Money Markets

Money Markets

 
1. Money Market Characteristics and Purpose

2. Money Market Instruments: Treasury Bills

3. Money Market Instruments Other Than Treasury Bills

 Money Markets
5 – 1 Money Market Characteristics and Purpose

5.1a Money Market Defined

 Money markets are in many ways misnamed. They are not markets for currency or money
(those are called foreign exchange markets); instead, they are markets for financial assets that
are close substitutes for money. The financial assets bought and sold in money markets are
short-term promises to repay have a high level of liquidity, and have a very low level of default
risk. In many ways these money market instruments are a lot like money.

 Even the use of the term market can be confusing. Usually, when one think of market, one
thinks of a physical place where buyers and sellers meet, like a farmer’s market. A money
market, on the other hand, does not take place in one physical place. Instead it takes place
during telephone calls and on blinking computer screens, through which more than a trillion
dollars trade hands every business day.

 Thus a formal definition of a money market would be a wholesale market of short – term debt
instrumentsthat have
 4.1 Bank Regulation
Chapter 4
.1b Bank Regulation in the United States
 The asymmetric information problem also exists for bank depositors.
While the managers of a bank know whether their bank is well run,
depositors and other outsiders can never see the assets of any bank
in detail. A bank does not disclose to outsiders to whom they have made loans and for how
much. Thus it is difficult - if not impossible – for outsiders to truly judge the quality of bank
assets. That is why banks, in the modern era, have government sponsored deposit
insurance.

 Government – sponsored deposit insurance: protection offered to depositors by a

government agency that protects the depositors from losses that may occur if the depository
institution becomes insolvent or fails.

 PDIC – Philippine Deposit Insurance System. PDIC is a government instrumentality created

in 1963 by virtue of Republic Act 3591, as amended, to ensure the deposits of all banks.
PDIC exists to protect depositors by providing deposit insurance coverage for the depositing
public and help promote financial stability

 PDIC is an attached agency of the Department of Finance.

 Deposits are insured by PDIC up to 500,000 per depositor

 4.1 Bank Regulation
4.1b Bank Regulation in the United States Chapter 4

Bank Products

 Bank charters and government –sponsored deposit insurance are

only two types of negotiation that banks face.

 Glass – Steagall Act in 1933 – banks were forbidden from underwriting almost all stocks and bonds and
were banned from selling insurance.

 Banks complained that they should be allowed to offer discount brokerage services to their customers.
After numerous lawsuits and much negotiation, bank regulators acquiesced and allowed banks into these
more lucrative and more risky markets.

 But as time went on, banks wanted to be allowed to do even more. In April 1987 the Fed allowed bank
holding companies to establish Section 20 securities subsidiaries, called Section 20 affiliates, where banks
could underwrite a wide variety of commercial paper, mortgage-backed securities, and municipal bonds.

 Now banks didn’t need to establish Section 20 affiliates; they could own investment banks outright. As a
result there was a wave of commercial bank and investment bank mergers between 1997 and 2000.

 In 1999 the nail was finally driven into Glass – Steagall’s coffin with the passage of the Financial Services
Modernization Act, sometimes called the Gramm – Leach – Billey Act. The act allowed for bank holding
companies to morph into “financial services holding companies”, that is, holding companies that could be
made up of commercial banks and investment banks.
 4.1 Bank Regulation
4.1b Bank Regulation in the United States Chapter 4

Geography

 Since the founding of the country, banks were regulated mostly at the state
level and were forbidden from branching across state lines.

 The McFadden Act of 1927 forced federally chartered banks to obey state laws when it came to branching
essentially making it possible for all banks to cross the state line.

 These geographically limitations, however, placed US banks at some great disadvantages. By being tied
to only one state’s economy, bank’s asset diversification was greatly limited.

 Banks believed it was in their own interest to get around the restrictive geographical limitations they faced.
Banks first attempted to get around these regulations by creating bank holding companies. The idea was
a bank may not be able to have branches in more than one state, but a bank holding company could own
banks in several different states at one time. Thus the creation of a bank holding company was a way
around the McFadden Act.

