R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

R. GLENN

HUBBARDANTHONY PATRICK

O’BRIEN

Money,Banking, and

the Financial System


The Economics of Banking

C H A P T E R 10

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

10.1

10.2

10.3

Understand bank balance sheets

Describe the basic operations of a commercial bank

Explain how banks manage risk

10.4 Explain the trends in the U.S. commercial banking industry


WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY?

• In the recovery from the financial crisis of 2007–2009, banks had become extremely cautious in making loans.

• Banks were turning away borrowers with flawed credit histories and avoiding industries that were hard hit by the recession.

• As the value of real estate declined, the collateral that small businesses could use to borrow against also declined.

• An Inside Look at Policy on page 306 discusses how higher interest rates may reduce bank profits.

C H A P T E R 10The Economics of Banking

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 55

Key Issue and Question

Issue: During and immediately following the 2007–2009 financial crisis, there was a sharp increase in the number of bank failures.

Question: Is banking a particularly risky business? If so, what types of risks do banks face?


10.1Learning ObjectiveUnderstand bank balance sheets.


The Basics of Commercial Banking: The Bank Balance Sheet

Balance sheet A statement that shows an individual’s or a firm’s financial position on a particular day.

Assets = Liabilities + Shareholders’ equity.

• The key commercial banking activities are taking in deposits from savers and making loans to households and firms.

• A bank’s primary sources of funds are deposits, and primary uses of funds are loans, which are summarized in the bank’s balance sheet.

• The typical layout of a balance sheet is based on the following accounting equation:




Asset Something of value that an individual or a firm owns; in particular, a financial claim.

Liability Something that an individual or a firm owes, particularly a financial claim on an individual or a firm.

Bank capital The difference between the value of a bank’s assets and thevalue of its liabilities; also called shareholders’ equity.



Bank Liabilities

Checkable deposits Accounts against which depositors can write checks, also called transaction deposits.

Checkable Deposits

• Demand deposits are checkable deposits on which banks do not pay interest.

• NOW (negotiable order of withdrawal) accounts are checking accounts that pay interest.

• Checkable deposits are liabilities to banks and assets to households and firms.



Nontransaction Deposits

Federal deposit insurance A government guarantee of deposit accountbalances up to $250,000.

• The most important types of nontransaction deposits are savings accounts, money market deposit accounts (MMDAs), and time deposits, or certificates of deposit (CDs).

• Checkable deposits and small-denomination time deposits are covered by federal deposit insurance.

• CDs of less than $100,000 are called small-denomination time deposits. CDs of $100,000 or more are called large-denomination time deposits.CDs worth $100,000 or more are negotiable, which means that investors can buy and sell them in secondary markets prior to maturity.



Borrowings• Banks often make more loans than they can finance with funds they attract

from depositors.

• Bank borrowings include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and discount loans from the Federal Reserve System.

• Although the name indicates that government money is involved, the loans in the federal funds market involve the banks’ own funds. The interest rate on these interbank loans is called the federal funds rate.

• With repurchase agreements—otherwise known as “repos,” or RPs—banks sell securities, such as Treasury bills, and agree to repurchase them, typically the next day. Repos are typically between large banks or corporations, so the degree of counterparty risk is small.



Making the ConnectionThe Incredible Shrinking Checking Account

Households hold less in checking accounts relative to other financial assets than they once did, partly due to the wealth effect.

As wealth has increased over time, households have been better able to afford to hold assets, such as CDs, where their money is tied up for a while but on which they earn a higher rate of interest.



Bank Assets

Reserves and Other Cash Assets

Reserves A bank asset consisting of vault cash plus bank deposits with theFederal Reserve.

Vault cash Cash on hand in a bank; includes currency in ATMs and deposits with other banks.

Bank assets are acquired by banks with the funds they receive from depositors, with funds they borrow, with funds they acquired initially from their shareholders, and with profits they retain from their operations.



Required reserves Reserves the Fed requires banks to hold against demand deposit and NOW account balances.

Excess reserves Any reserves banks hold above those necessary to meet reserve requirements.

