Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 20
The Banking System
and Its Regulation
Dolan, Economics Combined Version 4e, Ch. 20
The U.S. Banking System
 Banks are financial institutions that accept deposits and
make loans
 Types of banks:
 Commercial banks
 Thrift institutions (savings and loans; mutual savings banks;
credit unions)
 The Federal Reserve System (Fed) is the central bank of
the United States
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The Balance Sheet
 A balance sheet is a financial
statement showing what a firm owns
and what it owes
 Assets are all the things that the firm
or household owns or to which it
holds a legal claim
 Liabilities are all the legal claims
against a firm by non-owners or
against a household by nonmembers
 Net worth, also listed on the righthand side of the balance sheet, is
equal to the firm’s or household’s
assets minus its liabilities. In
banking, net worth is called capital.
Assets
Liabilities
Net worth
The accounting equation:
Assets = Liabilities + Net Worth
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Balance Sheet of U.S. Banks
The principal assets of U.S. commercial banks are loans.
The principal liabilities are deposits.
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Risks of Banking
Types of risk
 Credit risk is the risk that
loans will not be repaid on
time and in full
 Market risk is the risk that
changes in market conditions
will cause a decrease in the
value of assets relative to that
of liabilities
 Liquidity risk is the risk that
a bank will have to sell
illiquid assets below the value
listed on the balance sheet,
resulting in a loss
Other important terms:
 An asset is said to be liquid if
it can be used as a means of
payment, or quickly and
easily converted to a means of
payment without loss of
nominal value
 A bank is said to be insolvent
if its liabilities exceed its
assets
 Reserves are cash or deposits
held at the Fed that a bank can
draw on to meet liquidity
needs
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Traditional Banking
Traditional banking earned
profits with an originate-tohold strategy
 Use funds from deposits to
make loans
 Hold the loans until they are
paid in full
 Earn a profit from the
difference between interest
rates on loans and interest
rates on deposits
 Hold cash reserves and
capital for safety
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Traditional Banking: Originate-to-Hold
Traditionally, banks rarely sold
loans to other investors
 No two loans were exactly
alike
 Bankers needed personal
knowledge of their
customers
 Buyers feared that any loan a
bank wanted to sell must be
a “lemon”
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The Beginnings of Securitization
 Starting in the 1930s,
Government Sponsored
Entities (GSEs) were created
to buy loans from banks
 Banks used the funds to make
new loans
 The GSEs bundled the loans
into securities and sold them
to investors—a process called
securitization
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Simple Pass-Through Bonds
 Earliest mortgage-backed
securities were simple passthrough bonds
 Each bond received an equal
share of all principal and
interest payments on a pool of
loans
 Each bond shared an equal part
of the loss from any default
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Senior-subordinate structure
 In important innovation was introduction
of tiers of bonds with different risk
(tranch)
 Senior bonds have first priority to receive
interest and principal payments, last to
bear losses
 Subordinate bonds bear the first risk of
losses from defaults, stand last in line for
income
 Mezzanine bonds stand in between
 Investors select safe, low-yield senior
bonds or riskier, high-yield subordinate
bonds according to their appetite for risk
Growing Complexity
Over time securitization became more complex. First households and firms borrow
from originating banks. The banks then sell the loans to GSEs and other
specialized intermediaries, who issue securities divided in "tranches"
according to risk Each type of security is rated and then sold to investors, often
hedge funds or other institutions, who buy the type of security that best fits
their appetite for risk. Investors can further protect themselves against risk by
means of credit default swaps which are a form of insurance purchased by the
investor.
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Perceived Benefits
For originating banks
 New sources of fee income
 No additional capital needed
 Reduced credit risk
For the economy
 Banks can make many more loans because they do not have to
hold the loans to maturity on their own books
 Credit risk borne by hedge funds, insurance companies, and other
investors thought best positioned to bear it
 Wide distribution of credit risk makes financial system more
stable
 Cost of credit reduced for everyone
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Housing and Social Policy
 In the 1990s, affordable housing
received increased attention as a
social issue
 Why should only the middle class
be able buy a home? Why were
low-income families excluded?
 Banks’ answer: Because loans to
low-income households are too
risky!
