Todays Agenda

1. The Financial System

2. The Importance of Commercial Banks

The Financial System 3. Risks in the Financial System

4. Information Challenges & the Financial

System

5. Government Regulation and Supervision

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The Financial System

The financial systems role is to channel funds:

1. From households, businesses, and governments

with surplus funds (i.e., from savers lenders)
The Financial System
2. To households, businesses, and governments with
a shortage of funds (i.e., to borrowers spenders).

The financial system is very complex.

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The Financial System Direct Finance
Direct finance channels funds:

1. From savers lenders

2. To borrowers spenders

directly through the financial markets.

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Direct Finance Direct Finance

Borrowers acquire funds directly from savers by Financial markets include:
selling (or issuing) financial instruments or
securities which include: 1. Exchangeslocations where buyers and sellers of
securities conduct business.
1. Equities, which are a ownership share of a
business, or 2. Investment banksfinancial institutions that
trade securities and assist businesses and
2. Bonds, which are a debt instrument.
governments issue them.
These securities are liabilities of the entity
selling (or issuing) them.
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Indirect Finance Indirect Finance
Indirect finance channels funds: Financial intermediaries include:

1. From savers lenders 1. Banks (or depository institutions), and

2. To borrowers-spenders 2. Non-bank financial intermediaries (shadow banks)

a. Insurance companies,
indirectly through financial intermediaries. b. Pension funds,
c. Finance companies,
d. Mortgage companies,
This is called financial intermediation. e. Mutual funds, and
f. Hedge funds.
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Indirect Finance Indirect Finance

Three key characteristics of shadow banks: Two major differences between the various
financial intermediaries are:
1. They are more lightly regulated than banks.
1. The types of liabilities that each issues, and
2. They are more highly leveraged than banks.
2. The types of assets each holds.
3. They fund themselves primarily with short-term
borrowings.

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Indirect Finance

The Importance of
Commercial Banks

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The Importance of Commercial Banks The Importance of Commercial Banks

Banks are important for 3 primary reasons:
1. Banks are depository institutions, i.e., they take
deposits which is how the public holds money.
2. The central banks open market operations
directly affect the banks deposits.
While banks are an important conduit for the
conduct of monetary policy, their balance
sheets can lead to instability in the financial
system.
This balance sheet consists of:

3. The multiple expansion of the money supply is 1. Assets

conducted through an increase in bank loans and
deposits. 2. Liabilities

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The Importance of Commercial Banks The Importance of Commercial Banks
A commercial banks assets include: The commercial banks loans:

1. Cash (primary reserves) 1. Consumer loans

2. Liquid security holding (secondary reserves)
2. Real estate loans
3. Investment securities
3. Commercial loans
4. Loans
4. Other loans
5. Other financial assets
6. Nonfinancial assets

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The Importance of Commercial Banks The Importance of Commercial Banks

Commercial Bank Balance Sheet
A commercial banks liabilities include:
Assets Liabilities
1. Deposits
Cash Deposits

2. Non-deposit borrowings Liquid security holdings Non-deposit borrowings

3. Equity capital Investment securities Equity capital

Loans

Other financial assets

Non-financial assets
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The Importance of Commercial Banks The Importance of Commercial Banks
ASSETS LIABILITIES Most bank assets, i.e., loans, are:
Cash
1. Relatively long-term and

Deposits 2. Relatively illiquid.

Loans
This maximizes the interest income (or return)
Borrowings from these assets.

Equity
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The Importance of Commercial Banks The Importance of Commercial Banks

Most bank liabilities, i.e., deposits and non- Banks profit primarily through their net interest
deposit borrowings, are: marginthe difference between the interest
income on their assets and the interest expense
1. Relatively short-term and of their liabilities (as a percentage of their
interest earning assets).
2. Relatively liquid.

This minimizes the interest expense (or cost)

of these liabilities.

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The Importance of Commercial Banks The Importance of Commercial Banks
A key profitability measure for banks is the ASSETS LIABILITIES
return on equity (or ROE). Cash

Return on equity =
(return on assets cost of liabilities) / equity capital Deposits
Loans

A bank can increase its ROE by increasing its

leverage ratio for any given net interest margin. Borrowings

Equity
Leverage ratio = assets / equity capital
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Risks in the Financial System

Banks (and non-bank financial institutions) face
3 significant asset-liability management issues:

1. Bank or deposit runs.

Risks in the Financial System
2. Liquidity crises.

