Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

Consequently, these deposits require fewer bank services and earn higher interest rates than checking accounts. Non-transaction deposits include:

Savings account is the most common and pays a higher interest than interest on checking accounts. However, savings accounts have fewer services than checking accounts.

Small-denomination time deposits (Also called Certificates of Deposit) have maturities ranging from several months to over 5 years. Although they are less liquid than a savings account, they pay higher interest.

Large-denomination time deposits are accounts that exceed $100,000. Corporations and banks invest in these securities. Investors can sell these time deposits in a secondary market before maturity. Therefore, they are liquid and an alternative to T-bills. As Table 1 shows, investors held $702.8 billion in large time deposits in December 2013.

Table 1. Commercial Banks Assets and Liabilities on December 2013

Source: Board of Governors of the Federal Reserve System. February 7, 2014. Assets and Liabilities of Commercial Banks in the United States (Weekly) - H.8. Available at http://www.federalreserve.gov/releases/h8/current/default.htm (access date: 02/12/14).

Borrowings become the last liability. A bank borrows funds if the bank can lend the funds to a borrower for a higher interest rate than the interest rate paid on the borrowings. Borrowings are not deposit accounts. Banks can borrow from the Federal Reserve or from other banks. We call a Federal Reserve loan a discount loans. We show the banks’ borrowings in Table 1. U.S. banks borrowed $97.1 billion from U.S. banks and $840.3 billion from others nonbanks.

On the other side of a bank’s balance sheet, a bank has assets. Bank takes funds from depositors and loans these funds to borrowers who pay interest. Thus, banks earn interest from the loans becoming a vital source of income for the bank. Reserves are the first and most liquid

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2013. After the 2008 Financial Crisis, banks started accumulating more capital to deal with future financial crises.

A Bank Failure

A bank failure is a bank develops financial problems and fails. Unfortunately, the bank cannot return the depositors’ money. A government imposes regulations to encourage banks to hold a large amount of reserves, marketable securities, and equity capital, reducing a chance of bank failure.

In this analysis, we use T-accounts. A T-account represents a simplified balance sheet listing only changes for assets, liabilities, and net worth. For example, you open a checking account at your bank and deposit $100 cash. We record the transaction below:

A central bank, for example, requires commercial banks to hold 10% of deposits in the form of vault cash and/or reserves at the central bank. Therefore, $10 of your checking account becomes required reserves while the remaining becomes excess reserves. Banks can lend their excess reserves to borrowers, and we record the transaction below:

Bank earns no interest on reserves, so the bank grants a loan to a borrower for $90. Loan becomes the bank’s source of income, and we record the transaction below:

For the bank to earn a profit, the bank must earn a higher interest rate on the loan than the level of interest the bank pays on your checking account. If a borrower defaults and does not repay the loan, subsequently, the bank must return your $100, when you demand it. The bank would pay $90 from the bank’s net worth and $10 from required reserves.

Banks face another complication, liquidity risk – the depositors withdraw more money from their accounts than the amount of cash held in a bank’s vault. Consequently, banks developed asset and liability management to prevent liquidity risk. Asset management is banks lend to

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borrowers, who will pay high interest rates and are not likely to default on their loans. Then, banks purchase securities that have high returns, are liquid, and have low default risk. If depositors begin withdrawing funds, the banks can sell the liquid securities and pay the depositors’ withdrawals. Liability management is banks cannot force customers to open checking and savings accounts. Thus, banks are limited in these funding sources. However, banks use financial instruments, such as certificates of deposits, Eurodollars, federal funds market, and repurchase agreements. Currently, banks have few restrictions in raising funds.

Illustrating liquidity risk for your bank, we show your bank’s balance sheet below. The Federal Reserve requires your bank to hold 10% of deposits as required reserves. Thus, your bank has enough funds to meet depositors’ withdrawals.

Depositors withdraw $10 million that decreases deposits by $10 million. Bank pays the funds from excess reserves, equaling $10 million. Consequently, this bank has met withdrawal demands. Both bank deposits and excess reserves decrease by $10 million, shown in the T- account below:

Depositors withdraw another $10 million, and the bank pays the withdrawals from required reserves. Both deposits and required reserves decrease by $10 million, shown in the T-account below

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Bank must hold 10% of deposits as reserves, and the bank must find $8 million for required reserves. Your bank has the following options:

Bank could sell $8 million of securities to raise funds.

Bank asks several borrowers to repay $8 million in loans. Moreover, the bank could sell loans to other banks.

Bank borrows the funds from the central bank or from another commercial bank.

Your bank borrows the $8 million from the Federal Reserve as a loan. Your bank managed the liquidity risk well. We show your bank’s balance sheet below:

How does a bank prevent a bank failure? A bank holds excess reserves and short-term, highly liquid securities to prevent a bank failure. In the next example, your bank has the following balance sheet below, and your bank will fail.

Public circulates a rumor the bank president lost millions in the derivatives market and had disappeared to the Bahamas. Consequently, you and the other depositors are afraid your bank will fail, so you and the depositors withdraw $20 million from your bank. Your bank sells $10 million in securities and uses $10 million in required reserves to meet depositors’ withdrawals, shown in the T-account on the next page.

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Now your bank needs $8 million in required reserves. If your bank sold the loans, the bank would sell the loans for a lower value than the bank’s book value. Furthermore, the other banks do not know your bank’s borrowers, so these banks will buy the loans for a fraction of the loan’s value, generating a substantial loss. Your bank could ask other banks for a loan, but other banks may decline if they believe your bank will fail. Your bank could ask the Federal Reserve for a loan, but the Fed may not grant the loan.

