BANKING AND BANK REGULATION

1. BANKING AND BANK REGULATION

2. Why do banks exist? • To intermediate • Between lenders and borrowers • Pooling resources for large-scale projects • Between maturities (long vs short) • Borrow short-term, lend long-term • Between risk-takers and the risk-averse • Pooling allows diversification • Between liquid and illiquid • Cash vs real estate etc.

3. TYPES OF BANKS We will analyze four types of banks: • Merchant Banks – e.g. The House of Rothschild. • Commercial Banks – i.e. depository institutions • Investment Banks, including hedge funds • Central Banks – e.g. the U.S. Federal Reserve System, which we will cover in the separate Monetary Policy lecture.

4. MERCHANT BANKS Historically, merchant banks antedated the other types of banks on our list. They were primarily: Money changers Bill brokers Family affairs (Rothschilds, Medicis etc.) They are provide system of payments No large financing of anything (except govt debt at times)

5. Antebellum banks • State-chartered: investors come together & petition for charter • Charter: • Must pass state legislature • Specifies capital paid in etc. • Gives right to issue bank notes • Delimits area of investment (if any) • Specifies shareholder (voting) rights

6. What banks did • They focused on stuff that’s banned today: • Print their own money (bank notes) • These circulate and are used for payment • Farther afield, they circulate at a discount • See Thompson’s Bank Note Reporter • Lend money to insiders • Bank directors get preferential access • Exploit charter-granted (local) monopolies • Financing local turnpikes or canals, roads etc.

7. More of what banks did • They solicit deposits from gullible suckers… er, esteemed depositors • Little reporting to outsiders (incl. minority investors) • Sometimes they overprint their own money and skip town

8. INVESTMENT BANKS Investment banks, as we know them today, emerged in the late 19th Century. They are primarily involved in Underwriting and Trading on the stock exchange Their trading activities have grown dramatically in the last three decades. Today, this trading is often conducted by hedge funds. Because they do not take deposits, historically, investment banks have not been as regulated as commercial banks.

9. COMMERCIAL BANKS What do (commercial) banks do? They provide financial intermediation. They “create” money. How do they perform these two functions? By adjusting their “balance sheets.” The bank balance sheet shows: Assets- e.g. reserves and loans Liabilities- e.g. deposits Stockholder Equity- i.e. bank capital Note that: Capital = Assets-Liabilities

10. The Balance Sheetof a Commercial Bank Assets Liabilities & Stockholders’ Equity • Cash Reserves 300 • Loans 1,000 • Real Estate 100 • Total Assets: $1,400 Savings Deposits 200 Checking Deposits 1,000 Total Liabilities $1,200 Bank Capital 200 Liabilities & Bank Capital: $1,400

11. Fractional reserve banking • FRB relies on the fact that depositors will not come all at once to withdraw deposits • Most of the time, a sound assumption: • This is what allows the intermediation: • Cash < Deposits (liabilities) • Assets less liquid than deposits • Loans are longer-term than deposits

12. The Balance Sheetof a Commercial Bank Assets Liabilities & Stockholders’ Equity • Cash Reserves 300 • Loans 1,000 • Real Estate 100 • Total Assets: $1,400 Savings Deposits 200 Checking Deposits 1,000 Total Liabilities $1,200 Bank Capital 200 Liabilities & Bank Capital: $1,400

13. The Balance Sheetof a Commercial Bank Assets Liabilities & Stockholders’ Equity • Cash Reserves 300 • Loans 500 • Real Estate 100 • Total Assets: $900 Savings Deposits 200 Checking Deposits 1,000 Total Liabilities $1,200 Bank Capital -300 Liabilities & Bank Capital: $900

14. Fractional reserve banking • FRB relies on the fact that depositors will not come all at once to withdraw deposits • When they do, it’s a run: • Depositors run for their money • Bankers run for their lives • (Swindlers run for the hills)

15. Central banks Historically central banks were essentially the government’s bank. It was where govt deposited its money It invested and traded in govt debt It provided payment system for govt It could occasionally be directed to certain politically sanctioned investment projects Such is the story of BoE, Austrian National Bank, Banque de France, 1BUSA & 2BUSA

16. Central banks Historically central banks were essentially the government’s bank. However, modern central banks perform two main functions: They serve as “lenders of last resort” – i.e. they provide liquidity to the banking system during a crisis. In other words, they are the bankers’ bank. Through regulation of commercial bank reserves, central banks control the money supply. The Fed also audits commercial bank balance sheets.

17. A few ideas from US bank regulation history • State chartering (1789 - ) • Free banking (post-1836) • Unit banking (19th – 20th centuries) • Establishing the Fed (1913) • FDIC (1933) • The Chinese wall (1933)

18. Problems with banking regulation • Ongoing financial innovation • New financial products (investment banks, trusts, holding companies, mutual funds, investment on margin, hedge funds, derivatives) • Laws age fast & fight the last war; regulation gets circumvented • Information asymmetry • Insiders always know more • Private sector pays better (i.e. gets better people) • Regulatory capture • Regulators respond to incentives, too • Familiarity breeds alliances • Too big to fail & moral hazard

19. U.S. BANKING HISTORY After the Revolution, states began chartering commercial banks. The first Bank of the United States was chartered by Congress in 1791. The second Bank of the United States was chartered in 1816. The second Bank’s charter expired after 1836; and it was not renewed.

20. LANDMARKS IN U.S. BANKING HISTORY (CONT.) National Bank Acts were passed in 1863,1864, and 1865. Major bank panics occurred in 1833, 1837, 1839, 1857, 1873, 1893, 1907, 1930-1933. The Federal Reserve System was created in 1913. The FDIC was created in 1933.