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eighth edition

Financial Markets
and Institutions
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eighth edition

Financial Markets
and Institutions
Anthony Saunders
Stern School of Business
New York University

Marcia Millon Cornett

Bentley University

Otgontsetseg (Otgo) Erhemjamts

Bentley University
 Final PDF to printer

FINANCIAL MARKETS AND INSTITUTIONS

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To Ingo Walter: a mentor, coauthor, and friend.
—TONY SAUNDERS

To my parents, Tom and Sue.

—MARCIA MILLON CORNETT

To my beautiful daughter, Oyuma.

—OTGO ERHEMJAMTS
ABOUT THE AUTHORS

Anthony Saunders of Science and Technology,

her MS degree in econom-
Anthony Saunders is the John M. Schiff Professor of Finance
ics from the University of
and former chair of the Department of Finance at the Stern
Idaho, and her PhD degree
School of Business at New York University. Professor Saun-
in Finance from Georgia
ders received his PhD from the London School of Eco-
State University. Dr. Erhem-
nomics and has taught both
jamts has written and pub-
undergraduate- and graduate-
lished articles in the areas Otgo Erhemjamts (photo by courtesy
level courses at NYU since of Chris San Antonio-Tunis)
of risk management, bank
1978. Throughout his aca-
performance, life insurer demutualizations, product mar-
demic career, his teaching
ket competition, industry structure, and corporate social
and research have specialized
responsibility. Her research has appeared in academic jour-
in financial institutions and
nals such as the Journal of Money, Credit, and Banking;
international banking. He has
Anthony Saunders
the Journal of Banking and Finance; the Journal of Risk
served as a visiting professor all
and Insurance; and the Journal of Business Ethics. Dr.
over the world, including INSEAD, the Stockholm School
Erhemjamts serves as an Associate Editor for the Global
of Economics, and the University of Melbourne.
Finance Journal. She has taught undergraduate- and
Professor Saunders holds or has held positions on the
graduate-level courses in financial institutions, risk manage-
Board of Academic Consultants of the Federal Reserve Board
ment and insurance, financial markets, investments, equity
of Governors as well as the Council of Research Advisors
valuation, and sustainable investing at Georgia State Uni-
for the Federal National Mortgage Association. In addition,
versity and Bentley University. Dr. Erhemjamts is a mem-
Dr. Saunders has acted as a visiting scholar at the Comptrol-
ber of the Financial Management Association, the American
ler of the Currency and at the International Monetary Fund.
Finance Association, and the Eastern Finance Association.
He is editor of the Journal of Financial Markets, Instruments
and Institutions, as well as the associate editor of a number
Marcia Millon Cornett
of other journals. His research has been published in all of
Marcia Millon Cornett is the Robert A. and Julia E. Dorn Pro-
the major finance and banking journals and in several books.
fessor of Finance at Bentley
He has just published a new edition of his textbook, with
University. She received her
Dr. Marcia Millon Cornett and Dr. Otgo Erhemjamts, Finan-
BS degree in economics from
cial Institutions Management: A Risk Management Approach,
Knox College in Galesburg,
for McGraw Hill (tenth edition). Professor Saunders was
Illinois, and her MBA and PhD
ranked the most prolific author out of more than 5,800 who
degrees in finance from Indi-
have published in the seven leading finance academic jour-
ana University in Bloomington,
nals from 1959 to 2008 (“Most Prolific Authors in the Finan-
Indiana. Dr. Cornett has written
cial Literature, 1959–2008,” Jean Heck and Philip Cooley).
and published several articles Marcia Cornett
in the areas of bank performance, bank regulation, corporate
Otgontsetseg (Otgo) Erhemjamts finance, and investments. Articles authored by Dr. Cornett have
Otgo Erhemjamts is Professor of Finance, Associate Vice appeared in such academic journals as the Journal of Finance;
President, and Associate Provost of Strategic Initiatives at the Journal of Money, Credit, and Banking; the Journal of
Bentley University. She received her BS and MS degrees Financial Economics; Financial Management; and the Journal
in information technology from the Mongolian University of Banking and Finance. She was recently ranked the 124th

vi
 About the Authors
most published out of more than 17,600 authors and the
number five female author in finance literature over the last
50 years. Along with Anthony Saunders and Otgo Erhem-
jamts, Dr. Cornett has recently completed work on the tenth edi-
tion of Financial Institutions Management (McGraw Hill).With
Troy A. Adair Jr. (Harvard University) and John Nofsinger
(University of Alaska, Anchorage), she has also recently com-
pleted work on the fifth edition of Finance: Applications and
Theory and the fourth edition of M: Finance (McGraw Hill).
vii
Professor Cornett serves as an associate editor for the Journal
of Banking and Finance, the Journal of Financial Services
Research, Review of Financial Economics, Financial Review,
and Multi-national Finance Journal. Dr. Cornett has served as
a member of the Board of Directors, the Executive Committee,
and the Finance Committee of the SIU Credit Union. She has
also taught at Southern Illinois University at Carbondale, the
University of Colorado, Boston College, Southern Methodist
University, and Boston University.
PREFACE

T
he last 35 years have been dramatic for the financial services industry. In the
1990s and 2000s, boundaries between the traditional industry sectors, such
as commercial banking and investment banking, broke down and competi-
tion became increasingly global in nature. Many forces contributed to this
breakdown in interindustry and intercountry barriers, including financial
innovation, technology, taxation, and regulation. Then in 2008–2009, the
financial services industry experienced the worst financial crisis since the Great Depres-
sion. Even into the mid-2010s, the U.S. and world economies had not recovered from this
crisis. Most recently, the financial consequences of the 2020 worldwide COVID-19 pan-
demic are unknown but are likely to be larger than any event in history. It is in this context
that this book is written.
As the economic and competitive environments change, attention to profit and, more
than ever, risk become increasingly important. This book offers a unique analysis of the risks
faced by investors and savers interacting through both financial institutions and financial mar-
kets, as well as strategies that can be adopted for controlling and better managing these risks.
­Special emphasis is also put on new areas of operations in financial markets and institutions
such as asset securitization, off-balance-sheet activities, and globalization of financial services.
While maintaining a risk measurement and management framework, Financial
­Markets and Institutions provides a broad application of this important perspective. This
book recognizes that domestic and foreign financial markets are becoming increasingly
integrated and that financial intermediaries are evolving toward a single financial services
industry. The analytical rigor is mathematically accessible to all levels of students, under-
graduate and graduate, and is balanced by a comprehensive discussion of the unique envi-
ronment within which financial markets and institutions operate. Important practical tools
such as how to issue and trade financial securities and how to analyze financial statements
and loan applications will arm students with the skills necessary to understand and man-
age financial market and institution risks in this dynamic environment. While descriptive
concepts so important to financial management (financial market securities, regulation,
industry trends, industry characteristics, etc.) are included in the book, ample analytical
techniques are also included as practical tools to help students understand the operation of
modern financial markets and institutions.

INTENDED AUDIENCE
Financial Markets and Institutions is aimed at the first course in financial markets and
institutions at both the undergraduate and MBA levels. While topics covered in this book
are found in more advanced textbooks on financial markets and institutions, the explana-
tions and illustrations are aimed at those with little or no practical or academic experience
beyond the introductory-level finance courses. In most chapters, the main relationships are
presented by figures, graphs, and simple examples. The more complicated details and tech-
nical problems related to in-chapter discussion are provided in appendixes to the chapters
(available through McGraw-Hill Connect Finance or your course instructor).

ORGANIZATION
Since our focus is on return and risk and the sources of that return and risk in domestic and
foreign financial markets and institutions, this book relates ways in which a modern finan-
cial manager, saver, and investor can expand return with a managed level of risk to achieve
the best, or most favorable, return–risk outcome.
Part 1 provides an introduction to the text and an overview of financial markets and
institutions. Chapter 1 defines and introduces the various domestic and foreign financial
viii
 Preface ix

markets and describes the special functions of FIs. This chapter also takes an analytical look
at how financial markets and institutions benefit today’s economy. In Chapter 2, we provide
an in-depth look at interest rates. We first look at factors that determine interest rate levels,
as well as their past, present, and expected future movements. We then review the concept
of time value of money. Chapter 3 then applies these interest rates to security valuation. In
Chapter 4, we describe the Federal Reserve System and how monetary policy implemented
by the Federal Reserve affects interest rates and, ultimately, the overall economy.
Part 2 of the text presents an overview of the various securities markets. We describe
each securities market, its participants, the securities traded in each, the trading process,
and how changes in interest rates, inflation, and foreign exchange rates impact a financial
manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5),
bond markets (Chapter 6), mortgage markets (Chapter 7), stock markets (Chapter 8), for-
eign exchange markets (Chapter 9), and derivative securities markets (Chapter 10).
Part 3 of the text summarizes the operations of commercial banks. Chapter 11 describes
the key characteristics and recent trends in the commercial banking sector. ­Chapter 12
describes the financial statements of a typical commercial bank and the ratios used to ana-
lyze those statements. This chapter also analyzes actual financial statements for representative
commercial banks. Chapter 13 provides a comprehensive look at the regulations under which
these financial institutions operate and, particularly, the effect of recent changes in regulation.
Part 4 of the text provides an overview describing the key characteristics and regula-
tory features of the other major sectors of the U.S. financial services industry. We discuss
other lending institutions (savings institutions, credit unions, and finance companies) in
Chapter 14, insurance companies in Chapter 15, securities firms and investment banks in
Chapter 16, investment companies in Chapter 17, pension funds in Chapter 18, and fintech
firms in Chapter 19.
Part 5 concludes the text by examining the risks facing a modern FI and FI manag-
ers and the various strategies for managing these risks. In Chapter 20, we preview the
risk measurement and management chapters in this section with an overview of the risks
facing a modern FI. We divide the chapters on risk measurement and management along
two lines: measuring and managing risks on the balance sheet, and managing risks off
the balance sheet. In Chapter 21, we begin the on-balance-sheet risk measurement and
management section by looking at credit risk on individual loans and bonds and how these
risks adversely impact an FI’s profits and value. The chapter also discusses the lending
process, including loans made to households and small, medium-size, and large corpora-
tions. Chapter 22 covers liquidity risk in financial institutions. This chapter includes a
detailed analysis of the ways in which FIs can insulate themselves from liquidity risk and
the key role deposit insurance and other guarantee schemes play in reducing liquidity risk.
In Chapter 23, we investigate the net interest margin as a source of profitability and
risk, with a focus on the effects of interest rate risk and the mismatching of asset and liabil-
ity maturities on FI risk exposure. At the core of FI risk insulation is the size and adequacy
of the owner’s capital stake, which is also a focus of this chapter.
The management of risk off the balance sheet is examined in Chapter 24. The chapter
highlights various new markets and instruments that have emerged to allow FIs to bet-
ter manage three important types of risk: interest rate risk, foreign exchange risk, and
credit risk. These markets and instruments and their strategic use by FIs include forwards,
futures, options, and swaps.
Finally, Chapter 25 explores ways of removing credit risk from the loan portfolio
through asset sales and securitization.

NEW FEATURES
· An all-new chapter on fintech companies has been added as Chapter 19 and discussion
of the rise of fintech firms has been added to Chapters 1 and 20.
· Updates on the major changes proposed for the regulation of financial institutions are
included where appropriate throughout the book.
x Preface

· Tables and figures in all chapters have been revised to include the most recently avail-
able data.
· Many end-of-chapter problems have been revised or updated.

Chapter Changes
· Chapter 1
· The initial impact of the COVID-19 pandemic.
· Updated discussions of the revised Volcker Rule as well as the impact of Brexit on
foreign banks.
· Chapter 2
· A discussion of many countries’ decision to set negative interest rates as part of their
monetary policy. The chapter also highlights the downward sloping yield curve seen
in the United States in 2019.
· Chapter 4
· A new discussion regarding FOMC activity on raising fed funds rate nine times from
December 2015 through December 2018.
· A new discussion on the spike in overnight lending rates in September 2019 and the
Fed’s response.
· A new discussion on the Fed’s balance sheet normalization program.
· A new figure on the Fed’s balance sheet and large-scale asset purchases.
· An updated discussion on Greek bailout by the EU and IMF.
· An updated discussion on the Bank of Japan’s balance sheet and large-scale asset
purchases.
· An updated discussion on the European Central Bank’s policy decisions regarding
negative interest rates.
· An updated discussion on the Bank of England’s four-point plan to prevent post-
Brexit recession.
· Chapter 5
· A new discussion on the review of financial benchmarks, LIBOR in particular, by
regulators and policymakers.
· An updated discussion on eurocommercial paper and its benchmark.
· Chapter 6
· An updated discussion on Puerto Rico’s debt crisis and bankruptcy process.
· An updated discussion on bond issuances by U.S. cities and municipalities.
· A new discussion on Yankee bonds and reverse Yankee bonds.
· An updated discussion on Greek debt crisis and the EU and IMF bailouts.
· Chapter 7
· A new figure on Fannie and Freddie’s share prices.
· An updated discussion on the U.S. Treasury’s investment in the two GSEs, terms of
the agreements, amendments to the agreements, GSE payments to the Treasury, and
the roadmap toward the end of conservatorship.
· Chapter 8
· A new discussion on the Tax Cuts and Jobs Act (TCJA) of 2017 with respect to capi-
tal gains and income tax rates.
· An updated discussion on U.S. IPO market activity.
· Chapter 9
· An updated list of countries that have adopted the euro as their sole currency.
· An updated discussion on the status of London as the dominant location for foreign
exchange trading.
· A new discussion on the total foreign exchange reserves of 149 countries and the
share of the U.S. dollar.
· An updated discussion on the events following Brexit—David Cameron stepping
down as Prime Minister, Theresa May taking the helm, Article 50 enactment of the
Lisbon Treaty, the “Divorce Bill,” etc.—and their effects on the British pound.
Preface xi

· Chapter 10
· A new discussion on the number of contracts CME group handles annually and the
percentage of volume coming from Globex trades.
· Chapter 11
· An updated discussion on the amounts of TARP injections to DIs, payments, and
write-offs.
· An updated discussion on ILC charter applications.
· An updated discussion on money center banks or globally systematically important
banks (G-SIBs).
· An updated discussion on the free trade agreement negotiations between the UK and
the EU following Brexit and the status of London as the world’s banker.
· Chapter 13
· An update on the efforts to repeal the 2010 Wall Street Reform and Consumer Pro-
tection Act (Dodd-Frank Act), including the 2018 Economic Growth, Regulatory
Relief, and Consumer Protection Act (EGRRCPA).
· A new discussion on the July 2019 final rule issued by the five federal financial
regulatory agencies and its implications on the Volcker Rule.
· A new discussion on the size of shadow banking assets in different countries and
jurisdictions.
· An updated discussion on the Financial Stability Oversight Council (FSOC)’s efforts
to identify, assess, and address potential risks imposed by nonbank financial firms.
· An updated description of the capital ratios.
· An updated list of the G-SIBs, based on 2018 data.
· A significantly revised and updated Appendix 13A to describe calculation of deposit
insurance premiums.
· A significantly revised and updated Appendix 13E to describe calculation of risk-
based capital ratios.
· Chapter 14
· An updated discussion on GE Capital (a finance company).
· A new table comparing average savings, deposits, and loan rates at credit unions and
banks.
· An updated discussion on NCUA’s recoveries from failed corporate credit unions.
· A new discussion on the Consumer Financial Protection Bureau (CFPB)’s payday
loan regulation.
· Chapter 15
· An updated discussion on the terrorism risk insurance program.
· A new discussion on losses from Hurricane Harvey, Hurricane Irma, and Hurricane
Maria.
· A new figure on the world’s natural catastrophes by overall and insured losses and
corresponding discussion on losses from Hurricanes Michael and Florence in the
Atlantic; Typhoons Jebi, Mangkut, and Trami in Asia; and wildfires in California.
· Chapter 16
· A new discussion on designated market makers (DMMs).
· A new discussion on noninterest income for banks.
· An updated discussion on the securities industry’s revenues and profits.
· An updated discussion on the enforcement actions filed by the SEC against securi-
ties firms.
· An updated discussion about dark pools and the SEC’s regulation in July 2018
regarding dark pools.
· Chapter 17
· A new figure on the net cash flow to mutual funds (long-term funds and money mar-
ket funds) and corresponding discussion.
· A new figure on the growth of total assets in passive mutual funds and passive ETFs
in comparison to active mutual funds and active ETFs and the corresponding discus-
sion on the shift from active to passive investment strategies.
xii Preface

· A new discussion on additional mutual fund share classes (e.g., I, R, N, X, and Y).
· A new figure on the expense ratios of mutual funds and ETFs.
· A new discussion on the introduction of zero-fee mutual funds and commission-free
ETFs.
· A new discussion on 2010 and 2014 amendments to the rules that govern money
market mutual funds (Rule 2a-7) and the impact of those reforms.
· A new figure on the total net assets of money market mutual funds and a correspond-
ing discussion on a shift from prime to government funds.
· A new discussion on negative net asset flows for the hedge fund industry.
· New figures on hedge fund launches and liquidations, as well as global hedge fund
fees.
· An updated discussion on hedge funder Steven Cohen and the penalties imposed on
his fund for an insider trading case.
· Chapter 18
· An updated discussion on the number of defined benefit pension plans and the num-
ber of defined contribution pension plans.
· A new figure on defined contribution plan assets by type of plan.
· An updated discussion on the abilities of states to cover their pension liabilities.
· A new discussion on the “Social Security 2100 Act” bill of 2017 and its proposals to
rescue Social Security from its pending insolvency in 2035.
· A new table on the net pension replacement rates for OECD and EU countries.
· Chapter 19
· This new chapter on fintech companies starts with an introduction on what fintech
means and why fintech has evolved into a disruptive force in the financial services
industry.
· A new discussion on the reversal in a decades-long growth trend in bank branches
and supply and demand factors contributing to this reversal and increasing adoption
of fintech.
· A new discussion on the changing relationship between banks and fintechs and the
advantages they hold.
· A new discussion on banking-as-a-service (BaaS).
· A new discussion on the types of fintech innovations in payments, clearing, and
settlement services; market support services; credit, deposit, and capital-raising ser-
vices; and investment management services.
· A new discussion on the regulatory approaches to fintech.
· Chapter 21
· An updated discussion of the increase in student loan debt and its risk.
· Additional new ratios.
· Chapter 22
· An updated discussion on the Fed’s gradual increases of the fed fund rate from
December 2015 to December 2018.
· A new discussion on mass surrender of policies faced by life insurers.
· A new discussion on the SEC’s 2016 rule that required mutual funds to implement
and document a program to manage liquidity risk, including monthly disclosures on
the relative liquidity of their assets.
· An updated Appendix 22B to describe liquidity risk measures.
· Chapter 23
· A new in-chapter example illustrating unequal interest rate changes on assets and
liabilities.
· Chapter 25
· A new figure on the U.S. asset-backed securities outstanding and a corresponding
discussion on the size of the CDO market.
· A new discussion on how CLO issuance is far surpassing other types of CDOs and
how, as a result, the rating profile of the leveraged loan universe has declined.
· A revised “Search the Site” exercise at the end of the chapter.
 Preface xiii

ACKNOWLEDGMENTS
We take this opportunity to thank all of those individuals who helped us prepare this and
previous editions. We want to express our appreciation to those instructors whose insight-
ful comments and suggestions were invaluable to us during this revision.
Keldon Bauer Ozde Oztekin
Tarleton State University Florida International University–Miami
Jen-Chi Cheng O. John Paskelian
Wichita State University University of Houston Downtown
Kathy English Blaise Roncagli
Wilmington University Cleveland State University
Andrew Fodor Matthew Ross
Ohio University–Athens Western Michigan University–Kalamazoo
Robert Goldberg Benjamin Thompson
Adelphi University Lincoln Memorial University
Walt Nelson Ann Marie Whyte
Missouri State University University of Central Florida–Orlando
Abdullah Noman David Zalewski
Nicholls State University Providence College
We would like to thank the staff at McGraw-Hill for their help and guidance, especially
Chuck Synovec, executive brand manager; Michele Janicek, product development man-
ager; Sarah Wood, freelance product developer; Pat Frederickson, lead content project
manager; Jamie Koch, content project manager; and Trina Maurer, senior marketing
manager.

