Money, Banks, and the Federal ReserveChapter 13, Part 2

CHAPTER

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• Bank becomes insolvent– when its total assets are less than its

total liabilities

• Bank failure– when an insolvent bank goes out of

business

Banking Panics

Bad Loans Cause Mid-Size Bank to Become Insolvent

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Total Assets = $850 million and total Liabilities = $875

Total Assets – Total Liabilities = $850 – 875 = $-25

15% of assets are bad

Bad Loans Cause Mid-Size Bank to Become Insolvent

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Equity Ratio: Calculated as Total Equity/Total Assets.

In this example: $125/$1000=12.5%.

Lehman Brothers equity ratio was 3% when it failed.

15% of assets are bad

Banking Panics• Run on the bank (Bank run)

– an attempt by many of a bank’s depositors to withdraw their funds

• Banking panic – depositors attempt to withdraw funds from

many banks simultaneously• Bank runs force banks to “close their

doors” (unable to honor their depositors’ requests for funds)

• Even if they were solvent

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During the Great Depression a large number of banks failed. The creation of the Federal Deposit Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the financial crisis of 2008–2009, bank failures were far fewer than in the 1930s.

Bank Failures in the United States, 1921–2011

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FDIC created in 1933

About 10,000 banks (1/3 of banks in the US) failed

during the Great Depression

Banking Panics• Largely eliminated after 1933

• Federal Reserve – learned important lesson during the Great Depression - ready to lend to banks more quickly in a crisis

• Federal Deposit Insurance Corporation insures deposits up to $250,000

• Increased government regulation of banks

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Bank Regulation• Continuous monitoring of bank financial

condition with a focus on the shareholders’ equity (called bank capital)

• Legal capital requirements: • Banks must hold a percentage of their assets as

equity (bank capital, 5% to 8%)• Dr. Neri does not believe the percentage is high

enough. • High equity encourages banks to lend

responsibly because the owner’s loose if lend recklessly.

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Bank Regulation• Capital ratio (equity ratio)

– A bank’s capital (shareholder equity) as a percentage of its total assets

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𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒆𝒒𝒖𝒊𝒕𝒚𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

Bank Regulation• Why require higher capital ratios

– Greater incentives to avoid risky loans• Reduces the likelihood of bank failures that

pass losses onto non-owners

– Some argue (the banks, duh!) this reduces the amount of interest-earning assets a bank can hold for each dollar of capital that the owners have invested• Reduces the rate of return to the bank’s

owners• Discourages people from forming or investing

in banks ( I don’t believe this)10

Banking Panics• Look at the slide on bank failures. What

happened in the 1980s and 90s? – many undercapitalized banks– many without FDIC insurance

• Banks were poorly regulated – banks made bad loans and had low capital ratio

• Reminder of the need for deposit insurance and high capital requirements.

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Shadow Banking System• To understand “shadow banking” must

first understand banks (depository)• Banks share four characteristics:

1. Have short-term liabilities in the form of deposits that can be demanded back on short notice

2. Invest in long-term assets

3. Their liabilities include deposits that are government-insured (FDIC)

4. Closely regulated by government, capital requirements 12

The Shadow Banking System

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• I really do not like this term, implies something illegal, and its not.

- non-depository financial intermediary less strictly regulated than a bank (non-bank)

- and with no government-guaranteed deposits

The Shadow Banking System• Shadow Banks share four characteristics:

1.The have short-term liabilities. Not deposits! Rely on borrowed funds which mature in a matter of days or weeks. Depend on “Roll-Over”

2. Invest in Long-term assets

3. Liabilities do not include government-insured deposits

4. Not closely regulated by government

Lehman Brothers, an investment bank is an example. Ford Motor Credit, GMAC, GE Credit, ……………

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• Lehman Brothers and Bear Sterns, investment banks that failed

• Ford Motor Credit and GMAC, GE Capital

• Fannie Mae

Examples of The Shadow Banks

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Banking Panics• Run on a shadow - bank

– Lenders simply say “no”. – meaning these non-banks can not “roll-

over” short-term loans. – Lenders essentially withdraw their funds

Assets Liab. + Equity

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30 –year Mortgage Loans

Over-night loan

The Shadow Banking System• During the 1990s and 2000s

– the shadow banking system grew: larger, more complex, and more interconnected with the regular banking system

• When the financial crisis hit– it became clear that bank regulations had

not struck the right balance– financial institutions around the world

failed and governments had to come to the rescue

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The Financial Crisis of 2008• 2007

– The collapse of housing prices in 2007– Followed by a recession in 2008

• Commercial banks and “shadow banks” invested heavily in mortgages and mortgage-backed securities which fell in value as housing prices fell.

• Estimates of total losses in asset values at U.S. banks: well beyond $1 trillion. Even more in “shadow banks”– Look at the Mid-Size Bank example

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Mortgage-backed securities: Securitization

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• Mortgages are loans and bonds are securities.

