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 circulation
R – 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
FED
Assets
Liabilities
Bonds +$100
Notes +$100
Banks
Assets
Reserves +$100
Bonds -$100
Liabilities
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
FED
Assets
Liabilities
Bonds +$100
Notes +$50
Reserves +$50
Banks
Assets
Reserves +$50
Liabilities
deposits +$50
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
Bank A
Assets
Liabilities
Reserves +$50
Loans +$50
deposits +$100
MB rises $100
M rises $150
Money Multiplier
Bank lending creates money.
DM = m x DMB
“change in”
D-
M = C + D the money supply
MB = C + R the monetary base
m – money multiplier
Money Multiplier
Bank lending creates money.
DM = m x DMB
“change in”
D-
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%,
•MB increases by $400
•Joe’s Bank lends it out
•rD = 50%
DM?
Joe’s Bank
Assets
Bonds -$400
Loans +$400
Liabilities
Multiple Deposit
Creation
•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?
Bank A
Assets
Liabilities
Reserves +$200
Loans +$200
Deposits $400
Multiple Deposit
Creation
•The money lent from Bank A
is eventually deposited in
Bank B
•Bank B lends its ER
Bank B
Assets
Liabilities
Reserves +$100
Loans +$100
Deposits $200
Multiple Deposit
Creation
•The money lent from Bank B
is eventually deposited in
Bank C
•Bank C lends its ER
Bank C
Assets
Reserves +$50
Loans +$50
Liabilities
Deposits $100
How much has the total money
supply changed?
Add the deposits
Bank A
Bank B
Bank C
$400
$200
$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 MB
m = 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?
iff
Who 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 policy
in 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.
BUT
long 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
p - inflation
y* - output target (potential GDP)
p* - inflation target
iff* - equilibrium real fed funds rate
iff = p +iff* + 1/2(p - p* ) + 1/2(y - y* )
What does this mean the Fed should
do if inflation and output are below
their targets?
20
16
12
8
4
0
-4
60
65
70
75
80
85
TAYLORRATE
90
95
FFR
00
05
10
10
8
6
4
2
0
-2
90
92
94
96
98
00
TAYLORRATE
02
04
FFR
06
08
10
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
Aggregate Supply &
Aggregate Demand
CPI
AS
AD
GDP
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)