Textbook v.2.1

THE FINANCIAL
SYSTEM AND
THE ECONOMY
PRINCIPLES OF MONEY AND BANKING
Éric Tymoigne
THE FINANCIAL
SYSTEM AND THE
ECONOMY
PRINCIPLES OF MONEY AND BANKING
SECOND DRAFT
ÉRIC TYMOIGNE
© August 2018 by Eric Tymoigne, Lewis & Clark College, Portland, OR, USA. All rights reserved.
TABLE OF CONTENTS
PREFACE ..................................................................................................................................................................... VII
PART 1: THE WORLD OF FINANCE ......................................................................................................................................................... 1
CHAPTER 1: BALANCE-SHEET MECHANICS AND FINANCIAL ACCOUNTS OF THE UNITED STATES .................... 1
WHAT IS A BALANCE SHEET? .............................................................................................................................................2
BALANCE SHEET RULES .................................................................................................................................................... 3
CHANGES IN THE BALANCE SHEET .......................................................................................................................................5
Net cash flow ........................................................................................................................................................5
Net addition to assets and liabilities .....................................................................................................................7
Net income ............................................................................................................................................................7
Net capital gain .....................................................................................................................................................7
MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL ACCOUNTS OF THE UNITED STATES ....................................................8
CHAPTER 2: FINANCE: A WORLD OF PROMISES ........................................................................................................................... 11
THE FINANCIAL SECTOR: A WORLD OF PROMISES.................................................................................................................12
CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS...................................................................................................14
CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO MATURITY, LIQUIDITY, RISKS, AND OTHER CHARACTERISTICS ....................15
MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES ...........................................................................................................18
Equity instruments .............................................................................................................................................. 18
Debt instruments ................................................................................................................................................ 23
Monetary instruments ........................................................................................................................................32
NON-MARKETABLE FINANCIAL INSTRUMENTS ..................................................................................................................... 37
CONCLUSION ............................................................................................................................................................... 43
CHAPTER 3: FINANCIAL INSTITUTIONS: AN OVERVIEW ........................................................................................................47
MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY ......................................................................................................48
PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND THRIFTS.................................................................................. 50
Commercial banks ...............................................................................................................................................50
Thrift institutions .................................................................................................................................................53
Savings institutions ........................................................................................................................................................... 53
Credit unions .................................................................................................................................................................... 55
INSURANCE COMPANIES.................................................................................................................................................57
Life insurance companies ....................................................................................................................................58
Property and casualty insurance companies.......................................................................................................60
FINANCE COMPANIES ....................................................................................................................................................62
FINANCIAL INVESTMENT COMPANIES ................................................................................................................................64
Pension funds ......................................................................................................................................................64
Regulated portfolio management companies: Mutual funds and others ...........................................................66
Lightly regulated portfolio management companies: Hedge funds....................................................................69
Real estate investment trusts .............................................................................................................................70
FINANCIAL MARKET COMPANIES ...................................................................................................................................... 72
Market-services companies: Organized exchanges ............................................................................................72
Investment banks ................................................................................................................................................73
Brokerage Firms: Security Brokers and Dealers and Security Brokers ................................................................74
Securitization vehicles: Special purpose entities .................................................................................................76
GOVERNMENT AND GOVERNMENT-RELATED FINANCIAL AGENCIES ..........................................................................................78
Government-sponsored enterprises ....................................................................................................................78
The Farm Credit System ................................................................................................................................................... 80
The Federal Home Loan Bank System .............................................................................................................................. 84
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Farmer Mac, Fannie Mae, Freddie Mac, and Sallie Mae .................................................................................................. 90
U.S. government agencies...................................................................................................................................90
TRUST BUT VERIFY: ACCOUNTING FIRMS ........................................................................................................................... 95
RECENT TRENDS AMONG FINANCIAL COMPANIES ................................................................................................................97
CONCLUSION ............................................................................................................................................................... 99
CHAPTER 4: LEVERAGE ............................................................................................................................................................................ 103
WHAT IS LEVERAGE? ..................................................................................................................................................104
WHAT ARE THE ADVANTAGES OF LEVERAGE? ...................................................................................................................105
WHAT ARE THE DISADVANTAGES OF LEVERAGE? ...............................................................................................................105
Interest-rate risk ...............................................................................................................................................105
Higher sensitivity of capital to credit and market risks .....................................................................................106
Refinancing risk and margin call risk ................................................................................................................106
Impact on mortgage debt: Refinancing risk ................................................................................................................... 106
Impact on security-based debt: Margin call risk ............................................................................................................ 108
EMBEDDED LEVERAGE .................................................................................................................................................110
BALANCE-SHEET LEVERAGE, SOME DATA .........................................................................................................................111
THE FINANCIALIZATION OF THE ECONOMY .......................................................................................................................112
PART 2: THE FEDERAL RESERVE SYTSEM ..................................................................................................................................... 117
CHAPTER 5: THE FEDERAL RESERVE SYSTEM: AN INSTITUTIONAL OVERVIEW ....................................................... 119
CHAPTER 6: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS ................................................. 121
BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM ...........................................................................................................122
FOUR IMPORTANT POINTS ............................................................................................................................................123
Point 1: The Federal Reserve notes are a liability of the Fed ............................................................................123
Point 2: The Fed does not earn any cash flow in USD .......................................................................................124
Point 3: The Fed does not lend reserves and does not rely on the taxpayers ...................................................125
Point 4: Banks cannot do anything with reserve balances unless they are dealing with other Fed account
holders ..............................................................................................................................................................127
CAN THE FED BE INSOLVENT OR ILLIQUID? .......................................................................................................................128
CHAPTER 7: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET ................................................ 131
THE MONETARY BASE AND THE MONEY SUPPLY.................................................................................................................132
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON-BORROWED ....................................................................................134
HOW DOES THE MONETARY BASE CHANGE? .....................................................................................................................138
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? .........................................................................................141
CHAPTER 8: MONETARY-POLICY IMPLEMENTATION ............................................................................................................ 145
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY?...................................................................................146
TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS ................................................................................................149
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET .........................................................................................152
TARGETING FFR AFTER THE GREAT RECESSION.................................................................................................................153
DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? ...........................................156
TO GO FURTHER: BEYOND THE FED FUNDS MARKET, EURODOLLARS AND REPURCHASE AGREEMENTS ......................................157
CHAPTER 9: TREASURY AND CENTRAL BANK INTERACTIONS....................................................................................... 163
MONETARY POLICY AND THE U.S. TREASURY ...................................................................................................................164
Treasury’s involvement in monetary policy during the 2008 crisis ...................................................................166
Other examples of Treasury’s involvement in monetary policy ........................................................................169
FISCAL POLICY AND THE FED .........................................................................................................................................173
A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES: SOME IMPLICATIONS .............................................175
Independence of the central bank ....................................................................................................................175
TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION ...........................................................175
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TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT ? .............177
PART 3: PRIVATE BANKING SYSTEM ................................................................................................................................................ 183
CHAPTER 10: THE PRIVATE BANKING BUSINESS ........................................................................................................................ 185
THE BALANCE SHEET OF A BANK .....................................................................................................................................186
WHAT DO BANKS DO? .................................................................................................................................................189
WHAT MAKES A BANK PROFITABLE? ...............................................................................................................................189
RISKS ON THE BANK BALANCE SHEET ...............................................................................................................................192
BANKING ON THE FUTURE ............................................................................................................................................194
EVOLUTION OF BANKING SINCE THE 1980S .....................................................................................................................195
CHAPTER 11: BANKING REGULATION............................................................................................................................................... 201
EXAMPLES OF BANK REGULATIONS .................................................................................................................................202
Reserve requirement ratios ...............................................................................................................................202
Capital adequacy ratios ....................................................................................................................................203
CAMELS rating ..................................................................................................................................................204
Underwriting requirements...............................................................................................................................204
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT ?.............................................205
Deregulation, competition and concentration ..................................................................................................205
Deenforcement and desupervision ...................................................................................................................208
Regulatory arbitrage .........................................................................................................................................209
THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS .....................................................................................210
Laissez faire, laissez passer: Crises as random events ......................................................................................210
Save capitalism from itself: Crises as internal contradictions ...........................................................................211
CHAPTER 12: MONETARY CREATION BY BANKS ........................................................................................................................ 217
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES .......................................................................................218
WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? ..........................................................................................................222
Point 1: The bank is not lending anything it has: when providing credit services, the bank swaps financial
instruments with its clients ...............................................................................................................................222
Point 2: The bank does not need any reserves to provide credit services .........................................................223
Point 3: The bank is not using “other people’s money”: it is not a financial intermediary between savers and
investors ............................................................................................................................................................223
Point 4: The bank’s financial instrument is in high demand .............................................................................225
HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION ..........................................................................................225
INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES
...............................................................................................................................................................................228
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? ....................................................................................230
MOVING IN STEP ........................................................................................................................................................231
LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS ..........................................................................231
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL
INTERMEDIATION........................................................................................................................................................232
PART 4: FINANCIAL MARKETS ............................................................................................................................................................ 237
CHAPTER 13: INSTITUTIONAL ASPECTS OF FINANCIAL MARKETS .................................................................................. 239
CHAPTER 14: PRICING SECURITIES .................................................................................................................................................... 241
A SMALL DETOUR: SAVINGS ACCOUNT AND INTEREST COMPOUNDING ...................................................................................242
BACK TO SECURITIES....................................................................................................................................................242
A simple rate of return: Current yield................................................................................................................242
Adding one complication: Time.........................................................................................................................243
Adding another complication: Capital gains or losses ......................................................................................245
A real world application: QE, deficit and rate on treasuries .............................................................................247
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Conclusion .........................................................................................................................................................247
WHAT IF THERE IS NO COUPON? ZERO-COUPON SECURITIES ...............................................................................................249
DISCOUNT, PAR, PREMIUM AND ARBITRAGE BETWEEN SECURITIES ........................................................................................250
BUBBLES OR NOT: ARE FINANCIAL MARKET EFFICIENT? ......................................................................................................251
TO GO FURTHER: DURATION AND CONVEXITY ..............................................................................................................253
CHAPTER 15: THE INTEREST RATE .................................................................................................................................................... 257
REAL THEORY OF INTEREST RATE: NATURAL INTEREST RATE AND EXPECTED INFLATION ..............................................................258
Gross substitution and indifference condition: Determinant of the nominal interest rate ...............................258
Inflation expectations .......................................................................................................................................259
The natural rate of interest ...............................................................................................................................259
Implications of the theory .................................................................................................................................262
Empirics .............................................................................................................................................................263
MONETARY THEORY OF INTEREST RATES: MONETARY CONDITIONS AND LIQUIDITY PREFERENCE .................................................266
Substitution effect vs. income effect .................................................................................................................266
Liquidity preference theory of interest rate ......................................................................................................268
Money rules the roost .......................................................................................................................................270
Liquidity preference and rates of return ...........................................................................................................271
Implications of the theory .................................................................................................................................273
Empirics .............................................................................................................................................................275
TO GO FURTHER: LIQUIDITY TRAP AND THE SQUARE RULE ...............................................................................................277
CHAPTER 16: INTEREST-RATE STRUCTURE .................................................................................................................................. 281
CHAPTER 17: OFF-BALANCE SHEET OPERATIONS: SECURITIZATION .............................................................................. 283
CHAPTER 18: OFF-BALANCE SHEET OPERATIONS: DERIVATIVES ...................................................................................... 285
PART 5: MONETARY SYSTEMS ............................................................................................................................................................. 287
CHAPTER 19: MECHANICS OF MONETARY SYSTEMS ................................................................................................................. 289
A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENT ............................................................................................290
ACCEPTANCE OF MONETARY INSTRUMENTS .....................................................................................................................291
ACCEPTANCE IN ACTION: AT WHAT PRICE SHOULD A MONETARY INSTRUMENT CIRCULATE AMONG BEARERS? ...............................294
FAIR VALUE AND PURCHASING POWER ............................................................................................................................295
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST ............................................................................299
WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS ...............................................................................300
CASE STUDY: DEMONETIZATION IN INDIA IN 2016 ............................................................................................................302
CHAPTER 20: SOME FAQS ABOUT MONETARY SYSTEMS ........................................................................................................307
Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? ..................................................308
Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? ...........................................................................................309
Q3: IS MONEY WHAT MONEY DOES? ..............................................................................................................................310
Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE ? OR, IS THE FAIR VALUE OF CONTEMPORARY
GOVERNMENT MONETARY INSTRUMENTS ZERO?...............................................................................................................312
Q5: IS MONETARY LOGIC CIRCULAR? IS FIAT MONEY A BUBBLE? ..........................................................................................313
Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? .........................................................314
Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? ..............................................................................314
Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND-PLAY BANKNOTES AND
COINS? WHAT ABOUT BITCOINS? ..................................................................................................................................314
Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS?..................................................................................316
Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE?.................................................317
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED?......317
Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? IS A MONETARY INSTRUMENT NECESSARILY WIDELY ACCEPTED BY OTHERS?
HOW DO I CREATE ONE? ..............................................................................................................................................318
Q13: DOES THE FORM THAT SOMETHING TAKES MATTER TO DETERMINE IF IT IS A MONETARY INSTRUMENT? ...............................319
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CHAPTER 21: HISTORY OF MONETARY SYSTEMS ........................................................................................................................ 321
MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM.................................322
MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL ......................................323
TOBACCO LEAVES IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS ........................325
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT .....................326
THE ABSENCE OF A REDEMPTION MECHANISM .................................................................................................................326
PART 6: FINANCE AND THE ECONOMY .......................................................................................................................................... 329
CHAPTER 22: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ...................................................................................331
THE REAL EXCHANGE ECONOMY ....................................................................................................................................332
Money supply is a veil .......................................................................................................................................332
Finance and the economy .................................................................................................................................333
Conclusions .......................................................................................................................................................335
THE MONETARY PRODUCTION ECONOMY ........................................................................................................................336
Money is everything ..........................................................................................................................................336
Why monetary incentives matter? what are other implications?.....................................................................337
Finance and the economy .................................................................................................................................339
Beyond incentives: The role of macroeconomic forces .....................................................................................339
Conclusions .......................................................................................................................................................341
CONCLUSION .............................................................................................................................................................341
CHAPTER 23: INFLATION ....................................................................................................................................................................... 345
THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION.....................................................................................346
INCOME DISTRIBUTION AND INFLATION: NON-MONETARY VIEW OF INFLATION .......................................................................349
TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION ................................................................353
CHAPTER 24: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ..................................................... 357
A PRIMER ON CONSOLIDATION ......................................................................................................................................358
THE THREE SECTORS OF THE ECONOMY ...........................................................................................................................359
SOME IMPORTANT IMPLICATIONS ..................................................................................................................................361
Point 1: The beginning of the economic process requires that someone goes into debt ..................................361
Point 2: Not all sectors can record a surplus at the same time .........................................................................363
Point 3: Public debt and domestic private net wealth ......................................................................................366
Point 4: Business cycle and sectoral balances ...................................................................................................368
Point 5: Policy space and self-imposed constraints...........................................................................................370
CONCLUSION .............................................................................................................................................................371
TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS .................372
TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING ......................................................................................373
CHAPTER 25: FINANCIAL CRISES ........................................................................................................................................................ 377
DEBT DEFLATION ........................................................................................................................................................378
Step 1: Overindebtedness and distress sales.....................................................................................................379
Step 2: Distress sales and deflation, the “Dollar Disease” ................................................................................379
Step 3: Deflation and debt liquidation; the “Debt Disease” ..............................................................................379
Step 4: Prices and profit and net worth, the “Profit Disease” ...........................................................................380
Step 5: The “amplifier effect” ............................................................................................................................380
Step 6: Pessimism ..............................................................................................................................................381
Step 7: Interest-rate spread ..............................................................................................................................382
Conclusion .........................................................................................................................................................383
ORIGINS OF DEBT DEFLATION ........................................................................................................................................384
Real exchange economy: Efficient markets and imperfections.........................................................................384
Monetary production economy: The financial instability hypothesis ...............................................................385
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Financial fragility ............................................................................................................................................................ 385
The Financial instability hypothesis ................................................................................................................................ 387
HOW TO DEAL WITH FINANCIAL CRISES............................................................................................................................388
TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET ............................................................................................389
TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW ....................................................................................390
CHAPTER 26: INTERNATIONAL ASPECTS ...................................................................................................................................... 393
EUROCURRENCY .........................................................................................................................................................394
Some historical background ..............................................................................................................................394
Accounting mechanics of eurodollars ...............................................................................................................394
Eurodollar operations with a branch located abroad ..................................................................................................... 395
Eurodollar operation with a foreign bank ...................................................................................................................... 396
eurodollar credit services ..................................................................................................................................397
Payment services...............................................................................................................................................398
Eurobonds .........................................................................................................................................................399
PART 7: POLICY AND THEORY ISSUES ............................................................................................................................................. 401
CHAPTER 27: MONETARY POLICY IN ACTION ........................................................................................................................... 403
GLOSSARY.................................................................................................................................................................405
ABOUT THE AUTHOR ...................................................................................................................................................414
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PREFACE
This text is the preliminary draft for a textbook that embodies of an extensive revision of posts published
on the blog neweconomicperspectives.org. There are three main reasons to write a new money and
banking text when there are already so many available. First, most texts do not have a coherent theme
that runs through them and that ties together all the chapters. Second, the monetary and banking
chapters most often present views that are inapplicable or that are too limited in their presentation of
the topic. Third, the macroeconomic sections tend to not use what was presented in the previous
chapters, leave aside important debates in academia, and only briefly deal with balance sheet
interrelationships to analyze macroeconomic issues. This preliminary text deals with these three issues.
Throughout the text, the accounting mechanics of the balance sheet is central and used to analyze all the
topics presented. Not only are balance sheets relevant to understanding financial mechanics, but they
also force an inquirer to fit a logical argument into double-entry accounting rules. This is crucial because
if that cannot be done there is an error in the logical argument. All economists should know some basic
accounting to make a proper analysis the financial system and its relation to the rest of the economy.
The monetary and banking aspects and their relation to the macroeconomy are analyzed extensively in
this text by relying on the literature that has been available for decades in non-mainstream journals. Yet,
this literature that has been mostly ignored until recently but gained to traction following the 2008
financial crisis. In addition, a clear difference is made between the inner workings of an economy with
fixed exchange rate regimes and flexible exchange rate regimes. Gone is the money multiplier theory,
gone is the financial intermediary theory of banks, gone is the idea that the central bank controls
monetary aggregates, gone is the idea that finance is neutral in any range of time, and gone is the idea
that nominal values are irrelevant. Preoccupations about monetary gains, solvency and liquidity are
central to the dynamics of capitalism. Finance is not constrained by the amount of saving.
The chapters dealing with monetary systems are also much more developed than in a typical textbook. As
such, the “money” chapter, usually first in M&B texts, comes much later in the form of three chapters,
once balance-sheet mechanics and financial concepts, such as present value, have been well understood.
In addition, the link between macroeconomic topics and banking theory is fully established to analyze
issues of inflation, economic growth, financial crisis and financial interlinkages.
Of course, all this is still a work in progress. There are many chapters missing for a full text, and some of
the chapters will need to be rewritten to account for comments by my students and others. I wish to thank
all my former and current students and readers posts who provided numerous helpful comments and
suggestions. Many thanks to Stavros N. Karageorgis for carefully reading and editing the first draft. Warren
Mosler, Susan Webber and Nick Estes provided valuable comments.
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PART 1:
CHAPTER 1:
After reading this Chapter you should understand:

What a balance sheet is
Why a balance sheet changes
How a balance sheet changes
What the Financial Accounts of the United States are
How the Financial Accounts of the United States work
What the limits of the Financial Accounts are
CHAPTER 1: BALANCE-SHEET MECHANICS AND FINANCIAL ACCOUNTS OF THE UNITED STATES
The core of the financial system consists of financial documents; among them are balance sheets. Balance
sheets provide the foundation upon which most of a M&B course can be taught: monetary creation by
banks and the central bank, nature of money, financial crises, securitization, financial interdependencies;
you name it, it has to do with one or several balance sheets. As Hyman P. Minsky noted, if you cannot put
your reasoning in terms of a balance sheet, there is a problem in your logic.
WHAT IS A BALANCE SHEET?

It is an accounting document that records what an economic unit owns (its “assets”) and owes (its
“liabilities”). The difference between its assets and liabilities is called net worth, or equity, or capital (Figure
1.1).
Figure 1.1 A balance sheet

There are many different ways to classify assets and liabilities. For our purposes, a balance sheet can be
detailed a bit according to Figure 1.2. Financial assets are claims on other economic units; nonfinancial
assets (aka real assets) may be reduced to physical things (cars, buildings, machines, pens, desks,
inventories, etc.) but may also include intangible things (goodwill among others). Demand liabilities are
liabilities that are due at the request of creditors (cash can be withdrawn from bank accounts at will by
account holders); contingent liabilities are due when a specific event occurs (life insurance payments to a
widow); dated liabilities are due at specific periods of time (interest and principal mortgage payments are
due every month).
Figure 1.2 A simple balance sheet

Balance sheets can be constructed for any economic unit. That unit can be a person, a firm, a sector of the
economy, a country, anybody or anything with assets and liabilities. Table 1.1 shows the balance sheet of
all U.S. households (and non-profit organizations) in the United States. In 2014, U.S. households owned
$98.3 trillion worth of assets and owed $14.2 trillion worth of liabilities, making net worth equal to $84.1
trillion (98.3 – 14.2). Households held $29.2 trillion of nonfinancial assets and $69.1 trillion of financial
2
assets. Their two main liabilities were mortgages ($9.4 trillion) and consumer credit (credit card debts,
student debts, healthcare debts, etc.) ($3.3 trillion).
Table 1.1 Balance sheet of households and NPOs.

