Class notes 2/22/2022

Why do we need banks

Pool savings
- Small deposits-> big loans
Safekeeping, payment system access, and accounting
Providing liquidity
- Maturity mismatch: borrow with deposits->long-maturity loans
Diversifying risk
- Banks pool risk by lending to different entities
Collecting and procession info
- Asymmetric information

Adverse selection
An agent seeks an agreement because she has some private information
- Occurs prior to transaction
Equity issue
- Cannot tell weak firms from strong ones
- If market offers average stock price
- Only bad firms would accept to go public
- Solution: disclosure requirements to list on the stock market
Debt issue
- Cannot tell reliable from unreliable borrowers (asymmetric information)
- If banks offer average risk premium->unreliable borrowers (adverse selection)
- Solutions: screening, private information collection, collateral

Moral hazard
An agent's behavior is unobserved, so she can take advantage if a contract
- Occurs after transaction
Equity issue (principal-agent problem)
- Cannot observe how hard a manager is working (Asymmetric information)
- Failure may be due to bad luck or laziness-> incentive is to shirk (adverse selection)
- Solutions: manager must invest in company, shareholder votes
Debt issue
- Owner’s have limited liability and leverage increases returns (asymmetric information)
- Firms leverage-> declares bankruptcy when risk is realized (adverse selection)
- Solutions: covenant restrictions, monitoring borrowers

Internal finance
- Most companies use internal funding to invest in capital
 Notes from reading about regulation 2/22/2022 (Chapter 12 pages 294 to 319, Chapter 13
pages 326 to 337, and Chapter 14 pages 357 to 388)

Chapter 12
Total bank assets= total bank liabilities + bank capital
Bank Capital = Bank Assets – Bank Liabilities
Reserve ratio= cash/deposits
Leverage ratio= assets/capital (usually 10), bank owners are multiplying earnings by 10
Capital is the cushion banks have against a sudden drop in the value of their assets or an
unexpected withdrawal of liabilities.

We can divide loans into five broad categories: business loans, called commercial and industrial
(C&I) loans; real estate loans, including both home and commercial mortgages as well as home
equity loans; consumer loans, like auto loans and credit card loans; interbank loans (loans
made from one bank to another); and other types, including loans for the purchase of other
securities.

Banks borrow from federal reserve and lend their surplus to federal funds market

ROA= net profit after taxes/total bank assets

ROE= net profit after tax/bank capital

Risks
- Liquidity risk, credit risk, interest rate risk, cyber attack risk, operational risk, sovereign
risk

Chapter 13

Chapter 14
There are three reasons for the government to get involved in the financial system:
- To protect investors.
- To protect bank customers from monopolistic exploitation.
- To safeguard the stability of the financial system.

Class notes 2/23/2022

Systemic risk
- Illiquidity: banks don’t have enough cash for withdrawals
- Bank run: bank supply liquidity on first-come, first-serve basis
- Two equilibrium model: good vs bad equilibrium
- Fire sales-> asset prices fall
- Insolvency: bank capital falls
- Bankruptcy: bank liabilities>assets
 - Asymmetric information: which banks are at risk?
- Bank panic: maybe all bank ar at risk
- Contagion-> all banks fail (asian financial crisis)

Government safety net

- Financial crisis impacts real economy
- U.S. Federal Reserve: lender of last resort
- FDIC: deposit insurance
- FDIC insures $250,000 worth of deposits per depositor
- U.S. treasury: government bailout (happened in 2008, can fix insolvency problems)
- Result: moral hazard
- Deposit insurance: depositors do not monitor banks
- Bailouts and lender of last resort-> banks get “too big too fail”

Regulation
- Regulators: U.S. Treasury, federal reserve system, FDIC, SEC
- Merger approval: Department of justice (has not been doing its job well)
- Reserve and capital requirements
- Disclosure requirements
- Supervision and examination
- CAMELS: Capital adequacy, Asset quality, Managers, Earnings, Liquidity, and
Sensitivity to risk
- Basel accords
- Liquidity coverage ratio

Notes before class Chapter 15 pages 393 to 415 and Chapter 16 pages 421 to 434 2/27/2022

- The role of the central bank is to print money and control the flow of money
- It has a monopoly on the issuance of currency
- Monetary policy is used to stabilize economic growth and inflation
- Fiscal policy: The government’s tax and expenditure policies, usually formulated by
elected officials.
- Time consistency: The condition in which there is no future incentive to renege on a
promise or policy commitment made today.

Notes in class 2/28/2021

- Zero Lower bond (zlb)

- No demand for bonds with negative nominal interest rates
- Cash is always better
- Can have demand for negative real interest rates
- Cash is also impacted by inflation
- Zero lower bound-> i>_0
- Effective lower bound
 - Nominal interest rates can be slightly negative for banks
- Cost of holding cash, need for banking services, reserve
requirements
- Low stable inflation
- Prices convey information about scarcity and value
- Avoid zero lower bound
- High stable growth
- If growth is too low
- Unemployment
- Underutilization of capital
- If growth is too high
- Malinvestment->possible asset bubble
- May lead to inflation
- Financial system stability
- Lender of last resort
- Moral hazard
- Financial system regulation
- Interest rate stability
- Businesses and households make intertemporal decisions
- Future value of asses based on expected interest rates
- Stable interest rates reduce intertemporal decision risk
- Exchange rate stability
- Import costs are based on foreign prices and exchange rates
- Exchange rate pass through
- Exports revenue is based on foreign prices and exchange rates
- Exchange-rate stability reduces international trade risk
- “Beggar thy neighbor” policies
- Principles of central banks
- Interdependence
- Seigniorage
- Accountability and transparency

Notes before class Read Chapter 17 pages 448 to 474 and watch brainsharks

- Foreign exchange reserves are the central bank’s and governments balance of foreign
currency.
- Discount loans are short term loans the FED makes to commercial banks
- Multiple deposit creation Part of the money supply process whereby a $1 increase in the
quantity of reserves works its way through the banking system, increasing the quantity of
money by more than $1. (17)
 Notes in Class 3/2/2022

Monetary aggregates
- Reserves=deposits at the fed + vault cash
- Required reserves (RR)
- Excess reserves (ER)
- Monetary base: MB=CC + R
- CC: Currency in circulation
- R: Reserves
- R=RR + ER
- RR=Rd+ER
- M1 Money Supply: M1=CC + DD
- DD: Demand Deposits (now includes savings accounts)
- M2 Money supply=M1 + time deposits (CDs)