5/5/22

Introduction
• The world’s leading central banks played a
key role in bringing the financial system
Chapter Fifteen and the economy back to safe harbor after
the peak of the financial crisis in 2008.
• They acted in unprecedented fashion to
prevent the financial system from capsizing
and, over time, to restore financial and
economic stability.
Central Banks in the World Today

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
15-2

1 2

Introduction Introduction
• The central bank of the U.S. is • In Part IV, we will study the evolving
the Federal Reserve (Fed). role of central banks.
• Central banks do not act only during times of
• The people who work there are crisis.
responsible for making sure that our • Their work is vital to the day-to-day
financial system functions smoothly so operation of any modern economy.
• Today there are roughly 170 central banks
that the average citizen can carry on
in the world.
without worrying about it.
• Most people only have a vague idea of what
central banks do.

3 4 15-4

15-3

The Basics: How Central

Introduction Banks Originated and Their
• This chapter begins to explain the role of central Role Today
banks in our economic and financial system.
• The central bank started out as the
• It will describe the origins of modern central banking.
government’s bank and over the years
• It will examine the complexities
added various other functions.
policymakers now face in meeting their
responsibilities. • A modern central bank not only manages
• It will highlight a central question that has the government’s finances but provides
become politically controversial: what is the an array of services to commercial
proper relationship between a central bank banks.
and the government?

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15-6

1

The Government’s Bank
• King William of Orange created the central
bank to finance wars.
• Napoleon Bonaparte did it in an effort to
stabilize his country’s economic and financial
system.
• These examples are more an exception because
central banking is largely a 20th century
phenomenon.
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7 8
The Government’s Bank
• As the government’s bank, the central bank
has a privileged position:
• It has the monopoly on the issuance of currency.
• The central bank creates money.
• Early central banks kept sufficient
reserves to redeem their notes in gold.
• Today, the Fed has the sole legal
authority to issue U.S. dollar bills.
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9 10
The Government’s Bank
• Why would a country want to have its own
monetary policy?
1. At its most basic level, printing money is a very
profitable business.
• A bill only costs a few cents to print.
2. Government officials also know that losing control
of the printing presses means losing control of
inflation.
• A high rate of money growth creates a high
inflation rate.
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The Government’s Bank
• In 1900, only 18 countries had a central bank.
• The U.S. Federal Reserve began operation in
1914.
• As the importance of a government and the
financial system grew, the need for a central
bank grew along with it.
15-8
The Government’s Bank
• The central bank can control the availability
of money and credit in a country's economy.
• Most central banks go about this by adjusting
short-term interest rates: monetary policy.
• They use it to stabilize economic growth and
information.
15-10
The Government’s Bank
• The primary reason for a country to create its
own central bank, then, is to ensure control
over its currency.
• Giving the currency-printing monopoly to someone
else could be disastrous.
• In the European Monetary Union, 16 European
countries have ceded their right to conduct
independent monetary policy to the European
Central Bank (ECB).
• This was part of a broader move toward economic
integration.
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2

• Counterfeiting has been used as a weapon in
wartime.
• The goal was to destabilize the enemy’s currency.
• Without a stable currency it is difficult for an
economy to run efficiently.
• This is why preserving the value of a nation’s
currency is one of the central bank’s most
important responsibilities.
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The Banker’s Bank
• As the banker’s bank, the central bank took
on the roles it plays today:
1. To provide loans during times of financial stress,
2. To manage the payments system, and
3. To oversee commercial banks and the financial
system.
• The ability to create money means that the
central bank can make loans even when no
one else can.
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15
The Banker’s Bank
• Every country needs a secure and efficient
payments system.
• Financial institutions need a cheap and reliable way
to transfer funds to one another.
• The fact that all banks have account at the
central bank makes the it the natural place for
interbank payments to be settled.
• In 2009, an average of more than $2.5 trillion
per day was transferred over Fedwire.
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5/5/22
The Banker’s Bank
• The political backing of the government,
together with their sizeable gold reserve, made
early central banks the biggest and most reliable
banks around.
• The notes issued by the central bank were viewed as
safer than those of smaller banks.
• The safety and convenience quickly persuaded
most other banks to hold deposits at the central
bank as well.
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14
The Banker’s Bank
• No bank, no matter how well managed, can
withstand a run.
• To stave off such a crisis, the central bank can
lend reserves or currency to sounds banks.
• By ensuring that sound banks and financial
institutions can continue to operate, the central
bank makes the whole financial system more
stable.
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16
The Banker’s Bank
• Finally, someone has to watch over commercial
banks and nonbank financial institutions so that
savers and investors can be confident these
institutions are sound.
• Those who monitor the financial system must
have sensitive information.
• Government examiners and supervisors are the
only ones who can handle such information
without conflict of interest.
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3
 5/5/22

The Banker’s Bank The Banker’s Bank

• As the government’s bank and the banker’s
bank, central banks are the biggest, most
powerful players in a country’s financial and
economic system.
• However, an institution with the power to
ensure that the economic and financial systems
run smoothly also has the power to create
problems.
• It is essential that we understand what a central
bank is not.
• It does not control securities markets, though it
may monitor and participate in bond and stock
markets.
• It does not control the government’s budget.
• That is determined by Congress and the president
through fiscal policy.
• The Fed only acts as the Treasury’s bank.

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19 20

The Functions of a Modern Stability: The Primary Objective of All

Central Bank Central Banks
• What makes the private sector incapable of
doing what we have entrusted to the
government?
• In the cases of pollution and national defense, the
answer is more obvious.
• Government involvement is justified by the
presence of externalities or public goods.
• Economic and financial systems, when left on
their own, are prone to episodes of extreme
volatility.

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21 22

Stability: The Primary Objective of All Stability: The Primary Objective of All
Central Banks Central Banks
• We can easily see examples of failure: • Central bankers work to reduce the volatility
1. The Great Depression of the 1930’s when the of the economic and financial systems by
banking system collapsed. pursuing five specific objectives:
• Economic historians state that the Fed failed to 1. Low and stable inflation.
provide adequate money and credit. 2. High and stable real growth, together with high
employment.
2. The crisis of 2007-2009
• The Fed was largely passive as intermediaries took 3. Stable financial market and institutions.
on increasing risk amid the housing bubble. 4. Stable interest rates.
• It also allowed the crisis to intensify for more than 5. A stable exchange rate.
a year after it had begun.