• Excess reserves can provide an important source of liquidity to banks, and during the financial crisis, bank holdings of excess reserves soared.

• Another important cash asset is claims banks have on other banks for uncollected funds, which is called cash items in the process of collection.



Securities

• Marketable securities are liquid assets that banks trade in financial markets.

• Banks are allowed to hold securities issued by the U.S. Treasury and other government agencies, corporate bonds that received investment-grade ratings when they were first issued, and some limited amounts of municipal bonds, which are bonds issued by state and local governments.

• Because of their liquidity, bank holdings of U.S. Treasury securities are sometimes called secondary reserves.

• In the United States, commercial banks cannot invest checkable deposits in corporate bonds or common stock.



Loans• The largest category of bank assets is loans. Loans are illiquid relative to

marketable securities and entail greater default risk and higher information costs.

• There are three categories of loans:

(1) loans to businesses—called commercial and industrial, or C&I, loans;

(2) consumer loans, made to households primarily to buy automobiles, furniture, and other goods; and

(3) real estate loans, including both residential and commercial mortgages.

• The development of the commercial paper market in the 1980s meant that banks also lost to that market many of the businesses that had been using short-term C&I loans.



Loans Figure 10.1The Changing Mix ofBank Loans, 1973–2010The types of loans granted by banks have changed significantly since the early 1970s. Real estate loans have grown from less than one-third of bank loans in 1973 to two-thirds of bank loans in 2010. Commercial and industrial (C&I) loans have fallen from more than 40% of bank loans to less than 20%. Consumer loans have fallen from more than 27% of all loans to about 20%.



Other Assets

Other assets include banks’ physical assets, such as computer equipment and buildings. This category also includes collateral received from borrowers who have defaulted on loans.



Bank Capital

• Bank capital, also called shareholders’ equity, or bank net worth, is the difference between the value of a bank’s assets and the value of its liabilities.

• In 2010, for the U.S. banking system as a whole, bank capital was about 12% of bank assets.

• A bank’s capital equals the funds contributed by the bank’s shareholders through their purchases of stock the bank has issued plus accumulated retained profits.

• Note that as the value of a bank’s assets or liabilities changes, so does the value of the bank’s capital.



Solved Problem 10.1Constructing a Bank Balance SheetThe following entries are from the actual balance sheet of a U.S. bank as of December 31, 2009.

a. Use the entries to construct a balance sheet similar to the one in Table 10.1, with assets on the left side of the balance sheet and liabilities and bank capital on the right side.

b. The bank’s capital is what percentage of its assets?The Basics of Commercial Banking: The Bank Balance Sheet


Solved Problem 10.1Constructing a Bank Balance SheetSolving the Problem

Step 1 Review the chapter material.

Step 2 Answer part (a) by using the entries to construct the bank’s balance sheet, remembering that bank capital is equal to the value of assets minus the value of liabilities.



Solved Problem 10.1Constructing a Bank Balance Sheet

Step 3 Answer part (b) by calculating the bank’s capital as a percentage of its assets.


Total assets = $2,223 billionBank capital = $231 billionBank capital as a percentage of assets¿

$231$ 2,223=0.104 , or 10.4%


10.2Learning ObjectiveDescribe the basic operations of a commercial bank.


The Basic Operations of a Commercial Bank

T-account An accounting tool used to show changes in balance sheet items.The T-accounts below show what happens when you open a checking account with $100 at Wells Fargo.

In this example, Wells Fargo uses its excess reserves to buy Treasury bills worth $30 and make a loan worth $60.


Making the ConnectionThe Not-So-Simple Relationship between Loan Losses and Bank Profits• During the term of the loan, if the bank decides that the borrower is likely to

default, the bank must write down or write off the loan.

• Banks set aside part of their capital as a loan loss reserve to anticipate future loan losses and avoid large swings in its reported profits and capital from write-offs.

• During the financial crisis of 2007–2009, banks set aside enormous loan loss reserves as they anticipated write-downs on mortgage-related loans.

• The SEC has argued that banks will sometimes increase their loan loss reserves more than is justified during an economic expansion, when defaults are relatively rare. The banks can then draw down the reserves during a recession, evening out their reported profits.

