CHAPTER 1

An Introduction to Money and the Financial System

Chapter Overview
Chapter 1 introduces students to the five parts of the financial system and to the
five core principles that will be used throughout the text as each topic is covered.
The organization of the text is also discussed.

Learning Objectives: Establish an understanding of :

● The parts of the financial system
● The core principles of money and banking
● Special features and organization of the book

I. THE FIVE PARTS OF THE FINANCIAL SYSTEM

A. The financial system has five parts, each of which plays a fundamental
role in our economy. The parts are:
1. Money: used to pay for purchases and store wealth.
2. Financial instruments: used to transfer resources from savers to
investors and to transfer risk to those best equipped to bear it.
3. Financial markets: allow us to buy and sell financial instruments quickly
and cheaply
4. Financial institutions: provide a myriad of services, including access to
financial markets, and collect information about prospective borrowers to
ensure that they are creditworthy.
5. Government regulatory agencies: responsible for making sure that the
elements of the financial system operate in a safe and reliable manner.
6. Central banks: monitor and stabilize the economy.
 B. While the essential functions of these five categories endure, their
physical form is constantly evolving.
1. Money has evolved from coins to paper money to today’s electronic
funds transfers.
2. Financial instruments where once investing was an activity reserved
for the wealthy, today’s small investors have the opportunity to
purchase shares in “mutual funds.”
3. Financial markets have evolved from trading places to electronic
networks. Transactions are cheaper and markets offer a broader
array of financial instruments than were available even 50 years ago.
4. Financial institutions: Today’s banks are more like financial
supermarkets offering a huge assortment of financial products and
services for sale.
5. Regulations: Dodd Frank Wall Street Reform and Consumer
Protection Act is the largest regulatory change since the 1930s.
6. Central banks: what had been government treasuries have evolved
into the modern central bank that controls the availability of money
and credit in such a way as to ensure low inflation, high growth, and
the stability of the financial system. Policy makers strive for
transparency in their operations, which were once shrouded in
mystery. Recent financial crises have compelled central banks to
experiment with new tools.
C. We must therefore develop a way to understand and adapt to the
evolutionary structure of the financial system.
D. One way to do that is to discuss money and banking within a
framework of core principles that do not change over time; this is the
focus of the next section.

THE FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. TIME HAS VALUE

a. The first core principle is that time has value.
b. As a result of interest, time affects the value of financial transactions.
2. RISK REQUIRES COMPENSATION.

a. The world is filled with uncertainty; some possibilities are welcome

and some are not.
b. To deal effectively with risk one must consider the full range of
possibilities: eliminate some risks, reduce others, pay someone else
to assume particularly onerous risks, and just live with what’s left.
c. Investors must be paid to assume risk and the higher the risk the
higher the required payment.
d. With even these first two principles we can understand the valuation
of a broad set of financial instruments; for example, lenders charge
higher rates if there is a chance the borrower will not repay.

3. INFORMATION IS THE BASIS FOR DECISIONS

a. Most of us collect information before making decisions, and the more

important the decision the more information we collect.
b. The collecting and processing of information is the foundation of the
financial system.
c. Some transactions are arranged so that information is NOT needed; for
example, stock exchanges are organized to eliminate the need for costly
information gathering and thus facilitate the exchange of securities.
d. In one way or another, information is the key to the financial system.

4. MARKETS DETERMINE PRICES AND ALLOCATE RESOURCES

a. Markets are the core of the economic system; they are the place, physical
or virtual, where firms go to issue stocks and bonds, and where individuals
go to purchase assets.
b. Financial markets are essential to the economy, channelling its resources
and minimizing the cost of gathering information and making transactions.
c. Well-developed financial markets are a necessary precondition for healthy
economic growth.
d. Markets determine prices and allocate resources and thus are sources of
information.
 e. By attaching prices to different stocks or bonds, markets provide the basis
for the allocation of capital.
f. Financial markets do not arise by themselves; they require rules to operate
properly and authorities to police them.
g. Even well-developed markets can break down.
h. For people to participate in a market it must be perceived as fair, and this
creates an important role for the government: when the government
protects investors, financial markets work well (otherwise they don’t).

