Dolan, Economics Combined Version 4e, Ch. 20
EconomicsCombined Version
Edwin G. DolanBest Value Textbooks
4th edition
Chapter 20The Banking Systemand Its Regulation
Dolan, Economics Combined Version 4e, Ch. 20
The U.S. Banking System
Banks are financial institutions that accept deposits and make loans
Types of banks:Commercial banksThrift institutions (savings and loans; mutual savings banks;
credit unions)
The Federal Reserve System (Fed) is the central bank of the United States
Dolan, Economics Combined Version 4e, Ch. 20
The Balance Sheet
A balance sheet is a financial statement showing what a firm owns and what it owes
Assets are all the things that the firm or household owns or to which it holds a legal claim
Liabilities are all the legal claims against a firm by non-owners or against a household by nonmembers
Net worth, also listed on the right-hand side of the balance sheet, is equal to the firm’s or household’s assets minus its liabilities. In banking, net worth is called capital.
Assets Liabilities
Net worth
The accounting equation:
Assets = Liabilities + Net Worth
Dolan, Economics Combined Version 4e, Ch. 20
Balance Sheet of U.S. Banks
The principal assets of U.S. commercial banks are loans. The principal liabilities are deposits.
Dolan, Economics Combined Version 4e, Ch. 20
Risks of Banking
Types of risk Credit risk is the risk that loans will not be repaid on time and in
full Market risk is the risk that changes in market conditions will
cause a decrease in the value of assets relative to that of liabilities Liquidity risk is the risk that a bank will have to sell illiquid
assets below the value listed on the balance sheet, resulting in a loss
Other important terms: An asset is said to be liquid if it can be used as a means of
payment, or quickly and easily converted to a means of payment without loss of nominal value
A bank is said to be insolvent if its liabilities exceed its assets Reserves are cash or deposits held at the Fed that a bank can draw
on to meet liquidity needs
Dolan, Economics Combined Version 4e, Ch. 20
Traditional BankingTraditional banking earned
profits with an originate-to-hold strategy
Use funds from deposits to make loans
Hold the loans until they are paid in full
Earn a profit from the difference between interest rates on loans and interest rates on deposits
Hold cash reserves and capital for safety
Dolan, Economics Combined Version 4e, Ch. 20
Traditional Banking: Originate-to-Hold
Traditionally, banks rarely sold loans to other investors
No two loans were exactly alike
Bankers needed personal knowledge of their customers
Buyers feared that any loan a bank wanted to sell must be a “lemon”
?
www.pdclipart.org.
?
Dolan, Economics Combined Version 4e, Ch. 20
The Beginnings of Securitization
Starting in the 1930s, Government Sponsored Entities (GSEs) were created to buy loans from banks
Banks used the funds to make new loans
The GSEs bundled the loans into securities and sold them to investors—a process called securitization
Dolan, Economics Combined Version 4e, Ch. 20
Simple Pass-Through Bonds
Earliest mortgage-backed securities were simple pass-through bonds
Each bond received an equal share of all principal and interest payments on a pool of loans
Each bond shared an equal part of the loss from any default
Senior-subordinate structure In important innovation was introduction
of tiers of bonds with different risk (tranch)
Senior bonds have first priority to receive interest and principal payments, last to bear losses
Subordinate bonds bear the first risk of losses from defaults, stand last in line for income
Mezzanine bonds stand in between Investors select safe, low-yield senior
bonds or riskier, high-yield subordinate bonds according to their appetite for risk
Dolan, Economics Combined Version 4e, Ch. 20
Growing ComplexityOver time securitization became more complex. First households and firms
borrow from originating banks. The banks then sell the loans to GSEs and other specialized intermediaries, who issue securities divided in "tranches" according to risk Each type of security is rated and then sold to investors, often hedge funds or other institutions, who buy the type of security that best fits their appetite for risk. Investors can further protect themselves against risk by means of credit default swaps which are a form of insurance purchased by the investor.
Dolan, Economics Combined Version 4e, Ch. 20
Perceived Benefits
For originating banks New sources of fee income No additional capital needed Reduced credit risk
For the economy Banks can make many more loans because they do not have to
hold the loans to maturity on their own books Credit risk borne by hedge funds, insurance companies, and other
investors thought best positioned to bear it Wide distribution of credit risk makes financial system more
stable Cost of credit reduced for everyone
Dolan, Economics Combined Version 4e, Ch. 20
Housing and Social Policy
In the 1990s, affordable housing received increased attention as a social issue
Why should only the middle class be able buy a home? Why were low-income families excluded?
Banks’ answer: Because loans to low-income households are too risky!
Subprime loans were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy www.pdclipart.org.
Dolan, Economics Combined Version 4e, Ch. 20
Standard vs. Subprime Mortgages
Standard (prime) mortgages: Borrowers are expected to
repay loan from current income
Lenders profit primarily from interest payments
Borrowers get full benefit of increase in home value or bear full loss from decrease
Subprime mortgages Banks rely on appreciation of
home value, not borrowers’ income, for repayment
Lenders profit primarily from fees for origination, servicing, and refinancing
Lenders share benefit from appreciation of home value and risk of loss if value decreases
Dolan, Economics Combined Version 4e, Ch. 20
Standard vs. Subprime Mortgage terms
Standard (prime) mortgage terms:
Loan to value ratio usually 80%-90%
Constant fixed rate for full 30-year life of mortgage
No prepayment penalty Require careful
documentation of income and assets of borrower
Subprime mortgage terms: Loan to value ratio up to
100% or even more Low teaser rate for 2 or 3
years followed by high step-up rate
Large prepayment penalty May not require
documentation of income or assets
Dolan, Economics Combined Version 4e, Ch. 20
Profitable in a Rising Market Subprime mortgages are
profitable to both lender and borrower in a rising market
Borrowers accumulate equity in homes they could not otherwise afford to buy
Lenders extract profit at end of initial 2 or 3 year period in one of three ways Through prepayment penalties if
property is sold or refinanced Through high step-up interest
rates if not refinanced Through foreclosure in case of
default www.pdclipart.org.