Your bank sells $40 million of loans, but the other banks will pay $25 million for them. Now your bank became insolvent because total liabilities exceed total assets. Unfortunately, your bank could fail. When a bank becomes insolvent, the U.S. federal government can legally take control of the bank. The bank could have prevented its failure if the bank had more reserves or more highly liquid securities. We display your insolvent bank’s balance sheet below.

As you can see from the previous example, a bank could fail if too many loans go bad. A bank is concerned about credit risk. Credit risk is a risk that borrowers will default on their loans. One method banks use to lower credit risk is to diversify their loan portfolios. Banks spread their loans across different industries, different regions, and different loan borrowers. For example, a bank grants loans for credit cards, mortgages where the homes are spread across the state, and commercial loans for hotels, restaurants, retail stores, and factories. If a factory bankrupts and defaults on its commercial loan, the loan default does not harm the bank severely because the bank is earning income on the other loans.

Adverse selection becomes a problem for banks. Some borrowers apply for bank loans, when the borrowers know they will default. Banks implement six procedures to reduce adverse selection, which include:

Banks perform credit-risk analysis. Bank collects information about the borrowers’ employment, income, and net worth. From this information, the bank assesses the borrowers’ ability to repay their loans.

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Bank prevents adverse selection by requiring collateral. Borrowers pledge assets to the bank. If a borrower defaults on the loan, then the bank will seize the asset. For example, the house becomes the collateral for a mortgage. If the homeowner defaults on the mortgage, then the bank takes possession of the house.

Bank minimizes adverse selection by credit rationing. Banks establish a maximum amount of loan for a borrower. For example, banks grant a maximum credit of $1,000 to college students. If a bank granted a credit limit of $10,000, then some students would borrow the full amount and cannot repay the credit-card balance.

Banks use restrictive covenants to minimize adverse selection. Banks specify conditions or restrictive covenants in the loan agreement that prevent the borrowers engaging in certain activities. For example, a person applies for a home-improvement loan and plans to use the loan to speculate in the derivatives market. Bank place a restrictive covenant in the loan agreement. Borrower can only use the loan for home improvement.

Banks may ask the borrower to have another relative having a good credit history co-sign the loan. If the borrower defaults, then the bank can demand payment from the borrower or co-signer.

Banks minimize adverse selection by fostering a long-term relationship with the borrowers. When the banks know their customers well, they can accurately assess the customers’ risk of default.

The Interest Rate Risk

Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk. Banks experience an interest-rate risk, when changes in the interest rates cause the banks’ profit to fluctuate. We show an example of a bank’s balance sheet below:

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Securitization and the 2008 Financial Crisis

Securitization is similar to a mutual fund. We define securitization as the process of transforming illiquid financial assets into marketable securities. Banks and financial institutions package similar loans together, such as mortgages, place them into a fund, and issue securities that are tied to the fund’s assets. Then investors buy the securities to earn the return on the fund’s assets. On average, the pool of funds has a predictable cash flow as people pay their loans. Then investors receive these payments as investment. Banks used securitization because they use computers to simplify the record keeping process.

Securitization is more complex because a fund could issue different bonds called tranches. A tranche is a French term meaning a portion or slice. Each tranche has a bond associated with a risk level and a different credit rating. Credit-rating agencies could rate some bonds as AAA that pays the lowest return to investors, but investors are first in line if the fund goes bust. Furthermore, the fund issues risky bonds, called speculative grade that pay a higher return, but investors would lose their investments if the fund bankrupts.

Banks did not use securitization on a large scale before the 1990s because the banks could not price the different tranches in the fund until a statistician, David Li, devised a method in 2000. Li’s method allows easy and quick pricing of these tranches. Consequently, the bankers and financiers applied securitization to a variety of assets. They securitized mortgages, car loans, third world debt, credit cards, and student loans. Securitization of mortgages has its own named, mortgage asset-back securities (ABS). Unfortunately, the securitization of mortgages led to the U.S. housing bubble between 2000 and 2007. Even in 2013, banks held $1.3 trillion in asset-back securities.

A problem of the U.S. housing bubble was the banks relaxed their loan requirements. Before 2000, banks would grant home loans only to borrowers with a stable work history and good credit history. Furthermore, the borrowers documented their incomes completely. During the housing bubble, several large U.S. banks relaxed their lending standards. Homebuyers could state their incomes without verifying them. Furthermore, banks granted mortgages to people with poor credit or poor work history, called subprime loans. After the U.S. economy had entered the 2007 Great Recession, the subprime loans turned into toxic loans as the subprime borrowers began defaulting on their loans in record numbers.

Banks relaxed their loan standards because they would not suffer from a mortgage default. Banks used securitization to “cash” out the mortgages and “pushed” the default risk onto the investors. Cashing out of the mortgages gave banks funds to grant new mortgages and continue the process. Consequently, the banks relaxed their loan standards maintaining a strong demand for mortgage loans. This credit flow rapidly appreciated housing prices in the United States between 2000 and 2007. If a borrower had defaulted on the mortgage, homes kept appreciating over time, so foreclosures did not harm banks and investors. Banks and investors foreclosed on homes that soared in value.

Banks earn short-term profits from the mortgage closing cost fees and managing the fund. In addition, attorneys earn legal fees from the fund’s setup. Of course, the banks do not earn the cash flow from a mortgage because the fund investors do. For example, if a family bought a

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