R.

GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN

Money, Banking, and the Financial System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall

CHAPTER

1

Introducing Money and the Financial System

LEARNING OBJECTIVES   After studying this chapter, you should be able to:  
1.1   Identify the key components of the financial system 1.2   Provide an overview of the financial crisis of 2007–2009   1.3   Explain the key issues and questions the financial crisis raises  

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

CHAPTER

1

Introducing Money and the Financial System

CAN THE FED RESTORE THE FLOW OF MONEY? • During the economic crisis that began in 2007, the financial system was disrupted as it hadn’t been since the 1930s. • Large sections of the U.S. economy were cut off from the flow of funds they needed. • Some government intervention was necessary to pull the economy out of a deep recession. • During the recession, more than 8 million jobs were lost, GM declared bankruptcy, and some Wall Street investment houses disappeared. • An Inside Look at Policy on page 20 reviews options the Fed considered to support the economy in late 2010.
© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Inc. © 2012 Pearson Education.1 Learning Objective Identify the key components of the financial system.1. Publishing as Prentice Hall 4 of 38 .

A financial asset is an asset that represents a claim on someone else for a payment.  Financial assets An asset is anything of value owned by a person or a firm. Publishing as Prentice Hall 5 of 38 . Inc.Three major components of the financial system: 1.  Financial institutions 3. 2.  The Federal Reserve and other financial regulators Key Components of the Financial System © 2012 Pearson Education.

bonds. A security is a financial asset that can be bought and sold in a financial market. Key Components of the Financial System © 2012 Pearson Education. Publishing as Prentice Hall 6 of 38 . Financial markets are places or channels for buying or selling stocks. and other securities. Inc.Financial Assets Economists divide financial assets into those that are securities and those that aren’t.

Publishing as Prentice Hall 7 of 38 . Inc.  Securitized loans Key Components of the Financial System © 2012 Pearson Education.  Stocks 3.  Money 2.  Foreign exchange 5.  Bonds 4.Financial Assets Five key categories of financial assets: 1.

Inc. Key Components of the Financial System © 2012 Pearson Education. The money supply is the total quantity of money in the economy.Financial Assets Money Money Anything that is generally accepted in payment for goods and services or to pay off debts. Publishing as Prentice Hall 8 of 38 .

Financial Assets Stocks Stocks are financial securities that represent partial ownership of a firm. Publishing as Prentice Hall 9 of 38 . Dividend A payment that a corporation makes to its shareholders. Key Components of the Financial System © 2012 Pearson Education. Inc. also called equities.

Financial Assets Bonds Bond A financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money. Interest rate The cost of borrowing funds (or the payment for lending funds). usually expressed as a percentage of the amount borrowed. Publishing as Prentice Hall 10 of 38 . Key Components of the Financial System © 2012 Pearson Education. Inc.

a domestic business or a domestic investor must first exchange domestic currency for foreign currency. Key Components of the Financial System © 2012 Pearson Education. Foreign exchange Units of foreign currency. Banks engage in foreign currency transactions on behalf of investors and business firms. Inc.Financial Assets Foreign Exchange To buy foreign goods and services or foreign assets. Publishing as Prentice Hall 11 of 38 .

Key Components of the Financial System © 2012 Pearson Education. Publishing as Prentice Hall 12 of 38 . it wasn’t possible to sell loans. Securitization The process of converting loans and other financial assets that are not tradable into securities. Note that what a saver views as a financial asset a borrower views as a financial liability. Loans were financial assets but not securities.Financial Assets Securitized Loans Before markets for loans were created. Financial liability A financial claim owed by a person or a firm. Inc.

Key Components of the Financial System © 2012 Pearson Education. that borrows funds from savers and lends them to borrowers.Financial Institutions •  The financial system matches savers and borrowers through two channels: (1)  Banks and other financial intermediaries Financial intermediary A financial firm. Publishing as Prentice Hall 13 of 38 . such as a bank. (2)  Financial markets •  Funds flow from lenders to borrowers indirectly through financial intermediaries. Inc. such as banks. or directly through financial markets. such as the New York Stock Exchange.

1 Moving Funds Through the Financial System The financial system transfers funds from savers to borrowers.Figure 1. and governments. businesses. Inc. Borrowers transfer returns back to savers through the financial system.• Key Components of the Financial System © 2012 Pearson Education. Savers and borrowers include domestic and foreign households. Publishing as Prentice Hall 14 of 38 .

are legally distinct from banks.and long-term needs for credit.” Firms rely on banks to meet their short.Financial Institutions Financial Intermediaries Commercial bank A financial firm that serves as a financial intermediary by taking in deposits and using them to make loans. Publishing as Prentice Hall 15 of 38 . Key Components of the Financial System © 2012 Pearson Education. and credit unions. Inc. Some financial intermediaries. