ECON 712 Financial Institutions

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ECON 712 Financial Institutions

• Prof. John M. Veitch

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Week 6

• Depository Institutions
• Central Banks

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Depository Institutions

• Banks
• Financial intermediaries which accept deposits
  and make loans, either directly or through
  purchase of securities.
• Banks are special
• Important link between savers and borrowers in
  economy.
• Collaborate to provide payments system for the
  economy.
• Bank Balance Sheet Structure
• Bank liabilities tend to be short maturities,
  deposits.
• Bank assets either short-term credit or longer
  term loans at higher rate of interest than paid
  on deposits.
• Profit from interest rate spread as return to the
  risks arising from the duration mismatch on their
  balance sheets.

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Depository Institution T-Account

• A T-Account shows banks financial position
• 1. accepts deposits,
• 2. keeps a portion as reserves,
• 3. lends out the rest.

First National Bank
Assets
Liabilities
Reserves 12 L-T Loans
148
Deposits 100 CDs
50 Equity 10
Total Assets 160
Total Liabilities 160
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Risks for Depository Institutions

• Liquidity Risk
• Balance sheet used for maturity transformation
  of ST liabilities into LT assets. Exposed to
  bank runs.
• Govt regulations of reserve requirements and
  deposit insurance schemes help limit this risk.
• Interest Rate Risk
• Profit made from interest rate spread but rates
  on ST liabilities can change faster than rates on
  LT assets.
• Asset/liability management techniques by banks.
• Credit Risk
• Competitive advantage in loans requiring
  monitoring, i.e. uncertainty.
• Govt capital requirements lender of last
  resort.

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Commercial Banks

• National Banks regulated by Federal Reserve Board
  and Bank Insurance Fund (BIF). State banks
  subject to some FRB reqs.
• Services
• Individual banking Consumer loans, mortgage
  loans, credit cards, auto loans, brokerage
  services.
• Institutional banking Loans to non-financial
  financial firms, government entities, Commercial
  real estate loans, leasing, factoring.
• Global banking Corporate/capital market
  financings, foreign exchange.
• Funding
• Deposits Demand deposits Time Deposits (CDs).
• Non-deposit borrowing Large CDs repos by
  Money Center Banks
• Common Stock Retained Earnings.

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Commercial Bank Regulation

• Historical Areas of Regulation
• Interest Rate Ceilings Essentially eliminated
  but prior to 1980s Regulation Q set maximum
  deposit rates payable.
• Led to innovations to circumvent including CDs
  Euro deposits.
• Geographical Branching Restrictions Each state
  has right to limit intrastate banking by McFadden
  Act (1926).
• Prevent large banks from forcing small banks out
  of business.
• Permissible Activities FRB regulates activities
  to limit risk in banking system. Glass-Steagall
  parts of 1933 Bank Act.
• Most of these restrictions on securities
  underwriting dealing lifted.
• Capital Requirements Risk-based capital
  requirements aimed at limiting bank insolvency
  risk govt exposure.
• Capital Requirements establish two tiers of
  capital Core (equity R/E) supplementary
  (reserves).
• Assets classified by risk with capital weights
  differing.

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Savings Loan Associations

• SLs chartered by either state or national.
  Regulator is Office of Thrift Supervision (OTS)
  and SAIF.
• Services
• Mortgages Mortgage-backed securities
• U.S. Government Securities
• Consumer loans Credit cards, auto home
  improve. loans.
• Non-Consumer Loans Commercial, corporate,
  agricultural.
• Municipal Bonds
• Funding
• Deposits Demand deposits Time Deposits (CDs).
• Common Stock Retained Earnings.
• SL Crisis
• Maturity mismatch high, volatile interest rates
  Insolvent

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Credit Unions

• Credit Unions either state or nationally
  chartered. NCUA is principal federal regulatory
  agency.
• Mutually-owned require common bond of
  members.
• Deposits are technically shares ensured by
  NCUSIF
• Services
• Mortgages Mortgage-backed securities
• U.S. Government Securities
• Consumer loans Credit cards, auto home
  improve. loans.
• Funding
• Deposits Shares from their membership.

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• Depository Institutions and the Supply of Money

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What is Money?

