – cost of $150 billion

Dealing with it

1989 – FDICIA• FDIC’s insurance fund was

running out of money• Congress lends them money• Mandate - FDIC must close

insolvent banks using the least costly method available – counters moral hazard problem

• Required regulators to assess capital/risk conditions of banks

• Provided for Treasury dept. lending to regulators in times of crisis.

S&L Debacle Summary

• Initial crisis due to – squeeze on profits – increase in real interest rates ’79-’80

• Crisis extended because of weakness of regulators– under-funded– tended to use assumption method, in

effect all deposits were guaranteed– politically influenced

• FDICIA helps prevent future crises– mandates dealing w/ insolvency– mandates using the cheapest method– give financial backup to regulators

Banking Crises

The rule not the exception

• Financial innovation is always occurring.

• Regulators struggle to keep up.

• Consequently– banks are regulated– regulators are regulated– enough regulation?

Monetary Policy Institutions

Federal Reserve

• check clearing• Economic research / data• Regulates Banks

– charters national banks and state banks that choose to join (about 1/3 of all banks)

– approves bank mergers

• Controls the Money Supply• Discount loans (original

purpose)

Structure of the Fed System

• Board of Governors (Washington D.C.)

– Chairman– appointed by president / confirmed by

Senate– Board Members have 14 year terms– Chairman has a 4 year term

• 12 Branch Banks • FOMC

– Makes decisions on monetary policy every 6 weeks

– 7 members of the board (including the chairman) and 5 branch presidents (always including NY)

Tools of Monetary Policy

• Reserve Requirement

• Discount Rate/lending

• OMO – decision of the FOMC– most important in practice – Chairman rules

Fed Independence

How?

• Congress/President can’t fire Board members or dictate policy

• Governors have 14 year terms and can be reappointed.

• Fed has its own source of funds and budget.

Fed Independence

Why?• Avoid continual print & spend

policy– excessive seignorage

• Gov’t revenue from inflation

– Fed can think long term– independence lowers inflation

• avoid the temptation to print money before an election

Fed Independence

Arguments against:

• too much power in too few hands

• undemocratic

• fiscal and monetary policy uncoordinated

Fed Balance Sheet

Assets:• Bonds• Discount Loans• Gold etc.• Foreign currencies

Liabilities:• Reserves deposits from banks• Legal tender (green stuff)

Very profitable business model.

Money Supply Process

Monetary Base or “High Powered Money” is

MB = C + R (liabilities of the Fed)

C – Currency in circulationR – Reserves

Changes in MB lead to large changes M=C+D

The Fed affects the MB through OMO and discount loans.

OMO example

Fed buys $100 in bonds from the banking system with its notes (cash).

Change in Monetary Base?

OMO purchase

Assets

Bonds +$100

Liabilities

Notes +$100

FED

Assets

Reserves +$100

Bonds -$100

Liabilities

Banks

OMO example

Fed buys $100 in bonds from the public w/ cash.

The public holds $50 as cash and deposits $50 in the bank.

Change in Monetary Base?

What if public deposits $75?

OMO purchase

Assets

Bonds +$100

Liabilities

Notes +$50

Reserves +$50

FED

Assets

Reserves +$50

Liabilities

deposits +$50

Banks

OMO

The effect of an OM purchase (or sale)

• on reserves R– depends on how much is held as

currency

• on the MB– is the same as the amount of the

purchase (sale)

The Fed and the MB

• To increase the MB the Fed buys bonds (or issues more discount loans).

• To decrease the MB the Fed …..

Changes in M

Why would a change in MB have a bigger change on M?

• Part of an increase in MB will be an increase in Excess Reserves.

• Some ER will be lent out and deposited again.

Example of Deposit Creation

• Fed buys $100 of bonds from Corp Z

• Corp Z deposits the $100 at Bank A

• Bank A lends you $50 cash

How much has M changed?$100 in deposits and $50 in cash

Deposit Creation

Assets

Reserves +$50

Loans +$50

Liabilities

deposits +$100

Bank A

MB rises $100

M rises $150

Money Multiplier

Bank lending creates money.

M = m x MB - “change in”

M = C + D the money supply

MB = C + R the monetary base

m – money multiplier

Money Multiplier

Bank lending creates money.

M = m x MB - “change in”

m measures how much changes in MB affect changes in the total money supply

similar to the multiplier from macro

Multiple Deposit Creation

•The Fed makes an OM purchase of $400 worth of bonds from Joe’s bank.

•MB increases by $400

•Joe’s Bank lends it out

•rD = 50%,

Assets

Bonds -$400

Loans +$400

Liabilities

Joe’s Bank

•MB increases by $400

•Joe’s Bank lends it out

•rD = 50%

M?

Multiple Deposit Creation

Assets

Reserves +$200

Loans +$200

Liabilities

Deposits $400

Bank A

•The money lent from Joe’s is eventually deposited in Bank A

•Bank A lends its ER. If the rD = 50%, how much can Bank A lend?

Multiple Deposit Creation

Assets

Reserves +$100

Loans +$100

Liabilities

Deposits $200

Bank B

•The money lent from Bank A is eventually deposited in Bank B

•Bank B lends its ER

Multiple Deposit Creation

Assets

Reserves +$50

Loans +$50

Liabilities

Deposits $100

Bank C

•The money lent from Bank B is eventually deposited in Bank C

•Bank C lends its ER

How much has the total money supply changed?

Add the deposits

Bank A $400

Bank B $200

Bank C $100

If this continues indefinitely, what’s the total change?

Total change (D and M) =400 + 200 + 100 + 50 +….

=400 + 400(0.5) + 400(0.5)2 + …

=400(1 + ½ + ¼ + ….)

400(2) = 800

MB increases by 400, M increased by 800.

The money multiplier

m = 1/rD = 1/0.5 = 2

Money Multiplier

M = m x MBm = 1/rD

Lower reserve requirement implies- higher money multiplier- more powerful deposit creation process

This formula for m assumes:• All ER are lent out• All loans are deposited (not held as

currency)

rD = 10% implies m = 10

Great Depression

• Stock Market Crash – Depression– bank failures– no FDIC – bank runs

• people held more cash

• lower m and M.

• Less credit available - depression worsens

• 1937 Fed raises rD

– more reserves– Effect on M?

The Fed and the MB

• The Fed can closely control the Monetary Base.

• In practice, they also have control over Reserves.

• Changes in the MB have big effects on the money supply.

Conduct of Monetary Policy

Tools

• OMO

• Discount Loans

• Reserve Requirement

All affect Reserves (part of MB) which affects the money supply (dramatically).

Analyze w/ S&D of R

S&D of Reserves

What’s the price of Reserves?

iffWho demands reserves?

banks

Who supplies?

banks and the FED

Slopes of S&D for R same as for money.

Determines equilibrium R and iff

Discount Lending & Reserves

• Banks can borrow reserves– from each other (at iff)

– or take discount loans at iD.

• If iff > iD where would banks go?

• The supply curve for reserves becomes horizontal at iD

• Is this a restriction on monetary policy?

No, the Fed controls iD directly.

Fed Policy and Reserves

Q: If the Fed want to lower interest rates, show how they would use OMO to do it. (Assuming iff < iD)

OMO affects the supply of reserves.

Tools /S&D for Reserves

• OMO shift Supply for Reserves left or right

• Changes in the Discount Rate shift Supply up or down

• Changes in the reserve requirement shift Demand

Problem

The federal funds rate is currently 2.75%.

If the discount rate was 3.5%, draw the graph for the supply and demand for reserves.

If the Fed decided to raise the fed funds rate to 3%, show how they could accomplish this with

• reserve requirement• open market operations• discount policy

If the Fed wanted to raise the fed funds rate to 5%, what would they have to do?

Monetary policyin practice

• Reserve requirement is fixed– rD=10%

• The discount rate is adjusted to be above the fed funds rate.

• Discount lending not actively used to change M.

• Open Market Operations – primary tool

– Fed sets iff

– influences MB, M & interest rates and the economy

Advantages of OMO

• Easy to fine tune

• Implement quickly

• Predictable

Discount Lending-still important

• standing lending facility

• Fed is the lender of last resort.

• Loans to banks in danger of default (Continental IL)– Recently AIG

• Helps FDIC with crises– prevent panics– Deal with large banks

Black Monday

• Stock market crash in 1987

• many brokerages were in danger of insolvency

• Banks stopped lending to brokerages.

• Fed guaranteed loans to brokerages.

• Few failures. The Fed did not actually make any loans.

Discount Policy

• Used to avert panics and provide liquidity (graph?)

• Allows Fed to indicate policy

• Can have unpredictable effects on MB and M.

Reserve Requirement

• too powerful - possibly destabilizing

• Have been eliminated in some countries (Switzerland) – higher bank profits

• SWEEP accounts make them less relevant.

Interest on Reserves

• Fed now has the ability to pay interest on Reserves.– More control over R

• Affect on S&D for Reserves?– min iff– Another kink in Supply

• Similar to “corridor” approach used in New Zealand

Problem

• Draw a graph of the S&D for reserves when the interest rate on reserves is zero, and there is some discount lending.

• Use the graph to show how the Fed could use OMO to lower the equilibrium fed funds rate.

• What would the Fed have to do to raise the equilibrium fed funds rate?

Goals of Monetary Policy

• low unemployment

• high (stable) growth

• low and stable inflation

• stable interest rates (smoothing)

• stable financial and international markets

• avoid deflation (recently important)

Unemployment

Should unemployment be 0%?

No, 0% cyclical is the goal.

“natural rate of unemployment”

NAIRU

Unemployment below the natural rate could cause wage and price inflation.

What is it? Good Q.

Inflation

• High / variable inflation makes planning difficult. – Bad for consumer and

businesses

• Penalizes savers.

• Hurts people on a fixed income.

• Some inflation is OK, avoids deflation, allows real wage flexibility.

Growth (GDP)

• Strongly tied to unemployment.• Excessive growth can lead to

inflation

Goals can conflict. Example: Achieving low

unemployment can lead to inflation.

BUTlong run – low inflation should help GDP/U

Targets

• Fed does not have precise control over its goals.

• Ex: can’t specify a GDP growth rate

• It has tight control over its Targets: MB, R, fed funds rate, discount rate

Intermediate targets

• It has indirect control over the Intermediate targets: – M1, M2, M3, longer term interest

rates– Affected by targets– Provide info (Fed & public)

Current approach

• Primary tool: OMO

• Primary target: fed funds rate

• Intermediate targets: reserves, monetary aggregates and interest rates

• Goals: – low stable inflation– high stable growth– smooth interest rates

Fed does not have stated goals.

Examples

• If high inflation is the biggest problem, what does the Fed do with iff ?

• What if a recession is the biggest problem?

– lower rates– cheaper to borrow– helps business invest– housing

Issues

• Should Fed state growth / inflation targets

• Should Fed concentrate solely on an inflation target (like ECB and others)?

• How to avoid deflation?

Q: Should the Fed respond to stock market/housing bubbles?

Taylor Rule

Rule on how to adjust iff

iff responds to inflation and output gaps

inflation gap – deviation from target

output gap – deviation from the natural rate

Taylor Rule

y - output

- inflation

y* - output target (potential GDP)

- inflation target

iff* - equilibrium real fed funds rate

iff = +iff* + y - y* )

What does this mean the Fed should do if inflation and output are below their targets?

-4

0

4

8

12

16

20

60 65 70 75 80 85 90 95 00 05 10

TAYLORRATE FFR

-2

0

2

4

6

8

10

90 92 94 96 98 00 02 04 06 08 10

TAYLORRATE FFR

Review questions

• Draw a graph for S&D for Reserves when there is no discount lending. The Fed makes a $100 open market bond purchase.– Show the change in the balance

sheet for the Fed and the bank they purchased the bonds from.

– Show the change in the graph.

Review Questions

• Show a graph of the S&D for Reserves when there is discount lending. Show and explain how the Fed could lower the Fed funds rate by changing the– Discount rate– Reserve requirement

Review Question

The recent crisis has increases banks desire to hold excess reserves. In response the Fed lowers the discount rate, which increases discount lending by $2000. Explain/show the changes in the following.– Balance sheets for the Fed and a

representative bank– Supply and Demand for Reserves– The Monetary Base– Supply and Demand for Money– If the reserve requirement is 10%, what

is the maximum change in the money supply?

Macro View of Monetary Policy

GDP

CPI

AD

AS

Aggregate Supply & Aggregate Demand

Aggregate Demand

Downward Sloping: As prices rise AD falls

Monetarist Explanation: MV = PY

• For fixed M and V• P rises then Y must fall

More money used per transaction

Changes in M shift AD

Aggregate Supply

Quantity firms produce at a given price level.

As prices rise• Potential profits increase• firms produce more

BUT: • Wages and input prices increase

too. • What really changes for the firms?

Aggregate Supply

• Wages and input prices tend to remain fixed (sticky) – so AS slopes up– Short run

• Long run– wages and input prices adjust

along with output prices– AS is vertical– Output determined by “real

factors.”• Quantity of labor• Quantity of capital• productivity

• Recessionary gap – equilibrium GDP is below potential

• Inflationary gap – equilibrium GDP is above potential

What is wrong with each?

How could the Fed act to cure each?

Problem

Use graphs for AS-AD and S&D of Reserves to show how the Fed would act to cure a recessionary gap.

What does the Fed do in terms of OMO?

What would happen to the money supply?

Review Problem

The equilibrium real fed funds rate is 2% and both inflation and output growth are at their targets of 2% and 3%, respectively. According to the Taylor rule, where should the Fed set the fed funds rate.

Starting from the situation above, both output and inflation rise 1% above their target levels. What should the new fed funds rate be (according to the Taylor rule)? Show the change using graphs for

• Reserves S&D (no discount lending)

• Money S&D• AD & AS (show LRAS)