Chapter 14: Money, Banking, and Financial Institutions (2)

Chapter 14Money, Banking, and Financial InstitutionsMcGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reservedFunctions of Money Medium of exchangeUsed to buy/sell goodsUnit of accountGoods valued in dollarsStore of valueHold some wealth in money formLiquid14-*Money Definition M1M1CurrencyCheckable depositsInstitutions offering checkable depositsCommercial banksSavings and loan associationsMutual savings banksCredit unions14-*Money Definition M2M2M1 plus near-moniesSavings deposits including money market deposit accounts (MMDA)Small-denominated time depositsMoney market mutual funds (MMMF)14-*Money Definitions Source: Federal Reserve SystemSavings deposits, including money market deposit accounts61%Money market mutual funds8%Small time deposits9%M122%Currency50%Checkable deposits50%Money supply, M1$1935 billionMoney supply, M2$9001 billion14-*What “Backs” the Money Supply?Guaranteed by government’s ability to keep value stableMoney as debtWhy is money valuable?AcceptabilityLegal tenderRelative scarcity14-*What “Backs” the Money Supply?Prices affect purchasing power of moneyHyperinflation renders money unacceptableStabilizing money’s purchasing powerIntelligent management of the money supply—monetary policyAppropriate fiscal policy14-*Federal Reserve — Banking SystemHistorical backgroundBoard of Governors12 Federal Reserve Banks Serve as the central bankQuasi-public banksBanker’s bank14-*Federal Reserve — Banking SystemCommercial banksThrift institutions(savings and loan associations,mutual savings banks, credit unions)The public(households andbusinesses)12 Federal Reserve BanksBoard of GovernorsFederal Open Market Committee14-*Federal Reserve — Banking SystemThe 12 Federal Reserve Banks14-*Federal Reserve — Banking SystemFederal Open Market CommitteeAids Board of Governors in setting monetary policyConducts open market operationsCommercial banks and thrifts6,800 commercial banks8,700 thrifts14-*Federal Reserve FunctionsIssue currencySet reserve requirementsLend money to banks Collect checksAct as a fiscal agent for U.S. governmentSupervise banksControl the money supply14-*Federal Reserve IndependenceEstablished by Congress as an independent agencyProtects the Fed from political pressuresEnables the Fed to take actions to increase interest rates in order to stem inflation as needed14-*Global SnapshotWorld’s 12 Largest Financial Institutions, 2011Source: Forbes Global 2000, www.forbes.comAssets (billions of U.S. dollars)BNP Paribas (France)2,681Deutsche Bank (Germany)2,557HSBC Holdings (U.K.)2,468Barclays (U.K.)2,328Royal Bank of Scotland (U.K.)2,266Bank of America (U.S.)2,265Mitsubishi UFJ (Japan)2,177Crédit Agricole (France)2,131JP Morgan Chase (U.S.)2,118Citigroup (U.S.)1,914ICBC (China)1,724Mizuho Financial (Japan)1,66714-*The Financial Crisis of 2007 and 2008Mortgage default crisisMany causesGovernment programs that encouraged home ownershipDeclining real estate valuesBad incentives provided by mortgage-backed bonds14-*The Financial Crisis of 2007 and 2008Securitization — the process of slicing up and bundling groups of loans into new securitiesAs loans defaulted, the system collapsed“Underwater” homeowners abandoned homes and mortgagesLO514-*The Financial Crisis of 2007 and 2008Failures and near-failures of financial firmsCountrywide: second largest lenderWashington Mutual: largest lenderWachoviaOther firms came close14-*The Financial Crisis of 2007 and 2008Troubled Asset Relief Program (TARP)Allocated $700 billion to make emergency loansSaved several institutions from failure14-*Postcrisis U.S. Financial Services Major categories of financial institutionsCommercial banksThriftsInsurance companiesMutual Fund companiesPension fundsSecurities firmsInvestment banks14-*InstitutionDescriptionExamplesCommercial banksState and national banks that provide checking and savings accounts and make loansJPMorgan Chase, Bank of America, Citibank, Wells FargoThriftsSavings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loansCharter One, New York Community BankInsurance companiesFirms that offer policies through which individuals pay premiums to insure against lossPrudential, New York Life, Northwestern Mutual, HartfordMutual Fund companiesFirms that pool customer deposits to purchase stocks or bondsFidelity, Vanguard, Putnam, Janus, T. Rowe PricePension fundsInstitutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefitsTIAA-CREF, Teamsters’ Union, CalPERsSecurities firmsFirms that offer security advice and buy and sell stocks and bonds for clientsMerrill Lynch, Smith Barney, Charles SchwabInvestment banksFirms that help corporations and governments raise money by selling stocks and bondsGoldman Sachs, Morgan Stanley, Deutsche Bank, Nomura SecuritiesMajor Categories of Financial Institutions14-*Postcrisis U.S. Financial Services Wall Street Reform and Consumer Protection ActPassed to help prevent many of the practices that led to the crisisCritics say it adds heavy regulatory costs14-*Fractional Reserve SystemThe goldsmithsStored gold and gave a receiptReceipts used as money by publicMade loans by issuing receiptsCharacteristics:Banks create money through lendingBanks are subject to “panics” 14-*Fractional Reserve SystemBalance sheetAssets = Liabilities + Net worthBoth sides balanceNecessary transactionsCreate a bankAccept deposits Lend excess reserves 14-*A Single Commercial BankTransaction #1Vault cash: cash held by the bankAssetsLiabilities and Net WorthCreating a BankBalance Sheet 1: Wahoo BankCash$250,000Stock shares$250,00014-*A Single Commercial BankTransaction #2Acquiring property and equipmentAssetsLiabilities and Net WorthAcquiring Property and EquipmentBalance Sheet 2: Wahoo BankCash$ 10,000Stock shares$250,000Property240,00014-*A Single Commercial BankTransaction #3Commercial bank functionsAccepting depositsMaking loans AssetsLiabilities and Net WorthAccepting DepositsBalance Sheet 3: Wahoo BankCash$110,000Checkable deposits$100,000Property240,000Stock shares250,00014-*A Single Commercial BankTransaction #4Depositing reserves in a Federal Reserve BankRequired reservesReserve ratioReserveratio=Commercial bank’srequired reservesCommercial bank’scheckable-deposit liabilities14-*A Single Commercial BankAssetsLiabilities and Net WorthDepositing Reserves at the FedBalance Sheet 4: Wahoo BankCash$ 0Checkable Deposits$100,000Property240,000Stock Shares250,000Reserves110,000Transaction #4Assume the bank deposits all cash on reserve at the Fed14-*A Single Commercial BankExcess reservesActual reserves - Required reservesRequired reservesCheckable deposits × Reserve ratioExample:Checkable deposits: $100,000Reserve ratio: 20 percent14-*A Single Commercial BankTransaction #5Clearing a check$50,000 check reduces reserves and checkable deposits AssetsLiabilities and Net WorthClearing a CheckBalance Sheet 5: Wahoo BankCheckable deposits $ 50,000Property240,000Stock shares250,000Reserves$ 60,00014-*Money-Creating TransactionsTransaction #6aGranting a loan$50,000 loan deposited to checkingAssetsLiabilities and Net WorthWhen a Loan Is NegotiatedBalance Sheet 6a: Wahoo BankCheckable deposits$100,000Property240,000Stock shares250,000Reserves$ 60,000Loans50,00014-*Money-Creating TransactionsTransaction #6bUsing the loan$50,000 loan cashed AssetsLiabilities and Net WorthAfter a Check Is Drawn on the Loan Balance Sheet 6b: Wahoo BankCheckable deposits $ 50,000Property240,000Stock shares250,000Reserves$ 10,000Loans50,000A single bank can only lend an amountequal to its preloan excess reserves 14-*The Banking SystemMultiple-deposit expansionAssumptions:20 percent required reservesAll banks “loaned up”Banks lend all of their excess reservesA $100 bill is found and depositedMultiple deposits can be created14-*The Banking SystemThe Banking System’s Lending PotentialAssetsLiabilities and Net WorthMultiple-Deposit Expansion ProcessCheckable deposits$+100 (a1)Loans+80 (a2) +80 (a2)Reserves$+100 (a1)-80 (a3)-80 (a3)Balance Sheet: Commercial Bank A14-*The Banking SystemThe Banking System’s Lending PotentialAssetsLiabilities and Net WorthMultiple-Deposit Expansion ProcessBalance Sheet: Commercial Bank BCheckable Deposits$ +80 (b1)Loans+64 (b2) +64 (b2)Reserves$+80 (b1)-64 (b3)-64 (b3)14-*Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther BanksBank(1)AcquiredReservesand Deposits(2)RequiredReserves(ReserveRatio = .2)(3)ExcessReserves(1)-(2)(4)Amount Bank CanLend; New MoneyCreated = (3)$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.5021.99$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.4017.59$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.4017.59$400.00The Banking System14-*The Monetary MultiplierMonetarymultiplier=1Required reserve ratio=1R14-*The Monetary MultiplierMaximum amount of new money created by a single dollar of excess reservesHigher R, lower mReversibilityMaking loans creates moneyLoan repayment destroys money14-*Bank Panics of 1930–1933Before deposit insuranceBank failure led to mass withdrawals Forced loan reduction25-33 percent decline in money supply1933 national bank holiday to evaluate all banksContributed to the Great DepressionRegulation protects the system today14-*