Money, Banking, and Financial
Markets
Professor A. Sinan Cebenoyan
Stern School of Business - NYU
Set 1
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US Depository Institutions
• Incentives, always incentives!
• Commercial Banks
Size, Structure, and Composition
Balance Sheet and Trends-Regulation
• Thrifts
S&L’s and Savings Banks
Credit Unions
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Commercial Banks
•
•
•
•
•
•
1985----->>> 14,416
1989----->>> 12,744
1994----->>> 10,384
1998----->>> around 9,000
Why? Failures and M&A
Community, Regional, Super Regional, and
Money Center Banks
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Commercial Banks continued
• Assets: Business Loans (C and I)
Securities
Mortgages
Consumer Loans
Other (LDC)
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Commercial Banks continued
• Liabilities: Deposits
transactions
NOW
Savings and Time
Negotiable CD’s
Borrowings and Other
Exposure Concerns
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Commercial Banks continued
• Off-Balance Sheet Activities
Fee-related activities
Letters of Credit
Derivatives
Swaps
Exposure Concerns
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Regulation
• FDIC
• COC
• The Fed
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Thrifts
• Savings and Loans
Long-term mortgages backed by short-term
savings deposits (helped by the yield curve)
after 1979 different Fed targets:
Disintermediation
Regulation Q
DIDMCA, DIA
Regulatory Forbearance
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Thrifts continued
• FSLIC in trouble.>>>>FIRREA (1989)
SAIF under FDIC
RTC
strengthen capital requirements
QTL test
Number of S&Ls down sharply
• Balance Sheet and Recent Trends
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Thrifts continued
• Savings Banks
New England
mutual to stock
more diversified than S&Ls (assets)
more reliant on deposits >>less borrow
State regulators
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Thrifts continued
• Credit Unions
65% of assets in small Consumer loans
hold large amount of Government Sec.’s
Residential mortgages very small
lending funded by savings deposits
NCUA and NCUIF
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Insurance Companies
• Life Insurance Companies
death, illnesses, and retirement
• Property-Casualty Insurance
personal injury and liability
accidents, theft, fire...
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Life Insurance Companies
• Life Insurance
Ordinary Life (Term, Whole, Endowment
Variable, Universal, Variable
Universal) ---- 58%
Group Life --- 40%
Industrial Life ---- 0.2%
Credit Life ------ 2%
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• Other Life Insurer Activities
Annuities
Private Pension Funds
Accident and Health Insurance
• Balance Sheet
Assets>>15.9% Gov.Sec., 65% corp.
Bonds and stock, 8% mortgs., balance
policy and other loans
Liabilities>>53% net policy reserves
• Regulation >> McCarran-Ferguson Act ‘45
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Property-Casualty Insurance
• PC Insurance
Fire Insurance
Homeowners
Commercial
Marine
Auto liability+ PD, Liability other
Reinsurance
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• Balance Sheet and Underwriting Risk
Loss Risk >>>Predictability:
Property(more) vs. liability(less predict.)
Severity vs. Frequency
Long tail(claims later) versus short tail
Product Inflation versus social infl.
Loss ratio (Losses/Premiums)
Expense risk
Investment Yield/Return Risk
Regulation
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Other Financial Institutions
• Securities Firms and Investment Banks
• Finance Companies
• Mutual Funds
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Securities Firms and Investment
Banks
• Size, Structure, + Composition of Industry
Number of firms
Sizes >>>Merrill Lynch to regionals
Activities: Investing, Investment Banking (IPO, PP)
Market Making, Trading (Position Trading,
Pure Arbitrage, Risk Arbitrage, Program
Trading), Back-Office and Other
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• Balance Sheet and Recent Trends
Commissions down after crashes, but up mostly in
the 90’s. Underwriting and Holdings of Fixed
income securities >>> Risk implications
Assets: Long Positions in Securities and
Commodities (26%) and Reverse repurchase
agreements (35%).
Liabilities: Repurchase agreements (47%)
securities and comm. sold short +loans+equity
• Regulation: SEC, NYSE, NASD, SIPC
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Finance Companies
• 2 Major Types:
1) Installment (auto) loans to consumers
2) Consumer+corporate loans, Factoring
• Commercial Paper used in Financing
• No Deposits -->>> Not much regulation
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Mutual Funds
• Diversification
• Lower Transaction Costs
• First in Boston, 1924,
360 in 1970
about 8,000 today ($5 trillion managed)
after last couple of weeks maybe $4 trillion!
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Mutual Funds continued
• Load Funds, REITs
• 12b-1 fees
• Short-term funds
Taxable or tax-exempt
Money market mutual funds
• Balance Sheets:
• MMMF 75% in short
term securities (foreign
and domestic deposits,
RP’s, CP, US gov.secs)
• Long term Funds 63%
in stocks, US Treasuries
and muni. bonds 23%.
• Long Term Funds
Bond, income, and equity funds
Returns: income and dividends,
capital gains when sold, capital
appreciation
Marked-to-Market daily
NAV
open versus closed-end
• Regulated by the SEC,
and States.
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Overview of the Federal Reserve
System
• Today, Fed’s duties are:
• Conducting the nation’s monetary policy…in
pursuit of full employment and stable prices
• Supervising and regulating Financial Inst.s…safety
and soundness…credit rights of consumers
• Maintaining the stability of the fin’l system
...containing systemic risk
• Providing certain fin’l services…major role in
operating the nation’s payment system
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Background
• History of failures.
• December 23, 1913 Wilson signs into law the Federal
Reserve Act
• To provide for the establishment of Federal Reserve Banks, to
furnish an elastic currency,…,effective supervision…
• Other Acts followed to fill in other needs
Structure of the System
•Board of Governors, Washington, D.C.
•12 Regional Federal Reserve Banks
•Federal Open Market Committee (FOMC)
•Board + President of NY Fed+ 4 rotating other presidents
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Three Major Tools Fed uses to conduct Monetary
policy:
•Open Market Operations - FOMC
•Reserve Requirements - Board has sole authority
•The Discount Rate - Board approves any change by a Fed bank
Banking Supervision
•shared with OCC + FDIC
•All member banks + BHCs + Foreign activities of
member banks, US activities of foreign banks, Edge Act
corporations
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Federal Reserve Banks
•12 regional feds with 25 branches: Operate the nationwide
payments system, distribute the nation’s currency and coin,
supervise, regulate member banks and BHCs, and serve as Banker
to the US Treasury.
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Monetary Policy
• Goals of Monetary Policy
– maximum employment
– stable prices
– moderate long-term interest rates
• Reserves Market
– Demand for Reserves
» Required reserves and excess reserves
– Supply of Reserves
» (Borrowed Reserves) Discount Window and
(Nonborrowed Reserves) Open Market Operations
– Federal Funds Rate
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Open Market Operations
• Buying and selling of Securities by the Fed
– Purchase adds to nonborrowed reserves, a sale reduces
them
– When fed buys securities, it pays by issuing a check on
itself, when the seller deposits the check in her bank,
the bank presents the check to the Fed for payment, and
the Fed increases the reserve account of the seller’s
bank at the federal reserve bank. The reserves of the
seller’s bank rise with no offsetting decline elsewhere;
consequently, the total volume of reserves increases.
– This dollar for dollar change in the reserves makes
Open M. Ops. The most powerful, flexible, and precise
tool of monetary policy.
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• Other factors Influencing Nonborrowed Reserves
(Technical factors):
– Amount of currency in circulation
– Size of Treasury Balances at the Fed
– Volume of Federal reserve Float
• Techniques of Open Market Operations
– Outright Purchases and Sales
• through auctions with dealers
– Repurchase agreements
• for temporary adjustments, buy from dealers who
will repurchase by a fixed date at a fixed price.
– Matched Sale-Purchase transactions
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• The Discount Window
• Complements Op. Mkt. Ops…and implementation
of longer-term monetary policy goals
• Facilitates B/S adjustments of individual banks that
face temporary changes in asset-liability structure
• Uniform Discount rate across all Reserve Banks
• If holding deposits subject to reserve requirements
then eligible for discount window access.
• Borrowing either done as discounting paper, or as an
advance secured by collateral
• Adjustment Credit: for short-term liquidity needs
– Fed provides credit at its own discretion
– Borrowing must be for appropriate reason
– other sources must be sought first
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• Seasonal Credit helps small institutions lacking access to national
money markets, e.g. agricultural banks
• Extended Credit: provided when exceptional circumstances or
practices adversely affect an institution.
• Emergency Credit: “unusual and exigent” circumstances, not used
since the 1930s
• Reserve Requirements:
– Since the MCA of 1980 all depository institutions, regardless of
membership in the Fed, are subject to reserve requirements
– 8-14 percent on transaction deposits, 0-9 percent on nonpersonal
time deposits
– The MCA broadened the reserve base and improved the
predictability of the link between reserves and M1
– In 1982 switch to Contemporaneous reserve requirement scheme
tightened the real-time link between M1 and reserves.
– 1984 focus shifts to M2, as M1 becomes highly sensitive to interest
rates
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• Consumer Protection
– Federal reserve writes regulations to implement Consumer
protection laws enacted by Congress
– Federal reserve enforces state-chartered member banks
– staff examiners regularly evaluate banks
• The Fed and the Payments System
– The Fed is an active intermediary in clearing and settling interbank
payments, as they maintain reserve or clearing accounts for the
majority of depository institutions.
– Cash Services:Currency and Coin…ensure enough in circulation to
meet public’s demand. Notes issued by the Feds, coin by the
Treasury.
– Noncash-Transaction Services
• Check processing
• Electronic Funds transfer: Fedwire for large ACH for small-dollar
payments
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• Fiscal Agency Functions
–
–
–
–
Maintaining the Treasury’s funds account
Clearing Treasury checks drawn on that account
Conducting nationwide auctions of Treasury securities
Issuing, servicing, and redeeming Treasury securities
• International Services
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Why are Financial Intermediaries
Special?
• Flow of Funds in a world without FI’s
Households
net savers
Cash
Corporations
net borrowers
Equity and debt claims
•Monitoring costs (covenants)
•Liquidity
•Price Risk
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• Flow of funds in a world with FI’s
Households
…
…
FI
Corporations
(brokers)
Cash
----------FI
Equity +
Debt
(asset-transformers)
Deposits and
insurance
policies
Cash
•Brokerage Function
reduce transaction costs, imperfections etc..
•Asset transformer:
purchase Primary Securities and sell deposits,
insurance policies,etc.(Secondary securities)
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• Information Costs
FI does the monitoring to reduce agency costs
hence a delegated monitor
economies of scale
frequent monitoring in Bank Loans allows the FI to
gather information constantly (insider?)
Reduction of imperfections and information
asymmetries
• Liquidity and price risk
Through diversification, FI’s offer highly liquid and
low price -risk contracts on the liability side of their
B/S while investing in relatively illiquid and higher
price-risk securities of corporations on the asset side.
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• Reduced Transaction Costs
Bulk asset purchases reduce costs (mutual funds and pension
funds)
Bid-ask spreads are lower in large quantity purchases
• Maturity Intermediation
Other Aspects
•
•
•
•
Transmission of Monetary Policy
Credit Allocation (residential mortgages, farming loans…)
Intergenerational Wealth Transfers (Time Intermediation)
Payment Services
check clearing and wire transfers
• Denomination Intermediation
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Specialness and Regulation
Negative externalities - Runs - Redlining
Net regulatory burden (Difference between the private benefits
to an FI from being regulated (guaranties) and the private costs of
regulations (examinations)).
• Safety and Soundness Regulation
Diversification (no more than 15% of own equity capital
can be lent to any one company or borrower
Capital requirements
Guaranty funds
Examinations
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• Monetary Policy Regulation
Outside Money
Inside Money
Reserve Requirements
• Credit Allocation Regulation
QTL
• Consumer Protection Regulation
CRA, HMDA
• Investor Protection Regulation
Securities Act of ‘33, Investment Co. Act ‘40
• Entry Regulation
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Changing Dynamics
• Table 4.3 1997 figures:
Commercial banks
Thrifts
Insurance companies
Investment Companies
Pension Funds
Finance companies
Securities brokers/dealers
Mortgage Companies
REIT’s
36%
11
19
14
12
6
1.5
0.3
0.2
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Risks of Financial Intermediation
• Interest Rate Risk: The risk incurred by an FI when the
maturity of its assets and liabilities are mismatched.
0
0
Liabilities
1
1
2
Assets
Suppose the cost of Funds (liabilities) is 9 %, and interest return on
assets is 10%. Profit spread of 1%. But there is Refinancing
Risk -The Risk that the cost of rolling over or reborrowing funds will
rise above the returns being earned on asset investments.
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• Reinvestment Risk - The risk that the returns on funds
to be reinvested will fall below the cost of funds
1
0
2
Liabilities
0
Assets
1
FI borrows at 9%, and invests in an asset yielding 10%. But at what
rate will reinvestment take place?
Market Value Risk: As interest rates rise market value of assets or
liabilities will fall. Moreover, mismatching maturities by holding
longer term assets than liabilities implies when rates rise asset MVs fall
more than liabilities. This could lead to economic loss and insolvency.
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• Market Risk - The Risk incurred in the trading of assets
and liabilities due to changes in interest rates, exchange
rates, and other asset prices.
– Barings Bank lost $1.2 billion on its trading position
(buying Futures on the Nikkei index and betting the
index would rise)
• Credit Risk - The risk that the promised cash flows from
loans and securities held by FIs may not be paid in full.
Virtually, all types of FIs face this risk. However, those
that make loans or buy bonds with long-maturities are
more exposed (banks, thrifts, and life insurance co.s).
Default of a borrower puts both the principal and the
interest payments at risk.
– Diversification helps. Firm Specific Credit Risk is reduced, while
the FI is still exposed to Systematic Credit Risk
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• Off-Balance-Sheet Risk - The Risk incurred by an FI due
to activities related to contingent assets. While all FIs, to
some extent, engage in Off-Balance-Sheet activities,
mostly larger banks have drawn attention.
– For example: A letter of Credit which is a guaranty issued by an
FI for a fee (makes it attractive) on which payment is contingent on
the default of the agent that purchases the letter of credit. Nothing
appears on the B/S but the fee appears on the income statement.
• Technology and Operational Risk
– Purpose of technology is to lower operating costs, increase profits
and capture new markets for the FI.
– Economies of Scale: The degree to which an FI’s average unit
costs of producing financial services fall as its output of services
increase
– Economies of Scope:The degree to which an FI can generate cost
synergies by producing multiple financial service products.
– Technology Risk occurs when technological investments do not
produce the anticipated
cost savings.
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- Operational Risk : The risk that existing technology or support systems may
malfunction or break down.
•Foreign Exchange Risk: The risk that exchange rate changes can affect the
value of an FI’s assets and liabilities located abroad. If a U.S. FI is net long in
foreign currency denominated assets, any depreciation of the foreign currency
against the US dollar would lead to a loss for the U.S. FI . If a net short position
prevails, then an appreciation of the foreign currency would lead to a loss.
- Even if we match the amounts of the assets and liabilities, we would still
not be fully hedged if we have exposure to foreign interest rate risk from a
maturity mismatch (simple maturity matching does not lead to a good hedge
either, we need to match durations, but more on that later).
•Country or Sovereign Risk: The risk that repayments from foreign borrowers
may be interrupted because of interference from foreign governments.
•Liquidity Risk : The risk that a sudden surge in liability withdrawals may leave
an FI in a position of having to liquidate assets in a very short period of time and
at low prices. ( Fire-Sale ) (RUN!)
•Insolvency Risk: Not having enough capital to offset a decline in asset values.
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