Depository Institutions: Banks and Bank Management

Bank assets equal bank liabilities plus bank capital.
1. Bank assets are the uses for bank funds.

Banks liabilities are the sources of bank funds.

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.
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.
Banks’ off-balance-sheet activities have become increasingly important in recent years.

Banks face several types of risk in day-to-day business. They include:
1. 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.

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 analyze borrowers’ creditworthiness.

iii. monitoring borrowers to ensure that they use borrowed funds properly.

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.

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.
Other risks banks face include foreign exchange risk, sovereign risk, and operational risk.

Many factors in the economic environment can lead to substantial deterioration of a firm’s balance sheets. Discuss the factors that occurred in the 200 that worsen adverse selection and moral hazard problems in financial markets and eventually caused a financial crisis.
What are the main concerns of asset management?

Discuss the changes in the way banks operate as a result of the flexibility in liabilities management that occurred after the 1960s.

What management methods are available to reduce a bank’s exposure to credit risk?
What financial innovations of the 60s, 70s, and 80s have contributed to the decline in traditional banking?
Ironically, the existence of deposit insurance increases the likelihood that depositors will require deposit protection, because the threat of withdrawals no longer constrains the managers of banks and thrifts from taking on too much risk. Discuss how the problems of asymmetric information have increased with insurance and provide examples to illustrate your points.
Discuss the ways that bank regulations reduce the adverse and moral hazard problems in banking.

Describe the too-big-to-fail policy.

The Money Supply Process

Know how to calculate the money supply if I give you the separate parts.
You do not need to go through all of the math, but I would like you to know the money supply equation and provide some basic information about the process to derive the equation. We started with the monetary base and moved into the multiple deposit creation, but this was too "perfect." How do currency and excess reserves fit into the picture?
What factors affect the money supply?

I. The Fed and the Monetary Base

A. One way the Fed manages the nation’s money supply is by controlling the monetary base, which is comprised of all currency in circulation and reserves held by banks.

B. The Fed’s principal liabilities are currency in circulation and reserves.

1. The Fed’s currency outstanding includes currency in circulation, which is currency held by the nonbank public, and vault cash, which is currency held by depository financial institutions.

2. Bank reserves equal vault cash in banks plus deposits by commercial banks and savings institutions with the Fed.

a. Total reserves are made up of amounts the Fed compels depository institutions to hold, called required reserves, and extra amounts that depository institutions elect to hold, called excess reserves.

b. The Fed specifies a percentage of deposits that banks must hold as reserves, which is known as the required reserve ratio.

C. The Fed’s principal assets are government securities and discount loans.

1. The Fed’s portfolio of government securities consists principally of holdings of U.S. Treasury securities.

2. When the Fed lends to depository institutions, the loans are called discount loans and the interest rate on the loans is called the discount rate.

D. The Fed increases or decreases the monetary base by manipulating the levels of its assets.

1. The most direct method the Fed uses to change the monetary base is open market operations, which is buying or selling U.S. government securities.

a. In an open market purchase the Fed buys government securities.

An open market purchase increases either bank reserves or currency in circulation;

therefore it increases the monetary base, which is the sum of reserves plus currency

(B = C + R).

c. The Fed can reduce the monetary base by an open market sale of government securities.

2. The Fed can also increase or decrease reserves—and, therefore, the base—by making discount loans to depository institutions.

3. Although open market operations and discount loans both change the monetary base, the Fed has greater control over open market operations than over discount loans.

a. The monetary base can be thought of as having two components: the nonborrowed base, B_non, and borrowed reserves, BR.

b. We can express the monetary base as B = B_non + BR.

II. The Simple Deposit Multiplier

A. The money multiplier links changes in the monetary base to changes in the money supply.

B. When the Fed purchases T-bills from a bank it creates excess reserves in the bank.

C. When a bank has excess reserves it typically loans them out or buys securities with them, thereby creating checkable deposits.

D. When businesses or individuals receive funds from a bank as a result of a loan from the bank or a security sale to the bank, they write checks using these funds, which end up being deposited in other banks in a process known as multiple deposit expansion.

E. Multiple deposit expansion extends the monetary base and increases the money supply.

The ultimate change in checkable deposits as a result of a change in reserves is given by the simple deposit multiplier:

D D = D R(1/(R/D)); where D = deposits, R = reserves, and (R/D)= the required reserve ratio.

G. If the Fed engages in an open market sale, it will set off a process of multiple deposit contraction.

III. The Money Multiplier and Decisions of the Nonbank Public

A. The simple deposit multiplier story contains the incorrect assumptions that individuals and businesses hold all their money as checkable deposits and that all excess reserves are loaned out.

B. The Fed acts to set the monetary base, but the behavior of the nonbank public and banks also influence the money supply.

C. The proportion of cash to checkable deposits is called the currency-deposit ratio, (C/D).

1. Because currency is a necessity asset, as the economy grows and national wealth increases, the currency-deposit ratio declines.

2. A decrease in interest rates paid on checkable deposits increases C/D.

3. During a banking panic when there is an increase in the riskiness of checkable deposits relative to currency, C/D increases.

4. Currency has an anonymity premium because it has higher value than checkable deposits in carrying out illegal activities.

a. Economic activity and income earned but not reported to taxing authorities is referred to as the underground economy.

b. Increases in activity in the underground economy or increases in illegal activity such as drug dealing will increase C/D.

IV. Bank Behavior: Excess Reserves and Discount Loans

A. Banks sometimes hold excess reserves, reducing the size of the money multiplier, and their decisions to incur discount loans also affect the amount of the monetary base that the Fed controls.

B. Banks generally hold small levels of excess reserves, but the amount of excess reserves fluctuates over time.

1. Holdings of excess reserves by banks are inversely related to the market interest rate.

2. Holdings of excess reserves are positively related to the expected level or variability of deposit flows.

C. The Fed makes discount loans available to banks, but the level of loans is determined by the banks themselves.

1. Economists have documented that when the spread between the rates on three-month T-bills and discount loans increases, so does the volume of discount lending.

2. The Fed generally discourages routine discount borrowing, but on occasion it has strongly encouraged banks to borrow from it, as it did during the October 1987 stock market crash.

V. Deriving the Money Multiplier and Money Supply

A. The expression that converts the monetary base to the money supply, taking into account the behavior of banks and the nonbank public, is called the money multiplier.

B. The money supply equals the money multiplier times the monetary base, or

M = (1 + (C/D))/[(C/D + (R/D)+ ER/D)](B).
C. The derivation of the money multiplier allows for a complete description of the money supply process.

1. The money supply equals the monetary base times the money multiplier.

2. The monetary base comprises the nonborrowed base, determined primarily by the Fed through open market operations, and discount loans, determined jointly by banks and the Fed.

3. The money multiplier depends on the required reserve ratio (determined by the Fed), excess reserves relative to deposits (determined by banks), and the currency-deposit ratio (determined by the nonbank public).