• Securitization is the process of pooling a lot of mortgage loans together and dividing them into smaller bonds called mortgage back securities

• A mortgage pool might be hundreds of mortgages totaling $100 million divided into 10 thousand $10,000 bonds.

• The bonds are sold to investors who receive monthly payments from the pool of mortgages

The Financial Crisis of 2008• How did these losses come about?

– With the collapse of housing prices, came the recession and declining income• Millions of homeowners began to default on

their mortgages

– No one wanted to buy mortgage-backed securities at prices anywhere close to their previous value

– Bank capital declined– Look at the Mid-Size bank example

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Bad Mortgage Loans Cause Mid-Size Bank to Become Insolvent

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Mortgages

Mid-size bank becomes insolvent because equity is less than 0.

It has $850 million in assets but owes $875 million.

The Financial Crisis of 2008• As capital declined, banks and “shadow

banks” had three choices:1. Acquire more equity capital by issuing and selling new shares - unappealing

2. Reduce the risk of their assets by selling risky assets and replace them with safer ones

• Banks tried to do this, but all at the same time, becomes a fire sale! Asset prices fell - unappealing.

3. Wait and hope22

The Financial Crisis of 2008• Wait-and-hope strategy was followed by

many banks in the U.S. • Deposit insurance

• With FDIC insurance, commercial banks avoided a “banking panic”

• Side effect: Increased reluctance to lend to banks. Everyone new bad loans existed, but did not know where!

• Banks would have to sell even more assets to pay back the debts coming due

• Causing the market value of the assets to fall further

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The Downward Spiral for Banks

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Feedback effect!

The Financial Crisis of 2008• Shadow - bank situation more dire than

for banks– they do not have insured deposits, only

short-term debt– lenders wanted their money back– Cannot use the “wait-and-hope” strategy

• Not closely regulated• Held very little capital relative to their assets

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The Financial Crisis of 2008• Shadow - bank situation more dire than

for banks– not closely regulated and held very little

capital relative to their assets– many non-bank held 3% or less (Lehman

Brothers and Bear Stearns)– were very highly leveraged

• Commercial banks held about 10% capital• Bears Stearns and Lehman Brothers

failed26

Government to the Rescue• The Federal Reserve

– extended emergency loans to financial institutions, even non-banks!

• October 2008, Congress approved the Troubled Asset Relief Program (TARP)– the government purchased shares of

stock in banks and, • A major non-bank (the insurance company

AIG)• A major automobile company (General

Motors)27

Government to the Rescue

• TARP– Helped restore confidence in some of the

nation’s largest banks and financial institutions

– Helped to keep the financial system running

– Prevented the recession from being even worse than it was

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Bank Failures and Government Rescue

• The Dodd-Frank Act (1,000 pages!)– The Dodd- Frank Wall Street Reform and

Consumer Protection Act of 2010– To prevent the need for another TARP-like

rescue in the future– Extended the regulatory power of the

Federal Reserve allowing the Fed to impose minimum capital ratios on any financial institution• Bank or non-bank

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Leverage at Financial Institutions

• Financial institution - simple leverage ratio =

• Leverage ratio acts as a “rate-of-return” multiplier

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Capital and Leverage at Financial Institutions• The greater the leverage ratio

–The more interest-earning assets the bank can acquire with each dollar of its capital (shareholders’ equity)

–They borrow more!–The greater the return it can earn for

its shareholders

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Capital and Leverage at Financial Institutions• Deleveraging

– The process of reducing leverage– Reducing the risk to your capital from any

further declines in asset prices• How to lower leverage ratio

– Increasing capital– Sell off assets rapidly– Stop lending! Called a credit crunch.

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Understanding Leverage Appendix to Chapter 4

• Purchase a house without leverage– purchase house for $500,000 cash and

next year 10% higher housing prices• have a 10% capital gain = • Return is 10%

– 10% lower housing prices• 10% capital loss = • Loss is 10%

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Understanding Leverage

• Leverage– Magnification of gains and losses through

borrowing• Using borrowed money to buy a home

–10% higher housing prices• More than 10% capital gain

–10% lower housing prices• More than 10% capital loss

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Understanding Leverage Appendix to Chapter 4

• Purchase a house with leverage– purchase house for $500,000– You put in $100,000 and borrow $400,000– next year 10% higher housing prices

• have a 50% capital gain =

– 10% lower housing prices• 50% capital loss =

• Magnification of gains and losses through borrowing

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Understanding Leverage

• In this example, you earn $50,000 on $100,000 investment – 50%

• Simple leverage ratio = “Rate-of-return multiplier”

• Rate of return on the (leveraged) investment – Rate of change in a home’s price times the

leverage ratio– 10% x ($500,000/$100,000)– 10% x 5 = 50%

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Understanding Leverage

• When asset prices rise– Leverage increases your rate of return

dramatically• When asset prices fall

– Leverage increases the chance of wiping out your entire investment

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