Source: Financial Accounts of the United States
BALANCE SHEET RULES

A balance sheet follows double-entry accounting rules so a balance sheet must always balance, that is, the
following must always be true:
Assets = Liabilities + Net Worth
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The practical, and central, implication is that a change in one item on the balance sheet must be offset by
at least one change somewhere else, so that a balance sheet stays balanced.
Start with a very simple balance sheet. The only asset is a house worth $100k that was purchased by putting
down 20k and asking for $80k from a bank (Figure 1.3).
Figure 1.3 A simple balance sheet

What is the impact of a bank forgiving $40k of principal on the mortgage? The value of the mortgage went
down by 40k and the value of the net worth went up by 40k so that the accounting equality is preserved
(Figure 1.4)
Figure 1.4 Effect of forgiving some of the mortgage principal

Going back to the first balance sheet, what is the impact of the value of the house going up by $20k? The
asset value went up by $20k and the net worth went up by $20k and here again the accounting equality is
preserved. (Figure 1.5).
Figure 1.5 Effect of higher house price

Sometimes, to get to the point more quickly and to highlight the changes, economists prefer to use so-
called “T-accounts” (because the shape of the table looks like a T) that record only the changes in the
balance sheet (Δ means “change in”). The offsetting accounting entry is shown more clearly. It comes from
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opposite changes in two items on the right side of the balance sheet (Figure 1.6), and a change in assets
and net worth by the same amount (Figure 1.7). Of course, these are not the only two ways the offsetting
is done to preserve the accounting equality. We will encounter other cases as we move forward. The point
is that one must change at least two things in a balance sheet to make sure that the equality A = L + NW is
preserved. One must always wonder what the offsetting change is. This has practical implications when
studying how banks and central banks operate.
Household
ΔAssets ΔLiabilities and Net Worth
Mortgage: -$40
Net worth: +$40
Figure 1.6 T-account that records the decline of the mortgage principal
Household
House: +$20 Net worth: +$20
Figure 1.7 T-account that records the higher house value
CHANGES IN THE BALANCE SHEET

One can classify factors that change a balance sheet into four categories:
- Cash inflows and outflows: net cash flow.
- Purchases and sales of assets, issuance and repayment of debts: Net acquisition of assets and
liabilities.
- Incomes and expenses: net income.
- Capital gains and capital losses: net change in the market value of assets and liabilities.
Cash flow, income and expenses, and capital gains and losses are recorded more carefully in other
accounting documents than the balance sheet, but this section focuses on their relation to the balance
sheet.
NET CASH FLOW
Cash inflows and cash outflows lead to a change in the outstanding value of monetary balances held by an
economic unit, that is, a change in the quantity of physical currency or funds in a bank account held on the
asset side. Some assets lead to cash inflows, while some liabilities and capital (dividend payments) lead to
cash outflows.
If the cash inflows are greater than the cash outflows, monetary assets held by an economic unit go up. The
economic unit can use them to buy assets or pledge them to leverage its balance sheet (see Chapter 7). If
net cash flow is negative, then monetary-asset holdings fall, and the economic unit may have to go further
into debt to pay some of its expenses (Figure 1.8).
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Figure 1.8 Balance sheet and cash flow

Going back to the balance sheet of Figure 1.3, assume that a salary of $40k is earned and that part of the
salary is used to service a 30-year fixed-rate 10 % mortgage. Assuming linear repayment of principal to
simplify, Figure 1.9 shows what the cash flow structure looks like.
Figure 1.9 Balance sheet and cash flows, an example

The balance sheet at the beginning of the following year is shown in Figure 1.10 (assuming all cash flows
involve actual cash transfers instead of electronic payments). Quite a few things have changed in the
balance sheet. There is a net inflow of cash of $29.3k; the principal of the mortgage fell by the amount of
principal repaid, and the change in net worth offsets for these two changes.
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Figure 1.10 Balance sheet after the cash-flow impacts
NET ADDITION TO ASSETS AND LIABILITIES
Net cash flow records the net addition of monetary balances, but there are many other assets on the
balance sheets. Over time, assets lose value via depreciation, or destruction, or repayment of principal;
some assets are sold while other assets are purchased. The net change in the monetary value of assets
(acquisitions minus loss of value and sales) impacts the balance sheet. Depreciation is counted as an
expense, so it impacts net income. Similarly, liabilities on the balance sheet are progressively repaid
(principal repayment) or reduced in other ways, while new liabilities are issued by an economic unit. The
net issuance of liabilities (new liabilities minus principal reductions) also impacts the balance sheet of their
issuers. It also impacts the balance sheet of the creditors given that the liabilities of someone are the
financial assets of someone else.
Current net worth = Previous net worth + Net addition to assets and liabilities of the period
Figure 1.3 shows the impact of acquiring nonfinancial assets (the house) and incurring new liabilities (the
mortgage). Figure 1.4 shows the impact of a decline in the principal amount of the mortgage.
NET INCOME
Net income leads to a change in net worth:

Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income
of the period
Net income can be positive or negative, so net worth may rise or fall. In the previous example (Figures 1.9
and 1.10), net cash flow and net income are the same thing; however, not all incomes necessarily lead to
cash inflows (see Chapter 4 and Chapter 4). There is a debate about whether or not one should record
capital gains and losses in the income statement. Given the pedagogical purpose of this section, the two
are clearly separated.
NET CAPITAL GAIN
The value of assets and liabilities change merely because of changes in their market prices even though
their quantities have not changed (no net addition). If accounting is done on a “mark-to-market” basis, that
is, by valuing balance-sheet items on the basis of their current market value, these changes are accounted
in the balance sheet on a daily basis. Some assets see their prices go up (capital gains) while other see their
7
prices go down (capital losses) and the difference between capital gains and capital losses (net capital gains)
affects the net worth accordingly:
Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income
of the period + Net capital gains of the period
The example of Figure 1.5 is a simple illustration of the impact of capital gains.
The effect of a change in the market prices of assets and liabilities may not be recorded in the balance sheet
if they are valued on a cost basis, that is, at the price at which they were acquired minus depreciation. For
financial assets, there are three options to record their value. Level 1-valuation uses the available market
price. Level-2 valuation is used for assets that do not have an active market; a proxy market is used as a
point of reference. Level-3 valuation, also called mark-to-model (or more cynically “mark-to-myth”), uses
an in-house model to give a dollar value to the asset. During the 2008 crisis, major financial institutions
argued that the market prices of some assets did not reflect their true value because of a panic in markets.
The Securities and Exchange Commission allowed them to move to level-2 or level-3 valuation to avoid
recording capital losses on their assets. Many analysts have been critical of that decision and considered it
a convenient way to hide major losses of net worth by financial institutions.
MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL

ACCOUNTS OF THE UNITED STATES
TO BE WRITTEN
Summary of Major Points

1- A balance sheet is one of the important financial documents used to record the financial state of an
economic unit.
2- Assets represent what is owned and liabilities represent what is owed by an economic unit.
3- Net worth/capital/equity is the difference between the monetary value of assets and liabilities.
4- A balance sheet must balance, that is, at all times the following must be true: Assets = Liabilities + Net
Worth.
5- A balance sheet follows double-entry accounting rules: a change somewhere leads to at least one
offsetting change somewhere else to ensure that the balance sheet stays balanced.
Keywords
Balance sheet, nonfinancial assets, financial assets, demand liability, time liability, contingent liability, net
worth, capital, net income, net cash flow, net capital gain, net acquisition of assets and liabilities, level-1
valuation, level-2 valuation, level-3 valuation
8
Review Questions
Q1: What does a balance sheet do?
Q2: If the value of assets goes up and the value of liabilities goes down, what happens to net worth?
Q3: If the value of assets and liabilities changes by the same amount, what happens to net worth?
Q4: If outstanding assets depreciate faster than the acquisition of new assets, what happens to the value
of assets? To the value of net worth?
Q5: If an economic unit takes on new debt faster than it repays outstanding principal, what happens to the
level of liabilities? Of net worth?
9
CHAPTER 2:

What the financial system broadly does
What financial instruments are
What the different types financial instruments are
Who holds and issues different types of financial instruments
How the liability structure influences the asset structure
CHAPTER 2: THE FINANCIAL SYSTEM: A WORLD OF PROMISES
The U.S. financial system is extremely complicated. Figure 2.1 provides an overview of that system that
consists of three main categories: financial markets, financial companies, and regulatory and supervisory
institutions. Chapter 2 emphasizes that the world of finance is a world of promises and it goes through most
of the different sorts of promises that exist. Chapter 3 overviews most of the private and public institutions
involved in the financial industry.
International Financial Markets (Foreign Exchange Markets, Eurocurrencies, Eurobonds, Foreign Bonds)
Capital Markets: Securities with a maturity superior to one year Primary Market
(Stocks, Bonds, Asset-Backed Securities)
Financial Markets Money Markets: Securities with a maturity of one year or less Organized Exchanges
(BAs, CDs, CPs, Federal funds loans, RPs, bills) Secondary Market
OTC Markets
Insurance Markets (Forwards, Futures, Options, Swaps)
Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)

Financial-Market Companies
Security Firms (Investment Banks, Brokerage Firms)
Commercial Banks
Depository Institutions
Thrift Institutions (Credit Unions, Savings Banks, Savings and Loan Associations)
Financial Sector Financial Companies
Financial Investment Companies (Hedge Funds, Pension Funds, Mutual Funds, Real Estate Investment Trusts)
Insurance Companies (Life Insurance Companies, Property and Casualty Insurance Companies, Monolines)
Finance Companies (Business Finance Companies, Consumer Finance Companies, Sales Finance Companies, SPEs)
Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

Government Financial Agencies SLMA)
Government Loan Guarantee Programs and Government Loan Programs (Ex-
Im Bank, FHA, FCA, GNMA, SBA, VA, DLP)
Federal Reserve System (Fedwire, Discount Window, Open Market Trading
Desk)
Private: National Associations (SIFMA, FINRA, NBA, NFA), Organized Exchanges, Clearing Systems (OC
Corp., CHIPS), Credit-Rating Agencies
Regulatory and Supervisory Institutions
Government: Department of Housing and Urban Development (FHFA), Department of Labor, Department of
Treasury (OCC, OTS), Independent Federal Agencies (CFTC, FCA, FDIC, Federal Reserve Board, Reserve
Banks, Fedwire, FTC, NCUA, SEC, CFPB), Interfederal agencies (FFIEC, FSOC), State Banking and
Insurance Commissioners
CBOE: Chicago Board Options Exchange, CBOT: Chicago Board of Trade, CFPB: Consumer Financial Protection Bureau, CFTC: Commodity Futures Trading Commission, DLP: Direct Loan Program,
Ex-Im Bank: Export-Import Bank, FAMC: Federal Agricultural Mortgage Corporation (“Farmer Mac”), FCA: Farm Credit Administration, FCS: Farm Credit System, FDIC: Federal Deposit Insurance
Corporation, FFIEC: Federal Financial Institution Examination Council, CHIPS: Clearing House Interbank Payment System, FHA: Federal Housing Administration, FHFA: Federal Housing Finance
Agency, FHLBS: Federal Home Loan Banks System, FHMLC: Federal Home Loan Mortgage Corporation (“Freddie Mac”), FNMA: Federal National Mortgage Association (“Fannie Mae”), FSA: Farm
Service Agency, FSOC: Financial Stability Oversight Council, FTC: Federal Trade Commission, GNMA: Government National Mortgage Association (“Ginnie Mae”), FINRA: Financial Industry
Regulatory Authority, NASDAQ: National Association of Securities Dealers Automated Quotation System, NBA: National Bankers Association, NCUA: National Credit Union Administration, NFA:
National Futures Association, NYSE: New York Stock Exchange, OC Corp.: Option Clearing Corporation, OCC: Office of the Comptroller of the Currency, OTC: Over-the-Counter, OTS: Office of
Thrift Supervision, SBA: Small Business Administration, SEC: Securities and Exchange Commission, SIFMA: Securities Industry and Financial Markets Association, SLMA: Student Loan Marketing
Association (“Sallie Mae”), SPE: Special Purpose Entity, VA: Department of Veteran Affairs.
Figure 2.1 The financial system in the United States
THE FINANCIAL SECTOR: A WORLD OF PROMISES

Anybody can make any kind of promise. “I will pick you up tonight at 8 PM,” “I will complete my homework
assignment tomorrow,” “I will provide you with a free pizza whenever you want,” “I will service my
mortgage every month for the next 30 years.” The hard parts are, first, to convince others of the
genuineness of the promise, so they are willing to accept it and, second, to fulfill the promise once it has
been accepted. If the issuer of a promise is not credible (maybe he has a reputation for being late and lazy,
maybe he defaulted on past debts), there is much less of a chance that the promise will be accepted, or it
will be accepted only at a high cost to the issuer. Thus, all promises involve the credibility of the issuer, that
is, trust in the ability and willingness of the issuer of a promise to fulfill that promise. The world of finance
establishes a framework to record the creation and fulfillment of formal promises that are financial in
12
nature, and to measure the credibility of issuers at any point in time. Finance more or less accurately
measures the credibility of these financial promises by pricing financial instruments (Chapter 14).
Casual promises
Promises Nonfinancial promises
Formal promises
Financial promises (financial instruments)
Figure 2.2 A categorization of promises
Figure 2.3 Some nonfinancial promises

Formal promises are promises that carry the weight of the law through either contractual agreements or
legislation. Such promises can be financial or nonfinancial depending on the nature of the promise made.
A free-pizza coupon is a nonfinancial promise because the reward provided by the issuer is not monetary
in nature. On the contrary, a mortgage note or a monetary instrument merely involves future monetary
13
transfers with the issuer (interest payments, tax payments, among others). This textbook studies financial
promises, which are known as “financial instruments” (Figure 2.2).
Figure 2.3 shows that a formal promise does not have to take a specific shape or to be made of a specific
material. Today, the cheapest means to make a financial instrument are through an electronic entry, but
an issuer may choose to do so by stamping gold or leather, or by printing paper; the object representing
the promise can be very fancy and big or very small and simple. The shape and material are irrelevant to
the existence of a claim. As long as key legal elements described below are included, there is a formal
promise.
CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS

The creation (and destruction) of any promise, financial or nonfinancial, involves at least two actors: the
issuer, who makes the promise, and the bearer, who accepts the promise and so chooses to trust the issuer.
There cannot be issuance without a willing bearer, and there be cannot a promise without a willing issuer.
As such, banks cannot create bank accounts if nobody wants to hold them (see Chapter 12), corporations
cannot issue shares if nobody wants to acquire them, etc.
The creation of a financial instrument is a complicated matter that involves lots of legalese explaining in
detail what the promise is, and what happens if the promise is not fulfilled. Lots of time is also spent on
determining how credible the issuer is—its creditworthiness—and the willingness of potential bearers to
hold the issuer’s financial instrument. The legal document that records all the details of a financial
instrument can run for hundreds of pages, and bearers and issuers are supposed to know all the details of
the agreement, which is sometimes not the case.
One may wonder why one may decide to issue a financial instrument and why others are willing to hold it.
People, businesses, governments and other entities issue financial instruments for all sorts of reasons.
Some want to obtain funds to be able to go to school or to buy a car, others want to buy expensive
equipment to expand their productive capacities. Another reason may be to provide meals to poor
households, to maintain and develop the infrastructure of the state, or to manage the overall national
economy. In general, financial instruments are issued because someone, the issuer, does not have enough
funds on its balance sheet to pursue the goal it sets for itself; the issuer has a deficit of funds. By issuing
financial instruments, the issuer asks economic units with a surplus of funds, or with the ability to create
those funds, to trust the issuer. The issuer promises to return the funds later on with some rewards.
Depending on the nature of the reward and the credibility of the issuer, the demand for a financial
instrument varies. When the financial instrument comes due, the issuer repurchases its financial instrument
from bearers by giving back to bearers the funds they provided in the first place.
Figure 2.4 shows the general logic behind financial instruments (here denominated in dollars). At issuance,
the issuer sells a financial instrument to the bearer. The bearer decides to buy the financial instrument of
the issuer at a certain price, say $100. The issuer then uses the $100 for whatever purpose. Until the
financial instrument is returned to the issuer, the bearer periodically receives a monetary reward from the
issuer (e.g., $10 every month or $20 every six months). When the principal is owed (“at maturity”), the $100
is paid back by the issuer to whoever presents the financial instrument. The issuer is effectively buying back
its financial instrument, and he does so at its face value, that is, the monetary sum inscribed on the financial
instrument. Once it has recovered his financial instrument, the issuer destroys it to prevent others from
acquiring it and so having a claim on the issuer.
14
Financial instrument of issuer
$$ (purchased price: fair price) At issuance
Issuer $$ (income) Bearer Until maturity

(Debtor) (Creditor)
$$ (repurchase price: face value) At maturity
Financial instrument of issuer

Figure 2.4 Broad logic behind financial instruments
As illustrated below and explained in Chapter 14, Figure 2.4 does not fit exactly the structure of all financial
instruments because sometimes the income is not paid until maturity (zero-coupon securities), sometimes
the principal is paid bit by bit over time (fully-amortized financial instruments) rather than at once at
maturity (unamortized financial instrument), sometimes the issuer never promises to buy back his financial
instruments and so never has to repay the principal (consols, corporate shares). However, the Figure
illustrates the general point that someone issued a financial instrument, pays a reward, and then fully
redeems its financial instrument at maturity. Chapter 19 shows that this logic applies to monetary
instruments.
CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO

MATURITY, LIQUIDITY, RISKS, AND OTHER CHARACTERISTICS
Balance sheets contain many types of financial instruments. Some of them are issued by an economic unit
to others who then have a claim on the issuer (financial liabilities). Some of them are held by that same
economic unit who then has claims on others (financial assets). The way a financial instrument is structured
varies widely depending on the needs of their issuers and potential bearers, but common questions that a
promise must answer are the following.
- Who is the issuer? That is, who made the promise? The mark of the issuer (name, head, etc.) is
present on the financial instrument, so bearers know who is supposed to fulfill the promise
contained in the financial instrument.
- What is the unit of account? Financial instruments cannot exist before there is a unit of
measurement for transactions and outstanding assets and liabilities.
- When will the issuer redeem its financial instrument? That is, how long will it take the issuer to
fulfill the promise? There is a term to maturity. At maturity, the issuer buys back the financial
instrument it issued. The term can go from zero (issuer takes back its financial instrument at the
bearer’s discretion) to infinity (issuer takes back its financial instrument at its discretion).
- At what price will the issuer redeem its financial instrument? A face value specifies the number of
units of account the financial instrument carries ($100, $10, $1, 25 cents, etc.) and so the monetary
value of the principal owed.
- How will the issuer redeem its financial instruments? How can bearers redeem the notes? The
expected means that will be used by the issuer to fulfill his promises, also called the “reflux
15
mechanisms/channels” or redemption channels (Chapter 19 shows that the way this question is
answered is crucial for financial stability)
- What is (are) the benefit(s)/reward(s) for those willing to trust the issuer? Income, voting rights,
settle debts owed to issuer, avoid prison, etc.
- Are there any protections for bearers in case the issuer is unable or unwilling to fulfill the promise?
If the issuer defaults on its promises, the bearers are paid by taking ownership of some assets of
the issuer (house for mortgages, etc.). The asset(s) that the issuer uses to secure a financial
instrument are (is) called collateral. If there is no collateral, the financial instrument is said to be
unsecured.
- Is it possible to transfer the financial instrument to another bearer? Financial instruments may be
marketable/transferable/negotiable, that is, the person to whom the promise has to be fulfilled
can be changed by transferring ownership of the financial instrument. Some financial instruments
are not transferable because they name the beneficiary and are not endorsable. Some, like checks,
have limited transferability through endorsement.
Depending on how these questions are answered, the name of a financial instrument changes, in the same
way the race of a dog changes depending on its physical characteristics; some are called stocks/shares,
bonds, or mortgages, others are called bills, commercial paper and student debt. While they differ in
characteristics, they all contain a promise made by someone (the issuer) to someone else (the bearer).
Depending on the previous characteristics, a financial instrument is also more or less liquid. Broadly, the
liquidity of an asset means the ability to sell it quickly without incurring major capital losses. A house is
one of the most illiquid assets. If someone decides to buy a house today for $500,000 and wants to sell it
the next day, it will be impossible to resell it at the same price. The owner will either have to wait—days,
weeks, months, or years depending on the popularity of the location of the house and the state of the
economy—to find someone willing to buy it for $500,000, or will have to offer a large discount to sell it
immediately; there are plenty of people willing to buy a house for $100.
One way to check if a financial instrument or any other asset is liquid is to analyze how its nominal price
behaves over time, that is, at what price it circulates over time among bearers. Figure 2.5 shows how the
price of three different financial instruments with the same face value changes over time. Financial
instrument #1 is perfectly liquid in the sense that the price at which it passes among economic agents is
constant; it always trades at face value, and so there is never any capital loss (or gain). Federal Reserve
notes (FRNs) are examples of perfectly liquid financial instruments; a $20 FRN is always accepted at $20.
Financial instrument #3 is highly illiquid because, even though one may be able to record a capital gain by
selling at the right time, its nominal price is highly volatile. Financial instrument #2 is less liquid than financial
instrument #1 but more liquid than financial instrument #3. Indeed, while the initial bearer will always make
a capital loss if he sells, the volatility of the price is low, and so later bearers will have less chance to record
large capital losses if they want to sell quickly.
Note that the notion of liquidity is different from the notion of purchasing power stability. A $20 Federal
Reserve note may circulate at $20 at all times, but the quantity of goods and services that $20 can purchase
varies through time. Chapter 23 and Chapter 19 explain that the mechanics at play in the determination of
liquidity and purchasing power are quite different.
Two main factors determine the liquidity of a financial instrument. One is its financial characteristics
presented above. Another is the existence of a well-organized financial infrastructure that allows for a
smooth trading of financial instruments according to their financial characteristics; in this case, the price at
which the financial instrument circulates reflects well the promise made.
16
Price
Financial instrument #3
Time
Figure 2.5 Liquidity and price volatility
In terms of financial characteristics, the most liquid financial instruments are those that are transferable, of
the shortest term to maturity, and with reflux mechanisms that are reliable and compatible with their term
to maturity (see Chapters 14, 19, and 20). Federal Reserve notes are due on demand, checking accounts are
due on demand, and so both are perfectly liquid given that existing reflux mechanisms do allow bearers to
redeem on demand.
In terms of financial structure, a well-developed deep market will promote liquidity. A deep market means
that the price at which a financial instrument trades is not influenced by major swings in its demand or
supply. If trading in a market is limited and participation is thin (few buyers and sellers at any price point),
the price of a security will be very sensitive to a change in demand or supply of that security. In this case,
there is a high chance to record a capital loss if some participants try to sell the security quickly. On the
contrary, if trading volume is strong and at any price point there are lots of willing buyers (so the price
cannot fall much) and sellers (so the price cannot rise much), a financial instrument will be more liquid given
its financial characteristics.
Once an economic unit has decided what type of financial instrument to issue and assuming some willing
bearers do exist, the difficult part becomes to fulfill what was promised. A bearer may also want to sell the
financial instrument to another bearer but may have difficulties to do so. As such, the bearer of a financial
instrument faces several risks, among which are:
- Credit risk: The issuer is unable or unwilling to fulfill what was promised when it was promised. The
income due is not paid, or only paid partially, or paid fully but not on time. The issuer is not able or
willing to repurchase partially or fully its financial instrument—that is, part, or all, the principal—
when he stated he would. More broadly, credit risk occurs when any part of a promise is not
accomplished in terms of dollar amount and/or timeliness. If credit risk does occur, the issuer is
said to have defaulted/to be in default/to be delinquent. This has important implications for the
creditworthiness of the issuer and for the price of its financial instrument as explained in Chapter
14.
- Prepayment risk: Some clauses in a financial instrument may allow the issuer to repay the principal
due more quickly than the stated term to maturity. For example, a bearer may buy a financial
instrument expecting to earn an income over 10 years, but the issuer may suddenly decide to
repurchase fully his financial instrument after 7 years, which leads to a loss of income for the bearer.
Households usually tend to repay their mortgages more quickly than the original term to maturity
17
(a 30-year mortgage is repaid in 20 years by making accelerated payment of the principal), some
bonds are callable (the issuer can repurchase them earlier than expected).
- Collateral risk: If the issuer defaults, the value of the collateral may not be high enough to recover
all the income, fees, and principal due to the bearer.
- Liquidity risk: If the bearer decides to sell a financial instrument, he may try to sell it to another
bearer (the issuer is under no obligation to buy it back until maturity). Doing so, however, may be
costly if the financial instrument is not liquid as explained above.
- Interest-rate risk: Interest rates may change in a way that negatively impacts the net worth of the
bearer. For example, the price of some financial instruments are more sensitive than others to
changes in interest rates (see Chapter 14), or banks may hold mortgages with fixed interest rates
but issued liabilities with flexible interest rates (Chapter 4).
Many other risks exist for bearers that are more or less pronounced depending on the structure of the
financial instrument (that is depending on what the issuer promised to do), the structure of the balance
sheet of the issuer and of the bearer and the state of the economy. The main point is that accepting to hold
a financial instrument is not without risks, not only because one must trust the issuer, but also because of
potential adverse changes in financial-market conditions and the overall economic situation. Given the
characteristics presented above, one may classify financial instruments into marketable (aka “securities”)
and non-marketable (aka “advances” or “loans”). The following uses the Financial Accounts of the United
States to present an overview of financial instruments. The Accounts measure how much of each
instrument is outstanding, who the issuers are and who the bearers are. Since 1945, a lot has changed in
terms of these elements.
MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES

While some securities are not marketable, most of them are because the promises that they contain can
be fulfilled to anyone who holds the security rather than to a specific person. Three broad types of securities
that are distinguished by their financial characteristics: equity instruments, debt instruments, and monetary
instruments. Monetary instruments are analyzed more carefully in Chapters 20 and 21.
EQUITY INSTRUMENTS
There are different types of equity instruments such as corporate stocks/shares/equities and mutual fund
shares. The main legal aspect of equity instruments is that they represent a residual claim on the business
that issued them. As such, they are paid last and take losses first. The income earned from the equity
instruments—called dividend—is a proportion of the profit. If the business does not make any profit, no
dividend is paid. Put differently, a dividend is paid if there is a residual income after all other creditors have
been paid. Even if there is a profit, a dividend payment is not guaranteed because the board of the company
may decide that it is best to allocate earnings in a different manner, such as the expansion of the business.
Not paying a dividend is, however, a risky strategy because unhappy bearers may decide to sell the stock
leading to a fall in its price. This could make the business subject to potential hostile takeover bids by
competitors who want to take control of the business by acquiring a large quantity of its stocks.
Equity security holders can participate in a vote on the major issues facing a business. Each shareholder has
a vote, and the more shares one owns in a business, the more voting power one has. Some holders of equity
instruments may prefer to give up that right in exchange for a more certain income. This is the main
18
difference between common stocks and preferred stocks, with the latter guaranteeing a dividend as long
as there is some profit, but also not giving a right to vote.
Equity holders are the first to take losses in a bankruptcy procedure. For example, assume a business only
has $100 worth of assets to make payments to thousands of creditors. The overall dollar amount owed in
terms of principal, income, and other claims is $10000 including $1000 worth of equity instruments. The
bankruptcy judge is tasked with distributing the $100 among claimants. One way would be to give 1 cent
per dollar claimed and to call it a day, but that is not how equity instruments are structured. Equity holders
take losses first and so the $1000 they are owed is wiped out first from the claims on the business. The
judge then moves to the next claimants, holders of debt instruments and other claims, to figure out how to
allocate losses.
Finally, the term to maturity of an equity security is infinite, which means that the issuer never promises to
pay back the principal owed; it is not redeemable. Issuers may choose to redeem their equity instruments
at their convenience, but they do not have to do so. For example, if one buys a corporate share with a face
value of $1000 from business X, business X is under no obligation to repay the $1000. If one wishes, one
may try to sell the share to someone else at the prevailing market price (that may be above or below $1000).
Interestingly, the corporate business sector has never used the stock market as a major source of funds.
Since the early 1980s, corporations have used many of their earnings to repurchase the shares they
previously issued. While some corporations have issued large quantities of shares to finance their business
operations—Facebook and Twitter may come to mind—other corporations have repurchased their shares
in quantities that dwarf new issues. Figure 2.6 shows that the net increase in corporate shares (issuances
minus repurchases) has been constantly negative since 1994 and averaged -$231 billion annually from 1994
to 2015.
Figure 2.6 Net issuance in corporate equities, billions of dollars.