3. Solvency crises.

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Bank or Deposit Runs Bank or Deposit Runs
1. A bank or deposit run occurs when depositors ASSETS LIABILITIES
attempt to withdraw more cash from the bank Cash
than the bank has in reserves.
1. The bank may be forced to quickly sell some of its more Deposits
illiquid assets in order to raise additional cash.
Loans
2. Because these assets are illiquid their price may decline
substantially in order to facilitate a quick sale.
Borrowings
3. This has the potential to turn a liquidity crisis into a
Equity
solvency crisis.
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Bank or Deposit Runs Liquidity Crises

To prevent bank or deposit runs: 2. A liquidity crisis occurs when providers of
short-term financing do not roll-over the loans.
1. Have banks hold more reserves.
1. The bank may be forced to quickly sell some of its more
2. Have banks increase their equity capital. illiquid assets in order to raise additional cash.

3. Have banks increase their borrowings. 2. Because these assets are illiquid their price may decline
substantially in order to facilitate a quick sale.
4. Have the central bank provide a liquidity injection. 3. This has the potential to turn a liquidity crisis into a
bank run and/or a solvency crisis.
5. Have deposit insurance.
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Liquidity Crises Liquidity Crises
ASSETS LIABILITIES To prevent liquidity crises:
Cash
1. Have banks increase their long-term borrowings.

Deposits 2. Have banks increase their equity capital.

Loans 3. Have the central bank provide a liquidity injection.

Borrowings

Equity
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Solvency Crises Solvency Crises

3. A solvency crisis occurs when a decline in the ASSETS LIABILITIES
value of the banks assets causes equity capital Cash
to become negative.

Deposits
Loans

Borrowings

Equity
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Solvency Crises
To prevent solvency crises:

1. Have banks hold higher levels of equity capital.

2. Have the government seize and liquidate the bank. Information Challenges
3. Have the government prepared to make equity and the Financial System
injection (bank bail-outs)

4. Let banks fail.

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Information Challenges, Financial System Information Challenges, Financial System

Financial intermediaries exist because of 2
problems endemic to financial markets:
1. Asymmetric information.
2. Free-rider problems.
1. Asymmetric information exists when one
party to a transactions has more accurate
information than the other party.
This can lead to a less efficient allocation of funds
because of problems associated with:

a. Adverse selection, and

b. Moral hazard.

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Information Challenges, Financial System
a. Adverse selection takes place before the
transaction is completed and arises because
the party most eager to engage in a transaction
is the one most likely to produce an
unfavorable (i.e., adverse) outcome for the
other party.
b. Moral hazard occurs after the transaction is
completed and arises when the other party will
engage in activities that are undesirable from
the first partys point of view.
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Information Challenges, Financial System
Financial intermediaries help solve asymmetric
information problems by:
1. Issuing private (non-traded) loans to reduce the
free-rider problem.
2. Using credit standards to avoid adverse selection.
3. Imposing loan covenants to prevent moral hazard.
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Information Challenges, Financial System
2. Free-rider problems are the barriers to
information collection that would help solve
the asymmetric information problem.
It occurs because savers lenders (i.e., investors)
who do not spend their own resources on
collecting information can take advantage of (i.e.,
get a free ride on) the information that other
parties collect.
This results in fewer resources being devoted to
collecting the necessary information.
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Information Challenges, Financial System
Loan covenants often include collateral
requirements.
Collateral is property the borrower promises in
the loan contract to the lender if the borrower
defaults on its debts.
This has two effects:
1. It reduces the consequences of adverse selection, and
2. It reduces moral hazard.
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 Government Regulation & Supervision
Two approaches for improving the quality of
information in financial markets are:

1. Government regulation, and

Government Regulation
2. Providing a safety net.
and Supervision

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Government Regulation & Transparency Government Safety Net

Governments can decrease information
asymmetry by directly promoting transparency
by requiring:
1. The disclosure of financial information by public
firms, and
2. The adherence to generally accepted accounting
standards.
Governments can create a safety net for bank
deposits (e.g., deposit insurance) so that:
1. Depositors will be more willing to provide banks
with funds, and
2. Deposit protection reduces contagion from one
bank failure to another.
However, government safety nets increase
moral hazard.

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Prudential Regulation and Supervision Prudential Regulation and Supervision
Prudential regulation is the rules set by the Prudential regulation continued:
government to prevent banks from taking on too
much risk by: 3. Encouraging banks to diversify their assets,

1. Limiting banks risk levels by promoting 4. Promoting accurate disclosure of banks financial
disclosure of their activities, conditions to the public, and

2. Restrict activities and asset categories that the 5. Holding adequate levels of capital as a cushion
government considers too risky for banks, against loans that go bad.

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Prudential Regulation and Supervision

Prudential supervision is the activities that the
government engages in to enforce prudent
regulation usually through:

Regular examination of banks assets and The End

liabilities.

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