• If true, this practice would amount to “earnings management,” which is prohibited under accounting rules because it may give a misleading view of the firm’s profits.



Bank Capital and Bank Profits

Net interest margin The difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.

Return on assets (ROA) The ratio of the value of a bank’s after-tax profit to the value of its assets.

• An expression for the bank’s total profits earned per dollar of assets is called return on assets.

ROA = After − tax profitBank assets



Return on equity (ROE) The ratio of the value of a bank’s after-tax profit to the value of its capital.

• ROA and ROE are related by the ratio of a bank’s assets to its capital:

• To judge how a bank’s managers are able to earn on the shareholder’s investment, we use the return on equity.

ROE = After − tax profitBank capital

ROE = ROA ×Bank assetsBank capital



Leverage A measure of how much debt an investor assumes in making an investment.

Bank leverage The ratio of the value of a bank’s assets to the value of its capital, the inverse of which (capital to assets) is called a bank’s leverage ratio.

• Managers of banks and other financial firms may have an incentive to hold a high ratio of assets to capital.

• The ratio of assets to capital is one measure of bank leverage, the inverse of which (capital to assets) is called a bank’s leverage ratio.

• A high ratio of assets to capital—high leverage—is a two-edged sword: Leverage can magnify relatively small ROAs into large ROEs, but it can do the same for losses.



• Moral hazard can contribute to high bank leverage.

• If managers are compensated for a high ROE, they may take on more risk than shareholders would prefer.

• Federal deposit insurance has increased moral hazard by reducing the incentive depositors have to monitor the behavior of bank managers.

• To deal with this risk, government regulations called capital requirements have placed limits on the value of the assets commercial banks can acquire relative to their capital.



10.3Learning ObjectiveExplain how banks manage risk.


Managing Bank Risk

Liquidity risk The possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.

Managing Liquidity Risk

• Banks reduce liquidity risk through strategies of asset management and liquidity management.

• Asset management involves lending funds in the federal funds market, usually for one day at a time.

• A second option is to use reverse repurchase agreements, which involve a bank buying Treasury securities owned by a business or another bank while at the same time agreeing to sell the securities back at a later date, often the next morning. These very short term loans can be used to meet deposit withdrawals.

• Liability management involves determining the best mix of borrowings from other banks or businesses using repurchase agreements or from the Fed by taking out discount loans.


Credit risk The risk that borrowers might default on their loans.

Managing Credit Risk

Diversification

• By diversifying, banks can reduce the credit risk associated with lending too much to a single borrower, region, or industry.

Credit-Risk Analysis

Credit-risk analysis The process that bank loan officers use to screen loan applicants.

• Banks often use credit-scoring systems to predict whether a borrower is likely to default. Historically, the high-quality borrowers paid the prime rate. Today, most banks charge rates that reflect changing market interest rates instead of the prime rate.

Prime rate Formerly, the interest rate banks charged on six-month loans to high-quality borrowers; currently, an interest rate banks charge primarily to smaller borrowers.Managing Bank Risk


Collateral

Credit rationing The restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate.

Credit Rationing

• Collateral, or assets pledged to the bank in the event that the borrower defaults, is used to reduce adverse selection.

• A compensating balance is a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank.

• Loan and credit limits reduce moral hazard by increasing the chance a borrower will repay.

• If the bank cannot distinguish the low- from the high-risk borrowers, high interest rates risk dropping the low-risk borrowers out of the loan pool, leaving only the high-risk borrowers—a case of adverse selection.

Managing Bank Risk


Monitoring and Restrictive Covenants

Long-Term Business Relationships

• Banks keep track of whether borrowers are obeying restrictive covenants, or explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities.

• The ability of banks to assess credit risks on the basis of private information on borrowers is called relationship banking.

• By observing the borrower, the bank can reduce problems of asymmetric information. Good borrowers can obtain credit at a lower interest rate or with fewer restrictions.

Managing Bank Risk


Interest-rate risk The effect of a change in market interest rates on a bank’s profit or capital.