Source: Board of Governors of the Federal Reserve System (series Z.1, F.102, line 38)
A central reason behind this trend has been a change in the management strategies of corporations because
of the financialization of the economy (see Chapter 4). For example, business managers have seen a change
in their remuneration structure away from salary and toward stocks and bonuses. This has pushed
19
managers to find means to boost up the short-term trend of stock prices, and one means to do so is to make
the stock of a company scarcer.
For every issuer of a financial instrument there is a bearer, for every creditor there is a debtor. Figure 2.7
and 2.8 illustrate this point by showing the structure of ownership of corporate shares and the structure of
issuers. In 2015, the market value of outstanding corporate stocks was about $36 trillion. Households hold
most of the stocks, either directly or indirectly via money managers (pension funds, mutual funds and
insurance companies). Figure 2.7 shows two trends in the evolution of the structure of ownership. One is
the growing role of money managers—also known as institutional investors—and another is the
internationalization of the ownership. Until the late 1950s, over 90 percent of corporate shares were held
directly by households and non-profit organizations (NPOs). Over time, money managers—especially
pension funds and mutual funds—have owned a greater proportion of corporate shares and, by 2015,
money managers held about 40 percent of all corporate shares, with another 40 percent held directly by
households. The rest of the world has also owned a growing proportion of outstanding corporate stocks in
the United States and today owns about 15 percent of them.
Over 70 percent of corporate shares outstanding are issued by nonfinancial corporations (Figure 2.8). This
proportion is even larger if one includes the shares issued by “captive financial institutions.” They are
financial affiliates of nonfinancial corporations that provide financial services to the customers of the parent
nonfinancial corporations (credit cards issued by retail stores, financing provided by a car dealer to its
customers, among others). Banks chartered in the United States, life insurance companies and non-MMMF
funds (closed-end funds and exchange-traded funds) are most of the other issuers of corporate shares.
Figure 2.9 shows that another major issuer of equity instruments are mutual funds with the market value
of their shares equaling $12 trillion. The evolution of the structure of ownership of mutual funds shares
follows a similar story to corporate shares with 100% of mutual funds shares held directly by households
until the 1960s, followed by a rapid increase of indirect ownership via money managers that today hold
about 40 percent of mutual fund shares. Foreign ownership is less pronounced for corporate shares with
only about 5 percent of mutual funds shares held by the rest of the world.
20
Figure 2.7 Structure of ownership of corporate equities (percent) and market value of outstanding shares
(trillions of dollars)
Source: Board of Governors of the Federal Reserve System (series Z.1, L.223)
Note: “Others” includes monetary authority (common stocks of American International Assurance
Company Ltd. (AIA) and American Life Insurance Company (ALICO) held between December 2009 and
January 2011 via special purpose entities AIA Aurora LLC and ALICO Holdings LLC), the federal government
(preferred shares issued by US banks to Treasury to access emergency injection of capital via the Troubled
Asset Relief Program), private depository institutions, state and local government, closed-end funds,
exchange-traded funds, and security brokers and dealers.
21
Figure 2.8 Structure of issuers of corporate equities (percent)

Figure 2.9 Structure of ownership of mutual fund shares (percent) and market value of outstanding shares
(trillions of dollars)
22
DEBT INSTRUMENTS
Debt instruments are distinct from equity instruments by the fact that they do not represent a residual
claim on the company but rather are an acknowledgment of debt. This acknowledgement by the issuer
comes with a promise to repay the principal and a reward, even if the issuer does not earn any income. The
issuer must sell assets, deplete its savings, or must find other means to pay the income due on debt
instruments. Debt instruments are also provided more protection in case of bankruptcy, the first layer being
provided by equity instruments. However, not all debt instruments are equal in bankruptcy and some may
be subordinated to others, that is, may absorb losses before other debt instruments. Chapter 17 on
securitization will develop this point.
The structure of debt instruments varies greatly to fit the needs of the issuer and bearers. Some pay a
periodical income—called coupon—but others do not, some are secured while others are not, and the
range of the term to maturity varies from one month to decades. A classic example of a short-term debt
security is commercial paper. Some businesses may mostly need extra funds for a short period of time in
order to pay their workers and to buy the raw material needed to start production. Once the production is
completed and the output sold, the businesses repay their debts. A commercial paper is a short-term
financial instrument that fulfill such financial needs. Its term to maturity at issuance is usually less than 270
days and averages 30 days in the United States. About 30 percent of commercial papers are issued by
nonfinancial corporations either to finance inventories (renting space, paying insurance, etc.), or to finance
production (paying wages, electricity, etc.). The rest is issued by financial companies that seek short-term
sources of funds.
Until the 1970s, finance companies were the main issuers of commercial papers with about 50 percent of
outstanding commercial papers issued by them. After the 1970s, captive financial institutions, issuers of
asset-backed securities, and the rest of the world (mostly foreign private financial companies) became
major issuers (Figure 2.11). About 50 to 60 percent of open-market papers is held by funding corporations
and money market mutual funds, in the form of commercial paper, and their outstanding amount peaked
at $2 trillion in 2007 before collapsing to less than $1 trillion in 2015, mostly due to the decline in issuance
of asset-backed commercial paper as explained below (Figure 2.10).
Given that the issuance of commercial papers is tied to economic activity, the outstanding dollar amount
of commercial papers fluctuates with the business cycle: it rises in an expansion and falls in a recession. A
commercial paper does not pay a coupon but rewards its bearer in another fashion explained in Chapter
14. Most commercial papers are unsecured but, with the rise of securitization, a secured form—called asset-
backed commercial papers (ABCP)—became prominent. Figure 2.12 shows that the outstanding volume of
ABCPs peaked at $1.2 trillion in 2007—about 50 percent of all types of commercial paper outstanding—
before collapsing to $240 billion by 2015 or about 25 percent of all types of outstanding commercial papers.
23
Figure 2.10 Structure of ownership of open-market papers (percent) and market value of outstanding
papers (trillions of dollars)
Figure 2.11 Structure of issuers of open-market paper (percent) and proportion of commercial paper in all
open-market papers
Note: Open-market papers include commercial paper and banker’s acceptances
24
Figure 2.12. Proportion of unsecured and secured commercial paper and outstanding dollar amount of
asset-backed commercial paper (trillions of dollars)
Source: Board of Governors of the Federal Reserve System (series “commercial paper”)
Note: There are four categories of commercial paper in the dataset: nonfinancial, financial, ABCPs and
others. “Others” represents an insignificant proportion and are included in commercial paper.
While commercial papers deal with the short-term needs for funds of businesses, corporate bonds deal
with their medium to long-term needs. Bonds pay an interest income. The interest income is called
“coupon” because bonds were formerly made of paper and small coupons were attached to the bond. Each
one had to be cut and redeemed to the issuer in order to receive the interest payment. At maturity, the
issuing corporation buys back the bonds from whoever holds them and pays the face value of the bond.
Figure 2.13 shows an old-fashioned bond with the bonds on the left stating a face value of 100 taels (a unit
of account that prevailed in China) and 18 coupons left on the right. This bond, issued by Tientsin Land
Investment Company has an initial term to maturity of 22 years. An interest income worth 3.5 taels was
due every six months, which means that 44 coupons were initially attached to the bond. Interest income
was paid whenever a coupon was handed to Tientsin and, after 22 years passed, the bond was to be
returned to Tientsin to get 100 taels. Today, all financial instruments, except for cash, take an electronic
form. This form is cheaper to create (it is just a matter of keystroking numbers and letters on a computer;
no need for fancy illustrations and calligraphy and cumbersome printing) and to track (centralized
accounting of dollar amount due and owners, quick crediting and debit of dollar amounts by keystroking on
the computer).
25
Figure 2.13 An old fashion bond

Figure 2.14 shows that a wide variety of economic entities are interested in buying such financial
instruments with an outstanding value of a little less than $12 trillion in 2015. Insurance companies, pension
funds, and, more recently, mutual funds have been major purchasers of corporate bonds and in 2015 held
about 50 percent of all corporate bonds, down from 85 percent in the 1960s. Today, other financial
institutions, such as exchange-traded funds and the rest of the world, have become major holders of
corporate bonds, with the rest of the world owning about 25 percent of outstanding corporate bonds in
2015.
Figure 2.15 shows that issuers of corporate bonds have also diversified considerably since 1945.
Nonfinancial businesses have been major issuers and so have been finance companies, but with the growth
of securitization in the 1980s, special purpose entities (“issuers of asset-backed securities” or ABS issuers)
have become major issuers. By 2007, 40 percent of outstanding corporate and foreign bonds were issued
by them. However, since the Great Recession, the volume of corporate bonds issued by ABS issuers has
diminished considerably. In 2015, only 10 percent of outstanding corporate and foreign bonds were issued
by ABS issuers.
26
Figure 2.14 Structure of ownership of corporate and foreign bonds (percent) and dollar amount
outstanding (trillions of dollars)
Note: “Others” includes money market mutual funds, exchange traded funds, security brokers and
dealers, and federal, state and local governments, among others.
Figure 2.15 Structure of issuers of corporate and foreign bonds, percent

27
A type of corporate bond that was at the center of the 2008 financial crisis is the private-label mortgage-
backed security (PL MBS). Figure 2.16 shows that in six years the dollar amount of PL MBS rose tenfold from
$200 billion in 2001 to over $2 trillion in 2007. In the Financial Accounts, the sector that issues them is called
“issuers of asset-backed securities,” which are special purpose entities created by private depository
institutions to hold mortgages and other financial instruments (see Chapter 17 on securitization). While
most PL MBSs were initially held by depository institutions (they bought the securities issued by the special
purpose entities they created), for reasons explained in the Chapter on securitization, government-
sponsored enterprises, insurance companies and the rest of the world came to hold 90 percent of them by
2000. Insurance companies and the rest of the world were especially eager to buy PL MBSs when their
issuance boomed in the early 2000s.
Figure 2.16 Structure of ownership of private-label mortgage backed securities and other asset-backed
bonds (percent) and dollar amount outstanding (trillions of dollars)
Commercial papers and corporate bonds are two debt instruments that satisfy widely different needs of
corporate businesses, but private companies are not the only issuer. The United States Department of the
Treasury (“the Treasury”) is a major issuer of debt instruments—called Treasuries—with terms to maturity
ranging from 1 month to 30 years. The name of a Treasury security changes depending on its initial term to
maturity. Treasury bills (T-bills) are Treasuries with an initial term to maturity of one year or less, Treasury
notes (T-notes) have an initial term to maturity between 2 and 10 years, and Treasury bonds (T-bonds) have
an initial term to maturity of more than 10 years. Also contrary to T-notes and T-bonds, T-bills do not pay a
coupon, and so the reward to holders comes in a different form, which is presented in Chapter 14. At the
statistical level, when the government compiles the size and structure of the public debt, the government
changes the classification a Treasury security as it gets closer to mature. Treasuries with an initial maturity
of 30 years are first classified as T-bonds, but, once 20 years have passed, they are classified as T-notes. As
explained in Chapter 9 and throughout this book, Treasuries are a cornerstone of the financial system. The
Treasury actively manages the level and structure (that is, proportions) of outstanding Treasuries to meet
the needs of other participants of the financial system and to help promote financial stability.
28
Figure 2.17 shows a similar trend to corporate equities with an internationalization of ownership and a
growing importance of money managers, especially pension funds. In 2015, about 40 percent of the $15
trillion of outstanding Treasuries held by the public were held by foreigners (foreign central banks, foreign
Departments of the Treasury, foreign businesses and households, and other foreign entities), and about 25
percent were held by money managers. A major difference with corporate equities is that the Federal
Reserve (“Fed”) has been a major holder of Treasuries. Since 1945, the Fed has usually held at least 10
percent of outstanding Treasuries. Chapter 7, Chapter 8 and Chapter 9 explain why Treasuries are central
to the operations of the Fed.
While the federal government is a major issuer of debt instruments, states and localities also issue them—
municipals or “munis”—and the issuance of new bonds to fund specific projects is often put on the ballot.
Municipals can be structured in two different ways: revenue bonds are issued to finance a specific project
(a toll bridge, etc.) which revenues will serve to pay the coupon and principal, while general obligation
bonds are issued to finance any project and are paid back with tax revenues. The outstanding dollar amount
of munis reached a little less than $4 trillion in 2015 and ownership has been highly diversified and mostly
domestic since 1945 (Figure 2.18).
Figure 2.17 Structure of ownership of Treasuries (percent) and dollar amount outstanding (trillions of
dollars)
Note: Treasuries held by intra-federal agencies are not included. For example, the United States Social
Security Administration holds a substantial dollar amount of Treasuries in its trust fund.
29
Figure 2.18. Structure of ownership of Municipals (percent) and dollar amount outstanding (trillions of
dollars)
Note: Others include the rest of the world, closed-end funds, exchange-traded funds, security brokers and
dealers, among others.
Other major issuers of debt instruments are federal agencies, government-sponsored enterprises (GSEs)
and the special purpose entities they back, which altogether issue securities called agency securities. Two
prominent GSEs are the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan
Mortgage Corporation (“Freddie Mac”). Their purpose is to promote homeownership, and they finance
their operations by issuing mortgage-backed securities. A federal agency called Government National
Mortgage Association (“Ginnie Mae”) helps further promote homeownership among veterans and low-
income households by guaranteeing payments on their mortgages in case of default and by issuing
securities backed by these mortgages. While not explicit, financial-market participants believe that, in case
of financial difficulties, the federal government will help GSEs—a belief that turned out to be correct as the
2008 financial crisis showed—, so securities issued by GSEs are considered very safe, which leads to a very
high demand for them. Federal agencies are part of the federal government and so their securities are
considered to be without credit risk, like Treasuries.
In 2015, there was about $8 trillion worth of agency securities (“Agency- and GSE-backed securities”),
outstanding and the ownership was highly diversified (Figure 2.19). While private depository institutions
were at first the main holders of agency securities, once again money managers and the rest of the world
have become major holders. Recently, the Federal Reserve has also become a major bearer of agency
securities by holding 20 percent of them following its massive purchases of financial instruments to help
contain the effects of the 2008 financial crisis (see Chapter 7 and Chapter 8). As Figure 2.20 suggests, GSEs
also had to intervene to help the special purpose entities (“mortgage pools”) they backed by buying their
securities and through the issuance of GSE securities backed by the purchased MBS.
30
Figure 2.19 Structure of ownership of Agency- and GSE-backed securities (percent) and dollar amount
outstanding (trillions of dollars).
Note: Agency- and GSE-backed securities include securities guaranteed or issued by US federal agencies
(Tennessee Valley Authority, Ginnie Mae, among others), securities issued by government-sponsored
enterprises (Fannie Mae, Federal Home Loan Bank, among others), and securities issued by special
purpose entities created by Ginnie Mae, Fannie Mae, Freddie Mac, and the Farmers Home Administration
to pool mortgages and mortgage-related securities.
31
Figure 2.20 Structure of issuer of Agency- and GSE-backed securities (percent).

MONETARY INSTRUMENTS
Monetary instruments are the last type of marketable financial instruments. Chapters 19 and 20 are
devoted to their analysis. One of the main characteristics of monetary instruments is that their term to
maturity is instantaneous, that is, they can be returned to the issuer at the will of the bearer—they are
redeemable on demand. In terms of cash, that is physical monetary instruments, the Financial Accounts of
the United States make a difference between currency, Treasury currency, and coins. Coins are not included
in the Accounts, currency refers to cash issued by the Federal Reserve (Federal Reserve notes), and Treasury
currency refers to cash issued by the US Treasury (the Treasury no longer issues any currency, but some of
it still circulates). Unless stated otherwise, the term “currency” will be used to include paper-made
monetary instruments issued by both the Federal Reserve and the Treasury. In 2015, the outstanding dollar
amount of currency was $1.5 trillion, and Figure 2.21 shows that 95 percent of that was held by the
domestic non-federal sectors and the rest of the world. In 2015, about 40 percent of the US-dollar-
denominated currency outstanding was held by the rest of the world, and about 55 percent was held by
the domestic private sector. The ownership structure of Treasury currency outside the Federal Reserve is
not provided by the Financial Accounts, but most of it must be held by the domestic private sector. The
Federal Reserve is a significant holder of Treasury currency although the significance of its holding has
shrunk over time. In 1945, Federal Reserve’s holdings of Treasury currency represented about 10 percent
of outstanding currency, but, by 2015, it represented less than 5 percent of outstanding currency.
32
Figure 2.21 Structure of ownership (percent) and level (trillions of dollars) of US currency and US Treasury
currency
Source: Board of Governors of the Federal Reserve System (series Z.1)
Note: Currency means Federal Reserve notes, Treasury currency includes banknotes no longer issued by
the Treasury but that the Treasury did not demonetize (United States notes, silver certificates, pre-1933
Federal Reserve notes convertible into gold coins at the Treasury, among others)
Beyond currency, another familiar monetary instrument is the checking account (aka checkable deposit)
and its outstanding amount was slightly less than $2.5 trillion in 2015. Checking accounts are held by all
sectors of the economy and, again, the rest of the world has held a growing proportion of US-dollar
denominated checking accounts (Figure 2.22). Following the definition of the Financial Accounts, currency
(Federal Reserve notes) and checkable deposits have been issued by two entities, the private depository
institution (private checking accounts) and the Federal Reserve (currency and checking accounts issued to
the Treasury, government-sponsored enterprise and the rest of the world). Figure 2.23 shows that from
1945 until 1990, the checking account issued by private depository institutions represented 75 percent of
outstanding checkable deposits and currency. Since 1990, the proportion issued by the Federal Reserve has
grown to 40 percent of outstanding currency and checkable deposits in 2015.
If one moves away from the narrow definition of checking accounts used by the Financial Accounts to
include all existing checking accounts and currency outstanding in the Financial Accounts, then one must
include the checking accounts issued by the Federal Reserve and the Federal Home Loan Bank to private
depository institutions. One must also include currency in the vault of private depository institutions.
Figures 2.24 and 2.25 show the implication of including these elements in the statistical analysis. The 2015
outstanding amount of checkable deposits and currency jumps to $6 trillion instead of $4 trillion (see
Chapter 7 for an explanation). The proportion of currency and checking accounts held by banks had been
declining from 1945 until 2008 to less than 10 percent of the outstanding dollar amount, but the financial
crisis led to a jump to 40 percent of all currency and checking accounts. From 1945 until 1990, the Federal
Reserve issued about 30 percent of the outstanding currency and checking account; this proportion rose
slowly in the 1990s and jumped to 60 percent following the 2008 financial crisis.
33
Figure 2.22 Structure of holders (percent) and level (trillions of dollars) of checkable deposits and currency
held by all sectors except private depository institutions
Source: Board of Governors of the Federal Reserve System (series Z1, Table L. 204)
Note: Checkable deposits held by private depository institutions at the Fed (“reserve balances”) are not
included in the Financial Accounts’ definition of checkable deposits. “Private financial businesses” includes
checking accounts issued by private depository institutions that are held by security brokers and dealers,
government-sponsored enterprises, pension funds, insurance companies, finance companies, money
market mutual funds and real estate investment trusts.
34
Figure 2.23 Structure of issuers of checkable deposits and currency held by all sectors except private
depository institutions
Source: Board of Governors of the Federal Reserve System (series Z1, L. 204)
Note: Monetary authority issued checkable deposits to the Federal government, the rest of the world,
and government-sponsored enterprises. Checkable deposits issued by the Federal Home Loan Banks to
private depository institutions are not included in Table L.204, checkable deposits issued by the Federal
Reserve to private depository institutions are also not included.
35
Figure 2.24 Structure of holders (percent) and level (trillions of dollars) of checkable deposits and currency
held by all sectors
Note: “Other private financial businesses” are the same as “private financial businesses” in Figure 2.22.
Figure 2.25 Structure of issuers of checkable deposits and currency held by all sectors, percent.
Source: Board of Governors of the Federal Reserve System (series Z1)
Note: Monetary authority issued checkable deposits to the Federal government, the rest of the world,
and government-sponsored enterprises, and private depository institutions.
36
NON-MARKETABLE FINANCIAL INSTRUMENTS

While many financial instruments can be traded among bearers, a large number of financial instruments do
not have an active market in which they can be traded. Once a bearer has decided to acquire that type of
instrument, it is difficult, if not impossible, for him to part with it. The bearer must wait for the financial
instrument to mature, or a willing issuer to repurchase it before maturity. Chapter 17 will explain how banks
and other financial-market participants have gone around this constraint by securitizing non-marketable
claims.
Maybe the most well known non-marketable financial instrument, especially after the 2008 financial crisis,
are mortgages. Mortgages are medium- to long-term financial instruments that are secured by residential
or commercial real estate (home, apartment building, store, among others). The issuer promises to pay
some interest income on a monthly basis and to repay the principal owed by the time of maturity. If the
mortgagor (the issuer of the mortgage like a household who buys a house) defaults, the mortgagee (the
bearer of the mortgage) can foreclose on the property, that is, the mortgagee can take ownership of the
property, evict the current resident, and sell the property to try to recover any unpaid interest income, fees
and principal owed. Figure 2.26 shows that the percentage of outstanding home mortgages in foreclosure
quadrupled in the late 2000s, with 4.5 percent of outstanding home mortgages in the process of foreclosure
compared to around 1 percent for 20 years prior to the Great Recession. Millions of households lost their
homes and had to find alternative housing. Although home foreclosures are back down today, evictions are
not because renters are now facing threats of eviction following a rapid increase in rent prices after the
financial crisis.
Figure 2.26 Percentage of residential home mortgages in the process of foreclosure, percent
Source: Mortgage Bankers Association (National Delinquency Survey)
Figure 2.28 shows that four main sectors issue, or issued, mortgages. Households are the main issuer with
70 percent of outstanding mortgages issued by them in 2015, followed by nonfinancial noncorporate
businesses (mostly small businesses) that issued 20 percent of outstanding mortgages. The rest of
outstanding mortgages was issued by nonfinancial corporations, the federal government, and real estate
37
investment trusts. The outstanding dollar amount of mortgages in 2015 was around $13 trillion and they
are held by a wide variety of sectors (Figure 2.27). Until the 1970s, households, insurance companies and
private depository institutions together held about 90 percent of all outstanding mortgages. After that, the
rise of securitization led to a change in the structure of ownership of mortgages away from private
depository institutions toward issuers of mortgage-backed securities. Private depository institutions
continued to be the main initial bearer because households and small business companies go to see them
to fund the purchase of real estate property (land, house, commercial building, among others). However,
once private depository institutions have obtained the mortgage note, they may sell it to a government-
sponsored enterprise or to special purpose entities (“Issuers of asset-backed securities”). Government-
sponsored enterprise may also sell the mortgage note to their own special purpose entities (“Agency- and
GSE-backed mortgage pools”). As a consequence, the proportion of mortgages held by special purpose
entities peaked to 45 percent right before the Great Recession. Following the Great Recession, GSEs bought
back from their special purpose entities a large proportion of the mortgages, so the proportion of mortgage
held by GSEs went from 5 percent to 35 percent.
Figure 2.27 Structure of issuers of mortgages, percent.

Source: Board of Governors of the Federal Reserve System (series Z1, L.217)
Note: Between 1957 and 1965, the federal government, via the Department of Defense, issued multi-
family mortgages (that is mortgages backed by dwellings housing multiple families) to build housing for
military families under the 1955 Capehart Housing Act.
38
Figure 2.28 Structure of holders (percent) and level (trillions of dollars) of mortgages.
Mortgages deal with long-term financial needs to purchase expensive physical assets. Households also need
funds for their daily expenses: to go to school, to buy food, to buy a car, among others. The category
“consumer credit” regroups all sorts of secured and unsecured financial instruments issued by households
with short- to medium-terms to maturity that are not marketable; credit card receivables, automobile
debts, student debts, health care debts, among other debts (Figure 2.30). Some of these financial
instruments, such as automobile debts, are secured (if a household defaults, the bearer of the note takes
the car and resells it). All of them promise to pay interest and principal periodically and on time.
Figure 2.29 shows that the outstanding amount of consumer credit has grown rapidly since the early 1990s
to reach $3.6 trillion in 2015. Until 1990, private depository institutions and finance companies were the
main holders of consumer credit. In the 1990s, with the rise of securitization, private depository institutions
sold some of their holdings to ABS issuers that held up to 20 percent of outstanding consumer credit prior
to the 2008 financial crisis. After 2008, private depository institutions repurchased from ABS issuers most
of the consumer debts that they sold to them. The federal government, through student debt, also has
come to hold a large and growing proportion of all consumer credit (25 percent in 2015).
Households and small businesses are not the only ones who issued non-marketable securities. The US
Treasury is a major issuer of such financial instruments. These are not marketable either because they are
issued to a specific person and so are not transferable (US savings bonds are issued to a specific individual
and so the coupon and principal can only be paid to that individual), or are held for internal purpose within
different agencies of the federal government. While US savings bonds (issued to households) used to be
the main type of non-marketable Treasury securities, in 2015 there were $2 trillion of non-marketable
Treasury securities and 90 percent of them were held by various federal government retirement funds
(Figure 2.31).
Other non-marketable financial instruments include pension entitlements and insurance contracts. These
types of financial instruments are contingent, that is, they make payments to the bearers when an
event/contingency occurs (retirement, car crash, etc.). In exchange, bearers have to make a periodic
39
payment to the issuer of these contracts (insurance premium, contributions to retirement accounts, etc.).
Chapter 3 studies them more carefully. For example, the outstanding amount of pension entitlements
(retirement savings plans such as individual retirement accounts and annuities) owed to households was
about $21 trillion in 2015. While the federal government retirement funds used to be the main issuers of
retirement savings plans with 60 percent of outstanding contracts, today that proportion has shrunk to 20
percent. State and local government pension funds and private providers of pension (pension funds and life
insurance companies) are now the main issuer of retirement savings plans (Figure 2.32).
Figure 2.29 Structure of holders (percent) and level (trillions of dollars) of consumer credit.
Notes: Non-profit organization holdings represent student debt originated under the Federal Family
Education Loan Program. Federal government holding includes debt originated by the Department of
Education under the Federal Direct Loan Program and Perkins Loans, as well as Federal Family Education
Loan Program, financial instruments that the government purchased from depository institutions, finance
companies, and nonprofit and educational institutions, and financial instruments in default.
40
Figure 2.30 Types of consumer credit, percent.

Note: Revolving consumer credit includes mostly credit card debt but also other miscellaneous consumer
credit such as overdraft plan on checking accounts (that is the ability to have a negative balance on a bank
account that is renewed as long as it is repaid in due time). Home equity lines of credit are not included in
revolving consumer credit, which are unsecured financial instruments, but are part of outstanding
mortgages.
Note: Prior to Q1 2006, “other student debts” is included in non-revolving consumer credit.
41
Figure 2.31 Type (percent) and outstanding dollar amount (trillions of dollars) of non-marketable
treasuries.
Source: Board of Governors of the Federal Reserve System (series Z.1, part of L.210)
42
Figure 2.32 Structure of issuers (percent) and level (trillions of dollars) of pension entitlements.
Note: Life insurance contracts consist in annuities, private pension funds contracts include unallocated
insurance company contracts beginning 1985:Q4, federal government contracts includes the Thrift
Savings Plan, the National Railroad Retirement Investment Trust, and other federal government
retirement funds.
CONCLUSION
There is a very wide range of financial instruments issued in the United States that vary in terms of term to
maturity, the type of income paid, the protection provided, among others. One may wonder why so many
different types of financial instruments are issued. One of the reasons is that issuers have different needs;
a household does not need, or want, to fund its grocery shopping with a 30-year mortgage. Buying a house
with a credit card, if possible, would be expensive and cumbersome. Another reason is that bearers have
different needs. Given the nature of their own liabilities (presented in Chapter 3), pension funds much
prefer to hold long-term securities that are safe, while money market mutual funds prefer short-term
securities. As such, the US Treasury, one of the main issuers of securities, actively managed the structure
of Treasuries to accommodate the needs of bearers. For example, if bearers want more long-term
treasuries, the US Treasury will consider those needs when it issues new Treasuries.
Not everybody can issue marketable financial instruments because the financial, legal, and administrative
requirements to meet are too high. For example, most individuals and small businesses do not need much
more than a few hundred of thousand of dollars—a few million at best—to buy a house and other assets.
This is not interesting to financial market participants that deal mostly with economic units who want to
raise hundreds of millions, or billions, of dollars. Similarly, the earnings of households and small businesses
are too small to provide an attractive income to financial market participants. Finally, to be able to issue
bonds and keep them listed of an organized exchange (see Chapter 3), one must go through several costly
and cumbersome steps such as releasing quarterly accounting documents (balance sheets and others).
Some celebrities, such as David Bowie, have been able to issue personal bonds (“Bowie bonds”), but they
43
needed tens of millions of dollars ($55 million for David Bowie, a small issuance) and have earnings (such
as music royalty revenue streams) that are large and stable enough to make payments due on the bonds.
The fact that there is such a wide variety of financial instruments that can be issued in the United States
make the financial sector highly accommodative of the financial needs of households, businesses and
governments. This promotes economic activity and financial security as long as the issuance of financial
instrument is done properly, which is not always the case as explained in Chapter 19.
Finally, within a country, there is a hierarchy of financial instruments, in the sense that some are more easily
accepted. The most widely accepted financial instruments are those that are negotiable, of the highest
creditworthiness, of the highest liquidity, and of the shortest term to maturity. In contemporary economies
with a monetarily sovereign government, central-bank monetary instruments (Federal Reserve notes and
checking accounts issued by the Federal Reserve) are at the top of the hierarchy. They are followed by bank
monetary instruments (banknotes, if possible, and bank accounts). Below monetary instruments are
financial instruments traded on an organized exchange. They are issued mostly by governments (U.S
Treasuries, municipal bonds, etc.) and corporations (shares, bonds, notes, bills, etc.); instruments issued by
national government are more easily accepted than other marketable financial instruments. At the bottom
of the hierarchy are all sorts of promises such as local currencies and personal non-marketable financial
instruments. This hierarchy is not fixed and, throughout history, the top monetary instrument was not
always a government monetary instrument. Figure 2.33 shows a classification of the domestic financial
instruments presented above from the most accepted (government monetary instruments) to the least
accepted (non-marketable financial instruments). One may note in passing that Figure 2.33 assumes a
monetarily sovereign government, an issue of great importance as explained in Chapter 9 and Chapter 24.
Gov.
monetary
instruments
Private bank
monetary
instruments
National government
marketable
instruments
Other
marketable
instruments
Non-marketable
instruments and
others
Figure 2.33 Hierarchy of some financial instruments issued in the United States
Figure 2.34 shows the outstanding dollar amount and structure of all the financial instruments presented
above together with a few others. Note that off-balance sheet derivative contracts (see Chapter 18) are not
included, although their outstanding value is around $700 trillion. Other instruments not included are
special drawing rights, US-dollar denominated foreign account (Eurodollars), and other items in the
Financial Accounts such as tax payables and trade payables. In 2015, there was about $160 trillion of
outstanding financial instruments in the United States (all of them valued at book value except equity
44
instruments that are valued at market price). In 2015, 12 percent of them were monetary instruments and
close substitutes (categories 1 to 4) and consisted mostly of time and savings accounts. Another 15 percent
were non-marketable financial instruments, mostly mortgages (categories 5 to 8). About 25 percent were
debt instruments (categories 10 to 14), 30 percent were equity instruments (categories 15 to 18), and 15
percent were contingent financial instruments (life insurance, pension, property insurance contracts)
(Categories 19 to 21). The rest were trade credit that represented about 3 percent of outstanding financial
instruments.
1 Currency and Treasury currency in circulation 12 US Treasuries

2 Checking accounts at Monetary Authority and FHLB (includes reserve balances) 13 Agency securities
3 Checking account at private depository institutions 14 Municipals
4 Time and savings accounts at private depository institutions 15 Corporate equities
5 Consumer credit 16 Closed-end funds and ETF shares
6 Mortgages 17 Mutual funds shares
7 Others advances by private depository institutions 18 MMMFs shares
8 Other advances 19 Life insurance reserves
9 Trade credit 20 Pension entitlements
10 Open market paper 21 Policy payables of property and casualty insurance companies
11 Corporate and foreign bonds
Figure 2.34 Structure (percent) and outstanding dollar amount of most financial instruments included in
the Financial Accounts (trillions of dollars)
Note: Contrary to the Financial Accounts, category 2 includes checking accounts of private depository
institutions (“reserve balances”). Following the Financial Accounts, currency in circulation means currency
outside banks and the federal government plus vault cash. Life insurance reserves represents the
discounted value of expected payments by life insurance.
45

1- Finance is a world of promise, some issue promises, the issuers, others accept the promises, the bearers.
2- Financial promises are different from nonfinancial promises because the former involves monetary
payments.
3- Financial instruments are the formal and legal representation of a financial promise.
4- A wide variety of financial instruments can be issued, and they have different names to reflect their
different financial characteristics.
5- The broader the spectrum of financial instruments that can be issued, the more flexible the financial
system is in its ability to accommodate the needs of issuers and bearers.
6- There are three broad categories of marketable financial instruments: equity instruments, debt
instruments, monetary instruments.
7- In any economy, there is a hierarchy of financial instruments because some are more widely accepted
than others are.
Keywords
Creditworthiness, deficit, surplus, face value, issuer, unit of account, term to maturity, reflux mechanisms,
redemption, collateral, unsecured, secured, marketable, liquid, capital gain/loss, deep market, credit risk,
prepayment risk, default, delinquent, foreclosure, callable, collateral risk, liquidity risk, equity instrument,
debt instrument, monetary instrument, dividend, coupon, common stock, preferred stock, money
manager, institutional investor, subordinated, interest income, Treasuries, T-bill, T-note, T-bond, Treasuries
held by the public, municipals, revenue bond, general obligation bond, agency securities, insurance
premium, monetarily sovereign government.
Review Questions
Q1: What are the broad characteristics of a financial instrument?
Q2: In order for a financial instrument to exist, there must be an issuer and a bearer, why?
Q3: What happens when a financial instrument is issued?
Q4: What happens when a financial instrument is redeemed? When can a financial instrument be
redeemed?
Q5: If someone accepts a financial instrument, what are some of the potential risks?
Q6: How does the price of a liquid financial instrument behave compared to the price of an illiquid financial
instrument?
Q7: What makes a financial instrument liquid?
Q8: Why is it difficult for most individuals to issue securities?
Q9: Why are there financial instruments with different characteristics?
Q10: Who are the two main issuers and the two main bearers of the different types of financial instruments
presented above?
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CHAPTER 3:

What the main concerns of for-profit financial institutions are
How the business purpose influence the structure of the balance sheet
What the different financial companies do and how they do it
Why there is a need for different types of financial companies
That the federal government does not operate with the goal of being
profitable
That the federal government operates smoothly despite a massively negative
net worth
That the federal government heavily manages and subsidizes the U.S.
financial sector
How the financial sector has changed over the past 40 years
CHAPTER 3: FINANCIAL INSTITUTIONS: AN OVERVIEW
Financial companies are involved in creating, buying, selling, and pricing financial instruments. Given the
multitude of financial instruments that carry different sorts of risks and the complexity involved in issuing
and trading financial instruments, financial companies tend to specialize in specific aspects of the financial
sector:
- Activities surrounding marketable financial instruments: the creation and maintenance of a market
in which securities can trade require many resources, and some companies specialize in the
provision of such resources. They set up a trading platform and determine the rules for quoting
securities, trading securities, issuing new securities and many other aspects necessary to make
trading smooth. Other companies focus on ensuring that issuance can be done properly and that
issuers continuously meet the requirements of the platform.
- Providing opportunities to diversify asset portfolios: some financial companies provide
opportunities for economic units with a surplus of funds to pool funds to buy financial and
nonfinancial assets that provide higher rates of return, and, possibility, to use leverage to do so.
- Promoting specific economic activities that are deemed socially beneficial but riskier and/or less
profitable: private companies and government work together to provide low cost sources of funds
to specific economic units.
- Risk management and evaluation: some financial companies provide opinions about the
creditworthiness of issuers of financial instruments to determine which economic activity is viable,
and to guide the asset-portfolio decisions of financial market participants (what to buy, what to
sell).
- Providing and managing a payment system: a smooth economic system requires that payments be
done efficiently and reliably.
The specific functions performed are reflected in the structure of the balance sheet of each financial
institution. Their asset portfolio, that is the type of assets they hold, will contain financial instruments that
are more or less liquid, more or less due in the long term, and more or less secured. The structure of their
liabilities will contain a different proportion of contingent liabilities (claims that are due if an event happens,
such as, an accident or retirement), demand liabilities (claims that are due whenever claimants require it,
such as, withdrawals of cash from checking accounts, or the repurchase of shares on demand), and dated
liabilities (claims that are due after a certain time, such as the requirement to pay an interest periodically).
MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY

All for-profit financial companies ultimately have two core objectives: profitability and liquidity.
Profitability is the ability of a company to generate an income greater than its expenses so that it can
accumulate some net worth over time. Liquidity is about ensuring that enough cash and other liquid assets
are available at any time to meet immediate payments due to creditors. For-profit companies must meet
these two objectives to maintain their solvency, that is, their ability to pay creditors. Put differently solvency
can be judged in two ways:
- Cash-flow solvency: The capacity to acquire positive net cash inflows.
- Balance-sheet solvency: The capacity to generate a positive net worth so that if cash inflows are
insufficient one can repay creditors by selling assets.
For example, if a commercial bank is facing a bank run—many of its customers are lining up at the same
time to cash out their bank accounts—there are several possible outcomes depending on the structure of
the balance sheet of the bank:
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- Case 1: The balance sheet looks like this:

Assets Liabilities
Vault cash = $100 Accounts = $100
There is no net worth, but all the assets are liquid. The bank is liquid today (so it can respond to the
run) but is not profitable. The bank is solvent today but insolvent in the future because the bank
cannot pay its daily expenses such as salaries and electricity.
Assets Liabilities
Illiquid financial
instruments = $90
There is no equity in the bank and most financial instruments are illiquid. The bank is illiquid (it
cannot tackle a run on its own) but it is potentially profitable (illiquid financial instruments pay an
interest income). A run makes the bank insolvent today although the bank is solvent in the future
if it is given some time to operate, because it will receive income and will build equity.
Assets Liabilities
Illiquid financial Capital = $50
instruments = $50
There is some equity and the bank is profitable and has enough liquid assets. The bank can tackle a
bank run on its own and be profitable over time.
The necessity to stay solvent will lead to a different structure of assets given the structure of liabilities. For
example, a financial company will need to keep more liquid assets if it has a high proportion of demand
liabilities and/or highly unpredictable cash outflows. As such, banks that have a high proportion of demand
liabilities, must keep more cash on hand than pension funds that have a high proportion of long-term dated
liabilities and highly predictable cash outflows.
The following sections review the main characteristics of different financial companies and illustrate them
by using mostly the Financial Accounts of the United States. The Financial Accounts aim at measuring the
outstanding, and change in the, dollar value of nonfinancial assets, financial assets, financial liability, and
net worth of many different sectors of the economy. This goal is achieved imperfectly because the dataset
relies on many sources of data that are imperfect, incomplete, and rely on surveys and estimations. The
Financial Accounts also ignores some assets, such as land or coins, and do not capture well what goes on in
some corners of the financial sector because many of these activities are off-balance sheets and/or
unregulated, and so limited or no data is available. The dataset is also constantly changing with some
sectors and some instruments added or removed. Despite its limitations, the Financial Accounts of the
United States provide invaluable information about the financial states of different economic sectors, and
it is a core dataset for economic analysis.
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PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND

THRIFTS
Private depository institutions are financial companies in which one can open checking accounts. These
accounts give access to the payment system of private depository institutions—account holders can make
payments to someone else who has an account at any private depository institution—and are convertible
into cash on demand. These financial companies are commonly known as “banks” and they provide the
following financial services:
- Credit services: Evaluate the creditworthiness of deficit-spending economic agents through
screening (i.e. selection) and monitory (i.e. supervision).
- Payment services: Settle debts, transfers of funds, provision of monetary instruments that can be
used on banks’ payment system.
- Retail portfolio-management services: Provide portfolio management opportunities for savers to
earn better interest rate on savings.
In order to operate as a bank, depository institutions must obtain a charter that allows them to operate
either in a state (state bank) or on the entire territory (national bank). Chapter 10 through 13 examine the
operations of banks in more details.
COMMERCIAL BANKS
U.S. Congress gave the first national charter to the Bank of North America in 1781 in Pennsylvania.
Commercial banks specialize mostly in fulfilling the financial needs of small businesses and households.
Figures 3.1 to 3.3 provide details about the volume and structure of the balance sheet of FDIC-insured
commercial banks since 1934. During World War 2, private depository institutions were asked to help
finance the war through large purchases of Treasuries and the Federal Reserve ensured that they had the
means to do so throughout the war (Chapter 9). Consequently, the proportion of Treasuries rose from 20
percent of assets to 55 percent by the end of the war. After WWII, commercial banks returned to fulfilling
the financial needs of private economic units. The proportion of mortgages in the portfolio of banks rose
progressively to peak at 30 percent of assets prior to the Great Recession. Consumer, industrial, and
commercial credit—that is, non-marketable financial instruments that are not mortgages and that are
issued by households and businesses—have also consistently represented about a third of the asset
portfolio of banks.
With the rise of wholesale funding sources (see Chapter 7), federal funds loans and security repurchase
agreements (RPs) have grown as a proportion of the assets of banks and peaked at 15 percent of assets
prior to the Great Recession. The proportion of cash and accounts held by commercial banks (“due from”)
shrank from 25 percent of all assets after World War Two to 5 percent right before the Great Recession,
but represents today about 10 percent of all assets following emergency monetary policy during the Great
Depression. The book value of outstanding assets was worth $15 trillion in 2015. The book value equals the
face value of financial instruments less amortization (repayment of principal) plus the purchased price of
nonfinancial assets less depreciation (an accounting measure of the expenses due to wears and tears). The
book value is different from the market value of assets, the price at which the assets could be sold at any
given time.
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Liabilities of commercial banks consist mostly of accounts due to the private domestic sector, which have
represented at least 60 percent of their liabilities. Accounts issued to domestic governments and foreign
entities used to add another 20 percent to liabilities but since the mid-1980s their importance has shrunk
considerably to about 5 percent of liabilities. In their place, “borrowed funds” have grown in importance
since the 1960s, marking the growth wholesale funding sources for banks. The proportion of demand,
savings, and time accounts have varied widely since 1934 and today savings accounts represent 70 percent
of all accounts out of the $10 trillion outstanding.
Overall, while commercial banks accept long-term illiquid financial instruments (20 percent of their assets
are mortgages), their assets consist mostly of short-to-medium term maturity or relatively liquid financial
instruments (Treasuries, cash, consumer and business credit, fed funds loans). This is necessary given the
nature of their liabilities that are mostly due on demand or on a short-term basis (demand and savings
account, fed funds debt, among others). Commercial banks usually do not have to keep much cash in their
vault because withdrawals in retail bank accounts tend to be highly predictable, but some liquid safe assets
are kept in significant proportion. The greater reliance on wholesale sources of funds has increased the
ability to operate with no or limited reserves and other liquid safe assets but regulators do set minimum
liquidity ratios in the balance sheet of banks.
Figure 3.1 Structure (percent) and level (trillions of dollars) of the assets of FDIC-insured commercial
banks
Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB09 to CB13)
Note: “Other types of credit” include various items that have changed over time such as unplanned
overdrafts and advances to brokers and dealers in securities, any debtor for the purpose of purchasing
and carrying securities, and credit to nonprofit institutions and organizations, real estate investment
trusts, mortgage companies, holding companies of depository institutions, insurance companies, finance
companies, foreign governments and official institutions, churches, among others.
Note: “Other securities” includes corporate bonds, corporate equities, among others.
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Figure 3.2 Structure of liabilities of FDIC-insured commercial banks

Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB14, CB15)
Note: “Other accounts” represents mostly accounts of foreign and domestic financial institutions and
accounts of foreign governments and official institutions.
Note: “Borrowed funds” represents federal funds purchased (that is borrowed), securities sold under
agreements to repurchase, demand notes issued to the US Treasury, mortgage indebtedness, liabilities
under capitalized leases and all other liabilities for borrowed funds. From 1934 to 1968 borrowed funds
does not include mortgage indebtedness, which is netted against bank premises.
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Figure 3.3 Structure (percent) and outstanding dollar amount (trillions of dollars) of bank accounts
Source: Federal Deposit Insurance Corporation (Historical Statistics on Banking, Tables CB14, CB15)
THRIFT INSTITUTIONS
SAVINGS INSTITUTIONS
Savings and Loan associations emerged in the 1830s as “building and loan associations.” The initial business
model of savings institutions consisted in holding mortgages issued by households and businesses, and
encouraging thrift by providing interest-earning bank accounts. Prior to 1980, there were important
differences with commercial banks such as:
- A cap on the interest rate they could pay on savings accounts that was higher than commercial
banks (Regulation Q)
- They could not offer checking accounts
- There were restrictions on the assets they could hold, mostly mortgages and safer assets.
The sector was deregulated in the 1980s following changes in monetary policy practices in the 1970s that
made the initial business model of savings banks unprofitable. Large risk taking and fraudulent activities
followed as savings institutions tried to return to profitability, which led to the Savings and Loan crisis in
the late 1980s. The sector was hit by high credit risk and the value of its financial assets fell by $600 billion
(Figure 3.4). The sector was hit again by the mortgage crisis during the Great Recession, after which the
outstanding value of assets was the same as in 1985 ($1.3 trillion).
Like commercial banks, by the end of WWII, Treasuries represented 50 percent of the financial assets of
savings institutions. With the rise of homeownership after the war, residential mortgages once again
became a large proportion of the asset portfolio of savings institutions, and by 1980 mortgages of all sorts
represented 80 percent of all financial assets. After 1980, agency securities, corporate and foreign bonds
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as well as consumer, industrial and commercial credit grew from about 10 percent of assets to 30 percent
of assets.
Time and savings accounts have always been the overwhelming liabilities of savings institutions, especially
so prior to 1980 when they represented usually over 90 percent of liabilities (Figure 3.5). After 1980,
checking accounts and individual retirement accounts (IRAs) grew in proportion to 10-15 percent of
liabilities. Debts owed to GSEs (Federal Home Loan Banks and Sallie Mae) also became a significant
proportion of the liabilities of savings institutions. Contrary to commercial banks, savings institutions do not
rely much on the federal funds market to borrow funds.
Figure 3.4 Structure (percent) and level (trillions of dollars) of savings institutions
Source: Board of Governors of the Federal Reserve System (Series Z.1, previously L.114)
Note: Savings institutions include state-chartered savings banks, federal savings banks, cooperative banks,
and savings and loan associations. The sector “savings institutions” was discontinued from the Financial
Accounts at the end of 2011 due to filing regulatory changes and was merged with U.S. chartered
depository institutions, which are part of commercial banks.
Note: “Other financial assets” includes corporate equities, checkable deposits, time and savings deposits,
reserves, municipals, commercial paper, among others.
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Figure 3.5 Structure of the liabilities of savings institutions

Source: Board of Governors of the Federal Reserve System (Series Z.1, previously L.114)
Note: “Other liabilities” include taxes payable, bank advances not classified elsewhere, corporate and
foreign bonds, among others.
CREDIT UNIONS
Determining the creditworthiness of a client is costly, especially for those who have never had access to
prior credit and have limited income and assets. In addition, the risk of losses for a bank are intrinsically
greater if the amount of collateral available is limited or non-existent. Consequently, traditional banks are
reluctant to provide credit to poor, small, and rural economic units. Credit unions emerged in the 1910s in
the United States to service the credit needs of economic units that were not served well by commercial
banks.
Credit unions perform similar services as the thrifts and commercial banks but credit unions are local
cooperative, non-profit, tax-exempt associations. Given their non-profit nature, compared to traditional
bank they can offer a slightly higher interest rate on savings account, and a slightly lower interest rate when
granting credit. However, their business model is mostly localized and may not fit the needs of customers
that operate nationally or internationally. In addition, contrary to commercial banks and savings
institutions, not everyone can become a customer of a credit union. The law requires that a credit union
defines a field of membership, that is, that it states what the common bond is between its members. That
common bond can be narrow or broad depending on how the credit union is set up; a common employer,
a church, living in certain local counties, among others, are common criteria.
Figure 3.6 shows that the outstanding value of their assets was $1.2 trillion in 2015. Contrary to savings
institutions, they were not hit by the Great Recession; the non-profit nature of credit unions did not push
them to lower their credit standards to reach a profitability target. While credit unions did buy some
Treasuries during World War 2, this financial instrument never became more than 25 percent of their
financial assets. After the War, the financial assets of credit unions mostly consisted of mortgages, but they
rapidly specialized in providing consumer credit. In the 1990s, home mortgages (single-family housing
55
mortgages and home equity line of credit) grew again as a proportion of financial assets from 10 percent to
over 30 percent. Agency securities also became significant assets during that period to reach about 20
percent of their financial assets. Their main liabilities have been quite similar to savings institutions, with
time and savings accounts as the main liability and individual retirement accounts (IRAs) and checking
accounts gaining in importance in the 1980s. Credit unions have relied on the federal funds market even
less than savings institutions (Figure 3.7).
Figure 3.6 Structure (percent) and level (trillions of dollars) of the assets of credit unions.
Source: Board of Governors of the Federal Reserve System (Series Z.1, L.114)
Note: “Other financial assets” includes federal funds sold and repurchase agreements, municipal
securities, corporate and foreign bonds, and commercial paper, among others.
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Figure 3.7 Structure of the liabilities of credit unions

Note: “Other liabilities” includes federal funds and repurchase agreements, among others.
INSURANCE COMPANIES
Insurance companies issue policies that promise to provide protections against specific contingencies
(probable events) that adversely impact the balance sheet and income of an economic unit. Retirement
leads to a loss of income, an earthquake destroys a house, a car crash leaves someone without a car and
badly injured, the death or illness of a spouse leaves other family members in poverty. Economic units who
want financial protection must pay a periodic premium that is a main source of income for insurance
companies. This business model is profitable as long as contingencies—and so payouts to affected insured
economic units—are not too frequent nor too severe. In order to ensure that this is the case, insurance
companies protect themselves by screening and monitoring policyholders, and by ensuring that customers
have something to lose if they do not behave properly once they are insured. Insurance companies also
insure themselves.
In order to avoid adverse selection, that is, to avoid attracting mostly high-risk customers (sick individuals,
reckless drivers) before a policy contract is signed, insurance companies rely on screening. One must fill up
forms asking questions about age, sex, life habits, marital status, family illness, among others, in order to
determine the probability of occurrence of the contingency against which a client wants protection. The
probability is not established by studying the character of an individual but by relying on statistics. Long-
run data shows that motorcyclist have a much higher chance to get in a fatal crash, young male drivers are
at higher risk to get in a fatal car crash, someone with a history of cancer running in the family has a higher
chance to get cancer, American Indian women have a lower risk of getting breast cancer than white women.
Once the screening is done, an insurance company, either will refuse to insure a potential customer because
the risk is too high, or will adjust the premium to the risk; young single male drivers pay a much higher
premium than middle-aged married males.
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In order to avoid moral hazard, that is, to ensure that insured customers do not become careless once they
are insured—thereby raising the probability of a contingency—insurance companies make sure that its
clients have some stake in limiting risk taking. They do so by making sure that if the contingency does occur,
the client still has to incur some expenses. One way to do so is to set a deductible, that is, a minimum
amount that the client has to pay before reimbursement by the insurance company starts. For example, if
a medical insurance contract states that the annual deductible is $2000, the sum of medical expenses
incurred by an individual for the year has to reach $2000 before reimbursement starts. An insurance
company may also require coinsurance, that is, that the clients cover a percentage of any expense beyond
the deductible, such as 10 percent of medical expenses beyond $2000. Finally, insurance companies may
also require copayments beyond the deductible, that is, payments each time insurance service is requested.
Copayments are not counted toward meeting the deductible, only medical expenses are.
The reader may note that moral hazard and adverse selection are not limited to insurance companies. They
apply to all financial institutions. We will encounter them again in the Chapters on banking (Part 3).
LIFE INSURANCE COMPANIES
They emerged in the early 1800s to provide insurance services against loss of income induced by death,
disability, old age and other health problems. Cash outflows are highly predictable because probabilities
about life expectancy are well established and stable. Therefore, most of the funds earned are placed into
less liquid to illiquid assets. Similar to commercial banks, Treasuries used to represent a large proportion of
the assets of life insurance companies but that changed rapidly after WWII. Figure 3.8 shows that in 2015,
80 percent of their $6.5 trillion assets are corporate securities and mutual fund shares as well as non-
marketable financial instruments. Life insurance reserves (a measure of future payouts to beneficiaries) and
pension entitlements were the main liabilities of insurance companies, with pension entitlement
representing a growing share of liabilities. Since the end of the 1970s, the proportion of corporate shares
has grown in the liabilities of life insurance companies, and now represent about 5 percent of liabilities.
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Figure 3.8 Structure (percent) and level (trillions of dollars) of assets of life insurance companies
Note: “Other financial assets” includes money market mutual funds shares, commercial paper, checking
accounts and currency, security repurchase agreements, among others.
Note: Policy loans are loans made by life insurance companies secured by the cash value of a policy. If
default occurs, the amount of death benefits is reduced accordingly. Syndicated loans are loans made by a
group of creditors to nonfinancial businesses.
59
Figure 3.9 Structure of liabilities of life insurance companies

Note: “Other liabilities” include security repurchase agreements, taxes payable, among others.
PROPERTY AND CASUALTY INSURANCE COMPANIES
In response to blazes that burned down large cities such as London, several steps were taken to reduce the
scope of personal financial losses and to protect physical properties. Fire brigades were organized, building
codes were created, and fire insurance companies emerged. In the US, the first fire brigade was created in
1653 in Boston and the first fire insurance companies emerged around 1750s. Today, property and casualty
insurance companies protect against a wide variety of events, from accident, to theft, to natural disasters.
The cash outflows of this business model are less predictable because, even though there are statistical
regularities, unexpected adverse events like natural disasters can happen. As such, property and casualty
insurance companies hold more liquid assets than life insurance companies do. In 2015, their assets were
worth $2 trillion and were composed mostly of safer securities (Treasuries, agency securities and
municipals) (Figure 3.10). Their main liability is the claims customers have on existing policies (Figure 3.11).
Corporate shares peaked at 40 percent of liabilities from the mid-1990s to the mid-2000s, but since 2008
they have represented about 20 percent of liabilities.
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Figure 3.10 Structure (percent) and level (trillions of dollars) assets of property and casualty insurance
companies
Note: “Other financial assets” includes commercial paper, mutual funds shares, money market mutual
funds shares, commercial mortgages, security repurchase agreements, among others.
Figure 3.11 Structure of liabilities of property and casualty insurance companies

Note: “Other liabilities” includes advances from Federal Home Loan Banks, taxes payable, among others.
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FINANCE COMPANIES
They first specialized in providing credit to customers with a low creditworthiness, but now provide credit
to all types of customers. One can put finance companies in three categories:
- Sale finance companies: They are owned by nonfinancial companies, such as car dealers or
department stores, and provide credit to customers.
- Consumer finance companies: They provide credit to individuals with poor creditworthiness
(payday loan companies, car title loan companies, subprime mortgage companies, among others).
- Business finance companies: They lease equipment (airplanes, machines) to businesses and provide
credit for inventory financing, among others
Most of the assets of finance companies consist of non-marketable financial instruments issued by
households and nonfinancial businesses for consumption purpose (“consumer credit”) and business
purpose (“nonfinancial business credit”). Mortgages gained in importance in the 2000s, as mortgage
companies increased the volume of subprime mortgages they accepted, and peaked at 20 percent of
financial assets before collapsing to 5 percent of financial assets because of heavy losses during the Great
Recession. Corporate and foreign bonds also grew as a share of financial assets in the mid-1990s, and early
2000s to reach 15 percent of financial assets, but fell during the Great Recession, which reflects heavy losses
on mortgage-backed securities and related financial instruments (Figure 3.12). Losses on mortgages and
related securities led to a fall of the value of financial assets by $400 billion and, in 2015, they were worth
$1.5 trillion. Liabilities have been quite diverse given the wide range of activities in which finance companies
are involved, but since the late 1980s, the structure of liabilities has moved toward longer-term to maturity.
Corporate and foreign bonds have grown in proportion whereas commercial paper and advances from
banks have shrunk from 40 percent to 20 percent of liabilities (Figure 3.13).
62
Figure 3.12 Structure (percent) and level (trillions of dollars) of the assets of finance companies
Note: The sector includes retail captive finance companies and mortgage companies. Residential
mortgages include, home mortgages, home equity lines of credit and multifamily mortgages.
Figure 3.13 Structure of the liabilities of finance companies

Note: “Other liabilities” includes advances by the Federal Home Loan Banks, taxes payable, among others.
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FINANCIAL INVESTMENT COMPANIES

A wide variety of financial companies proposes to pool and manage funds saved by economic units in order
to buy income-earning and capital-gain-making assets. They vary in terms of the assets they buy, in terms
of the liabilities they issue, in terms of their tax status, among others. Pooling funds is beneficial because:
- Small savers may not be able to afford to buy securities in financial markets on their own.
- The absolute return obtained by pooling money together is higher.
- Pooling reduces the cost of financial placements and increases the diversification of portfolios.
For example, bonds usually have a market value close to $1000 so people with a small amount of savings
may not be able to afford to buy many of them unless they pool their funds together into a mutual fund.
Say Mr. Y has $100 and Mr. X has $900. Alone, none of them can buy a bond, but they can if they pool their
funds into a mutual fund. Interest received on the bond will be distributed to X and Y in proportion of the
amount of funds provided to the mutual fund. For example, if the interest income received on the bond is
$100, Y will receive $10 and Mr. X will receive $90, minus fees paid to the mutual fund.
PENSION FUNDS
Pension funds are tax-exempt institutions that promise to provide an income—called pension—to replace
partially or fully the loss of income induced by retirement. Individuals usually get access to a pension fund
through their employers, who are the sponsor of the fund. The employers match the contributions
employees make to the fund, and provide some financial backing to the fund. Individuals have to make
contributions that are used by the fund managers to buy earning assets. The contributions are tax-exempts,
that is, no income tax is paid for any part of gross income that is allocated to a pension fund. For example,
if an individual’s gross salary is $50,000 and she chooses to put $10,000 in a pension fund, the individual’s
income tax will be based on $40,000. The vesting period is the length of time over which one must
contribute to a pension fund before one can get a pension (usually 5 years in the US).
In the US, the first pension fund was established by New York City for its police force in 1857. There are two
forms of pension funds and both can be created by private and government economic units; defined-
contribution plans (401(k) plan, 403(b) plan, among others) and defined-benefit plans (Social Security and
the California Public Employees’ Retirement System (CalPERS) are the most well known).
In a defined-contribution plan, the pension received depends on the overall contribution of an individual
and the performance of the assets in the pension fund. For example, if by the time someone retires,
someone has contributed $1,000,000 to a pension fund and the assets purchased by the fund yield a 5
percent annual rate of return, the annual pension is $50,000. However, the rate of return (and so the
pension) is not fixed, it depends on what happens to the assets purchased by the pension funds. Most of
those assets are financial assets, and Chapter 2 showed that they are risks involved with them. Some issuers
may default, some financial instruments may be illiquid, economic and financial conditions may negatively
impact the value of securities. As such, as some retirees learned during the Great Recession, the pension
from a defined-contribution plan can dwindle to nothing. Finally, in order for this type of plan to be
beneficial, income earners must be able and willing to save during their working years. Many Americans do
not have the ability or willingness to do so in a significant fashion.
Defined-benefit plans guarantee a pension that is calculated based on years of work, age of retirement,
final salary, among other. For example, if one must work 40 years to get full benefits but merely worked 30
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years, and if the salary on the final year is $50,000, the annual retirement benefit will be $37,500 (3/4 of
$50,000). One of the main risk involved in such plan is a funding risk, that is, the pension fund and its sponsor
may become insolvent. This is a risk for pension funds that are sponsored by entities that are not monetarily
sovereign (state and local government pension funds, private pension funds, pension funds of non-
sovereign federal governments). The reader probably heard that Social Security will be insolvent soon and
so today’s youth should not rely on it (and should in fact be against it). This is not the case given that the
US government is monetarily sovereign so finding dollars to pay Social Security benefits is not a problem
(see Chapter 9). As shown below, the U.S. government’s net worth is massively negative but this does not
impact its ability to operate smoothly.
Given that defined-benefit plans are more costly and more risky to employers, most private businesses and
state and local governments have moved away from sponsoring defined-benefit plans. As such, the funding
risk of retirement has been shifted away from employers onto employees. The timing of the cash outflow
is well established and the liability is a long-term liability so most of the assets owned are less-liquid long-
term assets. In 2015, corporate securities and mutual fund shares represented about 60 percent of the
assets of pension funds, and Treasuries have consistently represented about 10 percent of assets since
1945. Early on, 80 percent of the funding of pension funds came from the sponsor’s payments to the funds
but today pension funds are much more autonomous and claims on sponsors represent about 20 percent
of assets (Figure 3.14). This reflects the move away from defined-benefit plans to defined-contribution
plans. The liability of pension funds is called pension funds reserves, which is a function of expected
pensions to be paid and must be matched by some assets.
Figure 3.14 Structure (percent) and level (trillions of dollars) of the assets of pension funds
Note: “Other assets” includes nonfinancial assets, checking accounts, time and savings accounts, money
market mutual funds shares, mortgages, commercial paper, among others.
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REGULATED PORTFOLIO MANAGEMENT COMPANIES: MUTUAL FUNDS AND

OTHERS
Portfolio management companies provide a wide variety of placement opportunities to economic units
with spare funds who do not want to, or cannot, directly buy securities or other assets. There are three
broad types of portfolio management companies: mutual funds, closed-end funds, and unit investment
trusts (UITs). One of the main differences between them is the characteristics of the shares they issue in
terms of marketability and the ability to redeem them. Mutual fund shares are nonmarketable and
redeemable on demand, closed-end fund shares are marketable and irredeemable, and UIT shares are
marketable and redeemable on demand. Closed-end funds and UITs do not continuously offer their shares
for sale. Rather, they sell a fixed number of shares in an initial public offering, after which the shares
typically trade on a secondary market such as the New York Stock Exchange or through the sponsor (for
UIT). The price of closed-end funds is determined in the market. Another main difference is the type of
asset they are allowed to acquire, with closed-end funds allowed to buy more illiquid assets than mutual
funds.
Within each of these three broad categories, there is a wide variety of funds in terms of the assets they
purchase, the placement strategies, and the means of issuance and redemption of shares (cash redemption
or security redemption). This wide variety of funds accommodates the financial preferences of most
shareholders. For example, some like risks and others do not; some like stocks others prefer bonds; some
want stable fund share prices others want to be able to make capital gains (while risking to make a loss).
They also have different level of minimum financial contribution to cater to different wealth groups. The
following focuses on mutual funds, which are the most common type of portfolio management companies.
Mutual funds became popular in the U.S. in the 1920s, but have existed since the 19 th century. They issue
shares to whoever wants to join, and use the proceeds to buy earning assets for the benefits of the
members. As shown in Chapter 2, 80 percent of mutual funds shares are held directly or indirectly (via
pension funds) by households. Mutual funds are open-end companies, that is, the outstanding number of
shares is allowed to change on a daily basis. The shares of mutual funds are not tradable and are
redeemable on demand, which is quite different from corporate shares that are tradable and irredeemable.
Economic units who want to place some funds in a mutual fund must purchase shares from the mutual fund
itself, not from other bearers. When economic units wish to retrieve their funds, they can redeem them—
that is, sale them back to the mutual fund—for a fee.
The price that an economic unit pays for mutual fund shares is approximately the net asset value (NAV) per
share. The NAV is the net worth of the fund (assets net of liabilities). For example, if a mutual fund has $100
of assets and $10 of liabilities, NAV is $90. The NAV is calculated on a daily basis by recording the market
value of assets and liabilities at the end of each day. The price at which a share can be bought and redeemed
is the NAV per share, and this price varies on a daily basis because of daily changes in the NAV and in the
outstanding number of shares. Thus, if the NAV is $90 and there are 100 shares outstanding, the price of a
mutual fund share is 90 cents that day.
In the mid-1970, money market mutual funds (MMMFs) emerged to bypass regulation Q. They purchase
mostly short-term, safe securities. MMMFs try to keep their NAV per share stable at $1 and the dividend
paid on MMMF shares closely follows short-term interest rates. Given these financial characteristics and
the fact that MMMF share are redeemable on demand, financial market participants consider MMMF
shares to be close substitutes to savings accounts.
Most assets of mutual funds are composed of corporate shares except for the decade 1985-1995 during
which Treasuries, agency securities, and municipals grew to represent 40 percent of the financial assets of
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mutual funds. Today, these types of securities only represent 15 percent of the $12.6 trillion of financial
assets held by mutual funds, while corporate shares represent 65 percent of the financial assets. As the
stock market plunged during the Great Recession, mutual funds recorded a $3-trillion decline in the value
of their assets, but they recovered their losses quickly as the stock market boomed again (Figure 3.15). Their
liabilities is composed mostly of their shares, but also of individual retirement accounts (IRAs) that have
grown to represent 20 percent of liabilities (Figure 3.16).
The assets of MMMFs are composed mostly of safe to safer assets that are of short-to-medium term
maturity, such as commercial paper, T-bills, agency securities, Treasuries, time and savings accounts, and
repurchase agreements (Figure 3.17). Prior to the crisis, MMMFs bought a lot of asset-backed commercial
paper because it looked safe. During the crisis, some MMMFs recorded large losses on asset-backed
commercial paper and the value of their assets fell by $1 trillion to $2.8 trillion. This led the NAV per share
to fall below $1 for some MMMFs; customers could not recover 100 percent of the principal they put in the
fund, in the same way one could not recover 100 percent of the funds in a savings account. As the NAV per
shares fell below $1, a run on MMMFs began—many customers tried to recover their funds by redeeming
their MMMFs shares at the same time, forcing MMMFs to sell assets quickly—that compounded the decline
in the value of MMMF shares, and the Federal Reserve intervened to help contain the run.
Figure 3.15 Structure (percent) and level (trillions of dollars) of the assets of mutual funds
Note: The Financial Accounts assume that all funds received are immediately put to work. The allocation
of funds is based on econometric analysis or discretionary decisions of the analyst.
Note: “Other financial assets” includes commercial paper, syndicated loans to nonfinancial businesses and
security repurchase agreements
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Figure 3.16 Structure of liabilities of mutual funds

Source: Board of Governors of the Federal Reserve System (Series Z.1, L.122 and L.227)
Figure 3.17 Structure (percent) and outstanding dollar amount (trillions of dollars) of the assets of money
market mutual funds
Note: “Other financial assets” includes checkable deposits, private foreign deposits, among others.
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Figure 3.18 Structure of liabilities of money market mutual funds

LIGHTLY REGULATED PORTFOLIO MANAGEMENT COMPANIES: HEDGE

FUNDS
Hedge funds emerged in the 1950s. Like mutual funds, hedge funds pool funds to buy return-earning assets
but, unlike mutual funds, they frequently use riskier balance-sheet strategies, such as leverage (see Chapter
4) and short selling, to achieve the rate of return they promise to their clients. Hedge funds are also more
lightly regulated and may not have to file full financial statements with regulatory agencies, although the
2010 Dodd-Frank Act increased the regulatory filing requirement. Finally, they cater to wealthy individuals.
Some hedge funds try to make a profit under whatever market conditions by implementing “market neutral
strategies.” This means that they speculate on the price direction of two assets by taking an opposite
position in each asset. For example, assume that the stocks of companies X and Y are worth respectively
$100 and $90. Hedge fund Alpha expects that the price of both stocks to be $95 in one week (Figure 3.19).
Week 1 Week2
X $100
$95
Y $90
Figure 3.19. Expectations of hedge fund Alpha about the price direction of two stocks
The hedge funds does two things to profit from this expectation:
- Take a short position in X shares: Borrow X stocks from a broker for a week and sell them
immediately at current market price ($100), and buy them back at $95 next week to repay the
broker. A capital gain of $5 per share is expected.
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- Take a long position in Y shares: Buy Y stocks today for $90 and sell them in Week 2 at $95: Expected
capital gain of $5 per share.
This placement strategy allows Alpha to “hedge” its portfolio position because it can avoid losses, to a
certain extent, if its expectations turn out to be incorrect. For example, assume that both stock prices
decreases by $10, in that case, the funds loses $10 on its long positions in share Y but gains $10 on its short
positions in share X (Figure 3.20). Of course, if X stock go up or go down by less than Y shares, then Alpha
will record a loss. Short positions are inherently more risky than long positions because the price of financial
assets cannot be negative so potential gains are limited by how much price can fall ($100 for stock X) while
potential losses are unlimited (the price of stock X can go up to infinity).
Week 1 Week2
X $100
$90
Y $90
$80
Figure 3.20 Actual price direction of two stocks
REAL ESTATE INVESTMENT TRUSTS
They were created in the 1960s to provide opportunities to take a position in real estate. They hold about
$500 billion in assets tied to the real estate in the form of actual real estate properties or financial
instruments linked to real estate (mortgages, agency securities, mortgage-backed securities) (Figure 3.21).
REITs also issue mortgages that, together with bonds, usually represent over half of the liabilities they issue.
Their short-term debts are in the form of reserve repurchase agreements and advances from private
depository institutions (Figure 3.22).
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Figure 3.21 Structure (percent) and level (trillions of dollars) of real estate investment trust
Source: Board of Governors of Federal Reserve System (Series Z.1, L.129)
Note: Nonfinancial assets have a negative value from 1968 to 1974 and from 1984 to 1989. This is due to
statistical discrepancies and errors because their value is measured indirectly as the difference between
liabilities and financial assets. The value is set at zero for those years.
Note: “Other financial assets” includes multifamily mortgages and other financial assets.
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Figure 3.22 Structure of liabilities of real estate investment trust

Source: Board of Governors of Federal Reserve System (Series Z.1, L.129)
Note: “Other liabilities” include advances by the Federal Home Loan Banks, commercial paper, among
others.
FINANCIAL MARKET COMPANIES
MARKET-SERVICES COMPANIES: ORGANIZED EXCHANGES
Securities do not trade themselves; there needs to be a platform that is reliable and standardized so trading
can be done smoothly and at low cost. Some businesses specialize is setting up such a platform, called an
organized exchange. An organized exchange sets up trading rules, quotation methods, methods of buying
and selling securities, and provides smooth means to transfer of securities among parties. It also provides
other market services such as extensive market data and trading services.
The most well known organized exchanges are the New York Stock Exchange (NYSE) and the NASDAQ.
NASDAQ used to be the acronym of "National Association of Securities Dealers Automated Quotations”
until the company became independent from the National Association of Securities Dealers in 2006.
Created in 1971, NASDAQ was the first organized exchange to provide automated trading of securities and
competitors followed.
Organized exchanges used to be a noisy place where many individuals were on the phone taking sell/buy
orders from clients and “talking” (more yelling) to each other to match buy and sell orders. The place was
actually so noisy that individuals working on the floor of the market had to develop some hand signals to
be able to carry their trading operations. Today, most organized exchange are very quiet places except for
a few markets that have not been automated. The NASDAQ is fully automated and its physical place is a
room with a giant digital screen on Time Square.
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Once an exchange has been set up, some businesses specialize in provide specific market services; issuing
securities, ensuring the continuous quotation of securities, redeeming securities, trading securities, among
others.
INVESTMENT BANKS
Investment banks complement commercial banks by focusing on the needs of medium to large businesses,
governments and other economic units with large needs for funds (think at least tens of millions of dollars).
When a client X needs a large sum of funds to acquire an expensive illiquid long-term asset with an uncertain
profitability—railroad, industrial plant, nuclear plant, Channel tunnel between the UK and France—a
commercial bank is not willing to take X’s financial instrument. Indeed, such a very large single financial
asset on the bank’s balance sheet that would greatly negatively impact the bank’s net worth in case of
problems (see Chapter 11). A bank is even more reluctant that complex industrial projects usually run into
delays, record significantly larger expenses than budgeted, and take decades to break even.
One solution is to share that risk through syndicated credit in which several commercial banks and other
financial institutions join to meet the financial needs of the client. However, even in that case, banks usually
do not want to keep all their share of financial instruments of X on their balance sheet and gauge the ability
to sell some of them before agreeing to provide credit to client X. Figure 3.23 shows that syndicated credit
to nonfinancial businesses boomed in 2004 to reach $550 billion. Major bearers are special purpose entities
(“issuers of ABSs”), mutual funds, security brokers and dealers, life insurance companies, and funding
corporations.
Figure 3.23 Syndicated credit to nonfinancial businesses

Source: Board of Governors of Federal Reserve System (Series Z.1, part of L.216)
While syndicated credit has become more popular, its outstanding volume is still small, especially compared
to alternative wholesale funding methods. Indeed, beyond syndicated credit, another solution to spread
the risk is to issue many marketable financial instruments. If client X needs $100,000,000, one way to obtain
that sum is to issue 100,000 bonds with a face value of $1,000. Each bearer takes on its balance some credit
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risk for up to the dollar amount of bonds each bought, which is much more limited than if a commercial
bank had to bear a single non-marketable financial instrument worth $100,000,000. In addition, bonds can
be traded—at least this is the hope—so if some of the initial bearers no longer want hold the bonds, they
can sell them to willing buyers.
While they may issue securities on their own, economic units who seek funds by issuing marketable financial
instruments may ask for the help of an investment bank in order to maximize the dollar amount raised by
the offering. Investment banks assist issuers of securities by determining which type of securities will be
the cheapest to issue, evaluating the creditworthiness of the issuer, and providing economic and financial
research to financial market participants. Investment banks design, market and underwrite securities in the
primary market:
- “Design” means to:
o Determine which type and what quantity of securities should be issued in order to raise as
much funds as possible at the lowest cost: if stock markets are booming, then issuing shares
is a better option, whereas issuing bonds is best if interest rates are low and profit
expectations of the issuer are high.
o Help meet filing requirement with the Securities and Exchange Commission
o Help get a rating from credit rating agencies by making sure that the issuer complies with
all the necessary requirements.
- “Market” means to determine the expected sale price of securities and to sell them:
o Initial public offering (IPO): For shares, investment banks must figure out what is the fair
price for the shares of a company that enters the stock market for the first time. For bond,
pricing is easier and based on the price of bonds of comparable risk and term to maturity.
o Seasoned offering: Pricing is based on current existing securities but the investment bank
must figure out how the new issue will affect the price of existing securities.
- “Underwrite:” Investment banks usually take some responsibility for the price at which they expect
the securities will sell, that is, they sign a contract with the issuer that guarantees that the issuer
will be able to raise a given dollar amount. If the securities sell above the contracted price, the
investment bank makes a capital gain. If the securities sell below, the investment bank may stop
selling securities for a while and hold the securities on their balance sheet.
BROKERAGE FIRMS: SECURITY BROKERS AND DEALERS AND SECURITY

BROKERS
Brokerage firms provide two types of market services:

- Brokering: To buy and sell securities for clients for a fee. The rise of automated trading and online
brokerage accounts has significantly reduce the fees that brokers can charge.
- Dealing: To buy and sell securities for one’s own account. Dealers usually play an important role of
market makers to promote market liquidity. They have specialists on the floor of the platform who
act as buffer between the demand and supply of securities. If there is a surplus, specialists buy for
their own account some securities to close the surplus; if there is a shortage, specialists sale
securities they own to close the shortage. With the emergence of automated trading, the need for
specialists has diminished considerably. Some dealers may choose to become primary dealers,
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which entail them to have a direct working relationship with the Federal Reserve to help implement
monetary policy (Chapter 7) and fiscal policy (Chapter 9).
The balance sheet of security brokers and dealers reflects the fact that they deal in securities (Figure 3.24).
Margin credit—advance provided to clients to buy securities on credit (see Chapter 4)—use to represent
up to 60 percent of their assets. From the 1970s, security repurchase agreements (RPs) have substituted
margin credit as their main assets. Clients seeking funds sell securities to brokers and dealers, and promise
to buy them back later at a price that will provide an income to security brokers and dealers. This is a form
of secured credit. Chapter 7 explains how security repurchase agreement are used to implement monetary
policy. The value of the assets held by security brokers and dealers peaked in 2008 at $4.6 trillion and has
been falling since to reach $3 trillion in 2015. Since the late 1980s, a great proportion of the business
operations of dealers and brokers has been to lend the securities they own. Claims on borrowers of
securities have represented at least 20 percent of their balance sheet.
The structure of liabilities reflects the shift in assets (Figure 3.25). Security brokers and dealers used to be
indebted to private depository institutions that provided the funds to clients requiring margin credit.
Brokers and dealers would make a profit on the interest rate differential between the interest rate charged
on margin credit and the interest rate charged on the credit that broker and dealers obtained from
depository institutions. Since the 1970s, repurchase agreements, in the form of reverse repurchase
agreements, have become the main liability of security brokers and dealers. They obtain funds by selling
securities and by promising to buy them back later at a price that rewards the seller.
Figure 3.24 Structure (percent) and level (trillions of dollars) of the assets of security brokers and dealers
Note: At times, the outstanding value of US Treasuries is negative, reflecting the fact that security dealers
had an overdraft on their Treasuries account at the Fed; they were borrowers of Treasuries.
Note: “Other financial assets” includes commercial paper, agency securities, municipals, syndicated
advances to nonfinancial business, among others.
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Figure 3.25 Structure of liabilities and equity of security brokers and dealers
Note: “Other liabilities” includes corporate shares, corporate and foreign bonds, various advances, trade
payable, taxes payable, among others.
SECURITIZATION VEHICLES: SPECIAL PURPOSE ENTITIES
Securitization is discussed in Chapter 17 but the following Figures together with the ones presented in this
Chapter and in Chapter 2, should convince the readers that companies involved in securitization have
become major participants in the financial sector. Figure 3.26 and 3.27 show the financial assets held by
issuers of asset-backed securities and issuers of mortgage-backed securities backed by federal agencies and
GSEs. Together, they held up to $8.5 trillion of financial instruments of all sorts in 2008, after which the
outstanding value of their financial assets felt to reach $3 trillion, half of the fall in the value is due to the
sale of $3-trillion worth of mortgages to government-sponsored enterprises. Since early 2000s, mortgages
have replaced consumer credit and agency securities are the main assets of issuers of asset-backed
securities.
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Figure 3.26 Structure (percent) and level (trillions of dollars) of the assets of mortgage pools backed by
federal agencies and government-sponsored enterprises
Figure 3.27 Structure (percent) and level (trillions of dollars) of the issuers of asset-backed securities.
Note: “Other financial assets” include funding agreement backing the ABS issuers and Treasuries.
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GOVERNMENT AND GOVERNMENT-RELATED FINANCIAL

AGENCIES
Government and government-related financial agencies include some federal budget agencies and some
for-profit companies chartered by the U.S. Congress. Their goal is to promote, through financial means,
specific economic activities that are deemed socially beneficial but that are underserved by the traditional
private financial sector because of their riskiness or low profitability.
GOVERNMENT-SPONSORED ENTERPRISES
Government-sponsored enterprises (GSEs) are private for-profit companies created by US Congress. They
help to promote specific economic activities by buying and/or insuring illiquid and risky financial
instruments that financial companies have on their balance sheet. By doing so they remove the credit risk—
and liquidity risk if they buy the financial instrument—from the balance sheet of the seller. This encourages
private financial companies to provide credit at more affordable terms (lower interest rate, longer term to
maturity) to specific economic units. Put differently, the point of GSEs is to intervene in the financial sector
to reduce the volatility, and to bring down the level, of interest rates on specific financial instruments, and
to raise the volume of issuance of such financial instruments. GSEs do so because these financial
instruments are issued to perform economic activities that U.S. Congress deems socially beneficial.
A point of entry in the world of GSEs are the Financial Accounts (Figures 3.28 and 3.29). From 1945 until the
mid-1980s, advances from the Farm Credit System and the Federal Home Loan Bank System, Farm
mortgages (that is mortgages backed by a farm excluding the farm dwelling), and home mortgages
represented about 80 percent of the assets of GSEs. After the mid-1980s, the promotion of farming shrunk
considerably in relative terms, with farm mortgages and Farm Credit System advances representing about
5 percent of the financial assets of GSEs in 2015. Agency securities, federal funds sold and corporate bonds
gained in importance. The financial crisis led to an enormous increase in the balance sheet of GSEs because
Fannie Mae and Freddie Mac purchased over $3 trillion of mortgage-backed securities from the special
purpose entities (“mortgage pools”) they back. MBSs from these pools now represent 60 percent of the
assets of GSEs. Most of the liabilities of GSEs consist of securities and securitized securities, and the
purchase of $3 trillion of MBSs by Fannie Mae and Freddie Mac was done by issuing bonds backed by them.
The following sections provide a more detailed presentation of some GSEs.
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Figure 3.28 Structure (percent) and level (trillions of dollars) of the financial assets of government-
sponsored enterprises.
Note: The GSE sector includes the following enterprises: Federal Home Loan Banks, Fannie Mae, Freddie
Mac, Farmer Mac, Farm Credit System, the Financing Corporation, and the Resolution Funding
Corporation and the Student Loan Marketing Association (Sallie Mae) until 2004:Q4. Mortgage pools
backed by GSEs are not included.
Note: Others financial assets include Sallie Mae financial assets, commercial paper, checking, savings and
time accounts, currency, among others.
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Figure 3.29 Structure of liabilities and equity of government-sponsored enterprises

Note: “Other liabilities” include federal funds purchased and reverse repurchase agreements, loans of U.S.
government to Sallie Mae, among others.
THE FARM CREDIT SYSTEM
The Federal Loan Act of July 1916 created the first government-sponsored enterprise; the Farm Credit
System (FCS). Its organization is based on the template provided by the Federal Reserve System created in
December 1913. The goal of the FCS is to help the agricultural sector and rural communities by providing a
stable and affordable source of funds to Agricultural Credit Associations (ACAs) and agricultural
cooperatives that compete with private banks.
ACAs provide credit and leasing services to rural providers of critical infrastructure (communication
services, power supply, water supply, among others), rural households seeking to become homeowners,
and farmers, ranchers, and other agribusinesses (to stock seeds, to buy capital equipment, to build barns,
among others). Contrary to traditional banks, an ACA does not issue bank accounts to their clients; it merely
accepts their financial instrument and makes payment on their behalf by using the payment system of
private banks. For example, if farmer F1 is granted a credit of $100 to buy a $100 tractor, the following
happens: The ACA makes the payment to the tractor company on behalf of farmer F1, and F1 will repay the
ACA bit by bit by servicing its financial instrument.
ACA
Financial instrument of Farmer F1: +$100
Bank account of ACA: -$100
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Farmer F1
Tractor: +$100 Financial instrument issued to ACA:
+$100
Tractor company
Tractor: -$100
Bank account of company: +$100
Each ACA is part of a district. The System is composed of four districts, each overseen by a Farm Credit
System Bank that is owned by the ACAs (Figure 3.30). There are four Farm Credit System Banks (FCS Banks);
three Farm Credit Banks (FCBs) and one Agricultural Credit Bank (ACB). FCS Banks issues Farm Credit System
debt instruments (FCS securities) via a funding corporation (the Federal Farm Credit Banks Funding
Corporation) that acts as fiscal agent for the four banks. The funding corporation determines the amount
and terms of FCS securities, issues them and handles their servicing. The term to maturity of FCS securities
varies from overnight to 30 years. The funds obtained from the issuance of securities are lent to ACAs and
cooperatives who then lend to rural communities. Beyond obtaining funds from the issuance of FCS
securities, ACAs also borrow funds from, and lend funds to, each other.
The Farm Credit System Insurance Corporation—established in 1987 when farmers were defaulting en
masse—ensures the timely servicing of FCS securities. It is an insurance plan in which each ACA pays a
premium and gets help in case of difficulty. The overall system is overseen by the Farm Credit
Administration (Figure 3.31).
Table 3.1 shows the unconsolidated balance sheet of the four FCS Banks. Their main assets are securities
(mostly Treasuries, federally-backed debts and GSE securities, but also federal funds sold, commercial paper
and negotiable certificates of deposit) and financial instruments issued by residents of rural communities
and ACAs (“Loan, notes, sales contracts, and leases”). Figure 3.32 shows that in 2016 about two-third of the
$220 billion of credit provided by FCS Banks goes to ACAs, while the rest is direct credit to rural communities
mostly for production, for agricultural cooperatives, and for infrastructure. Their main liabilities are $259
billion of FCS securities. Similar to Treasuries, FCS securities are generally recorded, and transferred, via
electronic entries at the Federal Reserve. FCS Banks have accounts at the Federal Reserve and they use this
payment system to make payments to private banks, service debt on their securities, among others.
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Figure 3.30 Districts of the Farm Credit System

Source: Farm Credit Administration
Figure 3.31 The institutional components of the Farm Credit System

Source: Federal Farm Credit Banks Funding Corporation
82
Farm Credit System Banks (Unconsolidated)

(Dollar Amounts in Millions)
ASSETS LIABILITIES AND NET WORTH
Cash 1,033 Systemwide notes and bonds outstanding 258,977
Securities 58,388 Subordinated notes and bonds 499
Accounts receivable 162 Other interest-bearing debt 1,928
Loans, notes, sales contracts, and leases 220,031 Accrued interest payable on 678
Accrued interest receivable 892 Accounts payable 420
Equity investments in other FC institutions 273 Other liabilities 848
Premises and other fixed assets 147
Other assets 633 Net worth 18,207
Total assets 281,558 Total liabilities and net worth 281,558
Table 3.1 The unconsolidated balance sheet of the four Farm Credit System Banks, 2016
Source: Farm Credit Administration
Note: There are four System Banks: AgFirst FCB in Columbia, SC; AgriBank, FCB in St. Paul, MN; CoBank,
ACB in Denver, CO; and FCB of Texas in Austin, TX.
Note: “Cash” includes actual cash but also, checks in the process of collection, accounts due from
domestic and foreign private depository institutions, and account “balances of all types, and for all
purposes, due from Federal Reserve banks (e.g., funds held at Federal Reserve banks for payment of
interest on consolidated and Systemwide bonds, purchase of securities, redemption of called
consolidated and Systemwide bonds, clearing and working balances, etc.).”
Source: Farm Credit Administration (View FCS Institutions)
Figure 3.32 Type of credit provided by the Farm Credit System Banks, unconsolidated, 2016
Source: Farm Credit Administration (View FCS Institutions)
Note: Credit for agricultural production includes real estate mortgages issued to finance productive
capacities (to purchase farm real estate, to refinance existing mortgages, or to construct various facilities
used in operations), as well as credit obtained to buy equipment and for business operations.
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THE FEDERAL HOME LOAN BANK SYSTEM
The Federal Home Loan Bank System (FHLBS) is also organized on similar premises as the Federal Reserve
System. It is much more similar to the Federal Reserve System than the FCS because the FHLBS issues
monetary instruments and has its own payment system. It was established by the Federal Home Loan Bank
Act of 1932 with the goal of promoting homeownership and community development. FHLBS is composed
of eleven Federal Home Loan Banks (FHL Banks) that each oversees a district (Figure 3.33). FHL Banks are
for-profit companies that are owned by members of the System. This System was first set up for Saving and
Loans Institutions but, since 1989, all federally-insured depository institutions (thrift institutions,
commercial banks and credit unions), insurance companies, and a few others (such as real estate
investment trusts and finance companies) can join if they wish.
Today, over 80 percent of members are commercial banks and credit unions, and 90 percent of all
commercial banks are members of the System (Table 3.2). Membership is voluntary and requires the
purchase of stocks of the FHL Bank of the district in which the financial institution operates. The stocks are
not tradable, cannot be pledge as collateral, must be held at face value, pay a dividend, and provide a voting
right to elect the director of the FHL Bank of the district. The Office of Finance is the fiscal agent of the
System. It does the accounting and oversees the issuance, redemption and servicing of FHLB securities. The
system is regulated and supervised by the Federal Housing Financing Agency.
The purpose of the FHLBS is to provide its member a stable and low-cost source of funds. The way this is
done can be understood by studying the consolidated balance sheet of the FHL Banks (Table 3.3). The main
asset is “advances” that were worth $705 billion. Advances represent financial instruments issued by
members to the FHL Banks. In exchange, FHL Banks provide credit and payment services in the same way
private banks and the Federal Reserve do (See Chapter 7 and Chapter 12).
FHL Banks compete among each other and with other financial institutions to provide credit to its members,
so each FHL Bank try to accommodate the financial needs of their members as much as possible. FHL banks
do so by accepting financial instruments with widely different financial characteristics. Advances can vary
in terms of term to maturity (overnight to 30 years), interest rate (fixed or variable), collateral, among
others. About 40 percent of advances have to be repaid within one year, and slightly more than half of all
advances have to be repaid within two years (Figure 3.34). Revolving lines of credit can also be open—think
credit card—that allow a member to continuously get access to FHLB credit.
The FHL Banks only accept the financial instruments of their members if they are secured by collateral that
is consistent with the mission of the FHLBS. The Federal Home Loan Bank Act limits the type of collateral
FHL Banks can accept to certain securities, residential mortgage loans, cash, deposits with the FHL Banks,
and other eligible real estate-related assets. Community development financial institutions may also pledge
secured financial instruments issued to them by small businesses, small farm, and small agri-business.
Figure 3.35 shows the type of collateral accepted by the FHL Bank of New York. In addition to a collateral
requirement, federally-insured members must at least have 10 percent of their assets in the form of
residential mortgages to be granted credit by FHL Banks. Put differently, before getting credit from a FHL
Bank, members have to show that they have granted credit to fund economic activities that are consistent
with the mission of the FHLBS.
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Percent of
Percentage
each type of
Number of total
financial
members
institutions
Commercial banks 4,520 63.5% 89.8%
Credit unions 1,389 19.5% 23.1%
Thrifts 778 10.9% N/A
Insurance companies 393 5.5% 6.6%
Community development
45 0.6% N/A
financial institutions
Total 7,125 100% -
Table 3.2 Members of the Federal Home Loan Bank System, 2016
Source: Office of Finance of the Federal Home Loan Bank System (Federal Home Loan Banks, Combined
Financial Report for the Year Ended December 31, 2016), Federal Reserve Bank of St. Louis (FRED), and
Credit Union National Association (Credit Union Reports), Insurance Information Institute.
Figure 3.33 The Federal Home Loan Bank System as of May 2017
Source: Federal Housing Financing Agency
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Federal Home Loan Banks Combined Statement Of Condition, 2016

(Millions of Dollars)
ASSETS LIABILITIES AND CAPITAL
Cash and due from banks 7,441 Total accounts 8,089
Interest-bearing accounts 2,878 Demand and overnight accounts 7,268
Securities purchased under agreements to resell 52,771 Term accounts 634
Federal funds sold 48,633 Other accounts 187
Total securities 187,735 Discount notes 409,815
Total non-mortgage-backed securities 49,085 Bonds 578,927
Certificate of deposits 3,050 Other liabilities 7,422
U.S. Treasuries 1,606
GSE and TVA securities 28,406
Other agency securities 6,249 Capital 52,459
State or local housing agency obligations 3,848
Federal Family Education Loan Program ABS 4,572
Others 1,354
Total mortgage-backed securities 138,650
GSE MBS 112,801
Agency MBS 14,658
Private-label MBS 10,951
Others 240
Advances 705,225
Mortgages 48,476
Other assets 3,553
Total assets 1,056,712 Total liabilities and capital 1,056,712
Table 3.3 Federal Home Loan Banks consolidated balance sheet
Source: Office of Finance of the Federal Home Loan Bank System (Federal Home Loan Banks, Combined
Financial Report, for the year ended December 31, 2016)
Note: “Cash and due from” represent cash, accounts at commercial banks, and accounts at the Federal
Reserve Banks.
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Figure 3.34 Outstanding advances (trillions of dollars) and term-to-maturity structure (percent)
Note: Overdrafts on demand accounts held by members at FHL Banks automatically lead to an advance
Figure 3.35 Types of collateral accepted by the Federal Home Loan Bank of New York
Source: Federal Home Loan Bank of New York
To fund its operations, that is to obtain the funds it needs to settle payments with other financial institutions
and with its members (see Chapter 12 on interbank payments and reserve requirement for an application
to the banking system), FHL Banks must obtain either federal funds or, if the institutions to whom they
must transfer funds do not have an account at the Federal Reserve, funds on a private bank account. To
obtain these funds the FHL Banks issue financial instruments.
For example, a FHL Bank can attract federal funds when other FHL Banks, commercial banks and
government institutions deposit federal funds (monetary assets of the FHL Bank go up) and get credited the
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equivalent dollar amount on a FHLB account (liabilities of the FHL Bank go up). FHLB accounts can be
demand accounts or term accounts, and overdraft is possible on demand accounts and lead to an automatic
advance to replenish the account. FHLB accounts can be used to make payments among members, that is,
the System has its own payment system that is an alternative to the Federal Reserve payment system and
the payment system of private depository institutions. Most FHLB accounts are overnight or demand
accounts so the FHL Banks are required to keep an equivalent dollar amount—$8 billion in 2016—of short
to medium term to maturity financial assets to avoid liquidity problems. These assets can be cash, federal
funds, demand accounts at private banks or FHL Banks, short-term repurchase agreements, Treasuries and
agency securities that mature in less than 3 years, among others.
Deposits are, however, a marginal funding source. The two main means to obtain funds are short-term FHLB
securities (“discount notes”) and long-term FHLB securities (“bonds”) that together amount to almost $1
trillion. FHL Banks issue these securities in domestic and global financial markets, and compete with the
U.S. Treasury, other GSEs, corporations and other issuers of debt instruments to find willing bearers. Figure
3.36 shows how the FHLB operates within the financial system. “Lenders” refers to FHLBS members (see
Table 3.2) that accept mortgages from “borrowers” (households and businesses) who purchase real estate.
Once they have accepted mortgages, FHLB members have illiquid long-term assets (mortgages) on their
balance sheet, while they have immediate needs for federal funds to make payments to their creditors
Chapter 12 shows that they are many means to obtain these federal funds and the FHL Banks are one of
them. FHL Banks themselves obtain federal funds by issuing securities.
Figure 3.36 How the Federal Home Loan Bank System works
Source: Federal Housing Financing Agency
Figure 3.36 may be potentially misleading in several ways to the reader of this text. It may seem that the
whole system is an intermediation between “investors” and “borrowers,” with the investors (the buyers of
FHLB securities) being the source of the funds that are then lent to the borrowers (households and
businesses) via the help of FHL Banks and “lenders” (FHLB members). This is not the case. As explained in
details in Chapter 12, there is no intermediation at play. Borrowers do not receive cash from investors, in
fact they never see any funds, and banks (the “lenders”) do not lend cash. Banks also do not wait for funds
obtained by the FHL Banks from investors to accept mortgages from households and businesses. In fact,
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banks must accept mortgages first before they can get access to FHLB refinancing channel. The point of
FHLB is not to provide credit to households and businesses; it is merely to provide an alternative source of
federal funds for its members, and a convenient means to make payments among its members.
Commercial banks have other means to obtain federal funds, so one may wonder why they would come to
the FHLBS. Given their size and given the implicit backing of the federal government, there is a high demand
for FHLB securities and so FHL Banks are able to issue securities at relatively lower cost. As such, the interest
rate FHL Banks pay on their liabilities is lower than that of their members. Given their cooperative structure,
FHL Banks pass the lower cost of their liabilities to their members, by granting credit are a lower cost than
what members may be able to get if they tried to get credit on their own. The interest rate charged on
advances is slightly higher than the interest rate on US Treasuries of similar maturity, and interest rates on
Treasuries are among the lowest at a given time for a given maturity.
Figure 3.37 FHLB advances (trillions of dollars)

Source: Board of Governors of the Federal Reserve System (series Z.1, part of L.216)
Note: In 2012, the “savings institutions” sector was merged with U.S.-chartered depository institutions
This is important especially in time of crises because interest rates on private financial instruments tend to
rise steeply as the number of potential bearers dwindle and the demand for safe assets, such as Treasuries,
rises. For FHLBS members, revolving advances have proven to be a reliable substitute to federal funds
market and security repurchase agreements to obtain federal funds, and, in times of stresses, advances
from the FHLB tend to be a preferred means to obtain funds. During the savings and loans crisis of the mid-
1980s, advances to thrifts peaked at $150 billion in 1988 (Figure 3.37). During the Great Recession, advances
to members peaked almost at $1 trillion in 2007 and 2008, with commercial banks asking for the bulk of
the $600 billion obtained by U.S. chartered depository institutions in 2008.
Thus, members can obtain loans of federal funds from a FHL Bank, or get an advance from a FHL Bank to
pay other members, at a more stable and lower cost than would otherwise have been the case. They can
also obtained those funds for a much longer period than alternative wholesale sources. This helps members
to lower the interest rates they charge to their customers: homebuyers, small businesses, farmers and
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others. Lowering the cost of getting credit for homeownership and community development helps to
promote these economic activities; precisely the goal of the FHLB.
FARMER MAC, FANNIE MAE, FREDDIE MAC, AND SALLIE MAE
This section closes the presentation of government-sponsored enterprise with a quick look at other GSEs.
They work in a similar fashion to the FCS, by issuing securities and using the proceeds to buy or back illiquid
financial instruments held by financial institutions. The goal is once again to lower the level and volatility of
interest rates on specific financial instruments, and to encourage credit for specific economic activities.
A GSE that is formally part of the FCS but independent from it is the Federal Agricultural Mortgage
Corporation (Farmer Mac). Farmer Mac issues its own securities and use the proceeds to purchase
mortgages from financial institutions that help fulfill the mission of the FCS. Farmer Mac also provides
guarantees against the mortgage-backed securities issued by its special purpose entities, and provides
advances that are secured by agricultural real estate and loans guaranteed by the US Department of
Agriculture, among others.
Fannie Mae (Federal National Mortgage Association) was a government agency created in 1938 to purchase
from banks mortgages insured by the Federal Housing Administration (FHA) and the Department of Veteran
Affairs (VA). Until the 1966 financial crisis, Fannie Mae remained a minor player in the secondary market
for mortgages, but the crisis led Fannie Mae to enlarge its purchases to conventional mortgages and it
became the largest participant in the secondary mortgage market. Heavy government involvement in
private affairs (here conventional mortgages) is never seen with a good eye in the United States, and this
involvement required larger spending than the U.S. Congress was willing to provide on a continuous basis.
Therefore, in 1968, the U.S. Congress split Fannie Mae into Ginnie Mae (Government National Mortgage
Association)—a government agency taking the role of Fannie Mae. Fannie Mae became a private
corporation that deals in conventional mortgages and related securities, that conform to specific criteria
set by Fannie Mae. Freddie Mac (Federal Home Loan Mortgage Corporation) was created by act of U.S.
Congress in 1970 to compete with Fannie Mae in the conventional mortgage market. The FHLBS also
competes with Fannie Mae and Freddie Mac to purchase mortgages. Both Fannie Mae and Freddie Mac
have created special purpose entities that pool mortgages, mostly conforming mortgages, and issue
mortgage-backed securities insured by Fannie and Freddie.
While most GSEs currently deal with residential and non-residential mortgages, from 1972 to 2004, Sallie
Mae (Student Loan Marketing Association) used to promote college education. The goal was to encourage
financial institutions to grant credit to students at affordable terms although students usually have no or
poor creditworthiness. In exchange of the payment of a premium, Sallie Mae guaranteed the timely
payment of the student debts to financial institutions. In 2004, Sallie Mae lost its congressional charter—it
became a normal private business—and began to provide credit to students.
U.S. GOVERNMENT AGENCIES
Like GSEs, the U.S. government is also involved in providing credit to, and protecting private financial
institutions against the default of, specific economic units for economic activities that are deemed socially
beneficial. Government financial programs cover housing, education, small businesses, agriculture and
others. These programs ensure that credit at preferential conditions (lower interest rate and/or longer term
to maturity and/or lower downpayment and/or lower credit score threshold, among others), to specific
economic units. Such economic units include low-to-moderate income households, veterans, students,
small businesses, small farms, households with low credit score, among others. Private financial institutions
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would normally, either refuse to grant credit to them, or do so only at high cost because of higher credit
risk. Given that these financial programs aim at delinking partly or fully credit risk from the terms of the
financial instruments, the financial instruments issued under these programs are unconventional and do
tend to record a higher delinquency rate.
Government indirectly provides credit through institutions such as the Federal Housing Administration
(created in 1934), the Veteran Affairs (created in 1930), the Small Business Administration (created in 1953),
and Ginnie Mae (Government National Mortgage Association). These Administrations provide protections
to the bearers of unconventional financial instruments by insuring or guaranteeing their servicing. For
example, FHA mortgages are mortgages issued by households and by held private financial institutions that
are insured by FHA. Households must pay a mortgage insurance premium every month and FHA ensures
the timely servicing of mortgages if households default. The VA also ensures timely servicing but merely by
providing its partial backing, that is, it ensures timely payment on a portion of the debt service due without
asking households to pay an insurance premium. SBA does something similar for the financial instruments
issued by small businesses. Ginnie Mae guarantees the timely payment on mortgage-backed securities
(MBSs) backed mostly by mortgages insured by FHA and guaranteed by the VA. This allows commercial
banks to sell these MBSs at a better price, and so to remove FHA and VA mortgages from their balance
sheet at a lower cost (see Chapter on securitization).
FHA mortgages have an average default rate of over 10 percent—well above the average of all mortgages
(Figure 3.38)—and so carry a higher interest rate. However, the default rate on these mortgages is also very
stable. This can be contrasted with subprime mortgages that have a volatile default rate and defaulted at a
much higher rate in 2009 and 2010, when one quarter of subprime mortgages were in default. Even the
default rate on prime mortgages tripled during that time from 2.5 percent to 7.5 percent. Chapter 19
explains that this had a lot to do with changes in underwriting requirements in the private financial sector.
Figure 3.38 Percentage of mortgages past due by type

Source: Mortgage Bankers Association
Beyond backing private financial instruments through insurance or guarantee, government also directly
provides credit. For example, students reading this book probably heard of the Perkins loan program, the
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Small Business Administration also directly provides disaster assistance loans to small businesses for
repairs, and the Farm Service Agency provides loans to farmers temporary unable to obtain credit through
private institutions.
Table 3.4 shows the balance sheet of Ginnie Mae in 2007. The two main assets among the $13 billion
outstanding are funds with the Treasury and Treasuries. Like many other federal government agencies,
Ginnie Mae has accounts at the Treasury and all receipts and expenses of Ginnie Mae are processed by the
U.S. Treasury. Its main liability amounts to $536 million related to loss reserves for its mortgage-backed
securities, that is, Ginnie Mae records a liability for the expected payments it will have to make to ensure
the timely payment of MBSs it guarantees. Loss reserves go down with actual losses and go up with
recovered funds (mostly obtained for servicing fees it charges on the payments that it makes to MBS
bearers). Ginnie Mae does not have capital; instead, the U.S. Government covers any discrepancy between
assets and liabilities by committing to make payments due by Ginnie Mae. In 2007, this discrepancy was
worth $12.6 billion and it represents mostly commitments made by Ginnie Mae to insure mortgage-backed
securities.
Government National Mortgage Association
(Dollars in Millions)
ASSETS LIABILITIES AND INVESTMENT OF U.S. GOV
Funds with the U.S. Treasury 4,433 Reserve for loss on MBS Program 536
U.S. Government securities 8,736 Other liabilities 554
Mortgages held for sale, net 19
Commitments and contingencies:
Properties held for sale 3 Investment of U.S. Government 12,621
Other assets 520
Total assets 13,711 Total liabilities and Investment of U.S. Gov. 13,711
Table 3.4. Balance sheet of Ginnie Mae for fiscal year 2007
Source: Government National Mortgage Association
Finally, one may look at the overall balance sheet of the U.S. Government to get a broad picture of its
involvement in the financial system (Table 3.5). The U.S. Treasury funds most of the operations of the U.S.
government, and maintains a record of incomes and outlays for all the Departments and Agencies. There
were $465 billion of monetary assets held by the U.S. government. The U.S. government counts as monetary
instruments unminted gold and silver that back gold certificates and silver certificates (the certificates are
included in other liabilities). There was $11 billion worth of gold (valued at the official price of $42.2222 per
fine troy ounces) to back the $11 billion worth of gold certificates still outstanding. The two other main
assets of the U.S. government are physical assets (building, land, furniture’s, among others), valued at $980
billion, and loans. Most loans are made by the Department of Education with a net outstanding amount of
over $1 trillion, followed by loans from the Department of Agriculture with net outstanding loans of $69
billion.
The main liability is Treasuries held by the public, that is, Treasuries held by economic units other than
federal agencies such as the Social Security Administration. The outstanding value of Treasuries held by the
public was $14.1 trillion. The second main liability, worth $7.2 trillion, is benefits to be paid to veterans and
federal employees (pensions, healthcare coverage, and burial services, among others).
One may note that the value of liabilities is far superior to the value of assets with a net worth valued at -
$19 trillion. The U.S. government is massively insolvent in terms of balance sheet (and cash flow given that
it usually records a deficit), if one thinks of the U.S. government in the same way as a private business. Of
course that is not the case, the U.S. government can make all payments due on its liabilities in a timely
fashion because its fiscal agent, the Federal Reserve System, is monetarily sovereign. The Federal Reserve
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System shares that sovereignty with the U.S. government, through a comprehensive coordination with the
U.S. Treasury to accommodate the financial needs of the U.S. government (see Chapter 9).
United States Government
(In billions of dollars)
ASSETS LIABILITIES
Monetary assets 465 Accounts payable 62
Total cash 381 Department of Defense 18.3
Unrestricted: Cash held by 347
Treasury for government-wide
operations Department of Veterans Affairs 4.8
Unrestricted: Other 11.6 Department of Justice 6.2
Restricted 22.4 Department of the Treasury 4.4
International monetary assets 59.6 Department of Education 4
Gold and silver 11.1 Department of Energy 3.6
Foreign currency 12.9 Department of State 2.5
Accounts and taxes receivable, net 133 Department of Homeland Security 2
Loans receivable, net 1,278 General Services Administration 2.4
Federal Direct Student Loans -
Education 958.9 Department of Agriculture 1.9
Federal Family Education Loans -
Education 114.9 U.S. Postal Service 1.8
Electric Loans - USDA 45.2 U.S. Agency for International Development 1.7
Rural Housing Services - USDA 23.1 Tennessee Valley Authority 1.5
Export-Import Bank Loans 23.7 National Aeronautics and Space Administration 1.3
Housing and Urban Development
Loans 16.7 Department of the Interior 0.7
Water and Environmental Loans -
USDA 12.5 All other 5.3
International Monetary Fund
Federal debt securities held by the public 14,221
Program - Treasury 8.6
All other programs 74 U.S. Treasuries 14,139.6
Inventories and related property, net 314 Agency securities: TVA 23.8
Property, plant and equipment, net 980 Agency securities: Others 0.2
Debt and equity securities 48 Accrued interest payable 57.5
Investments in GSEs 109 Federal employee and veteran benefits payable 7,209
Other assets 144 Environmental and disposal liabilities 447
Benefits due and payable 218
Insurance and guarantee program liabilities 122
Loan guarantee liabilities 18
Other liabilities 465
Capital (19,292)
Total assets 3,471 Total liabilities and Capital 3,471
Table 3.5. Balance sheet of the United States Government
Source: Bureau of Fiscal Service (2016 Financial Statements)
One can get an idea of how the balance sheet of the U.S. Government has changed over time by studying
the data of the Financial Accounts. The Accounts do not provide the same number as Table 3.5 because
they do not include all of its aspects. Notwithstanding, the Accounts show a massive negative net worth
with assets worth $5.4 trillion and liabilities worth $18 trillion (Figures 3.39 and 3.40). Financial assets
represent about 30 percent of total assets, and non-marketable financial instruments (mortgages, student
debts, and others) are the main financial assets. Financial liabilities are mostly composed of Treasuries and
retirement entitlement liabilities (claims of federal pension funds on the U.S. government and retiree health
care funds) although the relative importance of Treasuries has grown since the mid-1970s.
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Figure 3.39 Assets of the federal government

Note: Land is not included in nonfinancial assets.
Figure 3.40 Financial assets of the federal government

Note: “Other financial assets” includes equity in GSEs, trade receivables, nonofficial foreign currencies,
equity in the funding corporation set up for the Public–Private Investment Program created during the
Great Recession, among others.
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Figure 3.41 Structure of liabilities of the federal government

Note: “Other liabilities” includes budget agency securities, trade payables, multifamily residential
mortgages, special drawing rights, among others.
TRUST BUT VERIFY: ACCOUNTING FIRMS

In this and the previous Chapter, a lot has been said and shown about the balance sheet and the functions
of different sectors of the financial system, but a vital part of the system was left aside: accounting firms.
Accounting is tedious, unglamorous and relegated to the “back office,” but, without it, there cannot be a
financial sector. Accounting is about providing a record of transactions and outstanding balances to give
managers, and outside analysts, an idea of the financial state of an economic unit. Money is the blood of
finance, trust is its heart, and accounting is its backbone. Without accounting, one cannot draw a balance
sheet statement, income statement, or cash flow statement; finance becomes a black box and one can trust
but not verify. One should always verify, especially when money is at stake.
However, accounting rules are not absolute, they can be bent, they are subject to interpretations, and they
can be evaded. All economic units use accounting rules to their benefits and financial companies—that deal
with accounting on a daily basis—can be especially creative. Indeed, given that accounting is about giving a
picture of the financial state of an economic unit, and given that trust is central to finance, economic units
aim a giving the best financial picture to external analysts; especially in times of financial difficulties. Martin
Mayer, a famous commentator about Wall Street notes:
The fact is that large American banks keep four sets of books: one for the internal
management information system, which hopes to keep the bosses informed of what’s
happening; one for the regulators; one for the Internal Revenue Service; and one for the
stockholders. (Mayer 2001, 308)
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Accounting can be arcane and can be manipulated to one’s favors, and it is also the most effective tool to
create a fraudulent financial scheme. Fraud is about creating trust and subverting that trust for personal
gain; it is about deceiving others for personal gains. A fraudulent scheme cannot continue for long unless
one can subordinate accounting to the need of the scheme. Indeed cases of financial frauds have been
numerous, even since the beginning of the 21st century: Mortgage fraud, LIBOR fraud, securities fraud,
Fannie Mae accounting fraud, among others.
There are also conflicts and debates about the proper accounting standards. For example, one may wonder:
- How should the value of assets be measured? Shall one use their current market value, that is, the
value at which they can be sold now? Shall one use the value at which they were purchased minus
depreciation and if so how does one measure depreciation? Shall another method be used?
- How should the value of income and cash flow be measured? Shall we use an accrual basis or shall
we use a cash basis? Shall interest incomes due be recorded as incomes even if they have not been
paid (accrual accounting) or shall one wait for the actual payment to be made (cash accounting)?
- How should capital be measured? Can some bonds be included in capital? Are common stocks the
only financial instrument that can be counted as capital? What is a proper amount of capital?
Major financial stakes are at play depending on how these questions are answered. For example,
Countrywide reported $295 million in deferred interest revenues for the twelve months ending June 2006,
vs. $5.9 million in the previous twelve months. For other mortgage bearers, deferred interest represented
up to 67 percent of their pre-tax profit. Accrual accounting has its uses—most businesses and all
governments are required to use accrual accounting—but it can be easily abused.
Another example, occurred in 2009, the financial industry pushed for a relaxation of accounting rules in
order to avoid reporting major losses on securitized financial instruments. Major financial institutions
wanted to be allowed to use level-3 valuation (in-house model) instead of level-1 valuation (market value)
or level-2 valuation (proxy market) of their assets. They argued that the prevailing large discounts on
securitized financial instruments were the result of a liquidity crisis (and so temporary) instead of a solvency
crisis (and so permanent) so mark-to-market valuation (level 1) should be relaxed for a while. Both the
Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) resisted
the push to modify the reporting of financial information, and instead argued that government policies
should be used to help the economy. Mr. Hertz, Chairman of FASB, made the following statement:
We also agree with the SEC that suspending or eliminating existing fair value requirements
would not be advisable for the role of accounting and reporting standards is to help the
investing public in the capital markets with sound, unbiased financial information on
companies. Its purpose is not to determine regulatory capital or capital adequacy. [. . .]
Thus, to the extent there are valid concerns relating to procyclicality, I believe these are
more appropriately and more effectively addressed through regulatory mechanisms and
via fiscal and monetary policy than by trying to alter the financial information reported to
investors. (Herz in U.S. House of Representative 2009)
However, in a congressional hearing legislators from both sides, lobbied by the American Bankers
Association, demanded the FASB to act and lift the requirement to use level-1 valuation. Therefore, banks
could record higher profits and net worth by assuming that securities were worth much more than what
market participants were willing to pay for them.
Finally, major accounting firms (Ernst & Young, KPMG, among others) are subject to competitive pressures
and, combined with internal incentives, may give a “clean opinion” (that is put a stamp of approval on
financial documents they audited) when there are actually problems. Chief financial officers only last on
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average for two or three years, and so they have the incentive try to maximize short-term accounting gains.
Employees in the firm are happy because profitability targets are reached and so bonuses are paid. Some
accountants and others inside the firm may come to realize that something is amiss, but they are subject
to tremendous pressure not to say anything or are fired if they become whistleblowers. Matthew Lee at
Lehman Brothers, Carmen Segarra at the New-York Fed, are examples of such remarkable individuals.
RECENT TRENDS AMONG FINANCIAL COMPANIES