Dolan, Economics Combined Version 4e, Ch. 20
. . . but Risky in a Falling MarketIn a falling market, subprime
mortgages are more likely than prime mortgages to produce losses
Negative equity is more likely because of high initial loan-to-value ratio
Low income borrowers are more likely to default when equity becomes negative
Recovery rates on forced sales of low-quality housing may be low
www.pdclipart.org.
Dolan, Economics Combined Version 4e, Ch. 20
But house prices never fall, do they? From 1975 to 2006 house prices never had a nationwide down
year From 2000 on, prices rose far above the historical trend based on
gradually rising household incomes
Dolan, Economics Combined Version 4e, Ch. 20
Do Banks Take Excessive Risks?Spillover effects Failure of one bank may
trigger runs on other banks Failure of one bank may
causes losses for counterparties (other financial firms who do business with the bank)
Failure of the banking system damages the nonfinancial economy by interfering with normal flows of credit
Dolan, Economics Combined Version 4e, Ch. 20
Do Banks Take Excessive Risks?Gambling with other people’s
money
Conflicts of interest when one party gets the gains and the other party is stuck with the losses Managers vs. shareholders Managers vs. traders Shareholders vs. bondholders
In economic terminology, these are called principal-agent problems
Dolan, Economics Combined Version 4e, Ch. 20
Gambling with your own or others’ money
When gambling with their own money, many people choose games like the lottery that lose most of the time, but not
more than they can afford don’t win often, but have a
huge payoff when they do win
These are called positively skewed risks
When gambling with other people’s money, the best games are ones that. . . win a moderate amount most of
the time rarely lose, but may have really
huge losses when they do Once a big loss comes, the
game is over, but the gambler keeps past winnings and someone else bears the cost
Dolan, Economics Combined Version 4e, Ch. 20
Fiduciary Duties of Managers
Financial managers are paid to gamble with other people’s money
In doing so, they have a fiduciary duty to act in their shareholders’ best interests They should take prudent risks
when there is a good chance of a high return for shareholders. . .
. . . but they should not put their personal gain ahead of shareholder interests
Dolan, Economics Combined Version 4e, Ch. 20
Fiduciary Duties of Managers
Executive compensation plans are often misaligned with fiduciary dutiesBonuses for short-term
performanceLack of “clawback” (money
taken back in case of extraordinary circumstances)
Golden parachutes Such bonus-based
compensation plans cause managers to seek excessively risky strategies
Dolan, Economics Combined Version 4e, Ch. 20
Example of misaligned incentives
Strategy A – Prudent, moderate risk
5 quarters of $100 million profit
5 quarters of $10 million loss 10-quarter net for
shareholders: profit of $449.5 million
10-quarter result for executive: total bonuses of $500,000
Strategy B – Aggressive, high risk
9 quarters of $200 million profit
1 quarter of $2,000 million loss
10-quarter net for shareholders: loss of $201.8 million
10-quarter result for executive: total bonuses of $1.8 million
Strategy B has higher payoff for the executive but lower payoff for shareholders
Assume an executive bonus plan that pays 0.1% of net profit each quarter
Dolan, Economics Combined Version 4e, Ch. 20
Tools to Ensure Safety and Soundness
Lender of last resort During a bank panic, banks may be unwilling to lend to one
another Lack of interbank credit causes failure to spread Central bank makes emergency loans to protect banks from failure
– That is the FED in the US System
Deposit insurance
During a bank panic, a run may occur because depositors fear only the first in line will get their money back
Government deposit insurance means there is no need for a run – That is the FDIC in the US System
Dolan, Economics Combined Version 4e, Ch. 20
Sources of the Crisis
The housing bubble, financed by subprime lending
Ratings failures and disappearance of liquidity
Regulatory failures
Dolan, Economics Combined Version 4e, Ch. 20
Rehabilitating Failed Banks
Three questions for helping failed banks Who should be helped?
All banks or only failing banks?Are some too big to fail?
Who should bear the losses?Shareholders? Taxpayers?
How should aid be provided?Carve-out?Capital injection?
www.pdclipart.org.
Dolan, Economics Combined Version 4e, Ch. 20
How a Carve-out Works
The government first creates a bank assistance agency (example: TARP)
The bank assistance agency exchanges good government bonds for low-quality financial instruments (“toxic waste”)
If the value of the low-quality instruments turns out to be less than that of the good bonds, the bank assistance agency loses net worth and the financial institutions gain.
Dolan, Economics Combined Version 4e, Ch. 20
How a Capital Injection Works
The bank assistance agency exchanges good government bonds for equity (common or preferred stock) in financial institutions.
Low quality assets stay with the financial institutions
The value of the government’s stock rises or falls depending on what happens to the value of the low-quality assets