Anthony Saunders

Marcia Millon Cornett

Otgo Erhemjamts
 Introduction and Overview of Financial Markets part one
Confirming Pages

WALKTHROUGH

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apter

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The following special features have been
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Rates
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98
CHAPTER-OPENING OUTLINESPart 1 Introduction and Overview of Financial MarketsOverview
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mem- the main policy tool
RESERVE SYSTEM: CHAPTER OVERVIEW (Reserve Ratios)
The Federal Reserve, getsthe Money
RESERVE
Learning SYSTEM:
goals CHAPTER
(LGs) appear at the OVERVIEW
bers beginning of
sit on the Federal Open Market Committee, Purchases which
and makes
sales of key
The Federal Reserve, the Money (although
decisions the
affecting operations
the themselves are no
Central banks each determine,
chapter to implement,
provide a and
quick control
introductionthe monetary
to policy in their home Supply,
U.S. government andandfed-
Interest Rates
Reserve Bank of New York, as discussed below
availability of money
Central banks determine, implement, and control the monetary policy in their home and credit in the economy (see below).
Supply, and For
Interest example,
Rates the Federal Reserve
countries. The Federal Reserve (the Fed) isFed)
theBoard,
central bank ofthethe United States. Founded eral agency securities by of the monetary aggregates, sets the federal fu
the key chapter
countries. The Federalmaterial.
Reserve These
(the goals are
is the central also
through bank ofFOMC,
the Unitedcan and usually
States. Founded Effects
does set Reserve.
money of Monetary
supply and Tools rate targets.
interest
the FederalEffects of Monetary Toolsof the Federal Reserve in foreign exchange ma
by Congressintegrated
under
by the Federal
Congress under the
with theReserve
Federal Act in Act
Reserve
end-of-chapter 1913,
The the Fed’s
inFederal
1913,
questions the original
Fed’s
Reserve Boardduties
original duties
also were
were
sets banktotopro-
pro- requirements
reserve on Various
on Various Economic
(discussed
Economic in Chapter
reserve 13) and
requirements and the discount rate are n
videwith
the nation with a safer, more flexible, and more
vide the nation and a safer,
problems, more
which flexible,
allows and reviews
more
instructors to stable
stable
and easily monetary
monetary
approves theandandfinancial
financial
discount ratessystem.
system.
(see below) set Variables
Variables
by the 12 Federal are Reserve
monitoredBanks.
and guided by the FOMC. Assoc
This was needed following a number of banking crises and panicsthat
This was needed emphasize following a number
theoflearning of banking
goal(s) as they crises
The and
choose. Reservethat
1 panics
Federal had occurred
had
Board occurred inin
also has primary Money responsibility
Money Supplyfor
Supply versus release the supervision
versus and The Beige Book su
of the Beige Book.
the first decade the 20th century (particularly 1907)
1 and the last decades of the 19th Interest Rate subsidiaries
Targeting conditions by Federal Reserve district. Inform
the first decade of the 20th century (particularly 1907)
regulation ofand
(1) the
all last
bank
century. As time passed, additional legislation, including the Banking Act of 1935, the Full decades
holding of the
companies 19th (their nonbank
Interest Rate Targeting and their foreign
subsidiaries), (2) state-chartered BOLD banksKEY thatTERMS
are AND
members
International A
of MARGINAL
the
Monetary from reports
Federal
Policies Reservefrom
GLOSSARY bank directors, interviews w
System
century. As time passed,Act
Employment additional
of 1946, legislation,
and the Full including
Employmentthe andBanking
BalancedAct of 1935,
Growth Act ofthe Full
1978
(state-chartered memberGrowth banks), and (3)1978
Edge Act andInternational
Strategies
and agreementMonetary Policies
experts, and other sources. Meetings of the FO
Employment(also Actcalled
of 1946, and the Full Employment
the Humphrey-Hawkins Act), revised and Balanced
and supplemented the TheAct
original mainof
purposesterms 5
and and
concepts
Strategies
arecorporations
emphasized
economic
(through
meetings in the world. As the FOMC
and objectives of the Federal Reserve which
System.
(also called the Humphrey-Hawkins Act), revised and supplemented the original U.S.
These banks
objectives conduct
included foreign
economic operations).
growth
purposes The Systemwide
Fed also Rescue
shares supervisory and regu-
throughout the chapter Programs
byEmployed
bold key icy,terms called
its actions affect out
not only the U.S. economy
www.occ.treas.gov latory
and objectives of the Federal Reserve System. These objectives included economic responsibilities with state and other
growth federal supervisors
Systemwide (e.g.,
Rescuethe OCC, the FDIC),
in the text and defined in the margins
including overseeing both the operations of foreignduring
1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country
the Financial Crisis
banking
Programsorganizations
EmployedFunctions in the United by Federal Rese
Performed
StatesStockand the index
establishment,
fell by 50 percentexamination, Challenges
in less than a year, and termination Remain after
was in the midst of an economic recession. The New York Exchange duringofthebranches,
Financial commercial lend-
Crisis
As part of the Federal Reserve System, Federal R
and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank-
century PERTINENT country WEB the Crisis
was a financial crisis that hit the Uniteding
ruptcies;www.fdic.gov
1. The Panic of 1907 Statessubsidiaries,
and a near collapse of the U.S. financial system.
at the turn of the and20threpresentative
while the offices ADDRESSES
of foreign banks in the
Challenges Remain
United
after
tions.
States. The
These include assistance in the conduct of
was in the midst of an economic recession. The New York Stock Exchange
board index fell
approves by 50 percent
member in
bank Websiteless thanand
mergers a year,
acquisitions and specifies permissible nonbank
and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- addresses are thereferenced
Crisis ofin
95for the margins
member banks and other large financial institu
activities of bank holding companies. The board is also responsible the
of services development
such as new currency issue, check cl
ruptcies; and a near collapse of the U.S. financial system. throughout each chapter, providing additional
and administration of regulations governing the fair provision of consumer the federalcredit (e.g., themember banks, or the g
government,
resources to aid in the learning process.
Truth in Lending Act, the Equal Credit Opportunity Act). Finally, the Wall95
in Table Street
4–1. TheReform
In the News box in this section
and Consumer Protection Act of 2010 provided unprecedented powers extraordinary
to theservices
Federalin many of these areas in
Reserve, putting it in charge of monitoring any of the country’s biggest financial firms—
xiv
those considered critical to the health of the financial system as a whole. TABLE 4–1 Functions Performed by the Fed
sau72403_ch04_095-134.indd 95 07/03/20 06:32 PM
The chair of the Federal Reserve Board, currently Jerome Powell, often advises the
president of the United States on economic policy and serves as the spokesperson Assistance in the forconduct
the of monetary policy—
Federal Open Market Committee (FOMC). FRB
Federal Reserve System in Congress and to the public. All board members share the duties
Supervision and regulation—FRBs have supervi
 Assets. The major assets on the Federal Reserve’s balance sheet are Treasury and gov-
ernment agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold
and foreign exchange. While interbank loans (loans to domestic
Confirming Pages banks) are quite a small
portion of the Federal Reserve’s assets, they play an important role in implementing mon-
etary policy (see below).

Treasury Securities. Treasury securities (55.2 percent of total assets in 2018) are the
largest asset on the Fed’s balance sheet. They represent the111
Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates
Fed’s holdings of securities
issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve
Pedagogical Features
policy directive
the buying and selling of these securities. An increase (decrease) in Treasury securities
statement called the policy directive. The manager of the Trading Desk uses the policy
Statement sent to the Fed- directive to instructheld by the
traders Fed
on the leads
daily to anofincrease
amount (decrease)
open market in or
purchases thesales
money supply.
to trans-
eral Reserve Board Trading act. These transactions take place on an over-the-counter market in which traders are linked
Desk from the FOMC that U.S. Government
to each other electronically (see Chapter 5). Agency Securities. U.S. government agency securities are the
specifies the daily amount To determinesecond-largest
a day’s activity asset account
for open marketonoperations,
the Fed’sthebalance
staff at sheet
the FRBNY(38.8 percent of total assets in
of open market purchases begins each day with 2018). However,
a review in 2007 this
of developments account
in the wasmarket
fed funds 0.0 percent
since the of previous
total assets. This account grew as
or sales to transact. day and a determination of took
the actual
stepsamount of reserves
creditinmarket
the banking
YOUsystem andthe previ- the mortgage

?
the Fed to improve “DO liquidityUNDERSTAND”
support BOXES and housing
D O YO U ous day. The staffmarkets also reviews forecasts of short-term factors
during the financial crisis by buying that may affect the
mortgage-backed supply securities (MBS) backed by
U N D E R STA andNdemand
D of reserves on that day. With this information, the Thesestaff boxes
decidesallow
the levelstudents
of to test
Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC
transactions needed to obtain the desired fed funds rate. The themselves on thewith
process is completed maina concepts
1. What the main called for the purchase of up to $1.25
daily conference call to the Monetary Affairs Division at the Board trillion
presented of agency MBS.
within and
of Governors each The purchase
onemajor chapter activity began
functions of Federal on January 5, 2009, and continued
of the four voting Reserve Bank presidents (outside of New York) through March
section. 2010.
Solutions
to discuss Thus,
are provided in Connect. as
the FRBNY the Fed expanded its role
Reserve Banks for the day’spurchaser/guarantor
plansare? open market operations. of Once
assetsa in theisfinancial
plan approved,markets.
the Trading Desk is
instructed to execute the day’s transactions.
2. What the main
responsibilitiesOpen
of themarket operations
Gold andareForeign
particularly important and
Exchange because“INthey
TreasuryTHE NEWS”
are the primary
Currency. BOXES The Federal Reserve holds
deter-
Federal Reserve
minantBoard
of changesTreasury
in bank excess reserves in the banking system and thus directly impact
gold certificates that are redeemable These boxes demonstrate
at the U.S. Treasury the application
for gold. The Fed also
are? the size of the money supply and/or the levelofofTreasury-issued
interest rates (e.g., the fed funds rate). When
holds small amounts of coinage
chapter material
and foreign- todenominated
real current assets
events.to assist
3. How the FOMCthe Federal Reserve purchases securities, it pays for the securities by either writing a check
in foreign currency transactions or currency swap agreements with the central banks of
implements onmonetary
itself or directly transferring funds (by wire transfer) into the seller’s account. Either
policy? way, the Fed creditsother nations.
the reserve deposit account of the bank that sells it (the Fed) the securities.
IN-CHAPTER EXAMPLES
This assets
4. What the main IN THE NEWS
transaction increases the bank’s excess reserve levels. When the Fed sells
securities,
and liabilities
These examples it eitherInterbank
of thenumerical
provide collects checks receivedAs
Loans. as mentioned earlier, wire
payment or receives depository
transfers institutions
of funds in need of additional
Federal Reserve are? agents funds
from these (such as can borrow
banks) usingatfunds
the Federal
from their Reserve’s
accounts at discount
the Federalwindow
Reserve (discussed in detail below).
demonstrations of the analytical material
Banks to purchase The securities. This reduces the balance
The Financial Crisis: Toward an Explanation and P
interest rate or discount rateofcharged
the reserveonaccount of a bank
these loans that lower than other interest
is often
described in manypurchases
chapters. securities. Thus, when the Federal Reserve sells (purchases) securities in the
In the first half of 2007, as the extent the company’s balance sheet. That 2
open market, it decreases (increases) banks’ (reserve account) deposits at the Fed.
of declining home prices became month, the board also announced s
apparent, banks and other financial the creation of the Term Securities s
market participants started to reas- Lending Facility
Confirming Pages (TSLF), swapping lo
EXAMPLE 4–1 Purchases of Securities sess the byvaluethe Federal
of mortgages Reserve and Treasury securities on its balance a
Suppose the FOMC instructs the FRBNY Trading mortgage-backed
Desk to purchase securities
$500 that million of Trea- sheet for less liquid private securities B
sury securities. Traders at the FRBNY call primary they owned,
government especially thosedealers
securities in the of major held in the private sector, and the e
commercial and investment banks (such as Goldman
sau72403_ch04_095-134.indd 106 subprimeSachs segment andofMorgan
the housing Stanley),9 who Primary Dealer Credit Facility
07/03/20 06:32(PDCF).
PM c
provide a list of securities they have available market. for sale,The autumnthe
including of 2007 saw
denomination, matu- These actions, particularly the latter, in
rity, and the price on each security. FRBNY traders increasing seekstrains
to purchase the target
in a number of number represented of a significant expansion F
A F T E R theT$500 H Emillion. C RTheI FRBNY S I S then notifies its government bond department“AFTER
securities (at the desired maturities and lowest possible
market price) including
segments, until theyasset- have purchased
to receive
of the
THE CRISIS” federal financial safety net by F
backed commercial paper, and banks BOXES making available a greater amount of T
and pay the sellers for the securities it has purchased. The securities dealer sellers (such as
also began to exhibit a reluctance to central bank credit, at prices unavail- to
Goldman banks) in Reaches
turn deposit$5 Billion
these payments Settlement
in their accounts over heldMortgage-Backed
at their local Federal These boxes
ReserveSecurities use articles
lend to one another for terms much able in the market, to institutions (the D
Bank. As a result of these purchases, the Treasury securities account balance of pertaining
the Federal to events
longer
Reserve System is increased by $500 million and the total reserve accountscaused than overnight. This reluctance maintained primary dealers) beyond those banks th
In January 2016, Goldman Sachs residential mortgages, andbywhether
was reflected in amillion.
dramatic ofWe arisecomplex
in orthataffected
mortgage-linkedtypicallydeal. by theat the discount
borrow R
by these banks and dealers at the Fed are increased $500 illustrate these
agreed to paychanges
more than $5 Federal
billion, Reserve’s banksbalance
deceived investors by misrep- In February 2008–2009 financial crisis
to the sheet theinLondon
Table Interbank
4–5. Offered
In addition, Rate
there is2015,
also Morgan
window.
an Stanley
... fi
the largest regulatory
impact onpenalty in its bank resenting
commercial the quality
balance sheets. of reserves
(LIBOR)
Total underlying
at most(assets)maturities ofreached
greater
commercial
toathan
elaborate
preliminary
banks Inaccord
on chapter
the fall with the financial mar-
of 2008, $
history. In settling with the Justice
will increase by $500 million loans.
due The
to the government’s
126 overnight.
purchase ofinquiry
LIBOR
securities intois abymeasure
Justice
the
Part Fed, material.
1 ofDepartment
the demand
and
Introduction in
kets which
and worldwidethe firm
Overview experienced another
of Financial Markets
Department and a collection
deposits of other
(liabilities) Goldmandealers
of the securities related (those
torates
mortgage-backed
at
whowhich soldinternational agreed
the securities) banks attotheir
pay $2.6banks billion.ofThat
round month, volatility and his-
heightened to
state and federal entities, Goldman
will increase by $500 million. securities
10
We also theshow
firm make
packaged dollar
the changes and tosold
loans to one
commercial Goldman
another. banks’ saidbalance
in a regulatory
toric changes: filingLehman
that Brothers filed tw
resolved claims stemming from the between 2005 INTERNATIONAL
andSince
2007, when MONETARY been POLICIES AND STRATEGIES
sheets in Table 4–5. that initialthedisruption, it had
financial informed for by U.S.
Chapter officials
11 bankruptcy protec- le
Wall Street firm’s sale of mortgage housing market was booming
markets have and in aDecember
remained inCentral state banksof 2014 guidethat investment
tion; it might
the facebanking
monetary policy in virtually all
companies in
bonds heading into the financial crisis. investor demand for high related bonds
volatility, ainterest
with many European civil lawsuitrate stemming
Central Bankfrom
Goldman (ECB)the is and
Sachs the central
Morganbank Stanleyfor the Eu
o
INTERNATIONAL COVERAGE
It joined a list of other big banks in was strong. spreads at historically high government’s
of England is mortgage-bond
levels.
the central bankprobe. of the United Kingdom. Like
successfully submitted applications lo
An international
moving pasticon one
9. Asappears
of
of the
December in
biggest,
2019,the
and margin
there The latest
were 24 primary settlement
securities is justonone
dealers trading, average, $1.27 independent
In May,ofthe
trillion firmcentral
securities banks
was in whose
saidtoitbecome talks decisions do not need to b
with
In response to this turbulence, the bank holding companies; to
to easilymost
communicate per
costly, legal
day. where of international In
U.S.contrast, statethe People’stoBank of China, the Reserve Bank o
10. In problems
reality, not all ofthe of will
the $500 million several thatbeGoldman
generally Fed and
deposited has
in thepaid
demand in government
federal
deposit accounts ofand have
commercial authorities
Bank
banks, of resolve
America purchased Merrill s
materialcrisis
is being introduced.
era. The government hadwillearlier relation
hold allto
of the crisis. Goldman agreed of Brazil are Inless independent in that the government impos
and commercial banks not generally the $500
taken
million
a series
in reserve
of dramaticthose
accounts of Federal
relax these simplifying assumptions and look at the effect on total reserves and the monetary the
steps. claims.
As Banks.
Reserve
base operations
theWe
of
settlement,
Lynch;
these Wells Fargo
central banks. acquired Wachovia;of a cen
Independence re
won multibillion-dollar settlements to pay $1.2 billion 2007 in penalties
came to to the
a close, the Goldman agreed toPNC
later in the chapter.
pay to the Justice
theFederal
bank is free from Financial pressure Services Group pur-who mayd
from politicians
from J.P. Morgan Chase, Bank of Federal Housing Finance ReserveAgency Board announced Department
the cre- a $2.385 chasedbillionNational
civil City Corporation; and
activity in the short term (e.g., around election time) at the 1 e
America, and Citigroup. Crisis-related in 2014 to settle claims that it failed
ation of a Term Auction Facility monetary penalty. Goldman must
growth.(TAF), Therefore,the American International
independent central banks
xv operate withmm
settlements by banks, mortgage firms, to disclose the risks in on
whichmortgage
fixed amounts ofalso termprovide
funds $1.8ofbillion
Regardless theirinreceived
Group consumer
independence, significant financial
in the increasingly pg
brokerages and others total at least bonds it sold. In 2010, the firm
are auctioned to depository relief
around through
institu- debt
the world must forgiveness
assistance
work from to only
not the Federal
to guideReserve
the monetaryOp
$181.1 billion. agreed to pay $550 million
tions againstto settle a
any collateral borrowers,
eligible
tries, but also thetoconstruction
for and the Treasury
coordinate and
their effortsDepartment.
with those On of other ce
w
The investigations examined Securities and Exchange Commission
discount window loans. So while the financing
look at how of affordable
central housing,
the policy front,
banks around andthe
the Federal
world took Reserve
independent ti
WALKTHROUGH