5. STABILITY IMPROVES WELFARE

a. Reducing volatility reduces risk.

b. Only government policymakers can reduce some risks.
c. By stabilizing the economy monetary policymakers eliminate risks that
individuals can’t eliminate, and so improve everyone’s welfare in the
process.
d. Stabilizing the economy is the primary function of central banks. 5. A stable
economy grows faster than an unstable one.
LESSONS OF CHAPTER
A healthy and constantly evolving financial system is the
foundation for economic efficiency and economic growth. It has
six parts:
a. Money is used to pay for purchases and to store wealth.
b. Financial instruments are used to transfer resources and
risk.
c. Financial markets allow people to buy and sell financial
instruments.
Financial institutions provide access to the financial
markets, collect information, and provide a variety of
other services.
d. Government regulatory agencies aim to make the
financial system operate safely and reliably.
e. Central banks stabilize the economy.
 2. The core principles of money and banking are useful in
understanding all six parts of the financial system.
a. Core Principle 1: Time has value.
b. Core Principle 2: Risk requires compensation.
c. Core Principle 3: Information is the basis for decisions.
d. Core Principle 4: Markets determine prices and allocate
resources.
e. Core Principle 5: Stability improves welfare.

CHAPTER 2
Depository Institutions: Banks and
Bank Management
Chapter Overview
This chapter examines the business of banking, looking at where depository
institutions get their funds and what they do with them. It also examines the
sources of banks’ liabilities and the ways that they manage their assets. The
sources of risk that banks face are also considered, as well as how that risk can be
managed.

Reading this chapter will prepare students to:

● Understand banks’ balance sheets and how they make profit.
● Explain the risks in the day-to-day business of banks.
● Assess the degree to which banks can manage the risks they face.

IMPORTANT POINTS OF THE CHAPTER

Banks are the most visible financial intermediaries in the economy. These
depository institutions accept deposits from savers and make loans to borrowers.
They include commercial banks, savings and loans, and credit unions. Banks seek
to profit from their various lines of business; they provide accounting and record
keeping services, provide access to the payments system, pool the savings of
small depositors and use the funds to make loans to borrowers, and they offer
customers risk-sharing services. Banks are important, and when they are poorly
managed the entire economy suffers.

APPLICATION OF CORE PRINCIPLES

● PRINCIPLE 1: TIME. Banks hold only 3% of their assets as cash because

holding cash is expensive; it earns no interest.
● PRINCIPLE #3: INFORMATION. Among a bank’s off-balance sheet activities
is the provision of a line of credit to a trusted customer. Since the bank
usually knows the customer to whom it grants the line of credit, the cost of
establishing creditworthiness (an information cost) is negligible.
● PRINCIPLE #2: RISK. Banks are exposed to a host of risks, including
liquidity risk, credit risk, interest-rate risk, trading risk, and operational risk.
● PRINCIPLE #1: TIME. Holding excess reserves is expensive, since it
means forgoing the interest that could be earned on loans or securities.
● PRINCIPLE #3: INFORMATION. Since banks specialize in information
gathering, they attempt to gain a competitive advantage in a narrow line of
business. The problem is that doing so exposes the bank to added risks.

THE BALANCE SHEET OF COMMERCIAL BANKS

A. Assets: Uses of Funds
1. The asset side of a bank’s balance sheet includes cash, securities,
loans, and all other assets (which includes mostly buildings and
equipment).
2. Cash Items: The three types of cash assets are reserves (which
includes cash in the bank’s vault as well as its deposits at the
Federal Reserve); cash items in the process of collections
(uncollected funds the bank expects to receive); and the balances
of accounts that banks hold at other banks (correspondent
banking).
 3. Securities: The second largest component of bank assets; includes
U.S. Treasury securities and state and local government bonds.
Securities are sometimes called secondary reserves because they
are highly liquid and can be sold quickly if the bank needs cash.
4. Loans: The primary asset of modern commercial banks; includes
business loans (commercial and industrial loans), real estate loans,
consumer loans, interbank loans, and loans for the purchase of
other securities. The primary difference among the various types of
depository institutions is in the composition of their loan portfolios.

B. Liabilities: Sources of Funds

1. Banks need funds to finance their operations; they get them from
savers and from borrowing in the financial markets.
2. There are two types of deposit accounts, transactions (checkable
deposits) and non transactions.
3. Checkable deposits: A typical bank will offer 6 or more types of
checking accounts. In recent decades these deposits have declined
because the accounts pay low interest rates.
4. Non transactions Deposits: These include savings and time deposits
and account for nearly two-thirds of all commercial bank liabilities.
Certificates of deposit can be small ($100,000 or less) or large
(more than $100,000), and the large ones can be bought and sold in
financial markets.
5. Borrowings: The second most important source of bank funds; banks
borrow from the Federal Reserve or from other banks in the federal
funds market. Banks can also borrow by using a repurchase
agreement or repo, which is a short-term collateralized loan in which
a security is exchanged for cash, with the agreement that the parties
will reverse the transaction on a specific future date (might be as
soon as the next day).
C. Bank Capital and Profitability
1. The net worth of banks is called bank capital; it is the owners’
stake in the bank.
2. Capital is the cushion that banks have against a sudden drop in the
value of their assets or an unexpected withdrawal of liabilities.
3. An important component of bank capital is loan loss reserves, an
amount the bank sets aside to cover potential losses from
defaulted loans.
4. There are several basic measures of bank profitability: return on
assets (a bank’s net profit after taxes divided by its total assets)
and return on equity (a bank’s net profit after taxes divided by its
capital).
5. Net interest income is another measure of profitability; it is the
difference between the interest the bank pays and what it
receives.
6. Net interest income can also be expressed as a percentage of total
assets; that is called net interest margin, or the bank’s interest rate
spread.
7. Net interest margin is an indicator of future profitability as well as
current profitability.
D. Off-Balance-Sheet Activities
1. Banks engage in these activities in order to generate fee income;
these activities include providing trusted customers with lines of
credit.
2. Letters of credit are another important off-balance-sheet activity;
they guarantee that a customer will be able to make a promised
payment. In so doing, the bank, in exchange for a fee, substitutes
its own guarantee for that of the customer and enables a
transaction to go forward.
3. A standby letter of credit is a form of insurance; the bank promises
that it will repay the lender should the borrower default.
 4. Off-balance-sheet activities create risk for financial institutions and
so have come under increasing scrutiny in recent years.