 Subprime loans were invented to
resolve the conflict between the
conservatism of traditional banking
and the demands of social policy
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Standard vs. Subprime Mortgages
Standard (prime) mortgages:
 Borrowers are expected to
repay loan from current
income
 Lenders profit primarily from
interest payments
 Borrowers get full benefit of
increase in home value or bear
full loss from decrease
Subprime mortgages
 Banks rely on appreciation of
home value, not borrowers’
income, for repayment
 Lenders profit primarily from
fees for origination, servicing,
and refinancing
 Lenders share benefit from
appreciation of home value
and risk of loss if value
decreases
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Standard vs. Subprime Mortgage terms
Standard (prime) mortgage
terms:
 Loan to value ratio usually
80%-90%
 Constant fixed rate for full 30year life of mortgage
 No prepayment penalty
 Require careful
documentation of income and
assets of borrower
Subprime mortgage terms:
 Loan to value ratio up to
100% or even more
 Low teaser rate for 2 or 3
years followed by high stepup rate
 Large prepayment penalty
 May not require
documentation of income or
assets
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Profitable in a Rising Market
 Subprime mortgages are
profitable to both lender and
borrower in a rising market
 Borrowers accumulate equity
in homes they could not
otherwise afford to buy
 Lenders extract profit at end of
initial 2 or 3 year period in one
of three ways
 Through prepayment penalties if
property is sold or refinanced
 Through high step-up interest
rates if not refinanced
 Through foreclosure in case of
default
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. . . but Risky in a Falling Market
In a falling market, subprime
mortgages are more likely
than prime mortgages to
produce losses
 Negative equity is more likely
because of high initial loan-tovalue ratio
 Low income borrowers are
more likely to default when
equity becomes negative
 Recovery rates on forced sales
of low-quality housing may be
low
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But house prices never fall, do they?
 From 1975 to 2006 house prices never had a nationwide down
year
 From 2000 on, prices rose far above the historical trend based on
gradually rising household incomes
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Do Banks Take Excessive Risks?
Spillover effects
 Failure of one bank may
trigger runs on other banks
 Failure of one bank may
causes losses for
counterparties (other
financial firms who do
business with the bank)
 Failure of the banking system
damages the nonfinancial
economy by interfering with
normal flows of credit
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Do Banks Take Excessive Risks?
Gambling with other people’s
money
 Conflicts of interest when one
party gets the gains and the
other party is stuck with the
losses
 Managers vs. shareholders
 Managers vs. traders
 Shareholders vs. bondholders
 In economic terminology,
these are called principalagent problems
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Gambling with your own or others’ money
When gambling with their own
money, many people choose
games like the lottery that
 lose most of the time, but not
more than they can afford
 don’t win often, but have a
huge payoff when they do win
 These are called positively
skewed risks
When gambling with other
people’s money, the best games
are ones that. . .
 win a moderate amount most of
the time
 rarely lose, but may have really
huge losses when they do
 Once a big loss comes, the
game is over, but the gambler
keeps past winnings and
someone else bears the cost
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Fiduciary Duties of Managers
 Financial managers are paid
to gamble with other
people’s money
 In doing so, they have a
fiduciary duty to act in their
shareholders’ best interests
 They should take prudent risks
when there is a good chance of
a high return for shareholders. .
.
 . . . but they should not put
their personal gain ahead of
shareholder interests
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Fiduciary Duties of Managers
 Executive compensation plans
are often misaligned with
fiduciary duties
 Bonuses for short-term
performance
 Lack of “clawback” (money
taken back in case of extraordinary
circumstances)
 Golden parachutes
 Such bonus-based
compensation plans cause
managers to seek excessively
risky strategies
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Example of misaligned incentives
Assume an executive bonus plan that pays 0.1% of net profit each quarter
Strategy A – Prudent, moderate
risk
 5 quarters of $100 million
profit
 5 quarters of $10 million loss
 10-quarter net for
shareholders: profit of $449.5
million
 10-quarter result for
executive: total bonuses of
$500,000
Strategy B – Aggressive, high
risk
 9 quarters of $200 million
profit
 1 quarter of $2,000 million
loss
 10-quarter net for
shareholders: loss of $201.8
million
 10-quarter result for
executive: total bonuses of
$1.8 million
Strategy
B has higher payoff for the executive but lower
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payoff for shareholders
Tools to Ensure Safety and Soundness
Lender of last resort
 During a bank panic, banks
may be unwilling to lend to
one another
 Lack of interbank credit
causes failure to spread
 Central bank makes
emergency loans to protect
banks from failure – That is
the FED in the US System
Deposit insurance
 During a bank panic, a run
may occur because depositors
fear only the first in line will
get their money back
 Government deposit insurance
means there is no need for a
run – That is the FDIC in the
US System
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Sources of the Crisis
 The housing bubble,
financed by subprime
lending
 Ratings failures and
disappearance of liquidity
 Regulatory failures
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Rehabilitating Failed Banks
Three questions for helping failed banks
 Who should be helped?
 All banks or only failing banks?
 Are some too big to fail?
 Who should bear the losses?
 Shareholders?
 Taxpayers?
 How should aid be provided?
 Carve-out?
 Capital injection?
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How a Carve-out Works
 The government first creates a
bank assistance agency (example:
TARP)
 The bank assistance agency
exchanges good government
bonds for low-quality financial
instruments (“toxic waste”)
 If the value of the low-quality
instruments turns out to be less
than that of the good bonds, the
bank assistance agency loses net
worth and the financial
institutions gain.
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How a Capital Injection Works
 The bank assistance agency
exchanges good
government bonds for
equity (common or
preferred stock) in financial
institutions.
 Low quality assets stay
with the financial
institutions
 The value of the
government’s stock rises or
falls depending on what
happens to the value of the
low-quality assets
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