Managing Interest-Rate Risk

A rise (fall) in the market interest rate will lower (increase) the present value of a bank’s assets and liabilities.

Managing Bank Risk


Gap analysis An analysis of the difference, or gap, between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities.

Measuring Interest-Rate Risk: Gap Analysis and Duration Analysis

• Gap analysis is used to calculate the vulnerability of a bank’s profits to changes in market interest rates.

• Most banks have negative gaps because their liabilities—mainly deposits—are more likely to have variable rates than are their assets—mainly loans and securities.

Managing Bank Risk


Duration analysis An analysis of how sensitive a bank’s capital is to changes in market interest rates.

• If a bank has a positive duration gap, the duration of the bank’s assets is greater than the duration of the bank’s liabilities. In this case, an increase in market interest rates will reduce the value of the bank’s assets more than the value of the bank’s liabilities, which will decrease the bank’s capital.

Managing Bank Risk


Reducing Interest-Rate Risk

• Banks with negative gaps can make more adjustable-rate or floating-rate loans. That way, if market interest rates rise and banks must pay higher interest rates on deposits, they will also receive higher interest rates on their loans.

• Banks can use interest-rate swaps in which they agree to exchange, or swap, the payments from a fixed-rate loan for the payments on an adjustable-rate loan owned by a corporation or another financial firm.

• Banks have available to them futures contracts and options contracts that can help hedge interest-rate risk.

Managing Bank Risk


10.4Learning ObjectiveExplain the trends in the U.S. commercial banking industry.


Trends in the U.S. Commercial Banking Industry

National bank A federally chartered bank.

The Early History of U.S. Banking

Dual banking system The system in the United States in which banks are chartered by either a state government or the federal government.

The National Banking Act of 1863 made it possible for a bank to obtain a federal charter.



Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation• The Federal Reserve plays the role of a lender of last resort by making

discount loans to banks suffering from temporary liquidity problems.

• Before the Fed existed, banks were subject to bank runs.

• If many banks simultaneously experienced runs, the result would be a bank panic, which often resulted in banks being unable to return depositors’ money and having to temporarily close their doors.

• Bank panics typically resulted in recessions. After the severe bank panic of 1907, Congress passed the Federal Reserve Act in 1913.

• The Great Depression led to bank panics, and Congress responded with the creation of the Federal Deposit Insurance Corporation (FDIC), established in 1934.


Figure 10.2Commercial Bank Failures in the United States, 1980–2010Bank failures in the United States were at low levels from 1960 until the savings and loan crisis of the mid-1980s. By the mid-1990s, bank failures had returned to low levels, where they remained until the beginning of the financial crisis in 2007.



The Rise of Nationwide Banking

• In the early 1900s, banks were prohibited from crossing state lines. Unit banking meant that banks were kept small, serving the local area.

• In 1900, of the 12,427 commercial banks in the United States, only 87 had any branches.

• The U.S. system of many small, geographically limited banks failed to take advantage of economies of scale in banking.

• Restrictions on branching within the state loosened after the mid-1970s, and in 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed for the phased removal of restrictions on interstate banking.

• These changes led to rapid consolidation of banks, from 14,384 in 1975 to only 6,839 by 2009. In 2010, concerns about bank size and banks “too big to fail” were discussed in Congress, but no limits on size were finally enacted.





Expanding the Boundaries of Banking

Off-balance-sheet activities Activities that do not affect a bank’s balance sheet because they do not increase either the bank’s assets or its liabilities.

Off-Balance-Sheet Activities

• Between 1960 and 2010, banks increased their funds and borrowings; they relied less on C&I and consumer loans, and more on real estate loans; they expanded into nontraditional lending activities and activities generating revenue from fees instead of interest.




Four important off-balance-sheet activities that banks have come to rely on to earn fee income include:

1. Standby letters of credit.

2. Loan commitments.

Standby letter of credit A promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures.

Loan commitment An agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time.



Loan sale A financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.


Four important off-balance-sheet activities that banks have come to rely on to earn fee income include:

3. Loan sales.

4. Trading activities.

• Banks earn fees from trading in the multibillion-dollar markets for futures, options, and interest-rate swaps.