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4

Stability: The Primary Objective of All
Central Banks
• It is important to realize that instability in any
of these poses an economy-wide risk that
individuals can’t diversify away.
• The job of the central bank is to improve
general economic welfare by managing and
reducing risk.
• Understand that it is probably impossible to
achieve all five of their objectives
simultaneously.
• Tradeoffs must be made.
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25
Low, Stable Inflation
• Prices provide the information individuals and
firms need to ensure that resources are
allocated to their most productive uses.
• But, inflation degrades the information content
of prices.
• If the economy is to run efficiently, we need to
be able to tell the reason why prices are
changing.
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27
Low, Stable Inflation
• Most people agree that low inflation should be
the primary objective of monetary policy.
• How low should inflation be?
• Zero is probably too low.
• There would be a risk of deflation.
• This makes debts more difficult to repay,
increasing default, affecting the health of banks.
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5/5/22
Low, Stable Inflation
• Many central banks take their primary job as
the maintenance of price stability.
• They strive to eliminate inflation.
• The consensus is that when inflation rises, the
central bank is at fault.
• The purchasing power of one dollar, one yen,
or one euro should remain stable over long
periods of time.
• Maintaining price stability enhances money’s
usefulness both as a unit of account and as a
store of value.
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Low, Stable Inflation
• The higher inflation is, the less predictable it is,
and the more systematic risk it creates.
• High inflation is also bad for growth.
• In cases of hyperinflation, when prices double
every two to three months,
• Prices contain virtually no information, and
• People use all their energy just coping with the
crisis so growth plummets.
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28
Low, Stable Inflation
• Zero inflation would also be difficult for
companies.
• If an employer wished to cut labor costs, it would
need to cut nominal wages which is difficult to do.
• So, a small amount of inflation makes labor
markets work better, at least from an
employer’s point of view.
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5

• High inflation is more volatile than low
inflation.
• Volatile inflation means more risk which
requires compensation.
• High inflation means a higher risk premium, so
loan rates are higher.
• Volatile inflation makes long-term planning
even more difficult.
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31
High & Stable Real Growth
• The idea is that there is some long-run
sustainable level of production called potential
output, which depends on things like
• Technology,
• The size of the capital stock, and
• The number of people who can work.
• Growth in these inputs leads to growth in
potential output -- sustainable growth.
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33
High & Stable Real Growth
• Our hope is that policymakers can manage the
country’s affairs so that we will stay on a high
and sustainable growth path.
• Fluctuations in general business conditions are
the primary source of systematic risk, so
stability is important.
• Uncertainty about the future make planning
more difficult, so less uncertainty makes
everyone better off.
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5/5/22
High & Stable Real Growth
• To foster maximum sustainable growth in
output and employment is one of Chairman
Bernanke’s goals.
• This means he is working to dampen the
fluctuations of the business cycle.
• By adjusting interest rates, central bankers
work to moderate these cycles and stabilize
growth and employment
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32
High & Stable Real Growth
• A period of above-average growth has to be
followed by a period of below-average growth.
• The job of the central bank during such periods
is to change interest rates to adjust growth.
• In the long run, stability leads to higher
growth.
• The greater the uncertainty about future business
conditions, the more cautious people will be in
making investments of all kinds.
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34
Financial System Stability
• The Fed was founded to stop the financial
panics that plagued the U.S. during the late
19th and early 20th centuries.
• Given the recent crisis, we know that financial
and economic catastrophes are not limited to the
history books.
• Accordingly, financial system stability is an
integral part of every modern central banker’s
job.
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6

Financial System Stability
• If people lose faith in financial institutions and
markets, they will rush to low-risk alternatives.
• Intermediation will stop.
• The possibility of a severe disruption in the
financial markets is a type of systematic risk.
• Central banks must control this risk.
• The value at risk is the important measure here.
• This measures the risk of the maximum potential
loss.
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37
Interest-Rate an Exchange-Rate
Stability
• Why is interest-rate volatility a problem?
1. Most people respond to low interest rates by
borrowing and spending more and vice versa.
• Interest-rate volatility makes output unstable.
2. Interest-rate volatility means higher risk and
therefore a higher risk premium.
• Risk makes financial decisions more difficult,
lower productivity, and lessen efficiency.
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Central Bank Objectives:
Summary
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5/5/22
Interest-Rate an Exchange-Rate
Stability
• These goals are secondary to those of low
inflation, stable growth, and financial stability.
• In the hierarchy, interest-rate stability and
exchange-rate stability are means for achieving
the ultimate goal of stabilizing the economy.
• They are not ends unto themselves.
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Interest-Rate an Exchange-Rate
Stability
• The value of a country’s currency affects the
cost of imports to domestic consumers and the
cost of exports to foreign buyers.
• When the exchange rate is stable, the dollar
price of goods is predictable and planning
ahead is easier for everyone.
• For emerging market countries, exports and
imports are central to the structure of the
economy.
• Stable exchange rates are very important.
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40
• During the crisis, did the Fed sacrifice its
monetary policy independence and its objective
of low, stable inflation?
• Many Fed actions in the crisis were radical and
precedent-setting.
• Has the crisis made the Fed a slave of U.S.
government policy wishes?
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7

• In a financial crisis, the policy goals may be
mutually consistent.
• An independent central bank may wish to
cooperate with fiscal authorities to promote
financial stability and forestall deflation.
• An independent central bank must also be
prepared to reverse course when necessary to
keep inflation low.
• The difficulty is knowing when to exit.
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43
Meeting the Challenge: Creating a
Successful Central Bank
• In the past several decades, overall economic
conditions improved nearly everywhere.
• This was especially true in rapidly growing
emerging economics such as Brazil, China and
India.
• Growth was higher, inflation was lower, and
both were more stable than in the 1980s.
• What explains this long period of stability?
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45
Meeting the Challenge: Creating a
Successful Central Bank
• Today economists are exploring how to improve
financial regulation, and reconsidering the role that
central banks should play in financial supervision.
• To be successful, a central bank must:
1. Be independent of political pressure,
2. Make decisions by committee,
3. Be accountable to the public and transparent in
communicating its policy actions, and
4. Operate within an explicit framework that clearly states its
goals and makes clear the trade-offs among them.
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5/5/22
• Likely the greatest threat to the Fed
independence is the popular backlash following
the crisis bailouts of intermediaries like AIG.
• If heightened congressional scrutiny leads to
political efforts to influence future monetary
policy decisions, confidence in the Fed’s
commitment to low inflation could quickly
erode.
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44
Meeting the Challenge: Creating a
Successful Central Bank
• A prime candidate is that technology sparked a
boom just as central banks became better at
their jobs.
1. Monetary policymakers realized that sustainable
growth had gone up, so they could keep interest
rates low without worrying about inflation.
2. Central banks were redesigned.
• Many believe that improvements in economic
performance during the 1990s were related at
least in part to the policy followed by these
restructured central banks.
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The Need for Independence
• The idea of central bank independence, that
central banks should be independent of
political pressure, is a new one.
• After all, the central bank originated as the
government's bank.
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The Need for Independence The Need for Independence

• Independence has two operational • Successful monetary policy requires a long
components. time horizon.
1. Monetary policymakers must be free to • The temptation to forsake long-term goals for short-
control their own budgets. term gains is impossible for most politicians to resist.

2. The bank’s policies must not be reversible by • Knowing these tendencies, governments have
people outside the central bank. moved responsibility for monetary policy into a
• The U.S. Federal Open Market Committee’s
separate, largely apolitical, institution.
decisions cannot be overridden by the President,
Congress or the Supreme Court.

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49 50

The Need for Independence

• The Fed’s extraordinary actions during the
crisis of 2007-2009 led to political backlash in What drove politicians to
the U.S. against central bank independence. give up control over
• The lingering political question is whether monetary policy?
Congress will choose to sacrifice the hard-won
gains on the inflation front by weakening Realization that independent
central bankers would
central bank independence.
deliver lower inflation than
• It would be another costly legacy of the financial they themselves could.
crisis.

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Decision Making by Committee Decision Making by Committee

• Monetary policy decisions are made
deliberately, after significant amounts of
information are collected and examined.
• Crises do occur, requiring someone to be in
charge.
• During normal operations, however, it is better
to rely on a committee than an individual.
• Pooling the knowledge, experience, and
opinions of a group of people reduces the risk
that policy will be dictated by an individual’s
quirks.
• Vesting so much power in one individual also poses
a legitimacy problem.
• Therefore, monetary policy decisions are made
by committee in all major central banks in the
world.