 In 1956 Congress passed the Bank Holding Company Act (BCHA) gave the Federal Reserve the power to
regulate bank holding companies and prohibited bank holding companies headquartered in one state from
acquiring a bank in another state.

 The banks weren’t done yet in their fight for geographical diversification. In 1994 Congress passed the
Riegle – Neal Interstate Banking Act (officially known as the Interstate Banking and Branching Efficiency
Act), which allowed banks to merge across state lines, thus enabling them to have branches in other
states.
 4.2 Bank Balance Sheet and Bank Capital
4.2a Balance Sheet Regulations Chapter 4

 While have been successful in getting around product limitations and

geographical limitations, they have faced a harder time getting around
balance sheet regulations.

Loan and Credit Extension Amounts

 Currently, the maximum amount a national bank is allowed to lend or extend credit to one entity is 15% of
the bank’s combined capital and reserve on an unsecured loan. If the loan is secured by “readily
marketable collateral,” however, then the limit is 25%. These limits are considered necessary to ensure
banks have a well diversified loan portfolio, and this is seen as a way to limit corruption in bank lending.

Holding of Equities

 Proponents of banning banks from holding equities argue that this market banks safer and limits the
probability of contagion of financial market failures. Proponents of the ban point out that stock market
crashes are not uncommon. If banks are allowed to hold large amounts of equities and stock prices fall
dramatically, it is argued, the asset side of the bank’s balance sheet would contract, potentially making the
bank insolvent. Thus, by holding equities banks are made less stable and thus less safe, and therefore
banks should be banned from holding significant amounts of equities.
 4.2 Bank Balance Sheet and Bank Capital
4.2a Balance Sheet Regulations Chapter 4

 While have been successful in getting around product limitations and

geographical limitations, they have faced a harder time getting around
balance sheet regulations.

Loan and Credit Extension Amounts

 Currently, the maximum amount a national bank is allowed to lend or extend credit to one entity is 15% of
the bank’s combined capital and reserve on an unsecured loan. If the loan is secured by “readily
marketable collateral,” however, then the limit is 25%. These limits are considered necessary to ensure
banks have a well diversified loan portfolio, and this is seen as a way to limit corruption in bank lending.

Holding of Equities

 Proponents of banning banks from holding equities argue that this market banks safer and limits the
probability of contagion of financial market failures. Proponents of the ban point out that stock market
crashes are not uncommon. If banks are allowed to hold large amounts of equities and stock prices fall
dramatically, it is argued, the asset side of the bank’s balance sheet would contract, potentially making the
bank insolvent. Thus, by holding equities banks are made less stable and thus less safe, and therefore
banks should be banned from holding significant amounts of equities.
 4.2 Bank Balance Sheet and Bank Capital
4.2a Balance Sheet Regulations Chapter 4

 While have been successful in getting around product limitations and

geographical limitations, they have faced a harder time getting around
balance sheet regulations.

Loan and Credit Extension Amounts

 Currently, the maximum amount a national bank is allowed to lend or extend credit to one entity is 15% of
the bank’s combined capital and reserve on an unsecured loan. If the loan is secured by “readily
marketable collateral,” however, then the limit is 25%. These limits are considered necessary to ensure
banks have a well diversified loan portfolio, and this is seen as a way to limit corruption in bank lending.

Holding of Equities

 Proponents of banning banks from holding equities argue that this market banks safer and limits the
probability of contagion of financial market failures. Proponents of the ban point out that stock market
crashes are not uncommon. If banks are allowed to hold large amounts of equities and stock prices fall
dramatically, it is argued, the asset side of the bank’s balance sheet would contract, potentially making the
bank insolvent. Thus, by holding equities banks are made less stable and thus less safe, and therefore
banks should be banned from holding significant amounts of equities.
 4.2 Bank Balance Sheet and Bank Capital
4.2b Liabilities: Regulation Q Chapter 4

 On the liabilities side, for years there was a strict amount of regulation over
what banks could pay in terms of interest on deposits. This was the
Regulation Q.

 Regulation Q prohibited banks from paying interest on demand deposits, and

until 1986 it imposed interest rate ceilings on a variety of bank deposit accounts. The idea behind
Regulation Q was the belief that the bank failures during the early days of the Great Depression were
caused, in great part, by banks competing for deposits. This competition, it was believed, drove down the
interest rate spread between deposits and safe loan and thus pushed banks to take on more risks in a
search for higher returns. Thus Regulation Q was designed largely to limit the amount of competition
between banks.

 Even though this may have been the stated goal of Regulation Q, it sure wasn’t effective in its early days.
From the mid 1930s to the mid 1960s, the interest rate ceiling was above the interest rate banks paid on
deposits; thus Regulation Q was an ineffective interest rate ceiling. But by the mid 1960s, market interest
rates were increasing and Regulation Q became a binding interest rate ceiling. Even when it became
binding, however, Regulation Q really did not reduce competition among banks; it merely shifted how that
competition took place.

 In 1969 Morgan Guarantee Trust Company developed a program that sold participation in its loan portfolio
through repurchase agreements. Morgan was doing was not really new, but I came with an interesting
twist. The new twist was that Morgan could buy back the loan participation at any time – either on demand
or sometime in the future. So he created a liquid account that would not be subject to Regulation Q.
 4.2 Bank Balance Sheet and Bank Capital
4.2b Liabilities: Regulation Q Chapter 4

 Other banks were not so crafty as to create new financial products to get
around regulation Q; they merely paid depositors for deposits. It became
relatively common for banks to offer gifts in exchange for deposits. The
bank could not pay a depositor an interest rate higher than what was allowed
under Regulation Q.

 By the late 1970s Regulation Q had been so circumvented Congress decided to do away with the interest
rate ceiling component. The passage of DIDMCA of 1980 planned to phase out the interest rate ceiling
component of Regulation Q between 1981 and 1986. the only part of Regulation Q that was left was the
portion of the act that prohibited the paying of interest on demand deposits. That part of the law was
essentially eliminated with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010.

 While regulation over bank liabilities may have faded away over time, the regulations over bank capital
have intensified over the past few years.
4.2 Bank Balance Sheet and Bank Capital
4.2c Bank Capital Chapter 4

 Bank capital levels serves as a cushion against a decline in a bank’s asset

values. To understand why, think about the accounting equation in banking:
Assets = Liabilities + Bank Capital

 Now imagine something goes wrong: The economy stall and borrowers are
not liable to repay as promised. From a bank’s perspective , that means the value of the loans it has
written are declining. The bank has to write down, or decrease, the value f the loans that are going bad.
Thus the asset side of the bank’s balance sheet declines.

 For the accounting equation to hold when asset values are declining, something on the right side of the
equal sign has to decrease. Hopefully, the bank has enough bank capital to decrease, or “offset”, the
decline in assets. If the bank does not have enough bank capital then the bank is insolvent, or, from a
financial point of view, the bank is dead.

 This is why the level of bank capital is so important: Bank must have enough bank capital to write down
nonperforming assets. But what exactly is “enough” in this case? Can we leave it up to bank
management to determine what is enough bank capital to hold? Probably not. To understand why, think of
the incentives.
4.2 Bank Balance Sheet and Bank Capital
4.2c Bank Capital Chapter 4

Bank Management Incentives and Bank Capital

 In the modern era bank executives’ compensation is most often tied to a

bank’s stock price. The higher a bank’s stock price, the more executives
get paid. When a bank, or any corporation, earns a profit, it can pay that
profit to stockholders in the form of a stock dividend, it can pay income taxes, or it can hold on to that profit
in the form of retained earnings.

Basel Accords

 Because the incentive structure for bank executives may very well lead to undercapitalized banks, bank
regulators have tried to set international standards for bank capital. These international standards are laid
out in Basel accords.

 The first Basel Accord, called Basel 1, which was agreed to in 1988 by 12 major countries, attempted to
set bank capital levels based on the riskiness of bank’s assets. Banks with riskier asset would be required
to hold more bank capital compared with banks with safer assets.