• Bank losses from trading in securities became a concern during the financial crisis of 2007-2009.



Electronic Banking

• The first important development in electronic banking was the spread of automatic teller machines (ATMs).

• By the mid-1990s, virtual banks, or banks that carry out all their banking activities online, began to appear.

• By the mid-2000s, most traditional banks had also begun providing online services.

• Check clearing is now done electronically.



Making the ConnectionCan Electronic Banking Save Somalia’s Economy?

• For a market economy to function, a government needs to maintain a minimum level of order.

• Banks are particularly vulnerable to robberies. Not surprisingly, brick-and-mortar banks are scarce in Somalia, which has been subjected to incessant civil wars and rampant violence.

• But for the past three years, Somali GDP has been growing, and entrepreneurs have realized that they can provide virtual banking services through cell phones and Internet access.

• Somalis are now able to keep deposits online, transfer money, and obtain credit.

• While electronic banking appears to have contributed to the welcome economic progress, the country’s other problems present significant obstacles to maintaining that growth.



The Financial Crisis, TARP, and Partial GovernmentOwnership of Banks

• As the financial crisis unfolded, residential real estate mortgages began to decline in value.

• The market for mortgage-backed securities froze, meaning that buying and selling of these securities largely stopped, making it very difficult to determine their market prices. These securities became known as “toxic assets.”

• Evaluating balance sheets and determining the true value of bank capital was difficult.

• Banks responded to their worsening balance sheets by tightening credit standards for consumer and commercial loans. The resulting credit crunch helped bring on the recession that started in December 2007, as households and firms had increased difficulty funding their spending.



Troubled Asset Relief Program (TARP) A government program under which the U.S. Treasury purchased stock in hundreds of banks to increase the banks’ capital.

Another initiative to inject capital into banks, called the Capital Purchase Program (CPP), also relied on the U.S. Treasury to purchase stock in hundreds of troubled banks.



Making the ConnectionSmall Businesses: Key Victims of the Credit Crunch

• Small businesses play a key role in the economy. Businesses with fewer than 500 employees generate most of the jobs in the economy.

• During the financial crisis, banks were building their reserves and tightening lending requirements, so it became increasingly difficult for small firms to fund their operations.

• As commercial real estate values declined, borrowing against the value of stores or factories became more difficult.

• Banks worried that the severity of the recession would increase adverse selection and moral hazard. Pressure from government regulators to avoid making risky loans and credit limits on credit cards also limited the borrowing ability of small businesses.

• The large employment losses during the recession came in part from the difficulty of small businesses to obtain loans.



Answering the Key QuestionAt the beginning of this chapter, we asked the question:

“Is banking a particularly risky business? If so, what types of risks do banks face?”

In a market system, businesses of all types face risks, and many fail.

Economists and policymakers are particularly concerned about the risk and potential for failure that banks face because they play a vital role in the financial system.

In this chapter, we have seen that the basic business of commercial banking—borrowing money short term from depositors and lending it long term to households and firms—entails several types of risks: liquidity risk, credit risk, and interest-rate risk.


AN INSIDE LOOK AT POLICY

Interest-Rate Hikes Threaten Bank ProfitsREUTERS, U.S. Regulators Warn Banks on Interest Rate Risk

• In early 2010, the Federal Financial Institutions Examination Council (FFIEC) urged commercial banks to protect themselves against a likely increase in interest rates.

• Banks had profited by borrowing funds at low rates and purchasing assets such as Treasury securities that had higher yields.

• Some institutions are expecting interest rates to remain at historic lows, but it is unlikely that the Fed will keep rates near zero forever.

• As interest rates rise, banks relying heavily on short-term funds could see their funding costs accelerate. Longer-term assets may no longer be profitable to own, forcing banks to sell securities en masse and potentially weakening the financial sector again.

Key Points in the Article


AN INSIDE LOOK AT POLICY

Evidence of U.S. banks’ profits can be found in their balance sheets. Bank capital as a percentage of assets was lower when interest rates were higher prior to the financial crisis.

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R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN