Money and Banking Final Review

Chapter 10
Banking and the Management of Financial Institutions Banks • Financial institution • Financial intermediary o Take deposits, make loans • Banks make money on the spread between what they take in from loans and what they pay out on interest on deposits o (minus their expenses) • Government licensed institutions o Can be licensed by the federal government or the state government o Federally chartered or state chartered • Receiving, keeping, lending, money with interest o "Banco" ( bench or desk • Borrow short lend long o Borrow money short term, and lend in the long term o Take deposits, lend money with long term loans • Holding company o Citi bank ( citi group o Citi group owns citi bank and prime America, among others o Own other financial entities • Banks cannot own real estate in America

Types of banking activities • Retail banking o Deals directly with individuals and small businesses • Business banking o Provides banking services to midsize businesses • Corporate banking o Deals with large businesses (Fortune 100 and 500, etc.) • Private banking o Deals with high net worth individuals • Investment banking o Deals with financial markets *Citi, Bank of America, and JP Morgan Chase does all of the above • Islamic banking o Interest free o Under law you aren't allowed to give or charge interest o They do charge it but don't call it interest, they've worked around it o Don't believe in usury What do banks do? • Banks act as a payment agent o Take checks (cleared through Federal Reserve and take deposits • Enable customer payments through electronic systems o ACH automatic clearing house o ATM transactions • Borrow money (by accepting deposits) • Lend (loans) • Provide all types of payment services Banks are faced with a number of risks • 3 primary risks 1. Liquidity ▪ Pay deposits 2. Credit ▪ Risk of defaults 3. Interest rate ▪ Need to make sure there is a sufficient spread between what comes in and what is paid out Banks are faced with a number of challenges 1. Highly regulated o By the FDIC, the OCC, FRB, etc. 2. Each regulator has own regulations 3. Struggle to effectively manage interest rate spread 4. Managing their asset portfolio 5. Pressures from shareholders o Shareholders want to get paid 6. Increased competition Chapter 11 The Bank Balance Sheet

Assets (something that is owed to you) • Reserves • Cash items in process of collection • Deposits at other banks • Securities o Government securities ▪ US government has never defaulted on anything ▪ Banks are not permitted to buy stocks; too risky • Loans o Considered assets on a bank's balance sheet • Other assets Liabilities (what is owed by you) • Checkable deposits o Accounts that allow owners to write checks • Nontransaction deposits • Borrowings o Borrow from other banks, any borrowings • Bank capital o Assets-Liabilities=Bank Capital o i.e. net worth • Banks make profit by selling liabilities and buying assets o Borrow short lend long Bank Management • Liquidity Management o If banks don't have enough liquidity they may: ▪ borrow from Fed, borrow from other banks, sell securities (stocks), reduce lending • Asset Management o Diversify o Adequately underwrite or review loans (adverse selection) ▪ Due diligence before lending • Liability Management • Capital Adequacy Management o Return on assets (ROA) ▪ Determines profitability ▪ Net profit after taxes/assets o Return on equity (ROE) ▪ Net profit after taxes/equity o Negative ROA or ROE reduces your bank capital ▪ Putting you at greater risk of not surviving o Higher capital, safer financial institution Secondary Cap • NCUA • 7% • PCA • Subordinated debt o Debt that is paid after the regular debt holders are paid

Credit Risk • Risk that arises because borrowers may default • Borrower with a low credit score Interest-rate Risk • Risk that rates will change (?) • Banks need to manage interest rates • Fixed rate o Same rate now until you pay it off o Borrowers like this because you know what you're going to pay • Adjustable rate o Tied to an index and margin ▪ LIBOR, treasury funds, etc. ▪ As the rate goes up and down, the interest rate on the loan goes up and down o The rate fluctuates o Banks like the adjustable rate, because it changes with the times Credit Risk: Overcoming adverse selection and moral hazard • Screening and monitoring o Screening o Covenants • Long term customer relationships • Loan commitments • Collateral and compensating balances • Credit rationing Eight Categories of Banking Regulations 1. Government safety net (FDIC) 2. Restrictions on asset holdings (cannot hold stocks) 3. Capital requirement 4. Bank supervision o Chartering- screening of proposals to open new financial institutions to prevent adverse selection o Examinations- monitor capital requirements and restrictions on asset holding to prevent moral hazard ▪ Capital adequacy ▪ Asset quality ▪ Management ▪ Earnings ▪ Liquidity ▪ Sensitivity to market risk o Filing periodic “call reports” 5. Assessment of risk management o Greater emphasis on evaluating soundness of management process for controlling risk o Trading Activities Manual of 1994 for management rating based on: ▪ Quality of oversight provided ▪ Adequacy of policies and limits for all risky activities ▪ Quality of the risk measurement and monitoring systems 6. Disclosure requirements o Requirements to adhere to standard accounting principles and to disclose wide range of information o The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements o Sarbanes-Oxley act of 202 established the Public Company Accounting Oversight Board o Mark-to-market (fair-value) accounting 7. Consumer protection o Consumer Protection Act of 1969 (Truth-in-Lending Act) ▪ All lenders provide information to borrowers about the cost of borrowing money ▪ Interest rate (cost to borrow) vs. APR (annual percentage rate; total finance charges of a loan; interest rate + all other costs) o Fair Credit Billing Act of 1974 ▪ Requires billing complaints to be handled quickly o Equal Credit Opportunity Act of 1974, extended in 1976 ▪ Prohibits discrimination based on race, gender, national origin, age, and marital status o Community Reinvestment Act ▪ To prevent red-lining (ruling out lending money in risky areas) and help reinvest in communities where deposits were taken ▪ Rating= outstanding, satisfactory, or needs improvement • Lending test • Investment test • Service o The subprime mortgage crisis illustrated the need for greater consumer protection 8. Restrictions on competition • Justified as increased competition can also increase moral hazard incentives to take on more risk o Branching restrictions (eliminated in 1994) o Glass-steagall act (repeated in 1999) • Disadvantages o Higher consumer something o Something else Chapter 12

Historical development of the banking system • Bank of north America chartered in 1782 • Controversy over the chartering of banks

Primary supervisory responsibility of bank regulatory agencies • Federal reserve and state banking authorities: state banks that are members of the Federal Reserve system Financial innovation and the growth of the "shadow banking system" • Financial innovation is driven by the desire to earn profits • A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable o Financial engineering ▪ Research and development ▪ New and innovative products ➢ Financial institutions are Conducting R&D to come up with new products and services ➢ Those products and services are to meet the needs of consumers and make a profit

Types of Financial Engineering: 1. Responses to changes in demand condition • Adjustable rate mortgage (ARMs) ▪ Rate changes depending on market conditions ▪ Index o Risk premium that is added to the interest rate o London inter-bank offer rate (LIBOR) o Prime rate is the rate that banks offer businesses o Cost of funds index (COFI)- Cost that banks pay for their funds o Margin o Financial derivative ▪ A financial instrument that derives its value of some real stock or real good ▪ It is a contract between two parties 2. Responses to changes in supply condition • Bank card, debit card, credit card ▪ Bank card- a card that allows you to spend, visa, amex, etc. and is tied to a bank account ▪ Visa, mastercard, diners club, etc. tied to those banks ▪ Credit card- a card that is tied to a specific retailer ▪ You can only use it at that retail establishment, not anywhere else ▪ Macy's, et. ▪ Debit card ▪ You have a balance in your account and is immediately taken out of the account when you make a purchase • Electronic banking ▪ ATM ▪ Online banking 3. Avoidance regulation • 2 types of regulation that restrict the ways that banks can operate (make a profit) • Reserve requirements ▪ Banks must keep a certain amount of funds on hand ▪ Can borrow from other banks or the federal reserve • Restrictions on how much interest can be made Chapter 13
Central Banks and the Federal Reserve

Central bank of the US • The "banks' bank" • The U.S. fed is quasi-gov • Most significant and important central bank in the entire world • Created in 1913 • Before the central bank was created, people feared a centralized banking power • The system of our fed is very strange (?) • Every country has a central bank • Mange monetary policy of the country o Currency, last resort for banks

3 largest and most significant federal reserve banks 1. NY 2. Chicago 3. San Francisco

• They are the largest because they have the most banks in their district • These are all part private (government) and public (run by member banks of the federal reserve) Functions of the Federal Reserve banks 1. Clear checks 2. Issue new currency 3. Withdraw damaged currency from circulation 4. Administer and make discount loans to banks in their districts 5. Evaluate proposed mergers and applications for banks to expand their activities o If a bank wants to expand or acquire another bank or merge, the fed examines those applications 6. Act as liasons between the business communty and the federal reserve system 7. Examine bank holding companies and state chartered member banks 8. Collect data on local business conditions 9. Use staffs of professional economists to research topics related to the conduct of monetary policy Federal Reserve banks and monetary policy • Directors "establish" the discount rate • Monetary policy is: o The management of money supply and interest rates o Goal is to make sure • Decide which banks can obtain discount loans • Directors select one commercial banker from each district to serve on the federal advisory council which consults with the board of governors and provides info to help conduct monetary policy • 5 of the 12 bank presidents have a vote in the federal open market committee (FOMC) Goals of the Fed in terms of monetary policy 1. High employment (low unemployment) 2. Make sure there is economic growth o Important because it is an indicator of a stable economy 3. Make sure there are stable financial markets o (stock, bond, fx markets) o Important because it shows economic health with stable markets 4. Interest rate stability o Important because it shows that the economy is doing well 5. Want to make sure the dollar and fx market is stable Chairman of the Board of governors • Advises the president on economic policy • Testifies in congress • Speaks for the federal reserve system to the media • May represent the US in negotiations with foreign governments on economic matters

Chapter 14
The Money Supply Process Players in the Money Supply Process • Central bank (federal reserve system) o They control the money supply and interest rates; very critical • Banks (depository institutions; financial intermediaries) o Used by central bank • Depositors (individuals and institutions) o Used by banks • Borrowers o Use depositors and used by banks Markets • Stock o Equities market • Bond (where interest rates are set) o Debt market o OTC market o There is an inverse relationship between bond prices and interest rates • Foreign Exchange o OTC market o Largest market of the 3 o Where foreign currencies are traded o 2 types of exchange rate transactions 1. Spot ▪ Involves an immediate up to 2 day exchange of deposits ▪ It is a bank to bank exchange 2. Forward ▪ At some time in the future, you will exchange x amount of $ to euros or something else ▪ So you would lock into a forward transaction ▪ Bank to bank transaction at some point in the transaction of currency

Currency appreciation • U.S. dollar appreciates against the euro • The value of U.S. is worth more compared to the euro (you will get more euros for dollars) •
Currency depreciation • U.S. dollar depreciates against the euro • The value of U.S. is worth less compared to the euro (you will get less euros for dollars) *Exchange rates are important because they are used for trade

Chapter 15
Tools of Monetary Policy

• Open market operations o Affect the quantity of reserves and the monetary base o Consists of the Buying and selling of previously issued government securities • Changes in borrowed reserves o Affect the monetary base • Changes in reserve requirements o Affect the money multiplier o Percentage of a certain deposits in the bank's or the fed's vault or on hand o Fed rarely changes reserve requirements ▪ Typically banks need 10-12% of deposits in reserve • Federal funds rate: the interest rate on overnight loans of reserves from one bank to another o Primary instrument of monetary policy • Discount rate Discount window lending- When banks borrow from the fed in order to meet reserve requirements Discount Policy • Discount window • Primary credit: standing lending facility o Lombard facility • Secondary credit o Seasonal credit • Lender of last resort to prevent financial panics • Creates moral hazard problem • Deposits are highest around tax return season, holidays is when the deposits are the lowes