 It soon became clear that Basel 1 had major shortfalls, so in 2001 a new set of agreements, called Basel
II, were announced. In addition to adding operational risk to credit risk, the Basel II accord tried to improve
Basel I. Specifically, the Basel II Accord attempted to create a much better risk – sensitive measure of
bank capital, and it allowed banks to use their own internal rating – based (IRB) approach to determine
capital levels. The IRB approach essentially allowed banks to determine on their own whether they were
holding enough capital.
4.2 Bank Balance Sheet and Bank Capital
4.2c Bank Capital Chapter 4

Basel Accords

 Basel II: the second of the international banking regulation accords that was
issued in 2004 and was designed to be implemented in 2008. Three pillars
included (1) more flexible minimum bank capital levels, (2) changed super –
visory review, and (3) increased dependence on market discipline via increased bank disclosures.

 With the onset of the global financial crisis, regulators realized that banks were not holding sufficient levels
of bank capital. So, in September 2010 a revision of bank capital requirements were announced and were
labeled Basel III. These new guidelines recommend that banks hold tier I capital (retained earnings and
common stock) of at least 6% of the total risk – weighted assets, up from 4%. It also suggested no longer
using the bond rating of the borrower as a measurement of riskiness. In addition, Basel III also
recommended that banks maintain an extra layer of tier I capital – at least 2.55 of risk – weighted assets –
by 2016. This extra layer is called a “capital conservation buffer”. Finally Basel III recommended the level
of required bank capital be raised during economic good times and lowered during financial crises.
4.3 Bank Regulation: How It’s Done
 Call reports are detailed reports of the operations and financial condition of a
Chapter 4
bank that must be filed quarterly with their main regulator. The official name
is “Report of Condition and Income” for banks and “Thrift Financial Report”
for thrift institutions. The call report contains financial information including
the bank’s balance sheet and income statement.

 In addition to call reports, bank examiners can make unannounced on-site

examinations of a bank. Examiners come into the bank and take possession of the bank’s cash and
marketable securities. They are trying to determine whether what is reported on the call reports actually
exists. Next, the examiners go through the bank’s loan portfolio. First they ensure lending rules and
regulations are being adhered to. Then random samples of loans are fully analyzed to make sure they are
all current or, if not, what I being done to bring them current. Finally, the examiners evaluate the overall
management and structure of banks to ensure a set of checks and balance exist.

 If a bank’s operations are in violation of any f the banking rules and regulations, examiners can issue a
cease and desist order. The Financial Institutions Regulator Act of 1978 empowered regulators to give out
cease and desist orders; can also be enforced by courts.
 4.3 Bank Regulation: How It’s Done
4.3a CAMELS Ratings Chapter 4
 When bank examiners go into a bank for an on-site examinations or read
through the call reports, they need to standardized way to evaluate the bank.
The traditional standard format they use is the CAMELS rating system. The
acronym CAMELS stands for Capital, Assets, Management, Earnings,
Liquidity, and Sensitivity. Regulators generally rate a bank on a sale of 1 to 5.
In the CAMELS ratings a 1 is the best or highest rating and a 5 is the worst or the bottom of the scale.

 Capital Adequacy – bank examiners often look at the bank’s capital ratio, or capital level divided by assets.
In general, the higher the capital ratio, the lower the CAMELS score the bank receives. The more capital
the bank holds, the better prepared it is to withstand future losses. But bank examiners don’t rely solely on
the capital ratio. They also look at the bank’s overall financial condition. Can the bank raise additional
capital.

 Asset Quality – what are the bank’s lending policies? How do they determine who gets a loan and who
gets rejected? How many problem loans does the bank have? How are these problem loans resolved?
Has the bank set aside enough in loan loss reserves for their problem loans? Does the bank have a well
diversified investment portfolio? How does the bank determine its asset makeup?

 Management – who are the Board of Directors and management team at the bank? Are they able to
identify and manage the bank’s risks? How is the bank managed? How are problems resolved? How are
midlevel managers evaluated and promoted? How are the management team and bank employees
compensated.