Confirming Pages
End-of-Chapter Features
Confir

240 Policy, and Interest Rates

Chapter 4 The Federal Reserve System, Monetary Securities Markets
Part 2 133

SUMMARY
EXCEL PROBLEMS 7. Using a Spreadsheet to Calculate Mortgage Option 1:
Excel problems are featured in selected
This chapter 134
described the Federal Reserve Part
System 1in thePayments:
Introduction
United andWhat
States. The is
Overview theofmonthly
FederalFinancialpayment
Markets on Option 2:
Reserve is the central bank charged with a $150,000,
conducting 30-year
monetary mortgage
policy, supervising if and
the mortgage rate is Which opti
chapters and are denoted by an icon.
regulating depository institutions, maintaining5.75the percent?
stability 6.25
of thepercent?
financial7.5 percent?
system, and9 percent? (LG 7-4) 11.thisYou plan toonpu
Spreadsheet templates are available in6. MHM Bank currently has $250 million in transaction
providing specific financial services to the U.S. government, the public, and financial
What is the full effect of purchase b
deposits on its balance sheet. The current reserve require- and the money supply? mortgage obta
Connect. institutions. We reviewed the structure under which the Fed provides these functions, the
ment is 10 percent, but the Federal Reserve is increasing
Present b. What
TheisPayment down
the full effect of this paymen
purchase on b
monetary policy tools it uses, and the impact of monetary policy changesInterest on money sup-⇒
this requirement to 12Valuepercent. (LG 4-3)Periods Rate and the money
Will Be not payreturn
supply if borrowers off the
on
ply, credit availability, interest rates, security prices, and foreign exchange rates.
a. Show the balance sheet of the Federal Reserve and of these funds to their banks a. inYour
the form
banko
MHM Bank if MHM $150,000
Bank converts 30all
× excess
12 5.75%/12
reserves $ 875.36
deposits? payment:
QUESTIONS to loans, but borrowers 150,000
return only30 80×percent
12 of6.25%/12
these 923.58
9. Marly Bank currently has $650Option million1:in
1. Describe the functions performed by Federal Reserve funds to 10.
MHM What Bank 150,000
are as
thetransaction
tools used by
30 × 12
deposits. 7.50%/12 1,048.82
the Federal Reserve to imple-deposits on its balance sheet. TheOption current 2:
res
Banks. (LG 4-1) b. Show the balance 150,000
sheet policy?
ment monetary of the (LG 304-3)
× 12Reserve
Federal 9.00%/12
and ment is 1,206.93
10 percent, but the Federal Reserve
Which opti
2. Define the discount rate and the discount window. (LG MHM
4-2) Bank if MHM
11. Explain howBank converts
a decrease 85discount
in the percentrateof affects
its creditthis requirement to 9 percent. (LGb. 4-3)
Your bank
3. Describe the structure of the Board of Governors ofexcessthe reserves to loansand
availability and theborrowers return
money supply. (LG904-3)
percent a. Show the balance sheet of the Federal
payments:
Federal Reserve System. (LG 4-2) of these 12.
funds
Why
8.
to does
MHM You
theBank
plan
Federal
to
asReservepurchase
END-OF-CHAPTER
transaction a $200,000
rarelydeposits.
use the discount rate
house
QUESTIONS
to
using either a
Marly Bank if Marly Bank converts all ex
30-year mortgage obtained Option 1:
7. The
4. What are the primary responsibilities of the Federal FOMC hasimplement
Reserve its monetary
instructed the FRBNY AND
policy? (LG
Trading 4-3)Deskfrom
PROBLEMS to your local savings
to loans, butbank
borrowers return only 60 per
with a rate of 7.25 percent, or a 15-year mortgage Option 2:
with a Bank as transaction
Board? (LG 4-1) purchase $500 million in U.S. Treasury securities. The Fed-
13. What changes did the Fed implement to its discount funds to National depo
eral Reserve haswindow ratesetofpolicy
lending
currently 6.50
the
The questions
inpercent.
earlyYou
the requirement
reserve will
2000s? and
atin make
problems
ab.down
the late in the
Showpayment end-
of sheet of the
the balance
Which opti
Federal
5. What are the primary responsibilities of the Federal Open
Market Committee? (LG 4-2) 5 percent of 2000s?
transaction(LG20 percent
deposits.
4-3) of-chapter
of
Assume the purchase
U.S. banks material
price.
with- (LG appear
7-3) in
Marly separate
Bank if Marly12.
BankYou plan to
converts pu
90
6. What are the major liabilities of the Federal draw all excess
Reserve reservesofand
14. Which a. Calculate
thegive sections,
the (LG
out loans.
monetary tools amount allowing
available
4-3) ofto interestinstructors
the Federal to choose
and, separately,
its excess prin- to loans
reserves mortgage obta
and borrowe
System? Describe each. (LG 4-2) a. Assume alsoReserve is mostcipal
that borrowers often used?whether
eventually
paid Why?
return
on each(LG they
allmortgage.prefer
of these
4-3) Whatstudents
is the toofengage
percent
differencethesein funds to down
Marly paymen
Bank a
7. Why did reserve deposits increase to the point that funds
this to 15.
their banks how
Describe in the form ofpaid?
expansionary
interest transaction deposits.by the Fed- deposits.
activities conducted not pay off the
eral effect
Reserveofimpact
in
the money
quantitative or qualitative analysis
account represented the largest liability account on Whatthe is the full b. this purchase
Calculate youron supply, credit availability,
bank deposits
monthly payments on
10. the two
Brown mortgages.
Bank currently has a. Your
$350 bank
million in
and the money
Federal Reserve’s balance sheet in the late 2000s? (LG 4-2) interest rates, and securityof
supply? theDo
prices. material.
the same for Selected
contrac- problems are
What is the difference
4-4)assignable in the monthly deposits on
payment its
on balance
the sheet. The current
payment: res
8. What are the major assets of the Federal Reserve System?
tionary
b. What is the full activities.
effect of this(LG
purchase online in Connect.
on bank deposits ment is 10 percent, but the Federal Reserve
Summarize
two mortgages? Option 1:
Describe each. (LG 4-2) and the 16.
money supply the monetary policy
if borrowers returnmeasures
only 95takenper- by centralthis requirement to 11 percent. (LG 4-3)
You plan to the
purchase acrisis.
$240,000
(LG 4-5)house using either a Option 2:
9. Why did U.S. government agency securities go from nothing fundsto9.toaddress
cent of thesebanks the
their banksworldwide
in financial
form of transac- a. Show the balance sheet of the Federal
tion deposits? 30-year mortgage obtained from your local bank with a Which opti
to being the largest asset account on the Federal Reserve’s Brown Bank if Brown Bank converts all ex
ratethe
of FRBNY
5.75 percent, or Desk
a 15-year mortgageto with b. Your bank
balance sheet in the late 2000s? (LG 4-2) 8. The FOMC has instructed Trading to loans,a but
rateborrowers
of return only 50 per
5.00 percent. Yousecurities.
will makeThe a down payment of to
20Brown
percent payments:
purchase $750 million in U.S. Treasury funds Bank as transaction deposi
Federal Reserve has currently of the set
purchase price.requirement
the reserve (LG 7-3) Option 1:
b. Show the balance sheet of the Federal
PROBLEMS at 10 percent of transaction a. Calculate the amount
deposits. Assume of interest and, separately,
U.S. banks Brown Bankprin- if National BankOption
converts2:7
1. Suppose the Federal Reserve instructs the Trading withdraw
Desk all excess
set the reserves cipal
reserveand paid
give outon
requirement at each
loans.
10 (LGmortgage. What is the
4-3)of transaction
percent difference
its excess in to loans and
reserves Which opti
borrowe
a. Assume
to purchase $1 billion of securities. Show the result of this also that borrowers
deposits. (LG 4-3) eventually
interest paid? return all of these percent of these funds13. You plan to ap
to Brown Bank
transaction on the balance sheets of the Federal Reservefunds to theira. banks
If the in
b.theCalculate
Federalform of transaction
Reserve decreases
your deposits.
the
monthly reserve on thedeposits.
require-
payments two mortgages. mortgage obt
System and commercial banks. (LG 4-3) ment to 6 percent, show the balance sheet of BSW and
What is the difference in the monthly payment on the offered to you
2. Suppose the Federal Reserve instructs the Trading Desk to the Federal Reserve System just before and after the full
effect of thetwo mortgages?
reserve requirement change. Assume BSW ment of 20 pe
sell $850 million of securities. Show the result of this trans-
action on the balance sheets of the Federal Reserve System withdraws
10. Youallplan excessto reserves
purchase anda gives
houseoutforloans and
$115,000 using a 30-year a. Calculate y
and commercial banks. (LG 4-3) that borrowers eventually return all of these funds to
mortgage obtained from your local bank. You will make a b. Construct
BSW in the form of transaction deposits. How much
down payment of 20 reserve
percentrequirement.
of the purchase price. You will
3. Bank Three currently has $600 million in transaction depos-
SEARCH THE SITE
its on its balance sheet. The Federal Reserve has currently
b. Redo part
not
(a) using
pay off
SEARCH THE SITE
a 14 percent
the mortgage early. (LG 7-3) 14. You plan to p
5. National Bank currently has $500 million in transaction
Featured among
set the the end- at 10 percent of transaction
reserve requirement
deposits. (LG 4-3) Go to the Federal Reserve Board website and find the latest information available on the prime rate, the obt
deposits on a.
its Your
balancebank offers
sheet. Theyou the
current following
reserve two
require-options for payment: mortgage dis
of-chapter
a. If thematerial in most Option
ment is 10 percent, theMortgage
but 1: rate of
Federal Reserve 9 percent and zero points.
is decreasing offered to you
Federal Reserve rate, and the three-month
decreases the reserve requirement T-bill rate using the following steps. Go to www.federalreserve.gov. Under “Data
chapters,to these
8 percent,Internet
show the balance sheet of Bank Three and this requirement to 8 percent.
Option (LG 4-3) rate of 8.85 percent and 2 points.
2: Mortgage ment of 20 pe
on “Selected Interest
a. Show Rates.”
the balanceThe most
sheet ofrecent data
the Federal will be shown
Reserve and on your computer screen.
exercises weave the web,
the Federal Reserve System just before and after the full Which option should you
National Bank if National Bank converts all excess
choose? a. Calculate y
real data,
effect of the reserve requirement change. Assume
and practical Questions
Bank
reserves b.
to Your
loans, bank
but offers
borrowers you
return the
only following
50 percent two options for b. Construct
Three withdraws all excess reserves and gives out loans
applications with concepts of these fundspayment:
to National Bank as transaction deposits. How much
and that borrowers eventually return all of these 1. What are the
funds to
b.
current
Show
levels
the balance
for sheet
each ofof the
these interest
Federal
rates?
Reserve and
found inBanktheThree
book. in the form of transaction deposits.
2. Calculate the National
percentage Bankchange in each
if National Bankofconverts
these rates since December 2019.
75 percent
b. Redo part (a) using a 12 percent reserve requirement.
of its excess reserves to loans and borrowers return 60
4. BSW Bank currently has $150 million in transaction depos- percent of these funds to National Bank as transaction
its on its balance sheet. The Federal Reserve has currently deposits.
xvi
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CONTENTS IN BRIEF

Preface viii
part 4 OTHER FINANCIAL
INSTITUTIONS 460
Co part 1 INTRODUCTION AND OVERVIEW OF
14 Other Lending Institutions 460
FINANCIAL MARKETS 1
1 Introduction 1 15 Insurance Companies 485

2 Determinants of Interest Rates 27 16 Securities Firms and Investment Banks 511

3 Interest Rates and Security Valuation 60 17 Investment Companies 536

4 The Federal Reserve System, Monetary Policy, 18 Pension Funds 573

and Interest Rates 95 19 Fintech Companies 595

part 5 RISK MANAGEMENT IN FINANCIAL

part 2 SECURITIES MARKETS 135 INSTITUTIONS 620
5 Money Markets 135 20 Types of Risks Incurred by Financial
Institutions 620
6 Bond Markets 171
21 Managing Credit Risk on the Balance
7 Mortgage Markets 209
Sheet 641
8 Stock Markets 242
22 Managing Liquidity Risk on the Balance
9 Foreign Exchange Markets 284 Sheet 669

10 Derivative Securities Markets 313 23 Managing Interest Rate Risk and Insolvency
Risk on the Balance Sheet 693

part 3 COMMERCIAL BANKS 355

24 Managing Risk off the Balance Sheet with
Derivative Securities 722
11 Commercial Banks 355
25 Managing Risk off the Balance Sheet with Loan
12 Commercial Banks’ Financial Statements and Sales and Securitization 751
Analysis 382 References 779
13 Regulation of Commercial Banks 415 Index 781

xx

Preface viii
Co part 1
INTRODUCTION AND OVERVIEW OF
FINANCIAL MARKETS 1
1 Introduction 1
Why Study Financial Markets and Institutions?
Chapter Overview 1
Overview of Financial Markets 3 3 Interest Rates and Security
Primary Markets versus Secondary Markets
Money Markets versus Capital Markets 6
Foreign Exchange Markets 9
Derivative Security Markets 9
Financial Market Regulation 10
Overview of Financial Institutions 11
Unique Economic Functions Performed by
Financial Institutions 12
Additional Benefits FIs Provide to Suppliers of
Funds 15
Economic Functions FIs Provide to the
Financial System as a Whole 15
Risks Incurred by Financial Institutions 16
Regulation of Financial Institutions 17
Trends in the United States 17
Globalization of Financial Markets and
Institutions 22
Appendix 1A: The Financial Crisis:
The Failure of Financial Institutions’
Specialness 26
2 Determinants of Interest Rates 27
Interest Rate Fundamentals: Chapter
Overview 27
Loanable Funds Theory 28
Supply of Loanable Funds 30
Demand for Loanable Funds 31
Equilibrium Interest Rate 32
Factors That Cause the Supply and Demand
Curves for Loanable Funds to Shift 33
Movement of Interest Rates over Time 37
Determinants of Interest Rates for Individual
Securities 37
Inflation 38
Real Risk-Free Rates 38
Default or Credit Risk 39
Liquidity Risk 41
Special Provisions or Covenants 42
Term to Maturity 42
Term Structure of Interest Rates 44
CONTENTS
Unbiased Expectations Theory 44
Liquidity Premium Theory 46
Market Segmentation Theory 48
Forecasting Interest Rates 50
Time Value of Money and Interest Rates 51
Time Value of Money 51
Lump Sum Valuation 52
Annuity Valuation 54
4 Valuation 60
Interest Rates as a Determinant of Financial
Security Values: Chapter Overview 60
Various Interest Rate Measures 61
Coupon Rate 61
Required Rate of Return 61
Expected Rate of Return 62
Required versus Expected Rates of Return: The
Role of Efficient Markets 63
Realized Rate of Return 64
Bond Valuation 65
Bond Valuation Formula Used to Calculate Fair
Present Values 65
Bond Valuation Formula Used to Calculate
Yield to Maturity 67
Equity Valuation 68
Zero Growth in Dividends 70
Constant Growth in Dividends 71
Supernormal (or Nonconstant) Growth in
Dividends 72
Impact of Interest Rate Changes on Security
Values 73
Impact of Maturity on Security Values 74
Maturity and Security Prices 75
Maturity and Security Price Sensitivity to
Changes in Interest Rates 75
Impact of Coupon Rates on Security
Values 76
Coupon Rate and Security Price 77
Coupon Rate and Security Price Sensitivity to
Changes in Interest Rates 77
Duration 78
A Simple Illustration of Duration 78
A General Formula for Duration 80
Features of Duration 84
Economic Meaning of Duration 86
Large Interest Rate Changes and
Duration 87
Appendix 3A: Duration and Immunization 94
Appendix 3B: More on Convexity 94
xxi
xxii Contents
4 The Federal Reserve System,
Monetary Policy, and Interest
Rates 95
Major Duties and Responsibilities of the Federal
Reserve System: Chapter Overview 95
Structure of the Federal Reserve System
Organization of the Federal Reserve System 96
Board of Governors of the Federal Reserve
System 98
Federal Open Market Committee 99
Functions Performed by Federal Reserve
Banks 99
Balance Sheet of the Federal Reserve 104
Monetary Policy Tools 107
Open Market Operations 110
The Discount Rate 114
Reserve Requirements (Reserve Ratios)
The Federal Reserve, the Money Supply, and
Interest Rates 120
Effects of Monetary Tools on Various Economic
Variables 121
Money Supply versus Interest Rate
Targeting 122
International Monetary Policies and
Strategies 126
Systemwide Rescue Programs Employed during
the Financial Crisis 126
Challenges Remain after the Crisis 131
part 2 SECURITIES MARKETS 135
5 Money Markets 135
Definition of Money Markets: Chapter
Overview 135
Money Markets 136
Yields on Money Market Securities
Bond Equivalent Yields 137
Effective Annual Return 137
Discount Yields 137
Single-Payment Yields 138
Money Market Securities 139
Treasury Bills 141
Federal Funds 147
Repurchase Agreements 148
Commercial Paper 151
Negotiable Certificates of Deposit 156
Banker’s Acceptances 157
Comparison of Money Market Securities
Money Market Participants 158
The U.S. Treasury 159
The Federal Reserve 159
Commercial Banks 159
Money Market Mutual Funds 160
Brokers and Dealers 160
Corporations 161
Other Financial Institutions 161
Individuals 161
International Aspects of Money Markets 161
Euro Money Markets 162
Appendix 5A: Single versus Discriminating
Price Treasury Auctions 170
96
Appendix 5B: Creation of a Banker’s
Acceptance 170
6 Bond Markets 171
Definition of Bond Markets: Chapter
Overview 171
Bond Market Securities 172
Treasury Notes and Bonds 172
Municipal Bonds 183
116 Corporate Bonds 189
Bond Ratings and Interest Rate Spreads 195
Bond Market Indexes 198
Bond Market Participants 199
Comparison of Bond Market Securities 200
International Aspects of Bond Markets 201
Eurobonds, Foreign Bonds, and Sovereign
Bonds 201
7 Mortgage Markets 209
Mortgages and Mortgage-Backed Securities:
Chapter Overview 209
Primary Mortgage Market 211
Mortgage Characteristics 212
Mortgage Amortization 217
Other Types of Mortgages 222
Secondary Mortgage Markets 224
History and Background of Secondary Mortgage
Markets 225
136 Mortgage Sales 226
Mortgage-Backed Securities 226
Participants in the Mortgage Markets 235
International Trends in Securitization 236
Appendix 7A: Amortization Schedules
for 30-Year Mortgage in Example 7–2 and
No-Points versus Points Mortgages in Example
7–4 241
8 Stock Markets 242
158
The Stock Markets: Chapter Overview 242
Stock Market Securities 244
Common Stock 244
Preferred Stock 247
Primary and Secondary Stock Markets 249
Primary Stock Markets 249
Secondary Stock Markets 254
 Contents xxiii

Stock Market Indexes 263 part 3 COMMERCIAL BANKS 355

Stock Market Participants 268
Other Issues Pertaining to Stock Markets 270
11 Commercial Banks 355
Economic Indicators 270 Commercial Banks as a Sector of the Financial
Market Efficiency 270 ­Institutions Industry: Chapter Overview 355
Stock Market Regulations 274
Definition of a Commercial Bank 357
International Aspects of Stock Markets 276
Balance Sheets and Recent Trends 357
Appendix 8A: The Capital Asset Pricing Assets 357
Model 283 Liabilities 360
Appendix 8B: Event Study Tests 283 Equity 361
Off-Balance-Sheet Activities 363
9 Foreign Exchange Markets 284 Other Fee-Generating Activities 366
Size, Structure, and Composition of the
Foreign Exchange Markets and Risk: Chapter
Industry 366
Overview 284 Bank Size and Concentration 368
Background and History of Foreign Exchange Bank Size and Activities 369
Markets 285 Industry Performance 370
Foreign Exchange Rates and Transactions 290 Regulators 373
Foreign Exchange Rates 290 Federal Deposit Insurance Corporation 373
Foreign Exchange Transactions 290 Office of the Comptroller of the Currency 373
Return and Risk of Foreign Exchange Federal Reserve System 374
Transactions 295 State Authorities 375
Role of Financial Institutions in Foreign
Exchange Transactions 301 Global Issues 375
Advantages and Disadvantages of International
Interaction of Interest Rates, Inflation, and Expansion 376
Exchange Rates 304 Global Banking Performance 377
Purchasing Power Parity 305
Interest Rate Parity 307 12 Commercial Banks’ Financial
Appendix 9A: Balance of Payment Accounts 312 Statements and Analysis 382
Why Evaluate the Performance of Commercial
10 Derivative Securities Markets 313 Banks? ­Chapter Overview 382
Derivative Securities: Chapter Overview 313 Financial Statements of Commercial
Forwards and Futures 315 Banks 384
Spot Markets 315 Balance Sheet Structure 385
Forward Markets 316 Off-Balance-Sheet Assets and Liabilities 391
Futures Markets 318 Other Fee-Generating Activities 394
Income Statement 395
Options 325
Direct Relationship between the Income
Call Options 325
Statement and the Balance Sheet 399
Put Options 327
Option Values 329 Financial Statement Analysis Using a Return on
Option Markets 331 Equity Framework 400
Regulation of Futures and Options Return on Equity and Its Components 401
Return on Assets and Its Components 403
Markets 337
Other Ratios 408
Swaps 338
Impact of Market Niche and Bank Size on
Interest Rate Swaps 339
Currency Swaps 343 Financial Statement Analysis 409
Credit Swaps 344 Impact of a Bank’s Market Niche 409
Swap Markets 345 Impact of Size on Financial Statement
Analysis 409
Caps, Floors, and Collars 347
International Aspects of Derivative Securities 13 Regulation of
Markets 349 Commercial Banks 415
Appendix 10A: Black–Scholes Option Pricing Specialness and Regulation: Chapter
Model 354 Overview 415
xxiv Contents

Types of Regulations and the Regulators 416 Regulators 471

Safety and Soundness Regulation 416 Industry Performance 471
Monetary Policy Regulation 419 Finance Companies 473
Credit Allocation Regulation 419 Size, Structure, and Composition of the
Consumer Protection Regulation 419 Industry 473
Investor Protection Regulation 420 Balance Sheets and Recent Trends 474
Entry and Chartering Regulation 420 Industry Performance 479
Regulators 421 Regulation 480
Regulation of Product and Geographic Global Issues 482
Expansion 421
Product Segmentation in the U.S. Commercial
Banking Industry 421 15 Insurance Companies 485
Geographic Expansion in the U.S. Commercial
Two Categories of Insurance Companies:
Banking Industry 428
Chapter Overview 485
Bank and Savings Institution Guarantee Funds 429
Life Insurance Companies 486
The Federal Deposit Insurance Corporation
Size, Structure, and Composition of the
(FDIC) 430
Industry 486
The Demise of the Federal Savings and Loan
Balance Sheets and Recent Trends 491
­Insurance ­Corporation (FSLIC) 431
Regulation 494
Reform of Deposit Insurance 432
Non–U.S. Deposit Insurance Systems 433 Property–Casualty Insurance Companies 495
Size, Structure, and Composition of the
Balance Sheet Regulations 433
Industry 495
Regulations on Commercial Bank Liquidity 433
Balance Sheets and Recent Trends 497
Regulations on Capital Adequacy (Leverage) 434
Regulation 505
Foreign Versus Domestic Regulation
Global Issues 506
of Commercial Banks 439
Product Diversification Activities 439
Global or International Expansion Activities 440 16 Securities Firms and Investment
Appendix 13A: Calculation of Deposit Insurance Banks 511
Premiums 447 Services Offered by Securities Firms Versus
Appendix 13B: Calculating Minimum Required ­Investment Banks: Chapter Overview 511
Reserves at U.S. Depository Institutions 456 Size, Structure, and Composition of the
Appendix 13C: Primary Regulators of Industry 513
Depository Institutions 459 Securities Firm and Investment Bank Activity
Appendix 13D: Deposit Insurance Coverage for Areas 515
Commercial Banks in Various Countries 459 Investment Banking 515
Venture Capital 517
Appendix 13E: Calculating Risk-Based Capital
Market Making 519
Ratios 459 Trading 519
Investing 520
part 4 OTHER FINANCIAL Cash Management 520
INSTITUTIONS 460 Mergers and Acquisitions 521
Other Service Functions 522
14 Other Lending Institutions 460 Recent Trends and Balance Sheets 522
Recent Trends 522
Other Lending Institutions: Chapter Overview 460 Balance Sheets 525
Savings Institutions 461 Regulation 527
Size, Structure, and Composition of the
Industry 461 Global Issues 530
Balance Sheets and Recent Trends 463
Regulators 465 17 Investment Companies 536
Savings Institution Recent Performance 465
Investment Companies: Chapter Overview 536
Credit Unions 466
Size, Structure, and Composition of the Size, Structure, and Composition of the Mutual
Industry 468 Fund Industry 537
Balance Sheets and Recent Trends 470 Historical Trends 537
 Contents xxv

Different Types of Mutual Funds 538 Investment Management Services 615

Other Types of Investment Company Regulatory Approaches to Fintech 616
Funds 543 Fintech Charters and Other Licenses 616
Mutual Fund Returns and Costs 544 International Regulations 617
Mutual Fund Prospectuses and Objectives 544
Investor Returns from Mutual Fund
Ownership 548
part 5 RISK MANAGEMENT IN FINANCIAL
Mutual Fund Costs 550 INSTITUTIONS 620
Mutual Fund Balance Sheets and Recent
20 Types of Risks Incurred by Financial
Trends 553
Institutions 620
Long-Term Funds 553
Money Market Funds 555 Why Financial Institutions Need to Manage
Mutual Fund Regulation 556 Risk: Chapter Overview 620
Mutual Fund Global Issues 560 Credit Risk 621
Hedge Funds 562 Liquidity Risk 624
Types of Hedge Funds 563 Interest Rate Risk 625
Fees on Hedge Funds 567
Market Risk 628
Offshore Hedge Funds 568
Regulation of Hedge Funds 569 Off-Balance-Sheet Risk 629
Foreign Exchange Risk 631
18 Pension Funds 573 Country Or Sovereign Risk 633
Pension Funds Defined: Chapter Technology and Operational Risk 633
Overview 573 Fintech Risk 635
Size, Structure, and Composition of the Insolvency Risk 636
Industry 574 Other Risks and Interaction Among Risks 636
Defined Benefit versus Defined Contribution
Pension Funds 574
Insured versus Noninsured Pension 21 Managing Credit Risk on the Balance
Funds 576 Sheet 641
Private Pension Funds 577
Public Pension Funds 583 Credit Risk Management: Chapter
Overview 641
Financial Asset Investments and Recent
Trends 585 Credit Quality Problems 643
Private Pension Funds 585 Credit Analysis 644
Public Pension Funds 586 Real Estate Lending 645
Regulation 588 Consumer (Individual) and Small-Business
Lending 648
Global Issues 590
Mid-Market Commercial and Industrial
Appendix 18A: Calculation of Growth in IRA Lending 649
Value during an ­Individual’s Working Years 594 Large Commercial and Industrial Lending 657
Calculating the Return on a Loan 661
Return on Assets (ROA) 661
19 Fintech Companies 595 RAROC Models 663
Introduction 595 Appendix 21A: Loan Portfolio Risk and
The Evolution of Fintech 596 Management 668
Changing Relationship Between Banks and
Fintechs 600 22 Managing Liquidity Risk on the
Banking-as-a-Service 602 Balance Sheet 669
The Types of Fintech Innovations 603 Liquidity Risk Management: Chapter
Payments, Clearing, and Settlement Overview 669
Services 603
Market Support Services 609 Causes of Liquidity Risk 670
Credit, Deposit, and Capital-Raising Liquidity Risk and Depository Institutions 671
Services 615 Liability-Side Liquidity Risk 671
xxvi Contents
Asset-Side Liquidity Risk 674
Measuring a DI’s Liquidity Exposure 675
Liquidity Risk, Unexpected Deposit Drains, and
Bank Runs 680
Bank Runs, the Discount Window, and Deposit
Insurance 681
Liquidity Risk and Insurance Companies 684
Life Insurance Companies 684
Property–Casualty Insurance Companies 685
Guarantee Programs for Life and Property–
Casualty Insurance Companies 686
Liquidity Risk and Investment Funds 686
Appendix 22A: Statements of Cash Flows,
JPMorgan Chase, 2017–2019 692
Appendix 22B: New Liquidity Risk Measures
Implemented by the Bank for International
Settlements 692
23 Managing Interest Rate Risk and
Insolvency Risk on the Balance
Sheet 693
Interest Rate and Insolvency Risk Management:
­Chapter Overview 693
Interest Rate Risk Measurement and
Management 694
Repricing Gap Model 694
Duration Gap Model 703
Insolvency Risk Management 711
Capital and Insolvency Risk 712
24 Managing Risk off the Balance Sheet
with Derivative Securities 722
Derivative Securities Used to Manage Risk:
Chapter Overview 722
Forward and Futures Contracts 723
Hedging with Forward Contracts 724
Hedging with Futures Contracts 725
Options 728
Basic Features of Options 728
Actual Interest Rate Options 731
Hedging with Options 731
Caps, Floors, and Collars 732
Risks Associated with Futures, Forwards, and
Options 733
Swaps 734
Hedging with Interest Rate Swaps 734
Hedging with Currency Swaps 737
Credit Swaps 738
Credit Risk Concerns with Swaps 741
Comparison of Hedging Methods 742
Writing versus Buying Options 742
Futures versus Options Hedging 744
Swaps versus Forwards, Futures, and
Options 745
Appendix 24A: Hedging with Futures
Contracts 750
Appendix 24B: Hedging with Options 750
Appendix 24C: Hedging with Caps, Floors, and
Collars 750
25 Managing Risk off the Balance
Sheet with Loan Sales and
Securitization 751
Why Financial Institutions Sell and Securitize
Loans: Chapter Overview 751
Loan Sales 752
Types of Loan Sales Contracts 754
The Loan Sales Market 754
Secondary Market for Less Developed Country
Debt 757
Factors Encouraging Future Loan Sales
Growth 758
Factors Deterring Future Loan Sales
Growth 759
Loan Securitization 760
Pass-Through Security 760
Collateralized Mortgage Obligation 767
Mortgage-Backed Bond 771
Securitization of Other Assets 773
Can All Assets Be Securitized? 774
References 779
Index 781
 Introduction and Overview of Financial Markets part one

Introduction chapter

Learning Goals
1
O U T L I N E

LG 1-1 Differentiate between primary and secondary markets. Why Study Financial Markets
and Institutions? Chapter
LG 1-2 Differentiate between money and capital markets. Overview
Overview of Financial Markets
LG 1-3 Understand what foreign exchange markets are.
Primary Markets versus
Secondary Markets
LG 1-4 Understand what derivative security markets are.
Money Markets versus
LG 1-5 Distinguish between the different types of financial institutions. Capital Markets
Foreign Exchange Markets
LG 1-6 Know the services financial institutions perform. Derivative Security Markets
Financial Market Regulation
LG 1-7 Know the risks financial institutions face.
Overview of Financial
LG 1-8 Appreciate why financial institutions are regulated. Institutions
Unique Economic
LG 1-9 Recognize that financial markets are becoming increasingly global. Functions Performed by
Financial Institutions
Additional Benefits FIs
Provide to Suppliers of
Funds
Economic Functions FIs
WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? Provide to the Financial
CHAPTER OVERVIEW System as a Whole
In the 1990s, financial markets in the United States boomed. As seen in Figure 1–1, the Risks Incurred by Financial
Dow Jones Industrial Index—a widely quoted index of the values of 30 large corporations Institutions
(see Chapter 8)—rose from a level of 2,800 in January 1990 to more than 11,000 by the
Regulation of Financial
end of the decade; this compares to a move from 100 at its inception in 1906 to 2,800
Institutions
eighty-four years later. In the early 2000s, as a result of an economic downturn in the
United States and elsewhere, this index fell back below 10,000. The index rose to over Trends in the United States
14,000 in July 2007, but (because of an increasing mortgage market credit crunch, Globalization of Financial
particularly the subprime mortgage market) fell back to below 13,000 within a month Markets and Institutions
of hitting the all-time high. By 2008, problems in the subprime mortgage market esca- Appendix 1A: The Financial
lated to a full-blown financial crisis and the worst recession in the United States since the Crisis: The Failure of Financial
Great Depression. The Dow Jones Industrial Average (DJIA) fell to 6,547 in March 2009 Institutions’ Specialness
before recovering, along with the economy, to over 11,000 in April 2010. However, it took (available through Connect or
until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, closing at your course instructor)
14,253.77 for the day. The DJIA rose to over 27,300 in mid-2019 before falling to below
20,000 in March 2020 during the Coronavirus pandemic.

1
2 Part 1 Introduction and Overview of Financial Markets

Figure 1–1 The Dow Jones Industrial Average, 1989–2020

Index Value
DJIA Index Values
30,000

25,000

20,000

15,000

10,000

5,000

0 Date
Jan-89

Jan-91

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Jan-13

Jan-15

Jan-17

Jan-19
During the financial crisis of 2008–2009, market swings seen in the United States
quickly spread worldwide. Stock markets saw huge swings in value as investors tried
to sort out who might survive and who would not (and markets from Russia to Europe
were forced to suspend trading as stock prices plunged). As U.S. markets recovered in
2010–2013 and, as mentioned earlier, surpassed their pre-crisis highs, European stock
markets struggled as Greece battled with a severe debt crisis that eventually spread to
other European nations with fiscal problems, such as Portugal, Spain, and Italy. Even the
growth in the robust Chinese economy slowed to 6.7 percent in 2016, the lowest level in
seven years. A prolonged trade war with the United States saw growth in China drop even
further, to 6.2 percent in 2019, the lowest level in 30 years.
World markets were rocked again in June 2016 when the people of the United
Kingdom voted to leave the European Union (EU) after 43 years (dubbed “Brexit”).
The shock from the UK’s surprise vote to leave the EU swept across global markets, trig-
gering steep drops in stock markets and the British pound and a flight into safe assets
such as U.S. bonds and gold. The pound fell more than 11 percent to its lowest point since
1985. The DJIA dropped 610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell
7 percent, its steepest drop since 2008, while Japan’s Nikkei Stock Average declined
7.9 percent. Bonds also sold off sharply, pushing UK government borrowing costs
sharply higher, as traders and investors grappled with the market implications of Brexit.
The UK had its credit rating outlook cut to “negative” by the ratings agency Moody’s.
The UK’s vote to leave the European Union shook the region, precipitating an immedi-
ate political crisis in Britain and shifting the path of a European project created to bind a
continent torn by World War II. Britain’s decision, one of the most momentous by a Western
country in the past 50 years, reverses the course of expansion for the EU. It had grown over
decades to include most of Europe, absorbing former dictatorships in Greece, Spain, and
Portugal, and the countries of the east, formerly under Soviet domination. The UK would be
the first member nation to leave, a step some leaders warned beforehand would diminish the
global influence of the UK and the EU and risk setting in motion the European bloc’s even-
tual disintegration. Less than two weeks before the October 31, 2019, deadline, the UK still
had no deal with the EU on how the exit would be structured. The most recent shock to world
financial markets was the Coronavirus Pandemic in 2020. The pandemic resulted in a virtual
shut down of world economies and resulted in a 32.5 percent drop in the DJIA in just over
a month, from an all time high of 29,388.58 on February 6, 2020 to 19,830.01 March 19.
 Chapter 1 Introduction 3

Originally the banking industry operated as a full-service industry, performing directly

or indirectly all financial services (commercial banking, investment banking, stock invest-
ing, insurance provision, etc.). In the early 1930s, the economic and industrial collapse
resulted in the separation of some of these activities. In the 1970s and 1980s new,
relatively unregulated financial services industries sprang up (e.g., mutual funds, broker-
age funds) that separated the financial service functions even further.
The last 35 years, however, have seen a reversal of these trends. In the 1990s and
2000s, regulatory barriers, technology, and financial innovation changes were such that
a full set of financial services could again be offered by a single financial services firm
under the umbrella of a financial services holding company. For example, JPMorgan
Chase & Co. operates a commercial bank (JPMorgan Chase Bank), an investment
bank (JPMorgan Securities, which also sells mutual funds), and an insurance company
(JPMorgan Insurance Agency). Not only did the boundaries between traditional industry
sectors change, but competition became global in nature as well. For example, JPMorgan
Chase is the world’s sixth-largest bank holding company, operating in 60 countries.
The financial crisis produced another reshaping of all financial institution (FI) sectors
and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most
prominent investment banks in the world, Goldman Sachs and Morgan Stanley, converting
to bank holding company status. Indeed, as of 2010, all the major U.S. investment banks
had either failed, been acquired by a commercial bank, or become bank holding companies.
Further, legislation enacted as a result of the financial crisis represents an attempt to again
separate FI activities. For example, the “Volcker Rule” provision of the Wall Street Reform
and Consumer Protection Act prohibits the largest bank holding companies from engaging
in proprietary trading and limits their investments in hedge funds, private equity, and related
vehicles. Despite these most recent changes, many FIs operate in more than one FI sector.
As economic and competitive environments change, attention to profit and, more
than ever, risk becomes increasingly important. This book provides a detailed overview
and analysis of the financial system in which financial managers and individual investors
operate. Making investment and financing decisions requires managers and individuals to
understand the flow of funds throughout the economy as well as the operation and struc-
ture of domestic and international financial markets. In particular, this book offers a unique
analysis of the risks faced by investors and savers, as well as strategies that can be adopted
for controlling and managing these risks. Newer areas of operations such as asset securi-
tization, derivative securities, and internationalization of financial services also receive
special emphasis. Further, as the United States and the world continue to recover from
the collapse of the financial markets, this book highlights and discusses the impact of this
crisis on the various financial markets and the financial institutions that operate in them.
This introductory chapter provides an overview of the structure and operations of
various financial markets and financial institutions. Financial markets are differentiated
by the characteristics (such as maturity) of the financial instruments or securities that are
exchanged. Moreover, each financial market, in turn, depends in part or in whole on finan-
cial institutions. Indeed, FIs play a special role in the functioning of financial markets.
In particular, FIs often provide the least costly and most efficient way to channel funds to
and from financial markets. As part of this discussion, we briefly examine how changes in
the way FIs deliver services played a major part in the events leading up to the severe finan-
cial crisis of the late 2000s. A more detailed discussion of the causes of, the major events
during, and the regulatory and industry changes resulting from the financial crisis is pro-
vided in Appendix 1A to the chapter (available through Connect or your course instructor).

OVERVIEW OF FINANCIAL MARKETS

financial markets Financial markets are structures through which funds flow. Table 1–1 summarizes the
The arenas through which financial markets discussed in this section. Financial markets can be distinguished along
funds flow. two major dimensions: (1) primary versus secondary markets and (2) money versus capital
markets. The next sections discuss each of these dimensions.
4 Part 1 Introduction and Overview of Financial Markets

TABLE 1–1 Types of Financial Markets

Primary markets—markets in which corporations raise funds through new issues of securities.
Secondary markets—markets that trade financial instruments once they are issued.
Money markets—markets that trade debt securities or instruments with maturities of less than
one year.
Capital markets—markets that trade debt and equity instruments with maturities of more than
one year.
Foreign exchange markets—markets in which cash flows from the sale of products or assets
denominated in a foreign currency are transacted.
Derivative markets—markets in which derivative securities trade.

LG 1-1 Primary Markets versus Secondary Markets

primary markets
Markets in which corpora-
tions raise funds through
new issues of securities.
initial public offering
(IPO)
The first public issue of a
financial instrument by a
firm.
Primary Markets. Primary markets are markets in which users of funds (e.g., cor-
porations) raise funds through new issues of financial instruments, such as stocks and
bonds. Table 1–2 lists data on primary market sales of securities from 2000 through 2019.
Note the impact the financial crisis had on primary market sales by firms. New issues fell
to $1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007,
pre-crisis. As of 2018, primary market sales had still not recovered as only $1,725.2 billion
new securities were issued for the year.
Fund users have new projects or expanded production needs, but do not have
sufficient internally generated funds (such as retained earnings) to support these needs.
Thus, the fund users issue securities in the external primary markets to raise additional
funds. New issues of financial instruments are sold to the initial suppliers of funds
(e.g., households) in exchange for funds (money) that the issuer or user of funds needs.1
Most primary market transactions in the United States are arranged through financial
institutions called investment banks—for example, Morgan Stanley or Bank of America
Merrill Lynch—that serve as intermediaries between the issuing corporations (fund users)
and investors (fund suppliers). For these public offerings, the investment bank provides the
securities issuer (the funds user) with advice on the securities issue (such as the offer price
and number of securities to issue) and attracts the initial public purchasers of the securi-
ties for the funds user. By issuing primary market securities with the help of an investment
bank, the funds user saves the risk and cost of creating a market for its securities on its own
(see the following discussion). Figure 1–2 illustrates a time line for the primary market
exchange of funds for a new issue of corporate bonds or equity. We discuss this process in
detail in Chapters 6 and 8.
Primary market financial instruments include issues of equity by firms initially going
public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the
first time). These first-time issues are usually referred to as initial public offerings (IPOs).
For example, on May 10, 2019, Uber announced a $75 billion IPO of its common stock.

TABLE 1–2 Primary Market Sales of Securities (in billions of dollars)

Security Type 2000 2005 2007 2008 2010 2015 2018 2019*
All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,024.7 $1,843.2 $1,725.2 $1,023.5
Bonds 944.8 2,323.7 2,220.3 861.2 893.7 1,611.3 1,526.3 905.9
Stocks 311.9 115.3 168.8 206.8 131.0 174.0 131.3 88.0
Private placements 196.5 24.6 20.1 16.2 22.2 28.8 33.4 n.a.†
IPOs 97.0 36.7 46.3 26.4 37.0 29.1 34.2 29.6

*Through second quarter.

†n.a. = not applicable.

1. We discuss the users and suppliers of funds in more detail in Chapter 2.


secondary market
A market that trades finan-
cial instruments once they
are issued.
derivative security
A financial security whose
payoffs are linked to other,
previously issued securi-
ties or indices.
Chapter 1 Introduction 5
Figure 1–2 Primary and Secondary Market Transfer of Funds Time Line
Primary Markets
(Where new issues of financial instruments are offered for sale)
Users of Funds
Initial Suppliers
(Corporations Underwriting with
of Funds
issuing debt/equity Investment Bank
(Investors)
instruments)
Secondary Markets
(Where financial instruments, once issued, are traded)
Economic Agents Economic Agents
(Investors) Wanting Financial Markets (Investors) Wanting
to Sell Securities to Buy Securities
Financial instruments flow
Funds flow
The company’s stock was underwritten by 29 investment banks, including Morgan Stanley,
Goldman Sachs, Citigroup, and Bank of America Merrill Lynch. Primary market securities
also include the issue of additional equity or debt instruments of an already publicly traded
firm. For example, on September 4, 2019, Appian Corp. announced the sale of an additional
1.825 million shares of common stock underwritten by one investment bank, Barclays.
Secondary Markets. Once financial instruments such as stocks are issued in primary
markets, they are then traded—that is, rebought and resold—in secondary markets.
For example, on September 17, 2019, 14.5 million shares of ExxonMobil were traded
in the secondary stock market. Buyers of secondary market securities are economic agents
(consumers, businesses, and governments) with excess funds. Sellers of secondary market
financial instruments are economic agents in need of funds. Secondary markets provide a cen-
tralized marketplace where economic agents know they can transact quickly and efficiently.
These markets therefore save economic agents the search and other costs of seeking
buyers or sellers on their own. Figure 1–2 illustrates a secondary market transfer of funds.
When an economic agent buys a financial instrument in a secondary market, funds are
exchanged, usually with the help of a securities broker such as Charles Schwab acting as
an intermediary between the buyer and the seller of the instrument (see Chapter 8).
The original issuer of the instrument (user of funds) is not involved in this transfer. The
New York Stock Exchange (NYSE) and the National Association of Securities Dealers
Automated Quotation (NASDAQ) system are two well-known examples of secondary
markets for trading stocks. We discuss the details of each of these markets in Chapter 8.
In addition to stocks and bonds, secondary markets also exist for financial instruments
backed by mortgages and other assets (see Chapter 7), foreign exchange (see Chapter 9),
and futures and options (i.e., derivative securities—financial securities whose payoffs
6 Part 1 Introduction and Overview of Financial Markets
liquidity
The ease with which an
asset can be converted
into cash quickly and at
fair market value.
LG 1-2
money markets
Markets that trade debt
securities or instruments
with maturities of one year
or less.
over-the-counter
(OTC) markets
Markets that do not
operate in a specific fixed
location—rather, transac-
tions occur via telephones,
wire transfers, and com-
puter trading.
are linked to other, previously issued [or underlying] primary securities or indexes of pri-
mary securities) (see Chapter 10). As we will see in Chapter 10, derivative securities have
existed for centuries, but the growth in derivative securities markets occurred mainly in the
1980s through 2000s. As major markets, therefore, derivative securities markets are among
the newest of the financial security markets.
Secondary markets offer benefits to both investors (suppliers of funds) and issuing
corporations (users of funds). For investors, secondary markets provide the opportunity
to trade securities at their market values quickly as well as to purchase securities with
varying risk-return characteristics (see Chapter 2). Corporate security issuers are
not directly involved in the transfer of funds or instruments in the secondary market.
However, the issuer does obtain information about the current market value of its finan-
cial instruments, and thus the value of the corporation as perceived by investors such as
its stockholders, through tracking the prices at which its financial instruments are being
traded on secondary markets. This price information allows issuers to evaluate how well
they are using the funds generated from the financial instruments they have already issued
and provides information on how well any subsequent offerings of debt or equity might do
in terms of raising additional money (and at what cost).
Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into
cash quickly at its fair market value—as well as information about the prices or the value
of their investments. Increased liquidity makes it more desirable and easier for the issuing
firm to sell a security initially in the primary market. Further, the existence of central-
ized markets for buying and selling financial instruments allows investors to trade these
instruments at low transaction costs.
Money Markets versus Capital Markets
Money Markets. Money markets are markets that trade debt securities or instruments
with maturities of one year or less (see Figure 1–3). In the money markets, economic
agents with short-term excess supplies of funds can lend funds (i.e., buy money market
instruments) to economic agents who have short-term needs or shortages of funds
(i.e., they sell money market instruments). The short-term nature of these instruments
means that fluctuations in their prices in the secondary markets in which they trade are usu-
ally quite small (see Chapters 3 and 23 on interest rate risk). In the United States, money
markets do not operate in a specific location—rather, transactions occur via telephones,
wire transfers, and computer trading. Thus, most U.S. money markets are said to be
over-the-counter (OTC) markets.
Money Market Instruments. A variety of money market securities are issued by
corporations and government units to obtain short-term funds. These securities include
Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable certifi-
cates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major money
market securities. Figure 1–4 shows outstanding amounts of money market instruments
in the United States in 1990, 2000, 2010, and 2019. Notice that in 2019 federal funds
and repurchase agreements, followed by Treasury bills, negotiable CDs, and commercial
paper, had the largest amounts outstanding. Money market instruments and the operation
of the money markets are described and discussed in detail in Chapter 5.
Figure 1–3 Money versus Capital Market Maturities
Capital Market Securities
Money Market
Securities Notes and Bonds Stocks (Equities) Maturity
0 1 year to 30 years to No specified
maturity maturity maturity
 Chapter 1 Introduction 7

TABLE 1–3 Money and Capital Market Instruments

MONEY MARKET INSTRUMENTS

Treasury bills—short-term obligations issued by the U.S. government.

Federal funds—short-term funds transferred between financial institutions usually for no more
than one day.
Repurchase agreements—agreements involving the sale of securities by one party to another with a
promise by the seller to repurchase the same securities from the buyer at a specified date and price.
Commercial paper—short-term unsecured promissory notes issued by a company to raise
short-term cash.
Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and
maturity date and are negotiable (i.e., can be sold by the holder to another party).
Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by a bank.

CAPITAL MARKET INSTRUMENTS

Corporate stock—the fundamental ownership claim in a public corporation.

Mortgages—loans to individuals or businesses to purchase a home, land, or other real property.
Corporate bonds—long-term bonds issued by corporations.
Treasury bonds—long-term bonds issued by the U.S. government.
State and local government bonds—long-term bonds issued by state and local governments.
U.S. government agency bonds—long-term bonds collateralized by a pool of assets and issued
by agencies of the U.S. government.
Bank and consumer loans—loans to commercial banks and individuals.

Figure 1–4 Money Market Instruments Outstanding

1990 2000
$2.06 trillion $4.51 trillion
outstanding outstanding

18.1% 26.5%
27.1% 35.6%

2.6%
25.7% 14.4%
26.5% 23.3%
0.2%

2010 2019
$6.5 trillion $8.77 trillion
outstanding outstanding

25.6%
46.0%
16.7%
12.2%
Federal funds and repurchase
28.6% agreements
0.0%
0.0% 13.5% Commercial paper
29.1% 28.3% U.S. Treasury bills
Negotiable CDs
Banker’s acceptances

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues,
www.federalreserve.gov
8 Part 1 Introduction and Overview of Financial Markets

capital markets
Markets that trade debt
(bonds) and equity (stocks)
instruments with maturities
of more than one year.
Capital Markets. Capital markets are markets that trade equity (stocks) and debt
(bonds) instruments with maturities of more than one year (see Figure 1–3). The major
suppliers of capital market securities (or users of funds) are corporations and governments.
Households are the major suppliers of funds for these securities. Given their longer
maturity, these instruments experience wider price fluctuations in the secondary markets
in which they trade than do money market instruments. For example, all else constant,
long-term maturity debt instruments experience wider price fluctuations for a given change
in interest rates than short-term maturity debt instruments (see Chapter 3).

Capital Market Instruments. Table 1–3 lists and defines the major capital market
securities. Figure 1–5 shows their outstanding amounts by dollar market value. Notice
that in 2019, corporate stocks or equities represent the largest capital market instru-
ment, followed by mortgages, Treasury securities, and corporate bonds. The relative
size of the market value of capital market instruments outstanding depends on two

Figure 1–5 Capital Market Instruments Outstanding

1990 2000
$14.93 trillion $40.6 trillion
outstanding outstanding

3.7%
16.8%
25.5% 23.6%

10.6% 43.4%
7.9% 11.4%
7.7%
9.6% 11.1%
10.9% 12.1%
5.7%

2010 2019
$67.9 trillion $109.6 trillion
outstanding outstanding

4.2% 3.7% 14.2%

20.9%

11.4% 8.3%
31.3% 43.8%
3.6%
6.4% 9.0% 14.1%
16.8% 12.3%

Corporate stocks State and local government bonds

Mortgages U.S. government agency bonds
Corporate bonds Consumer loans
Treasury securities

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases,
Washington, DC, various issues, www.federalreserve.gov
 Chapter 1 Introduction 9

factors: the number of securities issued and their market prices.2 One reason for the
sharp increase in the value of equities outstanding is the bull market in stock prices
in the 1990s. Stock values fell in the early 2000s as the U.S. economy experienced a
downturn—partly because of 9/11 and partly because interest rates began to rise—and
stock prices fell. Stock prices in most sectors subsequently recovered and, by 2007, even
surpassed their 1999 levels. Stock prices fell precipitously during the financial crisis
of 2008–2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had
fallen 53.8 percent in value in less than 1½ years, larger than the decline during the
market crash of 1929 when it fell 49 percent. However, stock prices recovered, along
with the economy, in the last half of 2009, rising 71.1 percent between March 2009
and April 2010. Capital market instruments and their operations are discussed in detail
in Chapters 6, 7, and 8.

LG 1-3 Foreign Exchange Markets

In addition to understanding the operations of domestic financial markets, a financial man-
ager must also understand the operations of foreign exchange markets and foreign capital
markets. Today’s U.S.-based companies operate globally. It is therefore essential that
financial managers understand how events and movements in financial markets in other
countries affect the profitability and performance of their own companies. For example,

?
Coca Cola’s global sales mean it is exposed to fluctuations in almost 70 different foreign
D O YO U currencies. The company reported that second quarter 2019 net sales in the Asia Pacific,
U N D E R STA N D
Europe, Middle East, and Africa segments were flat for the quarter, and revenue in
1. The difference Latin America fell 6 percent largely due to the impact of a strong U.S. dollar.
between primary and Cash flows from the sale of securities (or other assets) denominated in a foreign
secondary markets? currency expose U.S. corporations and investors to risk regarding the value at which
2. The major distinction foreign currency cash flows can be converted into U.S. dollars. For example, the actual
between money amount of U.S. dollars received on a foreign investment depends on the exchange
markets and capital
rate between the U.S. dollar and the foreign currency when the nondollar cash flow is
markets?
converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative
3. What the major
instruments traded in
to the U.S. dollar over the investment period (i.e., the period between the time a foreign
the capital markets investment is made and the time it is terminated), the dollar value of cash flows received
are? will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar,
4. What happens to the the dollar value of cash flows received on the foreign investment will increase.
dollar value of a U.S. While foreign currency exchange rates are often flexible—they vary day to day with
investor’s holding of demand for and supply of a foreign currency for dollars—central governments sometimes
British pounds if the
intervene in foreign exchange markets directly or affect foreign exchange rates indirectly
pound appreciates
(rises) in value against by altering interest rates. We discuss the motivation and effects of these interventions
the dollar? in Chapters 4 and 9. The sensitivity of the value of cash flows on foreign investments
5. What derivative to changes in the foreign currency’s price in terms of dollars is referred to as foreign
security markets are? exchange risk and is discussed in more detail in Chapter 9. Techniques for managing, or
“hedging,” foreign exchange risk, such as using derivative securities like foreign exchange
(FX) futures, options, and swaps, are discussed in Chapter 24.

LG 1-4 Derivative Security Markets

derivative security
markets
The markets in which
derivative securities trade.
derivative security
An agreement between two
parties to exchange a stan-
dard quantity of an asset at
a predetermined price at a
specified date in the future.
Derivative security markets are markets in which derivative securities trade. A derivative
security is a financial security (such as a futures contract, option contract, swap contract,
or mortgage-backed security) whose payoff is linked to another, previously issued secu-
rity such as a security traded in capital or foreign exchange markets. Derivative securities
generally involve an agreement between two parties to exchange a standard quantity of
an asset or cash flow at a predetermined price and at a specified date in the future.
2. For example, the market value of equity is the product of the price of the equity times the number of shares that are
issued.
10 Part 1 Introduction and Overview of Financial Markets

As the value of the underlying security to be exchanged changes, the value of the deriva-
tive security changes. While derivative securities have been in existence for centuries, the
growth in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4
shows the dollar (or notional) value of derivatives held by commercial banks from 1992
through 2019. Note the tremendous growth in these securities between 1992 and 2013,
and the large drop from 2013 to 2019. As we discuss in Chapter 10, part of the Wall Street
Reform and Consumer Protection Act, passed in 2010 in response to the financial crisis,
is the Volcker Rule which prohibits bank holding companies from engaging in proprietary
trading (i.e., trading as a principal for the trading account of the financial institution). This
included any transaction to purchase or sell derivatives. The Volcker Rule was implemented
in April 2014 and banks had until July 21, 2015, to be in compliance. The result was a
reduction in derivative securities held off-balance-sheet by these financial institutions.
In 2018, however, changes to the Volcker Rule gave bank holding companies more
freedom to conduct short-term trading of derivatives. The revision largely preserved the
Volcker Rule intact but had two key ramifications. It exempted smaller banks from the
full scope of the Volcker Rule. The amended rule also eliminated the presumption that
positions held for fewer than 60 days violated the rule unless bankers could prove oth-
erwise. This change made it easier for bank holding companies to trade for purposes of
market making. The amount of trading done to hedge, or to offset risk, could also grow.
The amended rule no longer requires banks to demonstrate how a trade is reducing a
specific risk. And traders would no longer need to certify their intent on transactions.
The amended Volcker Rule went into effect in 2019, and holdings of derivative securities
by bank holding companies increased to $201.32 trillion by 2019.
As major markets, derivative security markets are the newest of the financial security
markets. Derivative securities, however, are also potentially the riskiest of the finan-
cial securities. Indeed, at the center of the recent financial crisis were losses associated
with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs.
Losses from the falling value of subprime mortgages and the derivative securities backed
by these mortgages reached $700 billion worldwide by early 2009 and resulted in the
failure, acquisition, or bailout of some of the largest FIs and the near collapse of the
world’s financial and economic systems.
We discuss derivative security activity in Chapter 10. Derivative security traders can
be either users of derivative contracts for hedging (see Chapters 10 and 24) and other pur-
poses or dealers (such as banks) that act as counterparties in trades with customers for a fee.

www.sec.gov Financial Market Regulation

Financial instruments are subject to regulations imposed by regulatory agencies such
as the Securities and Exchange Commission (SEC)—the main regulator of securities
markets since the passage of the Securities Act of 1934—as well as the exchanges (if any)
on which the instruments are traded. The main emphasis of SEC regulations (as stated in
the Securities Act of 1933) is on full and fair disclosure of information on securities issues

TABLE 1–4 D
 erivative Contracts Held by Commercial Banks, by Contract Product
(in billions of dollars)

1992 2000 2008 2013 2016 2019

Futures and forwards $4,780 $9,877 $22,512 $45,599 $35,685 $46,165
Swaps 2,417 21,949 131,706 138,361 107,393 106,837
Options 1,568 8,292 30,267 33,760 30,909 44,134
Credit derivatives — 426 15,897 13,901 6,986 4,145
Total $8,765 $40,544 $200,382 $231,621 $180,973 $201,281

Note: Em dashes represent values that are too small to register.

Sources: Office of the Comptroller of the Currency website, various dates, www.occ.treas.gov
 Chapter 1 Introduction 11

to actual and potential investors. Those firms planning to issue new stocks or bonds to be
sold to the public at large (public issues) are required by the SEC to register their securities
with the SEC and to fully describe the issue, and any risks associated with the issue, in a
legal document called a prospectus.
The SEC also monitors trading on the major exchanges (along with the exchanges
themselves) to ensure that stockholders and managers do not trade on the basis of inside
information about their own firms (i.e., information prior to its public release). SEC regu-
lations are not intended to protect investors against poor investment choices, but rather to
ensure that investors have full and accurate information available about corporate issuers
when making their investment decisions.

OVERVIEW OF FINANCIAL INSTITUTIONS

LG 1-5 Financial institutions (e.g., commercial and savings banks, credit unions, insurance
companies, mutual funds) perform the essential function of channeling funds from those
financial institutions with surplus funds (suppliers of funds) to those with shortages of funds (users of funds).
Institutions that perform Chapters 11 through 19 discuss the various types of FIs in today’s economy, including
the essential function of (1) the size, structure, and composition of each type; (2) their balance sheets and recent
channeling funds from trends; (3) FI performance; and (4) the regulators who oversee each type. Table 1–5 lists
those with surplus funds and summarizes the FIs discussed in detail in later chapters.
to those with shortages of To understand the important economic function financial institutions play in the opera-
funds. tion of financial markets, imagine a simple world in which FIs do not exist. In such a world,
suppliers of funds (e.g., households), generating excess savings by consuming less than
they earn, would have a basic choice: they could either hold cash as an asset or directly
invest that cash in the securities issued by users of funds (e.g., corporations or households).
In general, users of funds issue financial claims (e.g., equity and debt securities or
mortgages) to finance the gap between their investment expenditures and their internally

TABLE 1–5 Types of Financial Institutions

Commercial banks—depository institutions whose major assets are loans and whose major
liabilities are deposits. Commercial banks’ loans are broader in range, including consumer,
commercial, and real estate loans, than are those of other depository institutions. Commercial
banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and
debentures, than do those of other depository institutions.
Thrifts—depository institutions in the form of savings associations, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend to
concentrate their loans in one segment, such as real estate loans or consumer loans.
Insurance companies—financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the event
of untimely death, illness, and retirement. Property casualty insurance protects against personal
injury and liability due to accidents, theft, fire, and so on.
Securities firms and investment banks—financial institutions that help firms issue securities
and engage in related activities such as securities brokerage and securities trading.
Finance companies—financial intermediaries that make loans to both individuals and
businesses. Unlike depository institutions, finance companies do not accept deposits but
instead rely on short- and long-term debt for funding.
Investment funds—financial institutions that pool financial resources of individuals and
companies and invest those resources in diversified portfolios of assets.
Pension funds—financial institutions that offer savings plans through which fund participants
accumulate savings during their working years before withdrawing them during their
retirement years. Funds originally invested in and accumulated in pension funds are exempt
from current taxation.
Fintechs—institutions that use technology to deliver financial solutions in a manner that
competes with traditional financial methods.
12
direct transfer
A corporation sells its stock
or debt directly to investors
without going through a
financial institution.
price risk
The risk that an asset’s
sale price will be lower
than its purchase price.
indirect transfer
A transfer of funds
between suppliers and
users of funds through a
financial intermediary.
Part 1 Introduction and Overview of Financial Markets
Figure 1–6 Flow of Funds in a World without FIs
Financial Claims
(Equity and debt instruments)
Users of Funds Suppliers of Funds
Cash
generated savings such as retained earnings. As shown in Figure 1–6, in such a world we
have a direct transfer of funds (money) from suppliers of funds to users of funds. In return,
financial claims would flow directly from users of funds to suppliers of funds.
In this economy without financial institutions, the level of funds flowing between sup-
pliers of funds (who want to maximize the return on their funds subject to risk) and users
of funds (who want to minimize their cost of borrowing subject to risk) is likely to be quite
low. There are several reasons for this. First, once they have lent money in exchange for
financial claims, suppliers of funds need to monitor continuously the use of their funds. They
must be sure that the user of funds neither steals the funds outright nor wastes the funds on
projects that have low or negative returns. Such monitoring is often extremely costly for any
given fund supplier because it requires considerable time, expense, and effort to collect this
information relative to the size of the average fund supplier’s investment. Given this, fund
suppliers would likely prefer to leave, or delegate, the monitoring of fund borrowers to others.
The resulting lack of monitoring increases the risk of directly investing in financial claims.
Second, the relatively long-term nature of many financial claims (e.g., mortgages,
corporate stock, and bonds) creates another disincentive for suppliers of funds to hold the
direct financial claims issued by users of funds. Specifically, given the choice between
holding cash and long-term securities, fund suppliers may well choose to hold cash for
liquidity reasons, especially if they plan to use their savings to finance consumption expen-
ditures in the near future and financial markets are not very developed, or deep, in terms of
the number of active buyers and sellers in the market.
Third, even though real-world financial markets provide some liquidity services, by
allowing fund suppliers to trade financial securities among themselves, fund suppliers face
a price risk upon the sale of securities. That is, the price at which investors can sell a secu-
rity on secondary markets such as the New York Stock Exchange (NYSE) may well differ
from the price they initially paid for the security either because investors change their valu-
ation of the security between the time it was bought and when it was sold and/or because
dealers, acting as intermediaries between buyers and sellers, charge transaction costs for
completing a trade.
Unique Economic Functions Performed by Financial Institutions
Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average investor
in a world without FIs would likely view direct investment in financial claims and markets
as an unattractive proposition and prefer to hold cash. As a result, financial market activity
(and therefore savings and investment) would likely remain quite low.
However, the financial system has developed an alternative and indirect way for inves-
tors (or fund suppliers) to channel funds to users of funds.3 This is the indirect transfer of
funds to the ultimate user of funds via FIs. Due to the costs of monitoring, liquidity risk,
and price risk, as well as for other reasons explained later, fund suppliers often prefer to
hold the financial claims issued by FIs rather than those directly issued by the ultimate
users of funds. Consider Figure 1–7, which is a closer representation than Figure 1–6 of
the world in which we live and the way funds flow in the U.S. financial system. Notice
3. We describe and illustrate this flow of funds in Chapter 2.
 Chapter 1 Introduction 13

Figure 1–7 Flow of Funds in a World with FIs

Users of Funds FI Suppliers of Funds

(Brokers)

Cash FI Cash
(Asset
transformers)

Financial Claims Financial Claims

(Equity and debt securities) (Deposits and insurance policies)

how financial intermediaries or institutions are standing, or intermediating between, the

suppliers and users of funds—that is, channeling funds from ultimate suppliers to ultimate
users of funds.
How can a financial institution reduce the monitoring costs, liquidity risks, and price
risks facing the suppliers of funds compared to when they directly invest in financial
claims? We look at how FIs resolve these cost and risk issues next and summarize them in
Table 1–6.

LG 1-6 Monitoring Costs. As mentioned previously, a supplier of funds who directly invests
in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions
in a timely and complete fashion. One solution to this problem is for a large number of
small investors to group their funds together by holding the claims issued by a finan-
cial institution. The FI groups the fund suppliers’ funds together and invests them in the
direct financial claims issued by fund users. This aggregation of funds by fund suppliers
in a financial institution resolves a number of problems. First, the “large” FI now has a
TABLE 1–6 Services Performed by Financial Institutions

Services Benefiting Suppliers of Funds:

Monitoring costs—aggregation of funds in an FI provides greater incentive to collect a firm’s
information and monitor actions. The relatively large size of the FI allows this collection of
information to be accomplished at a lower average cost (economies of scale).
Liquidity and price risk—FIs provide financial claims to household savers with superior
liquidity attributes and with lower price risk.
Transaction cost services—similar to economies of scale in information production costs, an
FI’s size can result in economies of scale in transaction costs.
Maturity intermediation—FIs can better bear the risk of mismatching the maturities of their
assets and liabilities.
Denomination intermediation—FIs such as mutual funds allow small investors to overcome
constraints to buying assets imposed by large minimum denomination size.

Services Benefiting the Overall Economy:

Money supply transmission—depository institutions are the conduit through which monetary
policy actions impact the rest of the financial system and the economy in general.
Credit allocation—FIs are often viewed as the major, and sometimes only, source of financing
for a particular sector of the economy, such as farming and residential real estate.
Intergenerational wealth transfers—FIs, especially life insurance companies and pension
funds, provide savers with the ability to transfer wealth from one generation to the next.
Payment services—the efficiency with which depository institutions provide payment services
directly benefits the economy.
14
delegated monitor
An economic agent
appointed to act on behalf
of smaller investors in col-
lecting information and/
or investing funds on their
behalf.
asset transformers
Financial claims issued by
an FI that are more attrac-
tive to investors than are
the claims directly issued
by corporations.
diversify
The ability of an economic
agent to reduce risk by
holding a number of differ-
ent securities in a portfolio.
Part 1 Introduction and Overview of Financial Markets
much greater incentive to hire employees with superior skills and training in monitoring.
This expertise can be used to collect information and monitor the ultimate fund user’s
actions because the FI has far more at stake than any small individual fund supplier. Sec-
ond, the monitoring function performed by the FI alleviates the “free-rider” problem that
exists when small fund suppliers leave it to each other to collect information and monitor
a fund user. In an economic sense, fund suppliers have appointed the financial institution
as a delegated monitor to act on their behalf. For example, full-service securities firms
such as Morgan Stanley carry out investment research on new issues and make investment
recommendations for their retail clients (or investors), while commercial banks collect
deposits from fund suppliers and lend these funds to ultimate users such as corporations.
An important part of these FIs’ functions is their ability and incentive to monitor ultimate
fund users.
Liquidity and Price Risk. In addition to improving the quality and quantity of infor-
mation, FIs provide further claims to fund suppliers, thus acting as asset transformers.
Financial institutions purchase the financial claims issued by users of funds—primary
securities such as mortgages, bonds, and stocks—and finance these purchases by selling
financial claims to household investors and other fund suppliers in the form of deposits,
insurance policies, or other secondary securities. Thus, in contrast to a world without FIs,
while funds are being transferred from suppliers of funds through FIs to users of funds,
ownership of the financial claims is not directly transferred from users of funds to the
suppliers of funds. For example, an individual investor in a mutual fund that purchases
Apple stock is not a shareholder of Apple Inc. The mutual fund owns Apple shares and the
individual investor owns shares of this mutual fund.
Often claims issued by financial institutions have liquidity attributes that are superior
to those of primary securities. For example, banks and thrift institutions (e.g., savings
associations) issue transaction account deposit contracts with a fixed principal value and
often a guaranteed interest rate that can be withdrawn immediately, on demand, by inves-
tors. Money market mutual funds issue shares to household savers that allow them to enjoy
almost fixed principal (depositlike) contracts while earning higher interest rates than on
bank deposits, and that can be withdrawn immediately. Even life insurance companies
allow policyholders to borrow against their policies held with the company at very short
notice. Notice that in reducing the liquidity risk of investing funds for fund suppliers, the
FI transfers this risk to its own balance sheet. That is, FIs such as depository institutions
offer highly liquid, low price-risk securities to fund suppliers on the liability side of their
balance sheets, while investing in relatively less liquid and higher price-risk securities—
such as the debt and equity—issued by fund users on the asset side. Three questions arise
here. First, how can FIs provide these liquidity services? Furthermore, how can FIs be
confident enough to guarantee that they can provide liquidity services to fund suppliers
when they themselves invest in risky assets? Finally, why should fund suppliers believe
FIs’ promises regarding the liquidity and safety of their investments?
The answers to these three questions lie in financial institutions’ ability to diversify
away some, but not all, of their investment risk. The concept of diversification is familiar
to all students of finance. Basically, as long as the returns on different investments are not
perfectly positively correlated, by spreading their investments across a number of assets,
FIs can diversify away significant amounts of their portfolio risk. (We discuss the mechan-
ics of diversification in the loan portfolio in Chapter 21.) Thus, FIs can exploit the law
of large numbers in making their investment decisions, whereas because of their smaller
wealth size, individual fund suppliers are constrained to holding relatively undiversified
portfolios. As a result, diversification allows an FI to predict more accurately its expected
return and risk on its investment portfolio so that it can credibly fulfill its promises to the
suppliers of funds to provide highly liquid claims with little price risk. As long as an FI is
large enough to gain from diversification and monitoring on the asset side of its balance
sheet, its financial claims (its liabilities) are likely to be viewed as liquid and attractive to
small savers—especially when compared to direct investments in the capital market.
 Chapter 1 Introduction 15

Additional Benefits FIs Provide to Suppliers of Funds

The indirect investing of funds through financial institutions is attractive to fund suppliers
for other reasons as well. We discuss these below and summarize them in Table 1–6.

Reduced Transaction Cost. Not only do financial institutions have a greater incentive
to collect information, but also their average cost of collecting relevant information is
economies of scale lower than for the individual investor (i.e., information collection enjoys economies of
The concept that cost scale). For example, the cost to a small investor of buying a $100 broker’s report may
reduction in trading and seem inordinately high for a $10,000 investment. For an FI with $10 billion of assets
other transaction services under management, however, the cost seems trivial. Such economies of scale of informa-
results in increased effi- tion production and collection tend to enhance the advantages to investors of investing
ciency when FIs perform via FIs rather than directly investing themselves. Nevertheless, as a result of technologi-
these services. cal advances, the costs of direct access to financial markets by savers are ever falling and
the relative benefits to the individual savers of investing through FIs are narrowing.

Maturity Intermediation. An additional dimension of financial institutions’ ability to

reduce risk by diversification is their greater ability, compared to a small saver, to bear the
risk of mismatching the maturities of their assets and liabilities. Thus, FIs offer maturity
intermediation services to the rest of the economy. Specifically, by maturity mismatching,
FIs can produce long-term contracts such as long-term, fixed-rate mortgage loans to house-
holds, while still raising funds with short-term liability contracts such as deposits. In addition,
although such mismatches can subject an FI to interest rate risk (see Chapters 3 and 23), a
large FI is better able than a small investor to manage this risk through its superior access to
markets and instruments for hedging the risks of such loans (see Chapters 7, 10, 21, and 25).

Denomination Intermediation. Some FIs, especially mutual funds, perform a unique

service relating to denomination intermediation. Because many assets are sold in very
large denominations, they are either out of reach of individual savers or would result in
savers holding very undiversified asset portfolios. For example, the minimum size of a
negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often
sold in minimum packages of $250,000 or more. Individual small savers may be unable
to purchase such instruments directly. However, by pooling the funds of many small
savers (such as by buying shares in a mutual fund with other small investors), small savers
overcome constraints to buying assets imposed by large minimum denomination size.
Such indirect access to these markets may allow small savers to generate higher returns
(and lower risks) on their portfolios as well.

Economic Functions FIs Provide to the Financial System as a Whole

In addition to the services financial institutions provide to suppliers and users of funds
in the financial markets, FIs perform services that improve the operation of the financial
system as a whole. We discuss these next and summarize them in Table 1–6.

The Transmission of Monetary Policy. The highly liquid nature of bank and thrift
deposits has resulted in their acceptance by the public as the most widely used medium of
exchange in the economy. Indeed, at the core of the most commonly used definitions of the
money supply (see Chapter 4) are bank and/or thrift deposit contracts. Because deposits are
a significant component of the money supply, which in turn directly impacts the rate of eco-
nomic growth, depository institutions—particularly commercial banks—play a key role in
the transmission of monetary policy from the central bank (the Federal Reserve) to the rest
www.federalreserve.gov of the economy (see Chapter 4 for a detailed discussion of how the Federal Reserve imple-
ments monetary policy through depository institutions).4 Because depository institutions

4. The Federal Reserve is the U.S. central bank charged with promoting economic growth in line with the economy’s
potential to expand.
16 Part 1 Introduction and Overview of Financial Markets

?
are instrumental in determining the size and growth of the money supply, they have been
D O YO U designated as the primary conduit through which monetary policy actions by the Federal
U N D E R STA N D
Reserve impact the rest of the financial sector and the economy in general.
6. The three major
reasons that suppliers Credit Allocation. FIs provide a unique service to the economy in that they are the
of funds would not major source of financing for particular sectors of the economy preidentified by society
want to directly
as being in special need of financing. For example, policymakers in the United States and
purchase securities?
a number of other countries such as the United Kingdom have identified residential real
7. What the asset
transformation
estate as needing special attention. This has enhanced the specialness of those FIs that
function of FIs is? most commonly service the needs of that sector. In the United States, savings associations
8. What delegated and savings banks must emphasize mortgage lending. Sixty-five percent of their assets
monitoring function must be mortgage related for these thrifts to maintain their charter status (see Chapter 14).
FIs perform? In a similar fashion, farming is an especially important area of the economy in terms of
9. What the link is the overall social welfare of the population. Thus, the U.S. government has directly encour-
between asset aged financial institutions to specialize in financing this area of activity through the
diversification and creation of Federal Farm Credit Banks.5
the liquidity of
deposit contracts?
Intergenerational Wealth Transfers or Time Intermediation. The ability of savers
10. What maturity
intermediation is? to transfer wealth from their youth to old age as well as across generations is also of great
11. Why the need
importance to a country’s social well-being. Because of this, special taxation relief and
for denomination other subsidy mechanisms encourage investments by savers in life insurance, annuities,
intermediation arises? and pension funds. For example, pension funds offer savings plans through which fund
12. The two major sectors participants accumulate tax-exempt savings during their working years before withdrawing
that society has them during their retirement years.
identified as deserving
special attention in
Payment Services. Depository institutions such as banks and thrifts are also special
credit allocation?
in that the efficiency with which they provide payment services directly benefits the
13. Why monetary policy
is transmitted through
economy. Two important payment services are check-clearing and wire transfer services.
the banking system? For example, on any given day, over $4.5 trillion of payments are directed through Fedwire
14. The payment services and CHIPS, the two largest wholesale payment wire network systems in the United States.
that FIs perform? Any breakdowns in these systems would likely produce gridlock to the payment system,
with resulting harmful effects to the economy.

LG 1-7 Risks Incurred by Financial Institutions

As financial institutions perform the various services described previously, they face
many types of risk. Specifically, all FIs hold some assets that are potentially subject to
default or credit risk (such as loans, stocks, and bonds). As FIs expand their services to
non-U.S. customers or even domestic customers with business outside the United States,
they are exposed to both foreign exchange risk and country or sovereign risk as well.
Further, FIs tend to mismatch the maturities of their balance sheet assets and liabilities
to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade
these assets and liabilities rather than hold them for longer-term investments, they are
further exposed to market risk or asset price risk. Increasingly, FIs hold contingent
assets and liabilities off the balance sheet, which presents an additional risk called off-
balance-sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal
or liquidity risk, depending on the type of claims they have sold to liability holders.
All FIs are exposed to technology risk and operational risk because the production of
financial services requires the use of real resources and back-office support systems
(labor and technology combined to provide services). Finally, the risk that an FI may not
have enough capital reserves to offset a sudden loss incurred as a result of one or more
of the risks it faces creates insolvency risk for the FI. Chapters 20 through 25 provide an
analysis of how FIs measure and manage these risks.
5. The Farm Credit System was created by Congress in 1916 to provide American agriculture with a source of sound,
dependable credit at low rates of interest.
 Chapter 1 Introduction 17

LG 1-8 Regulation of Financial Institutions

The preceding section showed that financial institutions provide various services to sectors
of the economy. Failure to provide these services, or a breakdown in their efficient provi-
sion, can be costly to both the ultimate suppliers of funds and users of funds as well as to
the economy overall. The financial crisis of the late 2000s is a prime example of how such
a breakdown in the provision of financial services can cripple financial markets world-
wide and bring the world economy into a deep recession. For example, bank failures may
destroy household savings and at the same time restrict a firm’s access to credit. Insurance
company failures may leave household members totally exposed in old age to the cost of
catastrophic illnesses and to sudden drops in income upon retirement. In addition, indi-
vidual FI failures may create doubts in savers’minds regarding the stability and solvency
of FIs and the financial system in general and cause panics and even withdrawal runs on
sound institutions. Indeed, this possibility provided the reasoning in 2008 for an increase
in the deposit insurance cap to $250,000 per person per bank. At this time, the Federal
Deposit Insurance Corporation (FDIC) was concerned about the possibility of contagious
runs as a few major FIs (e.g., IndyMac and Washington Mutual) failed or nearly failed.
The FDIC wanted to instill confidence in the banking system and made the change to avoid
massive depositor runs from many of the troubled (and even safer) FIs, more FI failures,
and an even larger collapse of the financial system.
FIs are regulated in an attempt to prevent these types of market failures and the
costs they would impose on the economy and society at large. Although regulation
may be socially beneficial, it also imposes private costs, or a regulatory burden,
on individual FI owners and managers. Consequently, regulation is an attempt to
enhance the social welfare benefits and mitigate the costs of the provision of FI ser-
vices. Chapter 13 describes regulations (past and present) that have been imposed on
U.S. financial institutions.

Trends in the United States

In Table 1–7, we show the changing shares of total assets of financial institutions in the
United States from 1948 to 2019. A number of important trends are clearly evident; most
apparent is the decline in the total share of depository institutions—commercial banks
and thrifts—since World War II. Specifically, while still the dominant sector of the finan-
cial institutions industry, the share of depository institutions declined from 62.7 percent
in 1948 to 30.9 percent in 2019. The effects of regulation imposed during the financial
crisis (e.g., the Financial Institutions Reform and Recovery Act of 2010 and Basel 3 capital
regulations discussed in Chapter 13) and historically low interest rates on bank deposits

TABLE 1–7 Percentage Shares of Assets of Financial Institutions in the United States, 1948–2019

1948 1960 1970 1980 1990 2000 2010 2016 2019

Depository institutions 62.7% 54.5% 56.9% 57.9% 43.3% 27.9% 31.3% 32.5% 30.9%
Insurance companies 23.4 22.6 18.1 15.7 16.2 14.4 14.2 14.1 13.8
Investment companies 1.1 3.7 3.8 3.8 9.9 24.0 24.7 28.5 31.0
Pension funds 9.1 13.0 13.3 13.7 15.3 14.3 12.5 13.4 13.2
Finance companies 2.5 4.7 5.1 5.2 5.3 4.1 3.5 2.3 2.0
Securities brokers and dealers 1.2 1.5 2.5 3.6 9.7 15.1 13.2 8.2 8.0
Real estate investment trusts — 0.0 0.3 0.1 0.3 0.2 0.6 1.0 1.1
Total (percentage) 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Total (trillions of dollars) $0.27 $0.63 $1.39 $4.10 $11.64 $29.91 $52.78 $67.18 $75.21

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, various issues, www.federalreserve.gov
18 Part 1 Introduction and Overview of Financial Markets

(discussed in Chapter 2) reflect this relatively large decline.6 Similarly, insurance compa-
nies also witnessed a decline in their share, from 23.4 to 13.8 percent.
The most dramatic trend involves the increasing share of pension funds and invest-
ment companies and securities brokers and dealers. Investment companies (mutual funds
and money market mutual funds) increased their share from 1.1 to 31.0 percent, while
pension funds increased from 9.1 to 13.2 percent over the 1948 to 2019 period. Investment
companies and pension funds differ from banks and insurance companies in that they give
savers cheaper access to the direct securities markets. They do so by exploiting the com-
parative advantages of size and diversification, with the transformation of financial claims,
such as maturity transformation, a lesser concern. Thus, open-ended mutual funds and
pension funds buy stocks and bonds directly in financial markets and issue savers shares
whose value is linked in a direct pro rata fashion to the value of the fund’s asset portfolio.
Similarly, money market mutual funds invest in short-term financial assets such as com-
mercial paper, CDs, and Treasury bills and issue shares linked directly to the value of the
underlying portfolio. To the extent that these funds efficiently diversify, they also offer
price risk protection and liquidity services.

The Rise of Financial Services Holding Companies. To the extent that the financial
services market is efficient and the data seen in Table 1–7 reflect the forces of demand
and supply, these data indicate a current trend: savers increasingly prefer investments that
closely mimic diversified investments in the direct securities markets over the transformed
financial claims offered by traditional FIs. This trend may also indicate that the regulatory
burden on traditional FIs—such as banks and insurance companies—is higher than that on
pension funds, mutual funds, and investment companies. Indeed, traditional FIs are unable
to produce their services as cost-efficiently as they previously could.
Recognizing this changing trend, in 1999 the U.S. Congress passed the Financial
Services Modernization (FSM) Act, which repealed the 1933 Glass-Steagall barriers
between commercial banking, insurance, and investment banking. The bill, promoted as
the biggest change in the regulation of financial institutions in 70 years, allowed for the
creation of “financial services holding companies” that could engage in banking activities,
insurance activities, and securities activities. After 70 years of partial or complete separa-
tion between insurance, investment banking, and commercial banking, the FSM opened
the door for the creation of full-service financial institutions in the United States simi-
lar to those that existed before 1933 and that exist in many other countries. Thus, while
Table 1–7 lists assets of financial institutions by functional area, the financial services
holding company (which combines these activities in a single financial institution) has
become the dominant form of financial institution in terms of total assets.

The Shift Away from Risk Measurement and Management and the Financial Crisis.
Certainly, the financial crisis of the late 2000s changed and reshaped today’s financial
markets and institutions. As FIs adjusted to regulatory changes brought about by the likes
of the FSM Act, one result was a dramatic increase in the systemic risk of the financial sys-
tem, caused in large part by a shift in the banking model from that of “originate and hold”
to “originate and distribute.” In the traditional model, banks take short-term deposits and
other sources of funds and use them to fund longer term loans to businesses and consum-
ers. Banks typically hold these loans to maturity and thus have an incentive to screen and
monitor borrower activities even after a loan is made.
However, the traditional banking model exposes the institution to potential liquid-
ity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate
improved return-risk tradeoffs, banks have shifted to an underwriting model in which

6. Although depository institutions assets as a percentage of total assets in the financial sector may have declined in
recent years, this does not necessarily mean that banking activity has decreased. Indeed, off-balance-sheet activities
have replaced some of the more traditional on-balance-sheet activities of commercial banks (see Chapter 11). Further,
as is discussed in Part Three of the text, banks are increasingly providing services (such as securities underwriting,
insurance underwriting and sales, and mutual fund services) previously performed exclusively by other FIs.
Another random document with
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 Pyscomancy, or Sciomancy,

An art among the ancients of raising or calling up the manes or souls

of deceased persons, to give intelligence of things to come. The witch
who conjured up the soul of Samuel, to foretel Saul the event of the
battle he was about to give, did so by Sciomancy.

Rhabdomancy,

Was an ancient method of divination, performed by means of rods or

staves. St. Jerome mentions this kind of divination in his
Commentary on Hosea, chap. vi. 12.; where the prophet says, in the
name of God: My people ask counsel at their stocks; and their staff
declareth unto them: which passage that father understands of the
Grecian Rhabdomancy.
The same is met with again in Ezekiel, xxi. 21, 22. where the
prophet says: For the king of Babylon stood at the parting of the
way, at the head of the two ways, to use divination; he made his
arrows bright; or, as St. Jerome renders it, he mixed his arrows; he
consulted with images; he looked in the liver.
If it be the same kind of divination that is alluded to in these two
passages, Rhabdomancy must be the same kind of superstition with
Belomancy. These two, in fact, are generally confounded. The
Septuagint themselves translate ‫ חצים‬of Ezekiel, by ῥαβδος, a rod;
though in strictness it signifies an arrow. So much however is
certain, that the instruments of divination mentioned by Hosea are
different from those of Ezekiel. In the former it is ‫ עצו‬etso, ‫מקלו‬
maklo, his wood, his staff: in the latter ‫ חצים‬hhitism, arrows. Though
it is possible they might use rods or arrows indifferently; or the
military men might use arrows and the rest rods.
By the laws of the Frisones, it appears that the ancient inhabitants
of Germany practised Rhabdomancy. The Scythians were likewise
acquainted with the use of it: and Herodotus observes, lib. vi. that
the women among the Alani sought and gathered together fine
straight wands or rods, and used them for the same superstitious
purposes.
 Among the various other kinds of divination, not here mentioned,
may be enumerated: Chiromancy, performed with keys;
Alphitomancy or Aleuromancy, by flour; Keraunoscopia, by the
consideration of thunder; Alectromancy, by cocks; Lithomancy, by
stones; Eychnomancy, by lamps; Ooscopy, by eggs; Lecanomancy,
by a basin of water; Palpitatim, Salisatio, παλμος, by the pulsation
or motion of some member, &c. &c. &c.
All these kinds of divination have been condemned by the fathers
of the Church, and Councils, as supposing some compact with the
devil. Fludd has written several treatises on divination, and its
different species; and Cicero has two books of the divination of the
ancients, in which he confutes the whole system. Cardan also, in his
4th Book de Sapientia, describes every species of them.
 ORACLE.

The word oracle admits, under this head, of two significations:

first, it is intended to express an answer, usually couched in very
dark and ambiguous terms, supposed to be given by demons of old,
either by the mouths of their idols, or by those of their priests, to
those who consulted them on things to come. The Pythian[36] was
always in a rage when she gave oracles.
Ablancourt observes that the study or research of the meaning of
Oracles was but a fruitless thing; and they were never understood
until they were accomplished. It is related by Historians, that Crœsus
was tricked by the ambiguity and equivocation of the oracle.
Κροισος Άλυν διαβας μεγαλην αρχην καταλνσει. rendered thus in
Latin:—
Crœsus Halym superans magnam pervertet opum vim.
Oracle is also used for the Demon who gave the answer, and the
place where it was given. (Vide Demon.)
The principal oracles of antiquity are that of Abæ, mentioned by
Herodotus; that of Amphiarus; that of the Branchidæ, at Didymus;
that of the Camps, at Lacedemon; that of Dodona; that of Jupiter
Ammon; that of Nabarca, in the Country of the Anariaci, near the
Caspian sea; that of Trophonius, mentioned by Herodotus; that of
Chrysopolis; that of Claros, in Ionia; that of Mallos; that of Patarea;
that of Pella, in Macedonia; that of Phaselides, in Cilicia; that of
Sinope, in Paphlagonia; that of Orpheus’s head, mentioned by
Philostratus in his life of Appolonius, &c. But, of all others, the oracle
of Apollo Pythius, at Delphi, was the most celebrated; it was, in
short, consulted always as a dernier ressort, in cases of emergency,
by most of the princes of those ages.—Mr. Bayle observes, that at
first, it gave its answers in verse; and that at length it fell to prose, in
consequence of the people beginning to laugh at the poorness of its
versification.
Among the more learned, it is a pretty general opinion that all the
oracles were mere cheats and impostures; calculated either to serve
the avaricious ends of the heathen priests, or the political views of
the princes. Bayle positively asserts, they were mere human artifices,
in which the devil had no hand. In this opinion he is strongly
supported by Van Dale, a Dutch physician, and M. Fontenelle, who
have expressly written on the subject.
There are two points at issue on the subject of oracles; viz. whether
they were human or diabolical machines; and whether or not they
ceased upon the publication and preaching of the Gospel?
Plutarch wrote a treatise on the ceasing of some oracles: and Van
Dale has a volume to prove that they did not cease at the coming of
Christ; but that many of them had ceased long before the coming of
that time, and that others held out till the fall of Paganism, under the
Empire of Theodosius the Great, and when it was dissipated, these
institutions could no longer resist.
Van Dale was answered by a German, one Mœbius, professor of
Theology, at Leipsic, in 1685. Fontenelle espoused Van Dale’s
system, and improved upon it in his history of oracles; wherein he
exposed the weakness of the argument used by many writers in
behalf of Christianity, drawn from the ceasing of oracles.
Balthus, a learned Jesuit, answered both Van Dale and Fontenelle.
He labours to prove, that there were real oracles, and such as can
never be attributed to any artifices of the Priests or Priestesses; and
that several of these became silent in the first ages of the Church,
either by the coming of Jesus Christ, or by the prayers of the Saints.
This doctrine is confirmed by a letter from Father Bouchet,
missionary to Father Balthus; wherein it is declared, that what
Father Balthus declares of the ancient oracles, is experimented every
day in the Indies.
It appears, according to Bouchet, that the devil still delivers
oracles in the Indies; and that, not by idols, which would be liable to
imposture, but by the mouths of the priests, and sometimes of the
bye-standers; it is added that these oracles, too, cease, and the devil
becomes mute in proportion as the Gospel is preached among them.
 It was Eusebius who first endeavoured to persuade the christians
that the coming of Jesus Christ had struck the oracles dumb; though
it appears from the laws of Theodosius, Gratian, and Valentinian,
that the oracles were still consulted as far back as the year 358.
Cicero says the oracles became dumb, in proportion as people,
growing less credulous, began to suspect them for cheats.
Two reasons are alleged by Plutarch for the ceasing of oracles: the
one was Apollo’s chagrin, who, it seems, “took it in dudgeon,” to be
interrogated about so many trifles. The other was, that in proportion
as the genii, or demons, who had the management of the oracles,
died and became extinct, the oracles must necessarily cease. He adds
a third and more natural cause for the ceasing of oracles, viz. the
forlorn state of Greece, ruined and desolated by wars. For, in
consequence of this calamity, the smallness of the gains suffered the
priests to sink into a poverty and contempt too bare to cover the
fraud.
Most of the fathers of the church imagined it to be the devil that
gave oracles, and considered it as a pleasure he took to give dubious
and equivocal answers, in order to have a handle to laugh at them.
Vossius allows that it was the devil who spoke in oracles; but thinks
that the obscurity of his answers was owing to his ignorance as to the
precise circumstances of events. That artful and studied obscurity,
wherein, says he, answers were couched, shew the embarrassment
the devil was under; as those double meanings they usually bore
provided for the accomplishment. When the thing foretold did not
happen accordingly, the oracle, forsooth, was always misunderstood.
Eusebius has preserved some fragments of a Philosopher, called
Oenomaus, who, out of resentment for having been so often fooled
by the oracles, wrote an ample confutation of all their impertinences,
in the following strain: “When we come to consult thee,” says he to
Apollo, “if thou seest what is in the womb of futurity, why dost thou
use expressions that will not be understood? if thou dost, thou takest
pleasure in abusing us: if thou dost not, be informed of us, and learn
to speak more clearly. I tell thee, that if thou intendest an equivoque,
the Greek word whereby thou affirmedst that Crœsus should
overthrow a great Empire, was ill-chosen; and that it could signify
nothing but Crœsus’ conquering Cyrus. If things must necessarily
come to pass, why dost thou amuse us with thy ambiguities? What
dost thou, wretch as thou art, at Delphi; employed in muttering idle
prophesies!”
But Oenamaus is still more out of humour with the oracle for the
answer which Apollo gave the Athenians, when Xerxes was about to
attack Greece with all the strength of Asia. The Pythian declared, that
Minerva, the protectress of Athens, had endeavoured in vain to
appease the wrath of Jupiter; yet that Jupiter, in complaisance to his
daughter, was willing the Athenians should save themselves within
wooden walls; and that Salamis should behold the loss of a great
many children, dead to their mothers, either when Ceres was spread
abroad, or gathered together. At this Oenamaus loses all patience
with the Delphian god: “This contest,” says he, “between father and
daughter, is very becoming the deities! It is excellent, that there
should be contrary inclinations and interests in heaven! Poor wizard,
thou art ignorant who the children are that shall see Salamis perish;
whether Greeks or Persians. It is certain they must be either one or
the other; but thou needest not have told so openly that thou
knewest not which. Thou concealest the time of the battle under
these fine poetical expressions, either when Ceres is spread abroad,
or gathered together: and thou wouldst cajole us with such pompous
language! who knows not, that if there be a seafight, it must either be
in seed-time or harvest? It is certain it cannot be in winter. Let things
go how they will, thou wilt secure thyself by this Jupiter, whom
Minerva is endeavouring to appease. If the Greeks lose the battle,
Jupiter proved inexorable to the last; if they gain it, why then
Minerva at length prevailed.”
 OURAN, OR URAN, SOANGUS,

The name of an imaginary set of magicians in the island

Gromboccanore, in the East Indies.
The word implies men-devils; these people, it seems, having the
art of rendering themselves invisible, and passing where they please,
and, by these means, doing infinite mischief; for which reason the
people hate and fear them mortally, and always kill them on the spot
when they can take them.
In the Portuguese history, printed 1581, folio, there is mention of a
present made by the king of the island to a Portuguese officer, named
Brittio, ourans, with whom, it is pretended, he made incursions on
the people of Tidore, killed great numbers, &c.
To try whether in effect they had the faculty ascribed to them, one
of them was tied by the neck with a rope, without any possibility of
disengaging himself by natural means; yet in the morning it was
found he had slipped his collar. But that the king of Tidore might not
complain that Brittio made war on him with devils, it is said he
dismissed them at length, in their own island.
 DREAMS, &c.

The art of foretelling future events by dreams, is called

 Brizomancy.
Macrobius mentions five sorts of dreams, viz. 1st, vision; 2d, a
discovery of something between sleep and waking; 3d, a suggestion
cast into our fancy, called by Cicero, Vesum; 4th, an ordinary dream;
and 5th, a divine apparition or revelation in our sleep; such as were
the dreams of the prophets, and of Joseph, as also of the magi of the
East.
 Origin of Interpreting Dreams.
The fictitious art of interpreting dreams, had its origin among the
Egyptians and Chaldeans; countries fertile in superstitions of all
kinds. It was propagated from them to the Romans, who judging
some dreams worthy of observation, appointed persons on purpose
to interpret them.
The believers in dreams as prognostics of future events, bring
forward in confirmation of this opinion, a great variety of dreams,
which have been the forerunners of very singular events:—among
these are that of Calphurnia, the wife of Julius Cæsar, dreaming the
night before his death, that she saw him stabbed in the capitol: that
of Artorius, Augustus’s physician, dreaming before the battle of
Philippi, that his master’s camp was pillaged; that of the Emperor
Vespasian dreaming an old woman told him, that his good fortune
would begin when Nero should have a tooth drawn, which happened
accordingly.
Cæsar dreaming that he was committing incest with his mother,
was crowned Emperor of Rome; and Hippias the Athenian Tyrant,
dreaming the same, died shortly after, and was interred in his
mother earth. Mauritius the Emperor, who was slain by Phocas,
dreamed a short time previous to this event, that an image of Christ
that was fixed over the brazen gate of his palace, called him and
reproached him with his sins, and at length demanded of him
whether he would receive the punishment due to them in this world
or the next; and Mauritius answering in this, the image commanded
that he should be given, with his wife and children, into the hands of
Phocas. Whereupon Mauritius, awakening in great fear, asked
Phillipus, his son-in-law, whether he knew any soldier in the army
called Phocas, he answered that there was a commissary so called;
and Phocas became his successor, having killed his wife and five
children. Arlet, during her pregnancy by William the Conqueror,
dreamed that a light shone from her womb, that illumined all
England. Maca, Virgil’s mother, dreamed that she was delivered of a
laurel branch.
 The ridiculous infatuation of dreams is still so prominent, even
among persons whose education should inform them better, and
particularly among the fair sex, that a conversation seldom passes
among them, that the subject of some foolish inconsistent dream or
other, does not form a leading feature of their gossip. “I dreamed last
night,” says one, “that one of my teeth dropped out.”—“That’s a sign,”
replies another, “that you will lose a friend or some of your
relations.”—“I’m afraid I shall,” returns the dreamer, “for my cousin
(brother, or some other person connected with the family or its
interests,) is very ill,” &c.
 Opinions on the cause of dreams.
Avicen makes the cause of dreams to be an ultimate intelligence
moving the moon in the midst of that light with which the fancies of
men are illuminated while they sleep. Aristotle refers the cause of
them to common sense, but placed in the fancy. Averroes places it in
the imagination. Democritus ascribes it to little images, or
representations, separated from the things themselves. Plato, among
the specific and concrete notions of the soul. Albertus to the superior
influences which continually flow from the sky, through many
specific mediums. And some physicians attribute the cause of them
to vapours and humours, and the affections and cares of persons
predominant when awake; for, say they, by reason of the abundance
of vapours, which are exhaled in consequence of immoderate
feeding, the brain is so stuffed by it, that monsters and strange
chimera are formed, of which the most inordinate eaters and
drinkers furnish us with sufficient instances. Some dreams, they
assert, are governed partly by the temperature of the body, and
partly by the humour which mostly abounds in it; to which may be
added, the apprehensions which have preceded the day before; which
are often remarked in dogs, and other animals, which bark and make
a noise in their sleep. Dreams, they observe, proceeding from the
humours and temperature of the body, we see the choleric dreams of
fire, combats, yellow colours, &c.; the phlegmatic, of water, baths, of
sailing on the sea, &c.; the melancholics, of thick fumes, deserts,
fantasies, hideous faces, &c.; the sanguines, of merry feasts, dances,
&c. They that have the hinder part of their brain clogged with viscous
humours, called by physicians ephialtes incubus, or, as it is termed,
night-mare, imagine, in dreaming, that they are suffocated. And
those who have the orifice of their stomach loaded with malignant
humours, are affrighted with strange visions, by reason of those
venemous vapours that mount to the brain and distemper it.
Cicero tells a story of two Arcadians, who, travelling together,
came to Megara, a city of Greece, between Athens and Corinth,
where one of them lodged in a friend’s house, and the other at an
inn. After supper the person who lodged at the private house went to
bed, and falling asleep, dreamed that his friend at the inn appeared
to him, and begged his assistance, because the innkeeper was going
to kill him. The man immediately got out of bed much frightened at
the dream but recovering himself and falling asleep again, his friend
appeared to him a second time, and desired, that as he would not
assist him in time, he would take care at least not to let his death go
unpunished; that the innkeeper having murdered him, had thrown
his body into a cart and covered it with dung; he therefore begged
that he would be at the city gate in the morning, before the cart was
out. Struck with this new dream, he went early to the gate, saw the
cart, and asked the driver what was in it; the driver immediately fled,
the dead body was taken out of the cart, and the innkeeper
apprehended and executed.
 FATE.

Fate, in a general sense, denotes an inevitable necessity,

depending on some superior cause. It is a term much used among
the ancient philosophers. It is formed a fando, from speaking; and
primarily implies the same with effatum, i. e. a word or decree
pronounced by God; or a fixed sentence, whereby the deity has
prescribed the order of things, and allotted every person what shall
befal him. The Greeks called θμαρμενη, quasi, θρμος, nexus, a
change, or necessary series of things, indissolubly linked together;
and the moderns call it Providence. But independent of this sense of
the word, in which it is used sometimes to denote the causes in
nature, and sometimes the divine appointment, the word Fate has a
farther meaning, being used to express some kind of necessity or
other, or eternal designation of things, whereby all agents, necessary
as well as voluntary, are swayed and directed to their ends.
Some authors have divided Fate into Astrological and Stoical.
Astrological fate, denotes a necessity of things and events,
arising, as is supposed, from the influence and positions of the
heavenly bodies, which give law to the elements and mixed bodies, as
well as to the wills of men.
Stoical fate, or FATALITY, or FATALISM, is defined by Cicero, an
order or series of causes, in which cause is linked to cause, each
producing others; and in this manner all things flow from the one
prime cause. Chrysippus defines it a natural invariable succession of
all things, ab eterno, each involving the other. To this fate they
subject the very gods themselves. Thus the poet observes, that the
“parent of all things made laws at the beginning, by which he not
only binds other things, but himself.” Seneca also remarks, Eadem
necessitas et deos alligat. Irrevocabilis divina pariter et humana
cursit vehit. Ipse ille omnium conditor et rector scripsit quidam
fata, sed sequitur; semel scripsit, semper paret. This eternal series
of causes, the poets call μοιραι, and parcæ, or destinies.
By some later authors Fate is divided into Physical and divine.
The first, or Physical fate, is an order and series of physical causes,
appropriated to their effects. This series is necessary, and the
necessity is natural. The principal or foundation of this Fate is
nature, or the power and manner of acting which God originally gave
to the several bodies, elements, &c. By this Fate it is that fire warms;
bodies communicate motion to each other; the rising and falling of
the tides, &c. And the effects of this Fate are all the events and
phenomena in the universe, except such as arise from the human.
The second, or divine Fate, is what is more commonly called
Providence. Plato, in his Phædo, includes both these in one
definition; as intimating, that they were one and the same thing,
actively and passively considered. Thus, Fatum Est ratio quædam
divina, lexque naturæ comes, quæ transiri nequeat, quippe a causa
pendens, quæ superior sit quibusvis impedimentis. Though that of
Bœtius seems the clearer of the two:—Fatum, says he, est inhærens
rebus molilibus despositio per quam providentia suis quæque nectet
ordinibus.
 PHYSIOGNOMY[37], ΦΥΣΙΟΓΝΩΜΙΑ.

There seems to be something in Physiognomy, and it may perhaps

bear a much purer philosophy than these authors (see Note,) were
acquainted with. This, at least, we dare say, that of all the fanciful
arts of the ancients, fallen into disuse by the moderns, there is none
has so much foundation in nature as this. There is an apparent
correspondence, or analogy between the countenance and the mind;
the features and lineaments of the one are directed by the motions
and affections of the other: there is even a peculiar arrangement in
the members of the face, and a peculiar disposition of the
countenance, to each particular affection; and perhaps to each
particular idea of the mind. In fact, the language of the face
(physiognomy,) is as copious, nay, perhaps, as distinct and
intelligible, as that of the tongue, (speech.) Thanks to bounteous
nature, she has not confined us to one only method of conversing
with each other, and of learning each other’s thoughts; we have
several:—We do not wholly depend on the tongue, which may
happen to be bound; and the ear, which may be deaf:—but in those
cases we have another resource, viz. the Countenance and the Eye,
which afford us this further advantage, that by comparing the reports
of the tongue, (a member exceedingly liable to deceive,) with those of
the face, the prevarications of the former may be detected.
The foundation of Physiognomy is the different objects that
present themselves to the senses, nay, the different ideas that arise
on the mind, do make some impression on the spirits; and each an
impression correspondent or adequate to its cause,—each, therefore,
makes a different impression. If it be asked how such an impression
could be effected, it is easy to answer; in short, it is a consequence of
the economy of the Creator, who has fixed such a relation between
the several parts of the creation, to the end that we may be apprized
of the approach or recess of things hurtful or useful to us. Should this
not be philosophical enough for our purpose, take the manner of the
Cartesian language, thus: the animal spirits moved in the organ by
an object, continue their motion to the brain; from whence that
motion is propagated to this or that particular part of the body, as
is most suitable to the design of nature; having first made a proper
alteration in the face by means of its nerves, especially the
Pathetici and Motores Occulorum. See Dr. Gurther’s work, anno
1604.
The face here does the office of a dial-plate, and the wheels and
springs, inside the machine, putting its muscles in motion, shew
what is next to be expected from the striking part. Not that the
motion of the spirits is continued all the way by the impression of the
object, as the impression may terminate in the substance of the
brain, the common fund of the spirits; the rest Dr. Gurther imagines,
may be effected much after the same manner as air is conveyed into
the pipes of an organ, which being uncovered, the air rushes in; and
when the keys are let go, is stopped again.
Now, if by repeated acts, or the frequent entertaining of a private
passion or vice, which natural temperament has hurried, or custom
dragged on to, the face is often put in that posture which attends
such acts; the animal spirits will make such passages through the
nerves, (in which the essence of a habit consists,) that the face is
sometimes unalterably set in that posture, (as the Indian religious
are by a long continued sitting in strange postures in their pagods,)
or, at least, it falls, insensibly and mechanically, into that posture,
unless some present object distort it therefrom, or some
dissimulation hide it. This reason is confirmed by observation: thus
we see great drinkers with eyes generally set towards the nose; the
abducent muscles (by some called bibatorii, or bibatory muscles,)
being often employed to put them in that posture, in order to view
their beloved liquor in the glass, at the time of drinking. Thus, also,
lascivious persons are remarkable for the oculorum mobilis
petulantia, as Petronius calls it. Hence also we may account for the
Quaker’s expecting face, waiting the spirit to move him; the
melancholy face of most sectaries; the studious face of men of great
application of mind; revengeful and bloody men, like executioners in
the act; and though silence in a sort may awhile pass for wisdom, yet
sooner or later, St. Martin peeps through the disguise to undo all. “A
changeable face,” continues Dr. Gurther, “I have observed to show a
changeable mind, but I would by no means have what has been said
be understood as without exception; for I doubt not but sometimes
there are found men with great and virtuous souls under very
unpromising outsides.”
“Were our observations a little more strict and delicate, we might,
doubtless, not only distinguish habits and tempers, but also
professions. In effect, does there need much penetration to
distinguish the fierce looks of the veteran soldier, the contentious
look of the practised pleader, the solemn look of the minister of state,
or many others of the like kind?”
A very remarkable physiological anecdote has been given by De La
Place, in his “Pièces Interrestantes et peu connues.” Vol. iv. p. 8.
He was assured by a friend that he had seen a voluminous and
secret correspondence which had been carried on between Louis
XIV. and his favourite physician De la Chambre on this science: the
faith of the monarch seems to have been great, and the purpose to
which this correspondence tended was extraordinary indeed, and
perhaps scarcely credible. Who will believe that Louis XIV. was so
convinced of that talent, which De la Chambre attributed to himself,
of deciding merely by the physiognomy of persons, not only on the
real bent of their character, but to what employment they were
adapted, that the king entered into a secret correspondence to obtain
the critical notices of his physiognomist. That Louis XIV. should
have pursued this system, undetected by his own courtiers, is also
singular; but it appears by this correspondence, that this art
positively swayed him in his choice of officers and favourites. On one
of the backs of these letters De la Chambre had written, “If I die
before his majesty, he will incur great risk of making many an
unfortunate choice.”
This collection of Physiological correspondence, if it does really
exist, would form a curious publication. We, however, have heard
nothing of it.
De la Chambre was an enthusiastic physiognomist, as appears by
his works: “The Characters of the Passions,” four volumes in quarto;
“The art of Knowing Mankind;” and “the Knowledge of Animals.”
 Lavater quotes his “vote and interest” in behalf of his favourite
science. It is no less curious, however, to add, that Phillip Earl of
Pembroke, under James I., had formed a particular collection of
portraits, with a view to physiognomonical studies.
The great Prince of Condé was very expert in a sort of
Physiognomy which shewed the peculiar habits, motions, and
positions of familiar life, and mechanical employments. He would
sometimes lay wagers with his friends, that he would guess, upon the
Pont Neuf, what trade persons were of that passed by, from their
walk and air.
The celebrated Marshal Laudohn would have entered when young,
into the service of the great Frederick, King of Prussia; but that
monarch, with all his penetration, formed a very erroneous judgment
of the young officer, (as he himself found in the sequel,) and
pronounced that he would never do; in consequence of which
Laudohn entered into the service of the Empress-Queen, Maria
Theresa, and became one of the most formidable opponents of his
Prussian Majesty. Marshal Turrene was much more accurate in his
opinion of our illustrious John Duke of Marlborough, whose future
greatness he predicted, when he was serving in the French army as
Ensign Churchill, and known by the unmilitary name of the
“handsome Englishman.”
In the fine arts, moreover, we have seen no less accurate
predictions of future eminence. As the scholars of Rubens were
playing and jesting with each other, in the absence of their master,
one of them was accidentally thrown against a piece on which
Rubens had just been working, and a considerable part of it was
entirely disfigured. Another of the pupils set himself immediately to
repair it, and completed the design before his master returned.
Rubens, on reviewing his work, observed a change, and a difference
that surprised and embarrassed him. At last, suspecting that some
one had been busy, he demanded an explanation; adding, that the
execution was in so masterly a manner, that he would pardon the
impertinence on account of its merit. Encouraged by this declaration,
the young artist confessed, and explained the whole, pleading, that
his officiousness was merely to screen a comrade from his master’s
anger. Rubens answered, “if any one of my scholars shall excel me, it
will be yourself.” This pupil was the great Vandyck.
 Lavater, who revived physiognomy, has, unquestionably, brought
it to great perfection. But it may justly be doubted whether he is not
deceived in thinking that it may be taught like other sciences, and
whether there is not much in his system that is whimsical and
unfounded. Every man, however, has by nature, something of the
science, and nothing is more common than to suspect the man who
never looks his neighbour in the face. There is a degree of cunning in
such characters, which is always dangerous, but by no means new.
“There is a wicked man that hangeth down his head sadly; but
inwardly he is full of deceit. Casting down his countenance, and
making as if he heard not. A man may be known by his look, and one
that hath understanding, by his countenance, when thou meetest
him.”—In several of Lavater’s aphorisms, something like the
following occurs: “A man’s attire, and excessive laughter, and gait,
shew what he is.”