How Banks Work

CHAPTER TWO

The Role of Banks

• A bank is a financial intermediary that accepts deposits from savers and makes loans to borrowers.

• By making larger loans out of small deposits, banks provide liquidity for borrowers and lenders.

• Banks are adept at:a) pooling fundsb) gathering information about borrowers

Asymmetric Information

• Both borrowers and lenders want to paint the best possible picture when presenting themselves to banks

• Asymmetric information is a situation where one party to a transaction knows more, has more information, than the other

• Two types of problems result– Adverse selection– Moral hazard

Adverse Selection

• Those at more than average risk are also more likely to enter a contract that is offered to everyone

• Example: the market for “lemons”…The salesperson has the advantage

• The least desirable (highest risk) borrowers are the most likely to accept loans at high interest rates

Moral Hazard

• The mere existence of a contract can change people’s behavior, incentivizing them to behave in ways they otherwise might not

• Example: car insurance…The sense of security provided may induce people to drive more recklessly than they would without it

• Borrowers may behave in ways that harm the bank, taking on more risk in order to get a loan than they would with their own capital

Solutions to Asymmetric Information Problems

• Banks have means to minimize the problems posed by asymmetric information

– Collateral can be accepted from borrowers, reducing borrowers’ incentive to engage in risky practices

– Borrowers can be required to maintain a minimum net worth, below which loans must be paid immediately

– Covenants can be inserted in loans to require borrowers to behave in certain ways

Failures of the Banking System

• The Savings-and-Loan Crisis: Undiversified portfolios and insecure long-term loans resulted in high risk of failure. A moral hazard problem was created by the government with new loans allowing for additional expansion.

• The Credit Crunch of the 90s: Banks lent less than normal with greater requirements of borrowers. Banks scrambled to add other assets to their portfolios, reducing the potential for capital investment in the economy.

Bank Balance Sheets

• The profit motive guides the bank’s decisions regarding how much to lend and to whom

Assets = liabilities + equity capital

• Assets primarily include reserves, securities, and loans the bank has made

• Loans represent the asset generating the greatest profit

• Liabilities include primarily savers’ deposits and borrowing on behalf or the bank

Bank Balance Sheets (cont.)

• Banks must balance each side of the balance sheet, such that assets = liabilities + capital

• Example: A saver’s deposit simultaneously increases reserves (asset) and transactions deposits (liability)

• Example: A bank’s purchase of government securities increases securities (asset) and decreases reserves (asset)

Reserve Accounting• Banks manage funds by adjusting the size of

their reserves. By law, banks are required to maintain a certain amount of reserves

Reserves = vault cash + deposits at the Fed

Excess Reserves

• Banks often keep more reserves on hand than is necessary to meet their requirements

• Excess reserves are the bank’s total reserves minus its required reserves

• Excess reserves are used in four ways1) Held by the bank2) Lent in the federal funds market3) Used to buy securities4) Used to make new loans

The Federal Funds Market• The federal funds market is the where banks

lend excess reserves to other banks desiring additional reserves

• The interest rate charged on these inter-bank loans is the federal funds rate

• If a bank has any amount in deposit at the Fed, it will usually loan in the federal funds market

• Small banks often carry excess reserves only as vault cash, precluding them from this market

Insufficient Reserves

• When banks cannot make their reserve requirement, they are faced with five options

1) Borrowing in the federal funds market

2) Borrowing from the Fed at the discount window (borrowing directly from the Fed at the discount rate)

3) Selling securities owned by the bank

4) Reducing outstanding loans

5) Issuing certificates of deposit

Spread & Bank Profits

• Most profit comes from interest paid to the bank on loans and securities

• Additional profits are earned through bank fees and services

• The size of a bank’s profit depends on the spread, or the difference between the average interest earned on its assets and the average interest paid on its liabilities

Banks & Competition

• As in all industries, competition keeps banks’ prices (i.e., interest rates) similar across banks

• More competition = smaller spread

• Banks with large volumes can take advantage of economies of scale

Banks & Risk

• Like all businesses, banks’ profits are not guaranteed, but tempered by risk– Default risk = the possibility that the bank’s borrowers do

not repay their loans

– Interest rate risk = the risk that changes in market interest rates decrease the value of the bank’s financial assets

• Risk is reduced through internal controls and audits, diversification of holdings, and active management of assets and liabilities

Sweep Accounts

• Sweep accounts “sweep” balances from a transactions account into an MMDA periodically (e.g. once a week)

• Used to help banks avoid holding reserves, as reserves do not pay interest

• Allows banks to earn additional interest on deposits and remain in compliance with Federal Reserve regulations

Effects of Sweep Accounts

• Banks have been able to increase profits by earning interest on reserves to which interest was previously unavailable

• This gain for banks is a simultaneous loss of revenue for the government, perhaps making monetary policy more challenging

• Banks now meet reserve requirements primarily with vault cash, leaving less on deposit with the Fed

Contemporaneous vs. Lagged Reserve Accounting

• The Fed has modified how banks account for reserves in response to sweeps

• Sweeps made contemporaneous accounting (counting all deposits over a two week period) even more volatile, making it difficult to forecast the demand for reserves

• In lagged reserve accounting, the time period is increased, giving banks more certainty in regard to the amount of reserves they need

Required Clearing Balances• A transition from a system emphasizing

required reserves to a focus on the balances banks hold at the Fed

• Required clearing balances are those a bank agrees to hold at the Fed for purposes of clearing transactions

• Simplifies the reconciliation of inter-bank transactions, such as check clearing

• These balances help the Fed to know how much money it needs to supply the economy