BANK RISK: WHERE IT COMES FROM AND WHAT TO DO ABOUT IT

A. Liquidity Risk
1. Liquidity risk is the risk of a sudden demand for funds and it can
come from both sides of a bank’s balance sheet (deposit withdrawal
on one side and the funds needed for its off-balance sheet activities
on the liabilities side).
2. If a bank cannot meet customers’ requests for immediate funds it
runs the risk of failure; even with a positive net worth, illiquidity can
drive it out of business.
3. One way to manage liquidity risk is to hold sufficient excess reserves
(beyond the required reserves mandated by the Federal Reserve) to
accommodate customers’ withdrawals. However, this is expensive
(interest is foregone).
4. Two other ways to manage liquidity risk are adjusting assets or
adjusting liabilities.
5. A bank can adjust its assets by selling a portion of its securities
portfolio, or by selling some of its loans, or by refusing to renew a
customer loan that has come due.
6. Banks do not like to meet their deposit outflows by contracting the
asset side of the balance sheet because doing so shrinks the size of
the bank.
7. Banks can use liability management to obtain additional funds by
borrowing (from the Federal Reserve or from another bank) or by
attracting additional deposits (by issuing large CDs).
B. Credit Risk
1. This is the risk that loans will not be repaid and it can be managed
through diversification and credit-risk analysis.
2. Diversification can be difficult for banks, especially those that focus
on certain kinds of lending.
 3. Credit-risk analysis produces information that is very similar to the
bond rating systems and is done using a combination of statistical
models and information specific to the loan applicant.
4. Lending is plagued by adverse selection and moral hazard, and
financial institutions use a variety of methods to mitigate these
problems.
C. Interest-Rate Risk
2. The two sides of a bank’s balance sheet often do not match up
because liabilities tend to be short-term while assets tend to be
long-term; this creates interest-rate risk.
3. In order to manage interest-rate risk, the bank must determine how
sensitive its balance sheet is to a change in interest rates; gap
analysis highlights the gap or difference between the yield on interest
sensitive assets and the yield on interest-sensitive liabilities.
4. Multiplying the gap by the projected change in the interest rate yields
the change in the bank’s profit.
5. Gap analysis can be further refined to take account of differences in
the maturity of assets and liabilities.
6. Banks can manage interest-rate risk by matching the interest-rate
sensitivity of assets with the interest-rate sensitivity of liabilities, but
this approach increases credit risk.
7. Bankers can use derivatives, like interest-rate swaps, to manage
interest-rate risk.
D. Trading Risk
1. Banks today hire traders to actively buy and sell securities,
loans, and derivatives using a portion of the bank’s capital in
the hope of making additional profits.
2. However, trading such instruments is risky (the price may go
down instead of up); this is called trading risk or market risk.
3. Managing trading risk is a major concern for today’s banks, and
bank risk managers place limits on the amount of risk any
 individual trader is allowed to assume.
4. Banks also need to hold more capital if there is more risk in
their portfolio.
E. Other Risks
1. Banks that operate internationally will face foreign exchange risk
(the risk from unfavorable moves in the exchange rate) and
sovereign risk (the risk from a government prohibiting the
repayment of loans).
2. Banks manage their foreign exchange risk by attracting deposits
denominated in the same currency as the loans and by using
foreign exchange futures and swaps to hedge the risk.
3. Banks manage sovereign risk by diversification, by refusing to do
business in a particular country or set of countries, and by using
derivatives to hedge the risk.
4. Banks also face operational risk, the risk that their computer
system may fail or that their buildings may burn down.
5. To manage operational risk the bank must make sure that its
computer systems and buildings are sufficiently robust to
withstand potential disasters.

Lessons of Chapter
1. Bank assets equal bank liabilities plus bank capital.
a. Bank assets are the uses for bank funds.
i. They include reserves, securities, and loans.
ii. Over the years, securities have become less important and
mortgages more important as a use for bank funds.
b. Banks liabilities are the sources of bank funds.
i. They include transactions and non transactions deposits, as
well as borrowings.
ii. Over the years, transaction deposits have become less
important as a source of bank funds.
 c. Bank capital is the contribution of the bank’s owners; it acts as a
cushion against a fall in the value of the bank’s assets or a
withdrawal of its liabilities.
d. Banks make a profit for their owners. Measures of a bank’s
profitability include return on assets (ROA), return on equity (ROE),
net interest income, and net interest margin.

e. Banks’ off-balance-sheet activities have become increasingly

important in recent years. They include
i. Loan commitments, which are lines of credit that firms can use
whenever necessary.
ii. Letters of credit, which are guarantees that a customer will
make a promised payment.
a. Banks face several types of risk in day-to-day business. They include
a. Liquidity risk – the risk that customers will demand cash
immediately
i. Liability-side liquidity risk arises from deposit withdrawals.
ii. Asset-side liquidity risk arises from the use of loan
commitments to borrow.
iii. Banks can manage liquidity risk by adjusting either their
assets or their liabilities.
b. Credit risk – the risk that customers will not repay their loans. Banks can
manage credit risk by:
i. Diversifying their loan portfolios.
ii. Using statistical models to analyse borrowers’
creditworthiness. iii. Monitoring borrowers to ensure that they
use borrowed funds properly.
iii. Purchase credit default swaps (CDS) to insure against
borrower default.
c. Interest-rate risk – the risk that a movement in interest rates will change
 the value of the bank’s assets more than the value of its liabilities.
i. When a bank lends long and borrows short, increases in
interest rates will drive down the bank’s profits.
ii. Banks use a variety of tools, such as gap analysis, to assess
the sensitivity of their balance sheets to a change in interest
rates.
iii. Banks manage interest-rate risk by matching the maturity of
their assets and liabilities and using derivatives like
interest-rate swaps.
d. Trading risk – the risk that traders who work for the bank will create
losses on the bank’s own account. Banks can manage this risk using
complex statistical models and closely monitoring traders
e. Other risks banks face includes foreign exchange risk, sovereign risk,
and operational risk.