Lecture 1: Money, Banking & Financial Markets
Why Study Financial Markets?
1. Channel funds from savers to investors, thereby promoting economic efficiency
2. Affect personal wealth and behavior of business firms
Bond Market
- where corporations and governments borrow funds
- where interest rates are determined
- affects consumers willingness to spend & save
- affects business spending decisions
Stock Market
- affects personal wealth
- affects business investment decisions
Foreign Exchange Market
- used for transfer of funds between countries
- affects costs of imports & exports for domestic and foreign consumers
- affects competitiveness of domestic versus foreign businesses
Number of Bank Failures Per Year
411
3 40 3
25
140
157
92
51
2418
00
25
50
75
100
125
150
175
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: FDIC
The Circular Flow Diagram
Financial System
Flow of FundsLenders/Savers
•Firms
•Households
•Government
•Foreigners
Financial Intermediaries
•Banks
•S&Ls
•CUs
Financial Markets
•Stock Market
•Bond Market
•FX Market
Borrowers/Spenders
•Firms
•Households
•Government
•Foreigners
$$
$$
Deposits
Securities
Securities
Securities
$$
$$
Direct Finance
Indirect Finance
Profit search is to money
what gravity is to water
The Heart Vs Bank AnalogyHow the Heart Works: Blood Flow Diagram
How Blood Flows Through a Healthy Heart.
Interest Rates and Recessions 1988-2016
0
1
2
3
4
5
6
7
8
9
10
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
0
1
2
3
4
5
6
7
8
9
10
Recession Baa Fed Funds 10-yr Treas Forecast
S&P 500 Stock Index
(monthly average)
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
2100
2200
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
0
1
2
3
4
5
6
7
8
9
10
Nominal Index Recession
Fed Funds Rate (RHS) Real Index
U.S. Dollar Versus Euro
Exchange Rate
$0.50
$0.60
$0.70
$0.80
$0.90
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
Euro/$
Euro/$$/Euro
$/Euro
U.S. Economic Output(Real GDP - Quarterly Growth Rate)
1.7
3.9
2.72.5
-1.5
0.8
4.6
2.7
1.9
0.5
0.1
2.8
0.8
3.1
4.0
-1.2
4.0
5.0
2.32.0
2.6
2.0
0.90.8
1.2
2.52.52.52.52.52.5
2.9
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
10:1 11:01 12:01 13:01 14:01 15:01 16:01 17:01
GDP Growth
2.5% Maximum Sustainable Growth Rate
Source: Department of Commerce.
GDP Output Gap
vs.
Federal Funds Rate
-8%
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%Recession
Output Gap (Left Axis)
Federal Funds Rate (Right Axis)
Source: CBO & Federal Reserve.
2.5% Target
Consumer Price Index
1970 to Present
5.6
3.33.4
8.7
12.3
6.9
4.9
6.7
9.0
12.5
8.9
3.83.84.04.44.4
4.7
6.1
3.12.92.72.72.5
3.3
1.71.6
2.6
3.4
1.6
2.41.9
3.33.5
2.5
4.1
-0.1
2.8
1.6
3.1
2.11.51.6
0.1
1.6
3.8
1.1
13.3
-1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
Federal Reserve Balance Sheet
(August 2014 vs January 2010 vs July 2009 vs July 2008)
($ Billions, H.4.1 Release, Table 10)
Assets Liabilities + Capital
T-Bills (0/18/18/22) Federal Reserve Notes (1,444/879/870/793)
T-Notes/Bonds (2,321/708/618/402)
TIPS (97/47/48/40)
Depository Institution Deposits (2,778/1,135/809/23)
Federal Agency Debt (41/161/102/0)
Mortgage-Backed Securities (1,678/969/526/0)
Repurchase Agreements (0/0/0/117) Reverse Repurchase Agreements (282/64/66/43)
Term Auction Credit (0/76/274/150) U.S. Treasury, General Account (29/124/65/4)
Primary Credit (1/18/34/14) U.S. Treasury, Supplementary Financing (0/5/200/0)
Secondary Credit (0/1/0/0)
Seasonal Credit (1/0/1/1)
Asset-backed CP MMMF Liquidity Facility (0/0/8/0) Interest on Federal Reserve Notes due to U.S. Treasury (2)
AIG Credit (0/25/43/0)
Term Asset-back Security loan Facility (1/298/26/0) Foreign Official Deposits (6/3/2/2)
Commercial Paper Funding LLC (0/14/111/0)
Money Market Investor Funding (0/0/0/0)
Maiden Lane I, II, III LLC (2/64/60/29) Capital Paid In (28/26/25/5)
Surplus (28/25/21/3)
Central Bank Liquidity Swaps (1/6/112/62) Other Capital (0/1/4/1)
Total Assets (4,413/2,295/2,074/913) Total Liabilities & Capital (4,413/2,295/2,074/913)
Italicized accounts represent new policy tools
M1, Monetary Base and
Money Multiplier
0200400600800
1,0001,2001,4001,6001,8002,0002,2002,4002,6002,8003,0003,2003,4003,6003,8004,0004,200
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
$ B
illi
on
0
1
2
3
4
Mo
ney
Mu
ltip
lier
MB Multiplier M1
Money Multiplier = M1/MB = 1 + c = 1+0.76 = 0.73
r + e + c 0.1+1.55+0.76
DM/M + DV/V = DP/P + DY/Y
DM/M + 0 = DP/P + 3.5%
Money Supply Growth, M1&M2
(% change year ago)
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
Recession M2 M1
Currency
Checking
Savings
MMA
MMMF
CD
Federal Government Surplus/Deficit(Billions of Dollars)
-74-79-128
-208-185-221
-150-155-153
-221-269-290
-255-203
-164
-107
-22
69
126
236
128
-158
-378-413
-318
-248
-161
-459
-1,400
-1,294-1,296
-1,079
-680
-480
-269-302
-220-196
-258-280-279
-339
-212
-$1,500
-$1,250
-$1,000
-$750
-$500
-$250
$0
$250
$500
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22
Source: Congressional Budget Office.
•Bank stock purchases (TARP)
•Stimulus plan
•Mortgage bailout plan
•Income-support programs
•Recession-induced falling revenues
Function of Financial Intermediaries
Financial Intermediaries
1. Engage in process of indirect finance
• borrow funds from savers, then lend funds to borrowers
• issue liabilities, then acquire assets
• take deposits, then make loans
2. More important source of finance than securities markets
3. Needed because of
• risk sharing
• asymmetric information
• transactions costs
UWCU Balance SheetAssets Liabilities + NW
Cash (13.7%) Deposits (90%)Share Draft (24%)
Investments (14.4%) Regular Share (29%)
MMA (25%)
Loans (65.7%) CDs (8%)
Consumer (26.5%) IRAs (3%)
Mortgage (30%)
Other Loans (9%) Borrowings (0%)
Building (2.9%) Net Worth (8.8%)
YOA - COF = NIM
+ Fee/Other Income
- Operating Expense
- PLL
= Net Income
*Required ROA = Asset Growth Rate x Capital Ratio(dependent variable) (choice variable) (current)
Treasury Yield Curves
0
1
2
3
4
5
6
1 2 3 5 10 15 20 25 30Years to Maturity
Yie
ld t
o M
atu
rit
y
June 2007
July 2016
Yield Curve &
the 3 Components of NIM
6
4
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
1 year 2 3 4 5 year 6
Years to Maturity
Perc
en
t
Funding
Spread
Interest Rate
Risk Spread
Credit
Spread
1-year CD
@ 3.0%
5-year loan
@ 7.5%
Asymmetric Information:A situation where one party lacks sufficient information about the
other party to make accurate decisions
Adverse Selection
1. Asymmetric information before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most
likely to seek loans and be selected
3. Adverse Selection => bankers willingness to lend
Moral Hazard
1. Asymmetric information after transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral)
activities making it more likely that won’t pay loan back
3. Moral hazard => bankers willingness to lend
4. Reputation: Declining social stigma regarding bankruptcy => M.H.
Asymmetric Information
Adverse Selection Moral Hazard
Stopping “bad credit risks” from
becoming borrowers
Stopping borrowers from
becoming “bad credit risks”
Screening process Monitoring process
Loan applicants
Approve
DenyLoan signing
date
Performing
Non-performing
A situation where 1 party
has more info
than the other party
Loan department Collections department
potential bad credit risks are the ones
who most actively seek out loans
the lender runs the risk that the borrower
will engage in risky activities that make
it less likely that the loan will be paid back
“The business of banking
is the business of collecting information”Good C.R.
Bad C.R.
2 types
Financial Intermediaries make Ps by Transactions costs
1. Experts on loan contracts
2. Experts with screening process
3. Experts with monitoring borrowers
4. Develop high level of lending expertise
5. Take advantage of economies of scale (lower average costs)
• number of transactions
(reduce average costs by spreading fixed costs over many transactions)
• scale of transactions
(make a few large loans instead of many small loans => variable costs)
• scope of operations
(offering many products and services => variable costs)
Regulation of the Financial SystemTwo Main Reasons for Regulation
1. Increase information to investors
Decreases adverse selection and moral hazard problems
SEC forces corporations to disclose information
SEC prohibits insider trading
2. Ensuring the soundness of financial intermediaries
Prevents financial panics
Six types of regulation:
1. Chartering – restrictions on entry
2. reporting requirements – disclosure of appropriate financial statements
3. restrictions on assets and activities
4. deposit insurance – up to $250,000 per person
5. anti-competitive measures – limits on branching (abolished by 1994 legislation)
6. Restrictions on interest rates
Econ 330
Homework 1Due Friday, September 16
Chapter 2, pages 46-47.
Questions 2, 4, 6, 7, 11, 14, 15, 17, 20