Since the 1970s, there has been major changes in the financial sector that can be categorized in terms of:
- Increased competition.
- Increased concentration and the emergence of financial conglomerate: financial holding
companies.
- The rise of off-balance sheet financial operations.
- The rise of money managers.
- The declining relative importance of private depository institutions.
- The internationalization of the financial system.
- The rise of quants and computer trading.
This Chapter presents briefly these different trends and some are developed more fully in other Chapters.
Since the 1970s, the extensive deregulation of the financial sector (see Chapter 11) has increased
competition by removing interest-rate ceilings on savings accounts, by allowing a greater diversification of
financial assets that could be held by each financial institution, and by removing branching restrictions.
Most of these regulations had emerged after the Great Depression to try to deal with the issues of the time.
These regulations progressively became outdated and bypassed as explained in Chapter 10 and Chapter 11.
Today, the U.S. banking industry is highly concentrated (Figure 3.42) and a few large financial holding
companies dominate the industry. Eighty percent of the assets of the banking industry are concentrated in
the 595 largest banks that account for about 10 percent of FDIC-insured banks. While there has been a
concentration of assets among banks, there has also been a concentration off-balance sheet activities.
Figure 3.42 and Table 3.6 show the recent data about derivative holding concentration among FDIC-insured
institutions; the seven biggest institutions hold 97 percent of derivative contracts held by FDIC-insured
institutions, worth almost $170 trillion notionally. Derivatives bring forward the rise of off-balance sheet
financial entities and instruments that will be studied in another Chapter. From the 1980s, because of
monetary policy and regulatory reasons, off-balance sheets operations became a core component of the
financial system.
The high concentration of the industry means that if one of the banks fails, it may have a major impact on
the financial system because it has many creditors. Banks may become “too big to fail,” and so must be
saved even though they are not economically viable. This may promote moral hazard—banks take more
risks than they would have otherwise because they know the government will rescue them—and so may
increase financial instability over time.
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Figure 3.42 Concentration of the banking industry

Source: Federal Deposit Insurance Corporation (Graph Book)
Note: Largest FDIC Insured Bank have over $10 Billion of Assets (595 institutions in 2016 or 10% of the
industry)
Percent of Spot Foreign

Derivative
Total Number of Exchange Size
Report Date Contracts
Derivative Banks Contracts Grouping
(Trillions)
Contracts (Billions)
December 7 Largest
$169.3 97% 7 $928.0
31, 2015 Participants
December All Other
$4.7 3% 1,400 $105.5
31, 2015 Participants
Table 3.6 Concentration of derivatives notional amounts

Source: Federal Deposit Insurance Corporation (Graph Book)
Beyond concentration, there has also been a diversification of the activities of financial institutions. While
the 1930s regulations had compartmentalized the financial system, this was not the case by the 1990s and
a financial holding company (all the major “banks” in the United States: Bank of America, Wells Fargo,
Goldman Sachs, among others) owns multiple companies that are involved in commercial banking,
insurance, investment banking, and money managing.
Figure 3.43 shows how the predominance of private depository institutions (commercial banks and thrifts)
in the financial sector has changed through time. From 1980 until 2000, the share of financial assets held
by them fell dramatically from 50 percent of all financial assets held by the financial industry to about 20
percent; this share has been a stable since 2000. Instead, money managers (mutual funds, pension funds,
etc.) have gained in importance as did financial institutions related to securitization, which together held
about 55 percent of the financial assets held by the financial industry in 2015. Moneylenders (payday loan
companies and others) have also grown in proportion since the mid-1960s.
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Figure 3.43 Allocation of financial assets within the financial sector

Note: Savings institutions were merged with other private depository institutions in 2011.
Finally, a more recent change has been the rapid growth of computer trading and quants. Computers can
execute thousands of sales and purchases of financial instruments in a blink of an eye, and they focus on
millisecond (or less) changes in the prices of those financial instruments. The rise of computer means a
growing need for empirics and mathematics among firms involved in trading, and so the rise of individuals
with quantitative skills (quants). When previously one would use intuitions and back of the envelop analysis,
together with some qualitative analysis, quants use empirics and mathematics to develop formal trading
rules that can be plugged into computers. Nuclear physicists and others mathematical whizzes with no
finance backgrounds have been hired to create complex financial instruments and trading algorithms.
CONCLUSION
This overall presentation of the US financial system shows that it is complex and vast. Still, this Chapter left
out most the multitude of private and government regulators and supervisors that are part of that system.
It also left out credit rating agencies.
Financial companies take promises and make promises of all sorts to accommodate the needs of economic
units that need funds to pursue economic operations of all sorts: production, consumption, investment,
speculation, management of inventories, and protection against all sorts of contingencies that could
negatively influence financial well-being.
Over the past few decades, the complexity and vastness of the financial system has increased tremendously,
with a few giant financial holding companies with revenues as large as the gross domestic product of some
countries having a large influence on the system. Another very large influence on the financial system is the
U.S. government, either directly through its agencies or indirectly through GSEs. The Federal Reserve
System analyzed in Chapters 4 through 9 also has a very large influence, in fact an overwhelming influence,
in the financial sector in terms of interest rates, reliable payment systems, and the economic impact of
99
financial crises. The financial sector is heavily controlled and subsidized to keep interest rate stables, to
reduce interest-rate spreads on specific economic activities, and to ensure that smooth and reliable
refinancing channels are available to private financial institutions. Finance is a public-private partnership.
Private depository institutions used to be the only institutions to have access to these government channels
given their crucial role in the payment system (if they close most payments freeze and economic activity
stops because most private economy units use private banks to make payments). The recent financial crisis
required extending access to safe refinancing channels to other institutions. This heavy involvement of the
government comes with heavy regulation and supervision, but, as explained in Chapter 11, the will to
enforce regulation may not be there.
1- A wide variety of different financial companies that specialize in specific aspects of the financial industry.
2- For-profit financial companies are concerned about staying solvent, which requires that they stay
profitable and liquid. The liquidity concern is the strongest for financial companies that issue demand
liabilities.
3- The federal government is involved in many different ways in the inner workings of the financial sectors
through the sponsoring of private companies (government-sponsored enterprises), through direct and
indirect provision of credit, through guarantees to ordinary for-profit companies, and through the Federal
Reserve System.
4- The federal government is able to operate smoothly even though it usually deficit spends and has a
negative net worth. This is possible and sustainable because the federal government does not operate on
a for-profit basis and because it is monetarily sovereign.
5- Over the past 40 years, the financial sector has become more concentrated, more competitive and more
internationalized. Money managers have gained in importance while private depository institutions have
lost ground in terms of holdings of financial assets.
Keywords
Portfolio, profitability, liquid, solvency, bank run, charter, state bank, national bank, wholesale funding
sources, retail funding sources, federal funds, federal funds market, repurchase agreements, book value,
market value, amortization, depreciation, Regulation Q, credit standards, insurance premium, adverse
selection, moral hazard, copayment, coinsurance, deductible, vesting period, defined-contribution plan,
defined-benefit plan, placement, primary market, secondary market, cash redemption, security
redemption, net asset value, net asset value per share, speculation, position, short position, long position,
capital gain, syndicated credit, offering, initial public offering, seasoned offering, fair price, broker, dealer,
market maker, specialist, primary dealer, margin credit, conventional mortgage, conforming mortgages,
loss reserves, Treasuries held by the public, fraud, mark-to-market valuation, too big too fail, money
manager, institutional investors, pension fund, mutual fund.
100
Review Questions
Q1: Explain what the following financial companies do: commercial bank, savings bank, insurance company,
pension fund, mutual fund, hedge fund, market service company, Federal Home Loan Bank System, Farm
Credit System, Fannie Mae.
Q2: Is the financial system more or less concentrated than it in the past? How do we know?
Q3: Why is it possible for the federal government to continue to operate with a negative net worth?
Q4: What happens to bank that holds a FHA mortgage in the case the homeowner defaults?
Q5: Why would a commercial bank prefer to obtain credit from the FHLB rather than the federal funds
market?
Q6: The FHLB system exist to promote homeownership, how does it do so?
Q7: Financial companies are subject to potential adverse selection and moral hazard. Explain how these can
negatively impact profitability and how financial companies protect themselves.
Q8: How is it possible to make a capital gain by taking a short position in an asset?
Q9: Why are defined-benefit plans more costly for a sponsor than defined-contribution plans?
101
CHAPTER 4:

What leverage is
What the advantages and disadvantages of leverage are
How beneficial leverage is for profitability
Why leverage increases the sensitivity of an economic unit to developments in
the financial sector
CHAPTER 4: LEVERAGE
Given that the concept of leverage will be used often in the upcoming Chapters, this Chapter spends some
time explaining what leverage is and some of its impacts on the balance sheet of economic units.
WHAT IS LEVERAGE?
Leverage is the ability to acquire assets in an amount that is larger than what one’s own capital allows one
to buy. Say that an economic unit has a net worth of $100, that it has no debt and that the counterpart is
$100 in cash (Figure 4.1). The balance sheet looks like this:
Figure 4.1 A balance sheet without leverage

What is the leverage? Leverage = asset/net worth = asset/equity = A/E = $100/$100 = 1. No debt used, all
the cash the economic unit has was acquired without the help of any debt (e.g., grandpa gave you $100 for
Christmas, or you worked to get $100). Now the economic unit decides to use its cash to buy a bond that
pays 10% yearly (Figure 4.2).
Figure 4.2 Another balance sheet without leverage

What is the leverage? Leverage = A/E = $100/$100 = 1. There is still no leverage but asset portfolio allows
the economic unit earns interest income: cash inflow is $10 yearly as interest payment. Of course, buying a
bond involves additional risks compared to cash:
 Default risk (the bond issuer does not pay the $10 interest and cannot repay part or all the principal
due)
 Market risk (the market value of the bond declines and one might have to sell it for less than what
one paid for it)
Going back to case 1, now the economic unit decides to get a $900 advance from a bank at 1% and to buy
10 bonds that pay 10% (Figure 4.3). What is the leverage? Leverage = A/E = $1000/$100 = 10. The economic
unit has acquired 10 times more assets than what its capital allows to buy. It did so by going into debt. This
example is the simplest form of leverage. There are many ways to introduce leverage in a financial deal.
Some of that leverage does not have to be reflected on the balance sheet in the form of a debt to someone.
As long as one can acquire an asset by paying upfront only a fraction of the value of that asset, there is
some leverage.
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CHAPTER 4: LEVERAGE
Figure 4.3 A balance sheet with 10x leverage
WHAT ARE THE ADVANTAGES OF LEVERAGE?

A key metric of profitability is the return on equity (ROE). This return is the ratio of profit over equity. The
ROE can be decomposed as follows:
Profit/Net worth = (Profit/Assets)*(Assets/Net worth)
ROE = ROA * Leverage
Return on Assets (ROA) measures the earning power of the assets on a balance sheet; ROE measures how
successfully an economic unit used its own capital. Leverage multiplies the impact of ROA on ROE because
it allows an economic unit to acquire more assets without having to pay the full amount due with one’s
own funds. Thus leverage gives the following advantages:
1- Better nominal return:
- No leverage: income = net income = $10
- 10x leverage: income = 10 x $10 = $100, Net income = $100 - $9 = $91 > $10
2- Better return
- Return on Asset (ROA)
o No leverage: interest/bond = $10/$100 = 10%
o 10x leverage: net interest/bond = ($100 - $9)/$1000 = 9.1%
- Return on equity (ROE)
o No leverage: interest/equity = $10/$100 = 10% = ROA
o 10x leverage: net interest/equity = ($100 - $9)/$100 = $91/$100 = 91%
By leveraging 10x, ROE is 10 times higher than ROA (9.1% vs 91%) simply because one could acquire ten
times more assets.
WHAT ARE THE DISADVANTAGES OF LEVERAGE?
INTEREST-RATE RISK
What if the interest rate on bank debt goes up to 12% in the previous example?
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CHAPTER 4: LEVERAGE
- No leverage: cash outflow = $0 => net cash flow = $10

- 10x leverage: cash outflow = $900 x .12 = $108 => net cash flow = -$8.
This risk is especially high if an economic unit went into debt on a short-term basis for a long-term portfolio
strategy. Assume one plans to hold 10 bonds for 2 years but issued debt with a 6-month term to maturity;
then one needs to refinance (i.e. repay the debt and ask for credit again) three times.
But there are more worries because economic units care much more about percentage gains (ROE) than
nominal gains. In this case, ROE losses are also multiplied by the size of the leverage.
- No leverage: ROA = ROE = 10%
- 10x leverage: ROA = -$8/$1000 = -0.8%
- 10x leverage: ROE = -$8/$100 = -8%
HIGHER SENSITIVITY OF CAPITAL TO CREDIT AND MARKET RISKS
The same percentage decline in the value of bonds (due to default or loss of market value) leads to much
bigger decline in equity (Figure 4.4).
- No leverage: A 10% decline in the value of the bond wipes out only 10% of net worth
- 10x leverage: A 10% decline in the value of bonds wipes 100% of net worth
Chapter 11 shows that banks can only tolerate a limited decline in the value of their assets. Indeed, not only
are they highly leveraged, but there are regulations governing the amount of capital they are required to
have, as well.
Figure 4.4 Impact on capital of a 10% decline in the value of bonds under no leverage and 10x leverage
REFINANCING RISK AND MARGIN CALL RISK
IMPACT ON MORTGAGE DEBT: REFINANCING RISK
Say that in 2006 a household wants to buy a house that costs $100k and that the bank states that one must
provide a 20% down-payment. How much of the cost of the house is the bank willing to fund at the
maximum?
0.8*100000 = $80000
Now, say that the value of the home goes down to $50000. Assuming the bank is still willing to provide up
to 80% of the house value, the maximum the bank will provide is:
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CHAPTER 4: LEVERAGE
0.8*50000 = $40000
For the same house, the bank is willing to provide less of an advance.
Table 4.1 shows three different contract structures with actual numbers when a household agrees to issue
an $80k mortgage note:
Year 2006 2006 2016
Case A B C
Structure A 30-year fully An 30-year IO with a 30-year 5% fixed-rate
amortized with a fixed 10% fixed rate, starts to fully amortized
rate of 10% amortize after 10 years
Debt Service $8,424.69 for 30 years First 10 Years: $8000 $5153.49 for 30-years
Last 20 years: $9264.21
Table 4.1 Mortgage notes with different terms

In the U.S. the traditional mortgage is a fixed-rate fully amortized (i.e. for which principal is repaid bit by bit
every month) mortgage (case A). During the 2000s housing boom, a lot of prime and subprime households
choose to issue interest-only mortgages (IOs) (case B). With an IO, a mortgagee can choose to pay only the
interest due for a certain time period (say 10 years), and after that the principal must be repaid bit by bit.
This means that for a period of time, case B is cheaper than case A.
The proportion of IO issued by non-prime households in a given year went from virtually 0% to 30% of
mortgages issued by non-prime households. As the Fed started to raise interest rate in 2004, the proportion
of pay-option mortgages issued by non-prime households grew (Figure 4.5). Pay-option mortgages allow
debtors to pay only part of the interest due.
The selling point offered by mortgage brokers was that IO mortgages are cheaper to service for 10 years
and that, while it is true that one might not be able to make that additional $1264 payment that will come
in 10 years, there is no need to worry because refinancing at better terms is always possible given that
home prices always go up.
Come 2016 and the household cannot make the additional $1264 payment. What can be done? One option
is to refinance by issuing an $80000 fixed-rate mortgage with better terms (option C) and by using the funds
to repay the $80000 due on the IO mortgage. Therefore, the household goes to a bank with the intention
to get a credit of $80000. Unfortunately, the bank states it can only provide $40000, that is, it refuses to
refinance unless the household can come up with $40000. Why? Because the home value is now $50000.
In times of crisis, the refinancing problem induced by the decline in the value of houses is actually reinforced
by the fact that the loan-to-value ratio declines. Instead of granting an advance of up to 80% of the home
value, now a bank will do only 60%, which means that the household can only get $30000 from the bank.
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CHAPTER 4: LEVERAGE
Figure 4.5 Share of exotic mortgages in non-prime mortgage originations, percent.

Source: Federal Deposit Insurance Corporation (FDIC Outlook, Summer 2006).
IMPACT ON SECURITY-BASED DEBT: MARGIN CALL RISK
Similar issues are at play with any other form of purchase of assets by using debt. In the balance of Figure
4.3, the outstanding amount of bonds is 10 times as large as the value of equity. The debt that funds the
position in bonds usually comes from a broker and, like for a mortgage transaction, there is a loan-to-value
ratio that determines the maximum dollar amount of funds a broker will provide to buy bonds and other
financial assets. In Figure 4.3, the loan-to-value ratio is 90%.
There are, however, a few differences relative to a mortgage transaction in terms of mechanics, vocabulary
used, and perspective (with an emphasis on the equity component instead of the debt component). First,
brokers require that whoever gets an advance from them open an account with them. This account is called
the margin account and it serves as equity in the financing of the asset position. In Figure 4.3, the economic
units had to deposit $100 in a broker account, which was used to finance a tenth of the bond position. Thus,
the equity-to-value ratio is 10%; 1 – LTV. The minimum equity-to-value ratio that ought to prevail at the
time of the broker participates in the funding of asset positions is called the initial margin requirement and
is regulated by the Federal Reserve System. Currently, the Federal Reserve sets the initial requirement at
50%, which means that at the maximum a client can only acquire twice as many assets as what the dollar
value of its margin account allows. Brokerage firms may choose to have a higher initial margin requirement,
that is, may choose to reduce the ability of their customer to use leverage. Thus, if an economic unit
deposits $500 in a margin account, it can acquire up to $1000 of bonds because the broker will provide up
to $500 more. Assuming an economic unit uses the funds that a broker is willing to provide, the balance
sheet for this transaction is shown in Figure 4.6. One must note that this balance sheet does not represent
the overall balance sheet of an economic unit, it only represents the funding of the bond holdings.
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CHAPTER 4: LEVERAGE
Figure 4.6 Acquisition of bonds with maximum leverage allowed

Second, once the asset has been acquired, the value of the assets purchased is revalued every day according
to the prevailing market price and resulting equity-to-value ratio is calculated. The Federal Reserve again
regulates the minimum value that the equity-to-value ratio must have as a client continues to hold the
assets acquired on margin. This minimum value is called the maintenance requirement and is currently set
at 25% of the value of assets. In the case of Figure 4.6, the value of bonds would have to fall by $250 to
reach the maintenance requirement. If the market value of bonds falls to $600 then the balance sheet of
Figure 4.7 holds. The value of bonds fell by 40% while the value of net worth fell by 80%, which is the result
of using a 2X leverage.
Figure 4.7 Undermargined bond position

The equity to value ratio is now 17% which is below the 25%; the economic unit is under margined in terms
of its holdings of bonds financed with the help of a broker. In order to bring back the equity to value ratio
to the maintenance requirement, the economic unit must either add more bonds to the balance sheet
(perhaps from its overall balance sheet), or increase the net worth of the balance sheet. Assume that the
economic unit decides to add to the net worth, which must be $150 to represent 15% of $600. To add $50
to the net worth, the economic units adds $50 to its margin account for a total of $550.
Things may get more complicated for the economic unit because in times of crises, brokers usually raise the
initial and maintenance requirements, that is, they lower the allowed loan-to-value ratio and time of
acquisition of assets and holding of assets. For example, if the maintenance margin goes up to 40%, in the
previous situation the net worth ought to be $240 (0.4*600). This means that the economic units has to
come up with $140 to add to its margin account. If the economic units cannot come up with the $140, the
broker is allowed to sell some of the bond to repay some of the debt owed so that the maintenance margin
is once again met.
109

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THE FINANCIAL

After reading this Chapter you should understand:

WHAT IS A BALANCE SHEET?

Figure 1.1 A balance sheet

Figure 1.2 A simple balance sheet

Table 1.1 Balance sheet of households and NPOs.

BALANCE SHEET RULES

Figure 1.3 A simple balance sheet

Figure 1.4 Effect of forgiving some of the mortgage principal

Figure 1.5 Effect of higher house price

CHANGES IN THE BALANCE SHEET

NET CASH FLOW

Figure 1.8 Balance sheet and cash flow

Figure 1.9 Balance sheet and cash flows, an example

Figure 1.10 Balance sheet after the cash-flow impacts

NET ADDITION TO ASSETS AND LIABILITIES

Net income leads to a change in net worth:

NET CAPITAL GAIN

MACROECONOMIC USE OF BALANCE SHEET: THE FINANCIAL

Summary of Major Points

After reading this Chapter you should understand:

Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)

Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

Figure 2.1 The financial system in the United States

THE FINANCIAL SECTOR: A WORLD OF PROMISES

Figure 2.3 Some nonfinancial promises

CREATION AND DESTRUCTION OF FINANCIAL INSTRUMENTS

Financial instrument of issuer

$$ (purchased price: fair price) At issuance

Issuer $$ (income) Bearer Until maturity

$$ (repurchase price: face value) At maturity

Financial instrument of issuer

CHARACTERISTICS OF A FINANCIAL INSTRUMENT: TERM TO

MARKETABLE FINANCIAL INSTRUMENTS: SECURITIES

Figure 2.6 Net issuance in corporate equities, billions of dollars.

Figure 2.8 Structure of issuers of corporate equities (percent)

Figure 2.13 An old fashion bond

Figure 2.15 Structure of issuers of corporate and foreign bonds, percent

Figure 2.20 Structure of issuer of Agency- and GSE-backed securities (percent).

NON-MARKETABLE FINANCIAL INSTRUMENTS

Figure 2.27 Structure of issuers of mortgages, percent.

Figure 2.30 Types of consumer credit, percent.

1 Currency and Treasury currency in circulation 12 US Treasuries

Summary of Major Points

After reading this Chapter you should understand:

MAINTAINING SOLVENCY: PROFITABILITY AND LIQUIDITY

- Case 1: The balance sheet looks like this:

PRIVATE DEPOSITORY INSTITUTIONS: COMMERCIAL BANKS AND

Figure 3.2 Structure of liabilities of FDIC-insured commercial banks

Figure 3.5 Structure of the liabilities of savings institutions

Figure 3.7 Structure of the liabilities of credit unions

LIFE INSURANCE COMPANIES

Figure 3.9 Structure of liabilities of life insurance companies

PROPERTY AND CASUALTY INSURANCE COMPANIES

Figure 3.11 Structure of liabilities of property and casualty insurance companies

Figure 3.13 Structure of the liabilities of finance companies

FINANCIAL INVESTMENT COMPANIES

REGULATED PORTFOLIO MANAGEMENT COMPANIES: MUTUAL FUNDS AND

Figure 3.16 Structure of liabilities of mutual funds

Figure 3.18 Structure of liabilities of money market mutual funds

LIGHTLY REGULATED PORTFOLIO MANAGEMENT COMPANIES: HEDGE

REAL ESTATE INVESTMENT TRUSTS

Figure 3.22 Structure of liabilities of real estate investment trust