 Earnings – what is the level, trend and stability of the bank’s earnings or profits? How likely are these
earnings level to change in the future? What is the banks return on assets? (ROA)? How does the bank’s
earnings level compare with that of similar banks?
 4.3 Bank Regulation: How It’s Done
4.3a CAMELS Ratings Chapter 4
 Liquidity – Does the bank have enough, or too many liquid assets? How
might the demand for liquidity change over time? How stable are the bank’s
deposits? How often does the bank have to go outside to obtain the liquidity
it needs?

 Sensitivity to market conditions – this is designed to get the bank examiners to think about not just how the
bank is doing to today but how might things change in the future. How will the bank fare if interest rates,
exchange rates, or the overall economy change significantly in the near future? This sensitivity analysis,
while only recently added to the Camels rating, is playing a larger role as time goes by. Static analysis, or
looking only at how things are currently, is being replaced by more dynamic analysis in which sensitivity
analysis plays a larger role.
 4.3 Bank Regulation: How It’s Done
4.3b Dealing with a Failed Institution Chapter 4
 When a bank fails, it is up to the FDIC to decide what to do with the institution.
The most straightforward approach is to close the institution, pay off the
depositors, and sell or liquidate the banks assets. This policy, aptly named
pay off and liquidate, was the policy the FDIC used for decades. If liquidation
of the bank’s assets was not enough to pay off the depositors, the insured
deposits would be paid off only to the stated maximum, and the other depositors would obtain pennies on
the dollar of deposits they had. Subordinated debt holders would be paid only after all of the depositors
were paid in full, if possible.

 The pay off and liquidate approach is very costly to the FDIC and sometimes very disruptive to the
community where the bank resides. To keep costs down and make things less disruptive, the FDIC started
to pursue purchase and assume policies over the past few decades. In a purchase and assume
agreement the FDIC finds a healthy bank to purchase the failed institution and assume all of the failed
bank’s liabilities. This means no depositor would lose any of their deposits.

4.3c Too Big to Fail (TBTF)

 A policy followed by bank regulators whereby some financial Institutions are so important to the entire
financial and economic system that these institutions will not be allowed to fail. That is, regulators will take
action to ensure that these systematically important institutions continue in operation.

 Institutions that are labeled TBTF would not be liquidated if they failed for fear this would trigger panic in
financial markets. Similarly, if they are in financial trouble, TBTF banks might be candidates for a purchase
and assume, if purchaser could be found, but that often is unlikely because these institutions are so large.
 4.4 Consumer Protection and Failures
 Banking regulation was primarily designed to keep banks safe and sound. Chapter 4
But there was another worry: making sure banks did not take advantage of
their customers. In part, there was an asymmetric information problem:
Bankers knew much more about finance and banking than did their
customers. This was especially true when the bank customers were
individual or families.

4.4a Truth in Lending Act of 1968

 Officially part of the Consumer Credit Protection Act of 1969, but more commonly known as the Truth in
Lending Act, this piece of banking regulation was designed to ensure that every borrower understands
what they are getting themselves into when they agree to borrow money. The act requires full disclosure
of the terms and costs involved in the loan. The act applies to any entity, not just banks, that lends money
to consumers or farmers.

 Some of the most important components of the Truth in lending Act is that lenders are mandated to state
the annual percentage rate (APR) being charged on the loan, with an explanation of how much interest will
be paid on the loan. The act applies to credit cards, home equity lines of credit, and motor vehicle loans.
 4.4 Consumer Protection and Failures
Chapter 4
4b The Community Reinvestment Act of 1997
 One of the most controversial banking practices in the past was the bank
policy of redlining. With redlining, bankers would lay out a map of a city or a
state and draw re lines around areas and neighborhoods into which they would
not lend. These redlined areas and neighborhoods often were populated by
minorities, working people, Catholics, Jewish people, and others whom bankers deemed unworthy. Some
in the banking community claim that redlining is little more than an urban myth and does not exist today,
nor did it ever exist.

 In reaction to claims of redlining by banks, however, Congress passed and president Carter signed into
law the Community Reinvestment Act (CRA) in1997. The CRA requires banks who want to merge, expand
their branches, or seek to undertake any action that requires regulatory approval to seek CRA certification.
To obtain CRA certification, banks must demonstrate that they are lending and providing financial services
to people across their geographical areas.

 Banks often claim that CRA certification documentation is burdensome and expensive. They often argue
that regulators should instead ask local community leaders whether the bank in question is providing
financial services. The downside to this approach is that the bank in question often makes substantial
contributions to the community leader who is to testify on the bank’s behalf.
 4.4 Consumer Protection and Failures
Chapter 4
.4c Fair Credit Reporting Act of 1970
 The Fair Credit Reporting Act (FCA) is enforced by the US Federal Trade
Commission and is designed to regulate the collections and use of consumer
credit information. The FCA was designed to ensure that credit bureaus that
issue credit reports on individuals are reporting only accurate information and
to create a way for people to know what is in their credit report and correct errors. The act requires
creditors to provide complete and accurate information to credit bureaus or face penalties. Consumers
also
are granted the right to know what is in their credit report, and consumers credit reporting agencies must
correct inaccurate information in credit reports usually within 30 days.

 Credit argue the FCA should ban the use of credit reports in the employment process. People who lose
their job, through no fault on their own, may run into financial difficulty while searching for another job.
This financial difficulty then lowers their credit rating and makes it nearly impossible for them to find work in
the future. Thus, they argue, the FCA is far too weak and should regulate who uses credit reports, not just
what is in them.
 4.4 Consumer Protection and Failures
Chapter 4
.4d Dodd-Frank Wall Street Reform and
Consumer Protection Act 2010
 In response to the worst economic crisis since the Great Depression, in 2010
Congress passed and President Obama signed the Dodd-Frank Act.
Consumer advocates argue a major contributor to the Great Recession was how many consumers and
families were taken advantage of by lenders, including banks. In the wake of the crisis there were many
calls to increase the amount of consumer protection in financial markets. The Dodd-Frank Act was the
result.

 Among other things, the Dodd-Frank Act created a Bureau of Consumer Financial Protection (BCFP). The
BCFP claims that it will, among other things, limit unfair or abusive lending practice, enforce federal
consumer protection laws, and enforce laws that outlaw discrimination and other unfair treatment in
consumer finance.

 Many in the banking industry have claimed the BCFP is an example of government overreach and that it
will result in burdensome regulation if it goes unchecked. In 2011 US Senator Richard Shelby of Alabama
that by having one single person lead the BCFP, the act created a consumer protection czar who was not
accountable to the American people. Some ever want the Dodd-Frank Act amended to completely
eliminate the BCFP.
 4.4 Consumer Protection and Failures
Chapter 4
.4e Why Has the US Bank Regulatory System Failed?
 When critics look at the banking regulatory system in the US in the wake of the
Great Recession, they all tend to agree that the system is broken. It is our
financial system, after all, that was the main cause of the worst economic
slowdown since the great Depression. But where the disagreement lies is why
this regulatory system failed to prevent the global financial crisis that started in 2008.

 The office of the Comptroller of the Currency and state banking authorities have been embroiled in a bottle
over who should be granted bank charters, leading to banks engaging in regulator shopping.

 Regulator shopping – when banks and other financial institutions are allowed to choose their regulator,
they may pit the regulators against each other and then choose the regulator that offers the most favorable
regulations.

 Needless to say, the state banking authorities did not take this lying down. They sued the office of the
Comptrollers of the Currency and the battle was on. Some believe banks can now regulator shop in that
they can threaten to switch their bank charter to whichever charter granting entity gives them the most
lenient level of regulations. The result has been weakened regulation and the willingness of the regulators
to turn a blind eye to many of the risky activities banks engage in.

 Banks also were able to engage in excessively risky activities because bank regulators suffered from what
Simon Johnson of MIT describes as intellectual capture. According to Johnson, intellectual capture goes
beyond the traditional concept of regulatory capture – where bankers control the regulatory agency, such
as the Fed – to a situation where all of society, including the regulators, believes what is good for banks is
good for all. Johnson argues that over the past few decades banks have o been able to convince
regulators that anything they do that increases bank profits is good for America
 US Financial Markets in the Early Twen
Century

End of Chapter 4