Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

certificates of deposits, the FDIC would insure a total of $250,000. If your bank fails, you are guaranteed that you will get at least $250,000 from FDIC, potentially losing $50,000. In some cases, the FDIC insured all deposits that exceeded $250,000 per person, while it did not for other bank failures. It depends how FDIC handles the bank failure.

FDIC receives its funding from insurance premiums. Every commercial bank that is a member of FDIC must pay approximately $100,000 per year. The FDIC became very successful because bank failures averaged 10 per year between 1934 and 1981. On the other hand, bank failures averaged 2,000 per year during the Great Depression before the U.S. government created the FDIC.

The FDIC uses two methods to deal with bank failures. First, the FDIC closes the bank and seizes the bank’s assets. Then the FDIC sells the bank’s assets and returns the money to the depositors. If FDIC does not receive enough money to pay all depositors from selling the bank’s asset, subsequently, the FDIC pays the difference from its own funds. Thus, the FDIC rarely uses the first method because the FDIC could pay out millions or billions in claims. Second, the FDIC purchases and assumes control of the failed bank. Next, the FDIC keeps the bank open and searches for another bank that will buy the failed bank. If the FDIC cannot find a buyer, then FDIC can grant extra incentives, such as low-interest rate loans from the FDIC, or the FDIC buys the problem loans from the failed bank’s portfolio. The FDIC also allows a bank to cross a state line to buy a failed bank. Although federal law prohibited banks from crossing state lines and opening banks in another state, the federal government did not hesitate to violate its own rules when it needed to.

The U.S. government established the FDIC to reduce the bank failure rate by preventing bank runs. A bank run is depositors discover their bank has financial trouble, so everyone runs to the bank to withdraw their deposits. Unfortunately, a bank holds only a fraction of the total deposits because a bank grants loans. Thus, a bank will close its doors after the bank has drained all the cash from the vault. Furthermore, if the bank granted many illiquid loans, then the bank must sell these loans at a discount in order to raise more reserves. Selling the illiquid loans at a discount can cause the bank to become insolvent. Insolvent occurs as a bank's total liabilities exceed its total assets. Consequently, any bank on the verge of failing cannot return money to its depositors. Even a financially healthy bank could fail if people spread rumors the bank has financial troubles. Then the rumor triggers a bank run.

Bank runs can lead to contagion. Contagion is a bank run on one bank leads to bank runs on other banks. For example, depositors line up at one bank to withdraw their accounts; subsequently, many depositors do not get their money back. Then the depositors tell friends and family, and they begin questioning the health of their banks. Many people cannot gauge the financial health of banks. Friends and family run to their banks to withdraw funds from their accounts, triggering more bank runs. As the contagion spreads, it causes a wave of severe bank runs called financial panics. Financial panics can push the economy into a serious recession.

The FDIC charges insurance premiums based on the total amount of deposits at the bank and the risk level the depository institutions pose to the FDIC. Many banks are experiencing financial difficulties that resulted from the 2008 Financial Crisis because the banks approved anyone for a mortgage. As the U.S. entered a recession in 2007, some homeowners started

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Money, Banking, and International Finance

What would happen if a bank stopped accepting deposits? Legally, the bank is no longer a bank and becomes exempted from the extensive U.S. bank regulations. Nonbank bank is simply a finance company.

Third innovation was the creation of money-market mutual funds (MMMF). MMMFs are pools of liquid money-market assets managed by investment companies. The MMMF is identical to a mutual fund. Investment companies sell shares to the public in small denominations, and the fund managers invest in money market instruments. Consequently, MMMF became very successful. MMMF grew from $3.3 billion in 1997 into $186.9 billion in 1981 and 959.8 billion by 2010.

The MMMFs began hurting the banks financially as people started withdrawing money from their bank accounts and investing them into MMMFs. MMMFs paid a higher interest rate, and they allow check-writing privileges. Accordingly, banks began losing customers, and they place pressure the regulatory agencies that, in turn, placed pressure on Congress and the President to change the laws. Since 1982, banks began offering money market deposit accounts (MMDA) that are similar to a MMMF with only one difference. The FDIC considers a MMDA to be a bank account and thus, it insures them, while it does not insure MMMFs. Finally, MMDAs have no reserve requirements, and they have grown rapidly as people started to invest in them.

Last innovation, automated teller machine (ATM), allowed banks to circumvent regulations. Modern computer technology allows a bank's customers to receive banking services through computer terminals located at banks, stores, and shopping malls. Customers can make deposits, withdrawals, and credit-card transactions. Technically, ATMs are not bank branches, and are not subjected to branch banking restrictions. Therefore, ATMs are located some distance away from the main bank. Furthermore, many banks created networks, so customers could access their accounts from any place within the United States and across the world. Moreover, banks offer debit cards. For example, a customer uses a debit card to pay for goods and services by electronically transferring funds from his checking account to a store's bank account. Thus, the debit card has replaced checks. Some businesses do not accept checks, but take debit cards because the merchants know they will receive money from the customer's bank.

