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Lecture 1: Money, Banking & Financial Markets Why Study Financial Markets?

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

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Lecture 1: Money, Banking & Financial Markets Why Study Financial Markets?

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  1. 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

  2. The Circular Flow Diagram

  3. Profit search is to money what gravity is to water Financial System Flow of Funds Lenders/Savers • Firms • Households • Government • Foreigners Securities Financial Markets • Stock Market • Bond Market • FX Market $$ Deposits Securities $$ Direct Finance $$ Financial Intermediaries • Banks • S&Ls • CUs Borrowers/Spenders • Firms • Households • Government • Foreigners Securities Indirect Finance $$

  4. The Heart Vs Bank Analogy How the Heart Works: Blood Flow DiagramHow Blood Flows Through a Healthy Heart.

  5. Euro/$ $/Euro $/Euro Euro/$

  6. Recession Factors: • Loose monetary policy • Poor regulation • Lax bank supervision • Opaque derivatives • Shadow banking system • Lax investor diligence • Poor governance • Misaligned incentives • fraud

  7. 2.5% Target

  8. Federal Reserve Balance Sheet (January 2010 vs July 2009 vs July 2008) ($ Billions, H.4.1 Release, Table 10) Assets Liabilities + Capital T-Bills (18/18/22) Federal Reserve Notes (879/870/793) T-Notes/Bonds (708/618/402) TIPS (47/48/40) Depository Institution Deposits (1,135/809/23) Federal Agency Debt (161/102/0) Mortgage-Backed Securities (969/526/0) Repurchase Agreements (0/0/117) Reverse Repurchase Agreements (64/66/43) Term Auction Credit (76/274/150) U.S. Treasury, General Account (124/65/4) Primary Credit (18/34/14) U.S. Treasury, Supplementary Financing (5/200/0) Secondary Credit (1/0/0) Seasonal Credit (0/1/1) Asset-backed CP MMMF Liquidity Facility (0/8/0) AIG Credit (25/43/0) Term Asset-back Security loan Facility ((298/26/0) Foreign Official Deposits (3/2/2) Commercial Paper Funding LLC (14/111/0) Money Market Investor Funding (0/0/0) Maiden Lane I, II, III LLC (64/60/29) Capital Paid In (26/25/5) Surplus (25/21/3) Central Bank Liquidity Swaps (6/112/62) Other Capital (1/4/1) Total Assets (2,295/2,074/913) Total Liabilities & Capital (2,295/2,074/913) Italicized accounts represent new policy tools

  9. Money Multiplier = M1/MB = 1 + c = 1+0.83 = 0.84 r + e + c 0.1+1.25+0.83

  10. Currency Checking Savings MMA MMMF CD DM/M + DV/V = DP/P + DY/Y DM/M + 0 = DP/P + 3.0%

  11. Bank stock purchases (TARP) • Stimulus plan • Mortgage bailout plan • Income-support programs • Recession-induced falling revenues

  12. Function of Financial Intermediaries Financial Intermediaries • 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 • More important source of finance than securities markets • Needed because of • risk sharing • asymmetric information • transactions costs

  13. UWCU Balance Sheet Assets Liabilities + NW Cash (7.5%)Deposits (88%) Share Draft (15%) Investments (6%) Regular Share (15%) MMA (29%) Loans (82%) CDs (25%) Consumer (20%) IRAs (4%) Mortgage (46%) Student (16%) Borrowings (2.5%) Building (4.5%)Net Worth (9.5%) YOA - COF = NIM + Fee/Other Income - Operating Expense - PLL = Net Income *Required ROA = Asset Growth Rate x Capital Ratio (dependent variable) (choice variable) (current)

  14. 5-year loan @ 7.5% Credit Spread Interest Rate Risk Spread Funding Spread 1-year CD @ 3.0%

  15. 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 • Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected •  Adverse Selection => bankers willingness to lend Moral Hazard 1. Asymmetric information after transaction occurs • Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back •  Moral hazard =>  bankers willingness to lend • Reputation: Declining social stigma regarding bankruptcy =>  M.H.

  16. A situation where 1 party has more info than the other party Asymmetric Information 2 types Adverse Selection Moral Hazard 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 Screening process Monitoring process Loan applicants “The business of banking is the business of collecting information” Good C.R. Performing Approve Deny Non-performing Loan signing date Bad C.R. Stopping “bad credit risks” from becoming borrowers Stopping borrowers from becoming “bad credit risks” Loan department Collections department

  17. Financial Intermediaries make Ps by Transactions costs • Experts on loan contracts • Experts with screening process • Experts with monitoring borrowers • Develop high level of lending expertise • 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)

  18. Regulation of the Financial System Two 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 • anti-competitive measures – limits on branching (abolished by 1994 legislation) • Restrictions on interest rates

  19. Econ 330 Homework 1Due Friday, September 13 Chapter 2, pages 49-50. Questions 2, 4, 7, 12, 17, 22

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