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9
 5/5/22

The Need for Accountability and The Need for Accountability and
Transparency Transparency
• Central bank independence is inconsistent with 1. Politicians would establish a set of goals.
representative democracy. 2. The policymakers would publicly report their
• How can we have faith in our financial system if progress in pursuing those goals.
there are no checks on what the central bankers • Explicit goals foster accountability and
are doing? disclosure requirements create transparency.
• Proponents of central bank independence had a • The institutional means for assuring
twofold solution. accountability and transparency differ from
one country to the next.

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55 56

The Need for Accountability and
Transparency
• Today every central bank announces its policy
actions almost immediately.
• However the extent of the statements that
accompany the announcement and the willingness
to answer questions vary.
• Central bank statements are very different
today than they were in the early 1990s.
• Secrecy is now understood to damage both the
policymakers and the economies they are trying to
manage.
The Need for Accountability and
Transparency
• The economy and financial markets should
respond to information that everyone received,
not to speculation about what policymakers are
doing.
• Policy makers need to be as clear as possible.
• Transparency can help counter the uncertainties
and anxieties that feed liquidity and deleveraging
spirals.

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57 58

The Policy Framework, Policy Trade-
offs, and Credibility
• To meet these objectives, central bankers must
be independent, accountable, and good
communicators.
• These qualities make up what we call the
monetary policy framework.
• This exists to resolve ambiguities that arise in the
course of the central bank’s work.
• Officials have told us what they are going to do.
• This helps people plan and keeps officials
accountable to the public.
15-59
The Policy Framework, Policy Trade-
offs, and Credibility
• The monetary policy framework also clarifies
the likely responses when goals conflict with
one another.
• All objectives cannot be reached at the same
time, and the Fed only has one instrument.
• It is impossible to use a single instrument to achieve
a long list of objectives.
• The goal of keeping inflation low and stable,
then, can be inconsistent with the goal of
avoiding a recession.
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10

The Policy Framework, Policy Trade-
offs, and Credibility
• Central bankers face the trade-off between
inflation and growth on a daily basis.
• In 2008 the FOMC judged that it was more
important to cut the policy rate in an effort to halt
the financial contagion that has resulted form the
run on Bear Stearns.
• Policymakers were forced to choose among
competing objectives amid great uncertainty.
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61
The Policy Framework, Policy Trade-
offs, and Credibility
• Finally, a well designed policy framework
helps policy makers establish credibility.
• For central bankers to achieve their objectives,
everyone must trust them to do what they say they
are going to do.
• Expected inflation creates inflation.
• Successful monetary policy, then, requires that
inflation expectations be kept under control.
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63
Fitting Everything Together: Central
Banks and Fiscal Policy
• Before a European country can join the
common currency area and adopt the euro it is
supposed to meet a number of conditions.
• The country’s annual budget deficit cannot exceed
3% of GDP, and
• The government’s total debt cannot exceed 60% of
GDP.
• Failure to maintain these standards can lead to
pressure from other member countries and even
to substantial penalties.
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5/5/22
The Policy Framework, Policy Trade-
offs, and Credibility
• Because policy goals often conflict, central
bankers must make their priorities clear.
• The public needs to know:
• What policymakers are focusing on and what they
are willing to allow to change, and
• The roles that interest-rate and exchange-rate
stability play in policy deliberations.
• This limits the discretionary authority of the
central bankers, ensuring that they will do the
job with which they have been entrusted.
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Central Bank Design:
Summary
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64
Fitting Everything Together: Central
Banks and Fiscal Policy
• By specifying a range of “acceptable” levels of
borrowing, Europeans are trying to restrict the
fiscal policies that member countries enact.
• For the European Central Bank to do its job
effectively, all the member countries’ governments
must behave responsibly.
• Funding needs create a natural conflict between
monetary and fiscal policy makers.
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66
11

Fitting Everything Together: Central
Banks and Fiscal Policy
• Central bankers, in their effort to stabilize
prices and provide the foundation for high
sustainable growth, take a long-term view.
• They impose limits on how fast the quantity of
money and credit can grow.
• In contrast, fiscal policymakers tend to ignore
the long-term inflationary effects of their
actions.
• They look for ways to spend resources today at the
expense of prosperity tomorrow.
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67
Fitting Everything Together: Central
Banks and Fiscal Policy
• If officials can’t raise taxes and are having
trouble borrowing, inflation is the only way
out.
• While central bankers hate it, inflation is a real
temptation to shortsighted fiscal policymakers.
• Inflation is a way for governments to default
on a portion of the debt they owe.
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69
Fitting Everything Together: Central
Banks and Fiscal Policy
• Both these policies must be reversed to prevent a
large future inflation.
• When faced with a fiscal crisis, politicians
often look for the easiest way out.
• If that way is inflating the value of the currency
today, they will worry about the consequences
tomorrow.
• Monetary policy can meet its objective of price
stability only if the government lives within its
budget and never forces the central bank to
finance a fiscal deficit.
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5/5/22
Fitting Everything Together: Central
Banks and Fiscal Policy
• Some fiscal policymakers resort to actions
intended to get around restrictions imposed by
the central bank.
• This erodes what is otherwise an effective and
responsible monetary policy.
• Today the central bank’s autonomy leaves
fiscal policymakers with two options for
financing government spending.
• Take a share of income and wealth through taxes.
• Borrow by issuing bonds in the financial markets.
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68
Fitting Everything Together: Central
Banks and Fiscal Policy
• U.S. Fiscal and monetary policies to combat
the crisis of 2007-2009 have led many
observers to worry both about future inflation
risks and about renewed financial instability.
• On the fiscal side, in 2009, the federal government’s
deficit neared 10% of GDP for the first time since
WWII.
• On the monetary policy side, the Fed accumulated
assets at an unprecedented pace as it sought to
prevent a meltdown of the financial system.
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70
Fitting Everything Together: Central
Banks and Fiscal Policy
• Responsible fiscal policy is essential to the success of
monetary policy.
• There is no way for a poorly designed central bank to
stabilize prices, output, the financial system, and
interest and exchange rates, regardless of the
government’s behavior.
• To be successful, a central bank must be independent,
accountable, and clear about its goals.
• It must also have a well-articulated communications
strategy and a sound decision-making mechanism.
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12
 5/5/22

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

• Popular fury over the crisis bailouts of large

financial firms fueled a congressional attack on
Fed independence. End of
• As of early 2010, it remains unclear whether
Congress will enact legislation that weakens the Fed Chapter Fifteen
or adds to its supervisory responsibilities.
• Regulatory reforms that aim to strengthen the
financial system can have troublesome
“unintended consequences.”
Central Banks in the World Today
15-73

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

73 74

13
 Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Introduction
• Most people use the word bank to describe a
depository institution.
• There are depository and non-depository
Chapter Twelve institutions that differ by their primary source
of funds - the liability side of their balance
sheet.
• Depository institutions include
• Commercial banks, savings and loans, and credit
unions.
Depository Institutions:
Banks and Bank Management 12-2

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

1 2

Introduction Introduction
• Banking is a combination of businesses • In this chapter we will:
designed to deliver the services discussed in • Examine the business of banking,
Chapter 11. • See where depository institutions get their funds
• The intent of which is to profit from each of these and what they do with them,
lines of business. • Study the sources of banks’ liabilities and learn how
• Remember that financial and economic they manage their assets, and
development go hand-in-hand. • Examine the sources of risk that bankers face, as
well as how those risks can be managed.
• An economy needs financial institutions to
effectively channel resources from savers to
investors.

12-3 12-4

3 4

The Balance Sheet of Commercial The Balance Sheet of Commercial

Banks Banks
• Commercials banks are institutions established • The difference between a bank’s assets and
to provide banking services to businesses, liabilities is the bank’s capital, or net worth.
allowing them to deposit funds safely and to • Net worth is the value of the bank to its owners.
borrow them when necessary. • A bank’s profits come from both service fees
• Total bank assets equal total bank liabilities and from the difference between what it pays
plus bank capital. for its liabilities and the return it receives on its
• Banks obtain funds from individual depositors assets.
and businesses, as well as by borrowing from • Table 12.1 shows a consolidated balance sheet
other financial institutions in financial markets. for all the commercial banks in the U.S. in
January 2010.
12-5 12-6

5 6

1
 Assets: Uses of Funds
• The asset side of the balance sheet shows what
banks do with the funds they raise.
• Assets are divided into four broad categories:
• Cash,
• Securities,
• Loans, and
• All other assets.
• In winter of 2010, bank assets were equivalent
to about 80 percent of one year’s GDP.

12-7 12-8

7 8

Cash Items Cash Items

Cash asset are of three types: 3. Balances of the accounts that banks hold at
1. Reserves - the most important. other banks.
• Regulations require a certain percent of cash held • Small banks have accounts at large banks -
in reserves. correspondent bank deposits.
• Include the cash in the bank’s vault, vault cash, • In January 2010, banks held more than 10%
and bank’s deposits at the Federal Reserve of their assets in cash.
System.
• Up until the financial crisis of 2007-2009,
• Cash is the most liquid of the bank’s assets.
banks held about 3%.
2. Cash items in process of collection.
• Banks want to minimize cash holdings
• The uncollected funds from checks.
because they earn less on cash.
12-9 12-10

9 10

Securities Securities
• Securities are the second largest component of • About half of all securities are mortgage-
bank assets. backed.
• Banks cannot hold stocks, so these are only • A sizeable portion are very liquid - can be sold
bonds. quickly if the bank needs cash.
• They are split between: • Securities are therefore sometimes referred to as
• U.S. government and agency securities (12.1% of secondary reserves.
assets), and • The share of securities in banks assets has
• Other securities (state and local government bonds) varied around 20% from 1973 to 2010.
(7.8% of assets).

12-11 12-12

11 12

2
 Loans
• Loans are the primary assets of modern
commercial banks, accounting for well over
one-half of assets.
• Loans can be divided into five categories:
1. Business loans called commercial and industrial
(C&I) loans;
2. Real estate loans, including both home and
commercial mortgages and home equity loans;
3. Consumer loans, like auto and credit card loans;
4. Interbank loans; and
5. Other types, including loans for the purchase of
other securities.
12-13
13
Loans
• Over time, commercial banks have become
more involved in the real estate business.
• The rise of the commercial paper market made
direct finance more convenient for large firms.
• The creation of mortgage-backed securities (MBS)
meant that banks could sell the mortgage loans they
made, which reduced the risk of illiquid assets.
12-15
15
Liabilities: Sources of Funds
• Banks get funds from savers and from
borrowing in the financial markets.
• To entice individuals to put funds into their bank,
institutions offer a wide range of services that we
discussed in chapter 11.
• There are two types of deposit accounts:
• Transaction accounts - checkable deposits, and
• Nontransaction accounts.
12-17
17
Loans
• The different loan types differ in their liquidity.
• The primary difference in various kinds of
depository institutions is their composition of
loan portfolios.
• Commercial banks make loans primarily to
businesses.
• Savings and loans provide mortgages to individuals.
• Credit unions specialize in consumer loans.
12-14
14
Balance Sheet of Commercial Banks:
Changes in Assets Over Time
12-16
16
Checkable Deposits
• Checking accounts can include NOW, super-
NOW, and insured market rate accounts.
• Financial innovation has reduced the
importance of checkable deposits in the day-to-
day business of banking.
• Checkable deposits plummeted from 40% of total
liabilities in the 1970s to less than 10% in 2009.
• Innovative accounts whose balances are easily
transferred to checking accounts change the amount
held in traditional deposit accounts.
12-18
18
3
 Nontransaction Deposits
• When choosing a bank, make sure to ask • In 2009 nontransaction deposits accounted for
questions. more than half of fall commercial bank
• What are the fees? liabilities.
• How easily can I reach a person? • Savings deposits, knows as passbook savings
accounts, were popular for may decades, but less so
• How is the customer service?
today.
• And if choosing an internet bank, make sure • Time deposits are certificates of deposit (CDs) with
they are a U.S. bank and are FDIC insured. a fixed maturity.
• Large CDs are greater than $100,000 in face
value and are negotiable - they can be bought
and sold in financial markets.
• Large CDs have an important role in bank
financing
12-19
12-20

19 20

Borrowings Borrowings
• Borrowing is the second most important source • Banks with excess reserves will lend their
of bank funds. surplus funds to banks that need them though
• Accounts for somewhat less than 20% of bank an interbank market called the federal funds
liabilities. market.
• Banks can borrow by: • The lending bank must trust the borrowing bank as
• Borrowing from the Federal Reserve, which is rare, these loans are unsecured.
or • Commercial banks will also borrow from
• Borrowing from other banks. foreign banks.

12-21 12-22

21 22

Borrowings
• Banks finally can borrow using an instrument
called a repurchase agreement, or repo.
• A short-term collateralized loan in which a security
is exchanged for cash.
• The parties agree to reverse the transaction on a
specific future date.

12-24

12-23

23 24

4
 Bank Capital and Profitability
• Remember that net worth equals assets minus
liabilities.
• Net worth is referred to as bank capital, or
equity capital.
• We can think of capital as the owners’ stake in
the bank.
• Capital is the cushion banks have against a
sudden drop in the value of their assets or an
unexpected withdrawal of liabilities.
• It provides some insurance against insolvency.
12-25
25
Bank Capital and Profitability
• The ratio of debt to equity in the U.S. banking
system was about 8 to 1 in January 2010.
• Although that is a substantial amount of
leverage, it is nearly 25% below the average
commercial bank leverage ratio that prevailed
prior to the financial crisis of 2007-2009.
• Debt-to-equity ratio for nonfinancial business in the
U.S. is only 1 to 1.
• Household leverage is less than 1/3 to 1.
• Leverage increases risk AND expected return.
12-27
27
Bank Capital and Profitability
There are several measures of bank profitability.
1. Return on assets (ROA).
• ROA is the bank’s profit left after taxes divided by
the bank’s total assets.
• It is a measure of how efficiently a particular
banks uses its assets.
• This is less important to bank owners than the
return on their own investment.
12-29
29
Bank Capital and Profitability
• An important component of bank capital is
loan loss reserves:
• Loan loss reserves are an amount the bank sets
aside to cover potential losses from defaulted loans.
• At some point the bank gives up hope a loan
will be repaid and it is written off, or erased
from the bank’s balance sheet.
• At this point, the loan loss reserve is reduced
by the amount of the loan that has defaulted.
12-26
26
Bank Capital and Profitability
• One of the explanations for the relatively high
degree of leverage in banking is the existence
of government guarantees like deposit
insurance.
• These government guarantees allow banks to
capture the benefits of risk taking without
subjecting depositors to potential losses.
12-28
28
Bank Capital and Profitability
2. The bank’s return to its owners is measured
by the return on equity (ROE).
• This is the bank’s net profit after taxes divide by
the bank’s capital.
• ROA and ROE are related to leverage.
• One measure of leverage is the ratio of banks
assets to bank capital.
• Multiplying ROA by this ratio yields ROE.
12-30
30
5
 Bank Capital and Profitability
• Prior to the financial crisis of 2007-2009, the
typical U.S. bank has a ROA of about 1.3%.
• For large banks, the ROE tends to be higher
than for small banks, suggesting greater
leverage, a riskier mix of assets, or the
existence of significant economies to scale in
banking.
• Given their performance during the crisis, it seems
their higher returns were at least partly due to more
leverage or a riskier mix of assets.
12-31
31
Bank Capital and Profitability
• Net interest income can also be expressed as a
percentage of total assets to yield: net interest
margin.
• This is the bank’s interest rate spread - the weighted
average difference between the interest rate
received on assets and the interest rate paid for
liabilities.
• Well-run banks have a high net interest income
and a high net interest margin.
• If a bank’s net interest margin is currently
improving, its profitability is likely to improve in
the future.
12-33
33
• China & India could grow even faster.
• China:
• 75% of investment goes through banks.
• State-owned enterprises (48% of GDP) receive 73% of credit.
• Resources are directed inefficiently and disproportionately to
government-favored firms.
• India:
• Banks hold 46% of deposits in Indian government bonds.
• People mistrust banks.
• Government needs to free banks to lend where resources are
best used.
12-35
35
Bank Capital and Profitability
3. The final measure of bank profitability is net
interest income.
• This is related to the fact that banks pay interest on
their liabilities and receive interest on their assets.
• Deposits and bank borrowing rate interest
expenses; securities and loans generate interest
income.
• The difference between the two is net interest
income.
12-32
32
• It is safe to assume that depository institutions
will be with us for some time.
• There are three basic types of depository
institutions: commercial banks, savings
institutions, and credit unions.
• Not all these depository institutions are likely
to survive the financial innovations and
economic upheaval of the coming decades.
12-34
34
Off-Balance-Sheet Activities
To generate fees, banks engage in numerous off-
balance-sheet activities.
1. Lines of credit - similar to limits on credit
cards.
• The firm pays a bank a fee in return for the ability
to borrow whenever necessary.
• The payment is made when the agreement is
signed and firm receives a loan commitment.
• When the firm has drawn down the line of credit,
the transaction appears on the bank’s balance
sheet.
12-36
36
6
 Off-Balance-Sheet Activities
2. Letters of credit
• These guarantee that a customer of the bank will
be able to make a promised payment.
• Customer might request that the bank send a
commercial letter of credit to an exporter in
another country guaranteeing payment for the
goods on receipt.
• In return for taking this risk, the bank receives a
fee.
12-37
Off-Balance-Sheet Activities
3. Standby letter of credit
• Standby letters of credit are letters issued to firms
and governments that wish to borrow in the
financial markets
• They act as a form of insurance.
• These off-balance-sheet activities expose a
bank to risk that is not readily apparent on
their balance sheet.
• By allowing for the transfer of risk, modern
financial instruments enable individual
institutions to concentrate risk in ways that
12-38
are very difficult for outsiders to discern.

37 38

Bank Risk: Where It Comes from and

What to Do about It
• Small stores act as financial intermediaries to • The bank’s goal is to make a profit in each of
provide loans to people who cannot borrow its lines of business.
from mainstream financial institutions. • They want to pay less for the deposits they receive
than for the loans they make and the securities they
• The most common type of loan is a payday buy.
loan. • In the process of doing this, the bank is
• They are very expensive and appeal only to exposed to a host of risks:
those who cannot get credit elsewhere. • Liquidity risk,
• Credit risk,
• Interest-rate risk, and
• Trading risk.

12-39 12-40

39 40

Liquidity Risk Liquidity Risk

• Liquidity risk is the risk of a sudden demand
for liquid funds.
• Banks face liquidity risk on both sides of their
balance sheets.
• Deposit withdrawal is a liability-side risk.
• Things like lines of credit are an asset-side risk.
• Even if a bank has a positive net worth,
illiquidity can still drive it out of business.
• In the past, the common way to manage
liquidity risk was to hold excess reserves.
• This is a passive way to manage liquidity risk.
• Holding excess reserves is expensive, because it
means forgoing higher rates of interest than can be
earned with loans or securities.
• There are two other ways to manage liquidity
risk.
• The bank can adjust its assets or its liabilities.

12-41 12-42

41 42

7
 Liquidity Risk
On the asset side a bank has several options.
1. The easiest option is to sell a portion of its
securities portfolio.
• Most are U.S. treasuries and can be sold quickly at
relatively low cost.
• Banks that are particularly concerned about
liquidity risk can structure their securities holdings
to facilitate such sales.
Liquidity Risk
2. A second possibility is for the bank to sell
some of its loans to another banks.
• Banks generally make sure that a portion of the
loans they hold are marketable for this purpose.
3. Another way is to refuse to renew a customer
loan that has come due.
• However this is bad for business.
• The bank can lose a good customer.
• Reducing assets lowers profitability.

12-43 12-44

43 44

Liquidity Risk
Bankers prefer to use liability management to
address liquidity risk.
1. Banks can borrow to meet any shortfall either
from the Fed or from another bank.
2. The bank can attract additional deposits.
• This is where large certificates of deposits are
valuable:
• They allow banks to manage their liquidity
risk without changing the asset side of their
balance sheet.
12-45

12-46

45 46

Liquidity Risk
• In the financial crisis of 2007-2009, banks
could neither sell their illiquid assets nor obtain
funding at a reasonable cost to hold those
assets.
• When the interbank lending market dried up,
many banks faced a threat to their survival.

12-47

12-48

47 48

8
 Credit Risk
• The risk that a bank’s loans will not be repaid
is called credit risk.
• To manage credit risk, banks use a variety of
tools.
1. Diversification is where banks make a variety
of different loans to spread the risk.
2. Credit risk analysis is where the bank
examines the borrower’s credit history to
determine the appropriate interest rate to
change.
12-49
49
Credit Risk
• Credit risk analysis produces information that
is very similar to the bond rating systems in
Chapter 7.
• Banks do this for small firms wishing to borrow,
and credit rating agencies perform the service for
individual borrowers.
• The result is an assessment of the likelihood that a
particular borrower will default.
• In the financial crisis of 2007-2009, banks
underestimated the risks associated with
mortgage and other household credit.
12-51
51
• Mark-to-market accounting rules require banks
to adjust the recorded value of the assets on
their balance sheets when the market value
changes.
• When the price falls, the value is “written down”
and writedowns reduce a bank’s capital.
• Banks don’t like to hold a large capital cushion
because capital is costly.
• The more leverage the greater the possible
reward for each unit of capital and the greater
the risk.
12-53
53
Credit Risk
• Diversification can be difficult for banks,
especially if they focus on a certain type of
lending.
• If a bank lends in only one geographic area or one
industry, it is exposed to economic downturns that
are local or industry-specific.
• It is important that banks find a way to hedge these
risks.
12-50
50
• A bank’s capital is its net worth - a cushion
against many risks, including market risk.
• Market risk is the decline in the market value of
assets.
• The larger a bank’s capital cushion, the less
likely it will be made insolvent by an adverse
surprise.
• In the financial crisis of 2007-2009, banks
were too leveraged - they had too many assets
for each unit of capital.
12-52
52
Interest-Rate Risk
• A bank’s liabilities tend to be short-term, while
assets tend to be long term.
• The mismatch between the two sides of the balance
sheet create interest-rate risk.
• When interest rates rise, banks face the risk
that the value of their assets will fall more than
the value of their liabilities, reducing the
bank’s capital.
• Rising interest rates reduce revenues relative to
expenses, directly lowering a bank’s profits.
12-54
54
9
 Interest-Rate Risk
• The term interest-rate sensitive means that a
change in interest rates will change the revenue
produced by an asset.
• For a bank to make a profit, the interest rate on
its liabilities must be lower than the interest
rate on its assets.
• The difference in the two rates is the bank’s net
interest margin.
• When a bank’s liabilities are more interest-rate
sensitive than its assets, an increase in interest
rates will cut into the bank’s profits.
12-55
55
Interest-Rate Risk
• Bank managers can use a number of tools to
manage interest-rate risk.
1. They can match the interest-rate sensitivity of
assets with that of liabilities.
• Although this decreases interest-rate risk, it
increases credit risk.
2. Alternatives include the use of derivatives,
specifically interest-rate swaps.
12-57
57
Trading Risk
• Today banks hire traders to actively buy and
sell securities, loans, and derivatives using a
portion of the bank’s capital.
• Risk that the instrument may go down in value
rather than up is called trading risk, or market
risk.
• Traders normally share in the profits from good
investments, but the bank pays for the losses.
• This creates moral hazard - traders take more risk
than the banks would like.
12-59
59
Interest-Rate Risk
• The first step in managing interest-rate risk is
to determine how sensitive the bank’s balance
sheet is to a change in interest rates.
• Managers must compute an estimate of the
change in the bank’s profit for each one-
percentage-point change in the interest rate.
• This procedure is called gap analysis.
• This can be refined to take account of differences in
the maturity of assets and liabilities, but it gets
complicated.
12-56
56
12-58
58
Trading Risk
• The solution to the moral hazard problem is to
compute the risk the traders generate.
• Use standard deviation and value at risk.
• The bank’s risk manager limits the amount of
risk any individual trader is allowed to assume
and monitors closely.
• The higher the inherent risk in the bank’s
portfolio, the more capital the bank will need to
hold.
12-60
60
10

• Traders are gambling with someone else’s money,
sharing the gains but no the losses from their risk
taking.
• Traders are prone to taking too much risk, and in the
cases here, hiding their losses when trades turn sour.
• The moral hazard presents a challenge to bank owners,
who must try to rein in traders’ tendencies.
• Odds are that someone who is making large profits on
some days will register big losses on other days.
12-61
61
Other Risks
• Sovereign risk arises from the fact that some
foreign borrowers may not repay their loans
because their government prohibits them from
doing so.
• If a foreign country is experiencing a financial
crisis, the government may decide to restrict dollar-
denominated payments.
• Banks have three options:
• Diversification,
• Refuse loans to certain countries, or
• Use derivatives to hedge the risk.
12-63
63
Summary of Sources and Management
of Bank Risk
12-65
65
Other Risks
• Foreign exchange risk comes from holding
assets denominated in one currency and
liabilities denominated in another.
• Banks manage this in two ways:
• They work to attract deposits that are denominated
in the same currency as their loans, matching assets
to liabilities.
• They use foreign exchange futures and swaps to
hedge the risk.
12-62
62
Other Risks
• Operational risk is when computer systems fail
or buildings burn down.
• This was an issue for some banks when the World
Trade Center was destroyed.
• The banks must make sure their computer
systems and buildings are sufficiently robust to
withstand potential disasters.
• This means anticipating what might happen and
testing to ensure a system’s readiness.
12-64
64
• In a single decade, the assets of Japanese
commercial banks had fallen nearly 15% while
those of U.S. banks had risen 80%.
• In 2001, net interest margin in Japan was only
1/3 of what it was in the U.S.
• In Japan, net interest income remained roughly
80% of total banks income from 1991 to 2001.
• During the 1990’s American banks found new
ways to produce revenue and profits.
12-66
66
11
 • Japanese banks’ profits, on the other hand, had • Japanese banks were allowed to compute their
turned negative. financial statements using the values they paid
• Why did Japanese banks perform so poorly? for their assets.
• Loan losses. • When the stock market fell, the assets were not
worth what the banks had paid.
• Capital losses.
• This means the value of assets and capital were
• Japanese banks are allowed to own stock, and a
overstated.
decline in the Japanese stock market caused
significant losses for the banks.

12-67 12-68

67 68

• When the Japanese banks had borrowers who

could not pay, they did not write off the loans.
• Instead they piled the interest into a new, larger
loan, inflating the bank’s balance sheet.
• The balance sheet measures overstated capital
in the Japanese banking system, and
understated its impairment.
• The impact of these problems was catastrophic
to the Japanese economy.
• With no new loans, firms can’t grow and neither
can the economy.
12-70
12-69

69 70

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

End of
Chapter Twelve

Depository Institutions:
Banks and Bank Management
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

71

12
 Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Introduction
• In Part III we will be focusing on financial
institutions and government regulatory
agencies.
Chapter Eleven • In this chapter we will examine financial
institutions’ purpose -- financial
intermediation.

The Economics of Financial

Intermediation 11-2

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

1 2

Introduction Introduction
• Financial institutions serve as intermediaries • Intermediaries investigate the financial
between savers and borrowers, so their assets condition of the individuals and firms who
and liabilities are primarily financial want financing to figure out which have the
instruments. best investment opportunities.
• These institutions pool funds from people and • Intermediaries increase investment and
firms who save and lend them to people and economic growth at the same time that they
firms who need to borrow. reduce investment risk and economic volatility.
• This transforms assets and provides access to
financial markets.

11-3 11-4

3 4

Introduction Introduction
• Without a stable, smoothly functioning
financial system, no country can prosper.
• Figure 11.1 plots a commonly used measure of
financial activity--the ratio of credit extended
to the private sector and to gross domestic
product--against real GDP per capita.
• We can see that there are not any rich countries
with very low levels of financial development.

11-5 11-6

5 6

1
 Introduction
• The flow of information among parties in a
market system is particularly rife with
problems.
• These problems can derail real growth unless
they are addressed properly.
• In this chapter we will discuss some of these
information problems and learn how financial
intermediaries attempt to solve them.
11-7
7 8
The Role of Financial Intermediaries
11-9
9 10
The Role of Financial Intermediaries
• These data highlight the importance of
intermediaries.
• Banks are still critical providers of financing around
the world.
• Intermediaries determine which firms can access
the stock and bond markets.
• Banks decide the size of a loan and interest rate to
be charged.
• Securities firms set the volume and price of new
stocks and bond issues when they purchase them for
sale to investors.
11-11
11
The Role of Financial Intermediaries
• Financial markets are important because they
price economic resources and allocate them to
their most productive uses.
• Intermediaries, including banks and securities
firms, continue to play a key role in both direct
and indirect finance.
• Table 11.1 illustrates the importance of direct
and indirect finance.
11-8
The Role of Financial Intermediaries
• From the table we can see:
• To make comparisons across countries of vastly
different size, we measure everything relative to
GDP.
• There is no reason that the value of a country's
stock market, bonds outstanding, or bank loans
cannot be bigger than its GDP.
• When you add up all the types of financing,
direct and indirect, as a percentage of GDP, the
numbers will generally sum to more than 100
in an advanced economy.
11-10
The Role of Financial Intermediaries
• Financial intermediaries are important because
of information.
• Lending and borrowing involves both
transactions costs and information costs.
• Financial institutions exist to reduce these
costs.
11-12
12
2
 The Role of Financial Intermediaries
In their role as financial intermediaries, financial
institutions perform five functions:
1. Pooling the resources of small savers,
2. Providing safekeeping and accounting services, as
well as access to payments system,
3. Supplying liquidity by converting savers’ balances
directly into a means of payment whenever
needed,
4. Providing ways to diversify risk, and
5. Collecting and processing information in ways
that reduce information costs.
11-13
13
Safekeeping, Payments System Access,
and Accounting
• Banks:
• Are a place for safekeeping.
• Provide access to the payments system -- the
network that transfers funds from the account of
one person or business to the account of another.
• Specialize in handing payments transactions,
allowing them to offer these services relatively
cheaply.
11-15
15
Safekeeping, Payments System Access,
and Accounting
• Financial intermediaries also help us manage
our finances.
• They provide us with bookkeeping and
accounting services, noting all our transactions
for us and making our lives more tolerable in
the process.
• These force financial intermediaries to write
legal contracts - but one can be written and
used over and over again - reducing the cost of
each.
11-17
17
Pooling Savings
• The most straightforward economic function of
a financial intermediary is to pool the resources
of many small savers.
• By accepting many small deposits, banks empower
themselves to make large loans.
• In order to do this, the intermediary:
• Must attract substantial numbers of savers, and
• Must convince potential depositors of the
institution’s soundness.
11-14
14
Safekeeping, Payments System Access,
and Accounting
• By giving us a way to pay for things, financial
intermediaries facilitate the exchange of goods
and services.
• This principal of comparative advantage leads
to specialization so that each of us ends up
doing just one job and being paid in some form
of money.
• Financial intermediaries, by providing us with
a reliable and inexpensive payments system,
help our economy to function more efficiently.
11-16
16
Safekeeping, Payments System Access,
and Accounting
• Much of what financial intermediaries do takes
advantage of economies of scale, in which the
average cost of producing a good or service
falls as the quantity produced increases.
11-18
18
3
 Providing Liquidity
• Liquidity is a measure of the ease and cost with
which an asset can be turned into a means of
payment.
• Financial intermediaries offer us the ability to
transform assets into money at relatively low
cost - ATM’s, for example.
• Banks can structure their assets accordingly,
keeping enough funds in short-term, liquid
financial instruments to satisfy the few people
who will need them and lending out the rest.
11-19
Providing Liquidity
• By collecting funds from a large number of
small investors, the bank can reduce the cost of
their combined investment, offering each
individual investor both liquidity and high rates
of return.
• Intermediaries offer both individuals and
businesses lines of credit, which provides
customers with access to liquidity.
11-20

19 20

Providing Liquidity
• A financial intermediary must specialize in • As a student, you usually have no credit
liquidity management. history.
• A credit card company will assume the worst.
• It must design its balance sheet so that it can
sustain sudden withdrawals. • Issuers charge high interest rates as
compensation for the risk they are taking.
• Remember that with a high interest rate,
borrowing is very expensive.

11-22
11-21

21 22

Diversifying Risk Collecting and Processing Information

• Financial institutions enable us to diversify our
investments and reduce risk.
• Banks take deposits from thousands of
individuals and make thousands of loans with
them.
• Each depositor has a very small stake in each one of
the loans.
• All financial intermediaries provide a low-cost
way for individuals to diversify their
investments.
11-23
• The fact that the borrower knows whether he or
she is trustworthy, while the lender faces
substantial costs to obtain that information,
results in an information asymmetry.
• Borrowers have information that lenders don’t.
• By collecting and processing standardized
information, financial intermediaries reduce the
problems that information asymmetries create.
11-24

23 24

4
 Information Asymmetries Information Asymmetries
and Information Costs and Information Costs
• Information plays a central role in the structure • Asymmetric information is a serious hindrance
of financial markets and financial institutions. to the operation of financial markets.
• Markets require sophisticated information to • It poses two important obstacles to the smooth
work well. flow of funds from savers to investors:
• If the cost of information is too high, markets cease 1. Adverse selection arises before the transaction
to function. occurs.
• Issuers of financial instruments know more • Lenders need to know how to distinguish good credit
about their business prospects and willingness risks from bad.
to work than potential lenders/investors. 2. Moral hazard occurs after the transaction.
• Will borrowers use the money as they claim?
11-25 11-26

25 26

Adverse Selection
• The Madoff scandal was a classic Ponzi scheme: • The market for lemons:
• Fraud in which an intermediary collects funds from new
investors, but instead of investing them, uses the funds to pay • Used car buyers can’t tell good from bad cars.
off earlier investors. • Buyers will at most pay the expected value of good
• Investors fail to screen and monitor the managers who and bad cars.
receive their funds. • Sellers know if they have a good car, and won’t
• A façade of public respectability contributes to the accept less than the true value.
success of a Ponzi scheme, and Madoff was a master at • Good car sellers will withdraw cars from the
burnishing his reputation. market.
• Everyone acted as if someone else was monitoring, so • Then the market has only the bad cars.
they could enjoy the free ride.

11-27 11-28

27 28

Adverse Selection in Financial Markets Solving the Adverse Selection Problem

• If you can’t tell good from bad companies • From a social perspective, the problems of
• Stocks of good companies are undervalued, and adverse selection are not good.
• Owners will not want to sell them. • Some companies will pass up good investments.
• If you can’t tell good from bad bonds • Economy will not grow as rapidly as it could.
• Owners of good companies will have to sell bonds • We must find ways for investors and lenders to
for too low a price, so distinguish well-run firms from poorly run
• Owners won’t want to do it. firms.

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5

• If you try to buy a house with a down payment
of less than 20 percent of the purchase price,
the lender may require you to buy private
mortgage insurance (PMI).
• PMI insures the lender in the event that the
borrower defaults on the mortgage.
• You can cancel the insurance when your loan
principal is less than 80 percent of the value.
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Disclosure of Information
• For example, in the U.S., the Securities and
Exchange Commission (SEC) requires firms to
produce public financial statements that are
prepared according to standard accounting
practices.
• However, with the help of some unethical
accountants, company executives found a
broad range of ways to manipulate the
statements to disguise their firms’ true financial
condition.
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Disclosure of Information
• Private information services face a free-rider
problem.
• A free-rider is someone who doesn’t pay the cost to
get the benefit of a good or service.
• The publications are expensive, but public
libraries subscribe to them and writers for
periodicals read them and write stories
publicizing crucial information.
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Disclosure of Information
• An obvious way to solve the problem of
asymmetric information is to provide more
information.
• In most industrialized countries, public
companies are required to disclose voluminous
amounts of information.
• Public companies are those that issue stock and
bonds that are bought and sold in pubic financial
markets.
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Disclosure of Information
• Although accounting practices have changed,
information problems persist.
• In a limited sense there is private information
collected and sold to investors.
• Research services like Moody’s, Value Line, and
Dun and Bradstreet collect information directly
from firms and produce evaluations.
• To be credible, companies cannot pay for this
research, so investors have to.
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• Deflation is harmful because it aggravates
information problems in ways that inflation
does not - it reduces a company’s net worth.
• When prices fall,
• The dollar value of the firm’s liabilities remains the
same, but
• The value of the firm’s assets fall with the price
level.
• Deflation drives down a firm’s net worth,
making it less trustworthy as a borrower.
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6
 Collateral and Net Worth
• Another solution for adverse selection is to
make sure lenders are compensated even if
borrowers default.
• If a loan is insured in some way, then the borrower
isn’t a bad credit risk.
• Collateral is something of value pledged by a
borrower to the lender in the event of the
borrower’s default.
• It is said to back or secure a loan.
• Ex: Cars, houses
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Collateral and Net Worth
• The net worth is the owner’s stake in a firm -
the value of the firm’s assets minus the value
of its liabilities.
• Net worth serves the same purpose as collateral
• If a firm defaults on a loan, the lender can make a
claim against the firm’s net worth.
• From the perspective of the mortgage lender,
the homeowner’s equity serves exactly the
same function as net worth in a business loan.
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Moral Hazard: Problem and Solutions
• The phrase moral hazard originated when
economists who were studying insurance noted
that an insurance policy changes the behavior
of the person who is insured.
• Moral hazard arises when we cannot observe
people’s actions and therefore cannot judge
whether a poor outcome was intentional or just
a result of bad luck.
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Collateral and Net Worth
• Collateral is very prevalent because adverse
selection is less of a concern - the lender gets
something of equal or greater value if the
borrower defaults.
• Unsecured loans, like credit cards, are loans
made without collateral.
• Because of this they generally have very high
interest rates.
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Collateral and Net Worth
• The importance of net worth in reducing
adverse selection is the reason owners of new
businesses have so much difficulty borrowing
money.
• Most small business owners must put up their
homes and other property as collateral for their
business loans.
• Only after establishing a successful business and
built up net worth, can they borrow without
personal property.
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Moral Hazard: Problem and Solutions
• A second information asymmetry arises
because the borrower knows more than the
lender about the way borrowed funds will be
used and the effort that will go into a project.
• Moral hazard affects both equity and bond
financing.
• How do we solve the problem?
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Moral Hazard in Equity Finance
• If you buy stock in a company, how do you
know your money will be used in the way that
is best for you, the stockholder?
• It is more likely that the manager will use the
funds in a way that is most advantageous to
them, not you.
• The separation of your ownership from their
control creates what is called a principal-agent
problem.
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Moral Hazard in Debt Finance
• When the managers are the owners, moral
hazard in equity finance disappears.
• Because debt contracts allow owners to keep
all the profits in excess of the loan payments,
they encourage risk taking.
• Lenders need to find ways to make sure
borrowers don’t take too many risks.
• People with risky projects are attracted to debt
finance because they get the full benefit of the
upside, while the downside is limited to their
collateral.
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Negative Consequences of
Information Costs
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Solving the Moral Hazard Problem in
Equity Financing
• During the 1990’s, a concerted attempt was
made to align managers’ interests with those of
stockholders.
• Executives were given stock options that provided
lucrative payoffs if a firm’s stock price rose above a
certain level.
• This gave managers incentives to misrepresent
companies’ profits.
• At this time, there is no foolproof way of
ensuring managers will behave in the owner’s
best interest.
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Solving the Moral Hazard Problem in
Debt Finance
• Legal contracts can solve the moral hazard
problem inherent in debt finance.
• Bonds and loans carry restrictive covenants that
limit the amount of risk a borrower can assume.
• The firm may have to maintain a certain level of net
worth, a minimum credit rating, or a minimum bank
balance.
• For example: home mortgages’ home insurance, fire
insurance, etc.
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• A key source of the financial crisis of 2007-
2009 was insufficient screening and monitoring
in the securitization of mortgages.
• Originators eased standards and reduced
screening to increase volume and short-term
profitability.
• The firms that assembled the mortgages for
sale, the distributors, could have required
originators to demonstrate a high level of net
worth.
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• When lending standards decline, securitization
becomes a game of “hot-potato”.
• The game ends when defaults soar and
someone is left with the loss.
• Ratings agencies could have halted the game
early, but instead gave their highest ratings to a
large share of mortgage-backed securities.
• Many investors and government officials
assumed agencies’ ratings were accurate - they
were free riders.
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Screening and Certifying to Reduce
Adverse Selection
• The lender uses the number to identify you to a
company that collects and analyzes credit
information, summarizing it for potential
lenders in a credit score.
• Every time someone requests a credit score,
they have to pay, eliminating the free rider
problem.
• Banks can collect information on a borrower
that goes beyond their credit report and loan
application.
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Monitoring to Reduce Moral Hazard
• In the financial world, intermediaries insure
against this type of moral hazard by monitoring
both the firms that issue bonds and those that
issue stocks.
• Many hold significant number of shares in
individual firms.
• They may place a representative on the company’s
board of directors.
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Financial Intermediaries and
Information Costs
• Much of the information that financial
intermediaries collect is used to:
• Reduce information costs, and
• Minimize the effects of adverse selection and moral
hazard.
• To do this, intermediaries:
• Screen loan applicants,
• Monitor borrowers, and
• Penalize borrowers by enforcing contracts.
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Screening and Certifying to Reduce
Adverse Selection
• Underwriters screen and certify firms seeking
to raise funds directly in the financial markets.
• Underwriters are large investment banks like
Goldman Sachs, JPMorgan Chase, and Morgan
Stanley.
• Without certification by one of these firms,
companies would find it difficult to raise funds.
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Monitoring to Reduce Moral Hazard
• For new companies, a financial intermediary
called a venture capital firm does the
monitoring.
• They specialize in investing in risky new ventures
in return for a stake in the ownership and a share of
the profits.
• They keep a close watch on the managers’ actions.
• Finally, the threat of a takeover helps to
persuade managers to act in the interest of the
stock and bondholders.
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9
 How Companies Finance Growth and How Companies Finance Growth and
Investment Investment
• We noted two things at the beginning of this • Instead of distributing profits to shareholders, a
chapter: firm can reinvest the earnings into the firm.
1. Wealthy countries have high levels of financial • A vast majority of investment financing comes from
development, and internal sources.
2. Intermediaries play key roles both in direct and • The fact that managers have superior
indirect finance. information about the way in which their firms
• In addition to direct and indirect finance, a are and should be run makes internal finance
firm can also use its own profits. the rational choice.

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55 56

How Companies Finance Growth and

Investment
• Due to the tightening of financial markets, a
number of peer-to-peer borrowing websites
have popped up.
• They are depending on credit scores, debt
ratios, and other factors to determine to whom
to lend money.
• Is this more efficient and cheaper than a bank?
• Will these peer-to-peer organizations replace
financial intermediaries?

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Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

End of
Chapter Eleven

The Economics of Financial

Intermediation
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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