Political climate was changing in the United States before the 2008 Financial Crisis. Innovation, rising interest rates, and deregulation were eroding the regulatory structure set up in the 1930s. Banks can cross state lines, open branches in other states, offer investment advice and brokerage services. Thus, the banking industry experienced two trends. First, banks can acquire other banks, reducing the number of banks in the United States. Second, as banks merge, they become bigger as their assets grow. U.S. banks were approaching the size of Japanese and German banks, which traditionally were larger in asset size.

Then the 2008 Financial Crisis struck the U.S. economy, causing many commercial and investment banks to teeter on bankruptcy. The U.S. federal government came to the rescue and purchased stock of many financial corporations. Taxpayers indirectly helped the corporations. Subsequently, the U.S. government helped and approved many bank mergers, including mergers between commercial and investment banks. Consequently, the U.S. government bailed out these banks because they were too big to fail. A wave of large bank failures would implode the whole

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3. Multinational Enterprises

This chapter defines and distinguishes the three business forms: proprietorships, partnerships, and corporations. Then students study the corporations extensively because they have many advantages over proprietorships and partnerships, as well as different management structures. Although corporations roughly comprise 20% of U.S. businesses, they dominate the business and financial markets. Unfortunately, the corporate structure has several disadvantages with the main one being susceptible to corporate fraud. Thus, students study the disadvantages and ways to minimize them. Finally, corporations dominate international trade and finance, which is why we study them in this book. Towards the end of the chapter, we explain the Law of Comparative Advantage, and why businesses engage and profit from free trade.

Forms of Business Organizations

Goal of a business is to earn profits. Alfred P. Sloan stated, “General Motors is not in the business of making automobiles. General Motors is in the business of making money.” All business owners seek profit, and we classify them as a sole proprietorship, partnership, and corporations. Sole proprietorship is one person owns the business. That one person becomes liable for all the business’s debts, and the business is dissolved legally, when the owner dies. Sole proprietors are the most numerous businesses in the United States, and they usually own farms, grocery stores, hotels, and restaurants.

A partnership is a business owned and managed by two or more people. Partnership is defined as general or limited liability. Under a general partnership, all partners become liable for the partnership’s debts and obligations. If one partner applies for a bank loan, steals the money, and flees the country, the remaining partners become liable for the bank loan. A limited liability partnership restricts liability and helps protect the partners’ assets that he or she does not use directly in the business. Thus, a partner can only lose assets invested in the partnership while his or her other assets are protected from creditors. On the other hand, general partnerships do not have this protection. If a general partnership bankrupts, then creditors can go after a partners’ assets such as the partners’ house, car, personal bank accounts, and other assets. Usual partnerships are accounting and law firms.

A corporation becomes the last form, and the focus of this chapter. Although corporations comprise approximately 20% of businesses in the United States, they dominate domestic and international markets because they enter into all spheres of business activity. Unfortunately, corporations can become so complex; the management loses sight on its goal of earning profits. For instance, shareholders represent the owners of the corporation, and they should benefit. Sometimes corporate managers lose sight of earning profits. Unfortunately, the managers do not maximize the shareholders’ wealth, maximize share price, or maximize a firm’s value. However, if a corporation continually earns losses year after year, then the business would fail, similarly to a proprietorship and partnership.

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Money, Banking, and International Finance

taxes, finance, and accounting, who handle operations for foreign countries. Advantages of the corporate form include:

A corporation has limited liability. Stockholders own the corporation, and they are not liable for a corporation's debt. If a corporation fails, subsequently, the stockholders only lose their investment, the amount of common stock that they had purchased.

Stockholders can easily transfer corporate ownership. Stocks are certificates that represent ownership in a corporation, and stockholders can freely buy or sell stock to other investors through the stock market.

Corporations have continuity of life. Theoretically, a corporation could live forever.

Stockholders do not have a mutual agency relationship, where the stockholders cannot bind a corporation to contracts. Stockholders have no say in the daily operation of the corporation even though they own the corporation.

Corporations have two disadvantages. First, government heavily regulates corporations. Corporations file many reports with government because corporations can expand into many countries, markets, and industries. Corporations may encourage regulations because bureaucratic red tape creates barriers to entry. Thus, new companies experience troubles entering the market with complex and arduous regulations. Second, government imposes taxes twice on corporations. Corporations pay taxes from their profits. Then stockholders receive profit from the corporation as dividends, and the dividends become income to the stockholder that a government also taxes.

Corporations could issue two different classes of stock: common stock and preferred stock. Common stock allows stockholders to vote at stockholder meetings, while preferred stock does not have any voting rights. For stockholders to give up their voting right, they will receive their dividends before the common stockholders. Consequently, a corporation could issue preferred stock to expand operations and not share control of the corporation with the new preferred stockholders. Moreover, corporations can pay different dividends, paying a higher dividend to the common shareholders.

We define preferred stock by the following categories:

Cumulative Preferred Stock – a corporation must pay past-due dividends to cumulative preferred stockholders before it pays dividends to common stockholders. Stockholders only receive dividends, when the board of directors declares them.

Protected Preferred Stock – a corporation must deposit part of its profits into a fund, and, thus, the corporation can guarantee dividend payments to preferred stockholders.

Redeemable Stock – a corporation has the right to repurchase the preferred stock in the future.

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