• Money not to be confused with wealth or income.
• Money is the set of assets used in transactions.
• Liquidity is ease with which an asset can be
  converted into money.
• Functions of Money
• Medium of Exchange - facilitates transactions.
• Unit of Account - used to quote prices.
• Store of Value - transfer purchasing power to
  future.
• Types of Money
• Commodity Money - has intrinsic value.
• Fiat Money - value by government decree.

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Money in the U.S.

• Money in U.S. is fiat money.
• Four measures
• C Currency
• M1 C Travelers Checks Demand Deposits
  Other Checkable Deposits.
• M2 M1 Savings Deposits Small Time Deposits
  Money Mkt. Mutual Funds.
• M3 M2 Large Time Deposits Term Repos
• L M3 Savings Bonds Short-term Treasury
  securities other liquid assets

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Banks and The Money Supply

• The behavior of banks can influence the quantity
  of demand deposits in the economy and therefore,
  the money supply.
• Fractional Reserve Banking System
• Banks hold a fraction of money deposited as
  reserves and lend out the rest.
• Reserve Requirement, rr
• Govt mandates a minimum level of reserves to be
  held as percentage of deposits,
• Reserves rr x Deposits
• Used to ensure liquidity of bank for depositors,
  i.e. control risk to the payments system.

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Bank T-Account Revisited
First National Bank
Assets
Liabilities

• A T-Account illustrates the financial position
  of a bank that
• 1. accepts deposits,
• 2. keeps a portion as reserves, and
• 3. lends out the rest.

Reserves 10.00 Loans 90.00
Deposits 100.00
Total Assets 100.00
Total Liabilities 100.00
Reserve Requirement .10 Required Reserves .1
x 100 10
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Banks Money Creation

• Central bank affects Money Supply through Open
  Market Operations.
• Money Supply Currency Deposits at Banks
• Commercial Banks important in Money Supply
  process.
• When a bank makes a loan (from its reserves) the
  money supply increases. When banks hold only a
  fraction of deposits in reserve, banks create
  money.
• The creation of money through loans does not
  create any wealth, but allow banks to charge
  interest several times on the same bit of wealth.

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Fractional Reserve Banking
BANK ONE
Assets
Liabilities
Reserves
Deposits
Loans
BANK TWO
Money Multiplier
Assets
Liabilities
Process
Reserves
Deposits
Loans
BANK THREE
Assets
Liabilities
Reserves
Deposits
Loans
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Banks and Money Creation

• MONEY CREATION PROCESS
• Original Deposit 1,000
• Bank One Lending (1-rr)x1000
• Bank Two Lending (1-rr)2 x1000
• Bank Three Lending (1-rr)3 x1000
• and so on _____________
• Total D Ms 1 (1-rr) (1-rr)2
• (1-rr)3 x 1,000
• (1/rr) x 1,000 5,000
• In a fractional reserve banking system, banks
  create money.

• Banks accept deposits, hold fraction in reserve,
  lend out rest.
• Reserve-deposits ratio minimum is regulated
  reserve requirement, rr.
• New loans made create new deposits, increasing
  the money supply.
• Money multiplier shows how much money created
  by 1 of deposits
• mm 1/rr.

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Complex Model of Money Supply

• Fractional Reserve Banking and MS
• Exogenous Variables of Money Supply Model
• Monetary Base, B Currency, C Reserves, R.
• Reserve-Deposit Ratio, rr fraction of deposits
  held as reserves.
• Currency-Deposit Ratio, cr Currency holdings as
  of deposits
• Definitions
• Money Supply M C D Monetary Base B C
  R
• dividing M/B C D/CR
• rearranging M/B C/D 1/C/D R/D
• Model of Ms M cr 1 x B mm x B
• cr rr
• where mm is the Money Multiplier in this more
  complicated model of money supply.

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• Central Banks and Monetary Policy

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U.S. Federal Reserve System

• U.S. Federal Reserve System started 1913 as an
  independent Federal agency.
• Run by Board of Governors (7 members, 14 year
  terms)
• System made up of Federal Reserve Board and 12
  regional Federal Reserve Banks.
• Regulates banks ensures health of banking
  system.
• Lender of Last Resort to banks.
• Sets monetary policy and controls money supply.
• Federal Open Market Committee (FOMC)
• Board of Governors 5 regional Fed. Bank
  Presidents.
• Meets every 6 weeks to determine monetary policy.
• Implemented by FRB-NY trading desk.

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Instruments of Monetary Policy

• Open Market Operations
• Purchase or sale of govt bonds by the central
  bank.
• Open Market purchase of bonds by central bank
  increases monetary base, and so the money supply.
• Reserve Requirements
• Govt regulates banks minimum reserve-deposit
  ratios.
• Increase in reserve requirements will lower money
  multiplier and so decrease money supply.
• Discount Rate
• Interest rate on reserves borrowed from central
  bank.
• Lower rate, cheaper borrowed reserves, more banks
  borrow, thus increasing money supply.

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Other Central Banks

• European Union
• European Central Bank modeled after Federal
  Reserve with Central banks from EU member
  countries.
• Independent of member govts, sets monetary
  policy. Regulation of commercial bank reserves,
  etc. remains with EU natl govts.
• Japan
• Bank of Japan managed by Governor, recently made
  independent of Ministry of Finance.
• Sets required reserves for commercial banks, has
  discount window open market operations.
• United Kingdom
• Bank of England is the oldest central bank.
  Recently independent of Exchequer. Sets monetary,
  interest rate exchange rate policy.
• Commercial banks not required to hold reserves at
  BOE, discount houses act as intermediaries for
  borrowing reserves from BOE.

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Possible Goals of Monetary Policy

• Stability of the Price Level
• Keep the inflation rate both low and stable.
• Often involves responding to external supply
  shocks.
• Economic Growth and Employment
• Ensure unemployment rate and output growth are
  sustainable without increases in inflation rate.
• Stabilizing Interest Rates
• Ensure stable financial environment to channel
  savings to best use in real investment, related
  to economic growth.
• Stability in Foreign Exchange Rates
• Prevent volatility in exchange rate which reduces
  trade.

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• Non-Depository Institutions Future Purchasing
  Power

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Modifying Future Cash Flows

• Look at Non-depositary institutions whose primary
  function is to provide assets with desirable
  future cash flow profiles.
• Pensions, Insurance, Mutual funds all provide
  vehicles by which individuals and companies can
  modify their future cash flows.
• Generally involves pooling of individuals and/or
  assets to provide cash flow profiles not
  available to individuals on their own.

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Provision of Future Cash Flows
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• I. Investment Companies

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Investment Companies

• Investment Companies
• Raise funds by selling shares to public
  investing proceeds in a diversified portfolio of
  securities.
• Open-End Funds
• Termed Mutual Funds buy /sell shares on
  continual basis.
• Net Asset Value
• MV of portfolio assets MV of liabilities /
  shares outstanding
• Load Funds impose commissions on amounts
  invested.
• No-Load Funds does not impose sales commission.
• Back-end Load Funds charge commission to redeem
  shares.
• 12b-1 Funds impose 1.25 of average daily funds
  for costs.
• Fees pay for costs of marketing and selling
  shares in fund.

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Investment Companies

• Closed-End Funds
• Sell shares but usually do not redeem them.
  Shares sell on organized exchange or OTC.
• Price depends on supply vs. demand so can trade
  at discount or premium to NAV of portfolio
• Discount due to tax liabilities, premium due to
  desirable access or info.
• Unit Trusts
• of shares issued fixed like closed-end
  fund,normally portfolio of bonds.
• No active trading of bonds once purchased. Held
  by trustee until redeemed by issuer.
• Has a fixed termination date. Sales commission to
  start.

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Structure of a Fund

• Structure
• Board of directors hires financial advisor
  selling firm.
• Advisor charges advisory fee (0.4- 1.5),
  custodial fees.
• Investment Objectives of Funds
• Wide range of objectives for manager of equity
  fund.
• Income/capital gains, blue chip/growth, specific
  industries.
• Wide range of objectives for manager of bond
  fund.
• Corporate bonds (high-quality vs junk),
  convertible bonds, mortgage-backed securities,
  munis, money market securities.
• Balanced funds invest in both stocks and bonds.
• Economic Rationale for Funds
• Maturity intermediation, risk reduction via
  diversification, lower costs of info.
  transactions, payments mechanism.

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Other Aspects of Funds

• Regulation
• Investment Company Act (1940). Shares registered
  with SEC. Provide periodic reports, approval to
  change policies.
• Investment co.s pay no tax if distribute 90 of
  income to shareholders annually. Also must
  diversify asset-holdings.
• Fees charged regulated by SEC, 8.5 maximum.
• Banks and Mutual Funds
• Banks offer mutual funds to stem
  disintermediation.
• Shares in bank mutual funds generally not
  govt-insured.
• Family of Funds
• Management firm offers numerous funds with
  different objectives. Transfers between funds at
  low or no cost.
• Attempt to capitalize on economies of scale and
  scope.

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• II. Pension Funds

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Pension Funds

• Pension Funds
• Established by plan sponsors (firms, unions,
  govts) to pay retirement benefits to eligible
  employees.
• Structure
• Financed by tax-exempt contributions by
  employer/employee.
• Often employee contributions matched to some
  extent by employer.
• Private provision of an illiquid asset, not
  available until retire.
• Regulation of Pension Funds
• ERISA (1974) federal act regulating pension plans
• Funding standards for minimum contributions by
  plan sponsor.
• Fiduciary standards for fund trustees or
  managers.
• Minimum vesting standards for plan participants.
• Establish insurance program for vested benefits.

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Types of Pension Funds

• Defined Benefit Pension Funds
• Plan sponsor ,makes guaranteed payments at
  retirement based on employee characteristics
  (years worked, salary).
• Plan sponsor at risk of investments not
  generating sufficient returns to meet payments.
• Defined Contribution Pension Funds
• Plan sponsor makes contributions for qualifying
  employees.
• Payments at retirement depend on return earned
  over life.
• Returns not guaranteed by plan sponsor, depend on
  investment vehicles chosen by employee.
• Hybrid Pension Funds
• Combines some aspects of defined benefits and
  contribution.
• i.e. guaranteed minimum cash benefits financed by
  employer employee contributions.

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• III. Insurance Companies

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Insurance Companies

• Insurance Companies
• Financial intermediaries which, for a price,
  will make a payment (or series of payments) if an
  event occurs.
• Insurance Policy
• Premium paid by policyholder to insurance company
• Sets specified payments contingent on future
  events.
• Insurance company underwrites the policyholders
  risk.
• Regulation
• Insurance policies are not guaranteed by the
  govt.
• Insurance companies regulated primarily at state
  level.
• Sets type of securities eligible for investment.
• How value of securities determined for reporting
• Annual statement plus meet adjusted regulatory
  capital reqs.

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Property Casualty Insurance

• Personal or commercial lines provide broad range
  of insurance protection against
• Loss, damage, or destruction of property.
• Loss or impairment of income-producing ability.
• Loss resulting from injury or4 death due to
  accident.
• Amount of liability specified in policy. Premium
  paid is invested until needed to pay on a claim.
• Liabilities and Risk
• Amount and timing of claims difficult to predict
  for individual but easier for pool of
  policyholders.
• Geographic risk, regulatory pricing risk,
  inflation risk.
• Assets geared more to equities than bonds,
  liabilities shorter term than life insurance.

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Life Insurance

• Life Insurance
• Insurance against death but many of the products
  have an investment income component as well.
• Term Life Insurance
• Provides a death benefit but no cash buildup
  prior to death.
• Timing of benefit unknown for individual but can
  estimate actuarially the amount payable on pool
  of holders.
• Whole Life Insurance
• Pays stated value upon death but also accumulates
  cash balance (cash surrender) against which
  holder may borrow.
• Risk is insurance co. may not earn return on its
  assets sufficient to meet crediting rate built
  into policy premium.
• Universal life offers benefit separate
  investment vehicle.

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Life Insurance

• Annuity (Insurance Against Life)
• Regular payment to policy-holder for specified
  period.
• Life-contingent vs. nonlife-contingent policies.
• While length of individuals life not known,
  actuarial data in pool of individuals allows good
  estimate.
• Single premium deferred annuity used by pension
  plans.
• Guaranteed Investment Contract (GIC)
• GIC is zero coupon bond issued by insurance
  company at guaranteed crediting rate.
• Risk that insurance co. assets will earn less
  than this forcing insurance company into
  bankruptcy.
• Pure investment product available at different
  maturities.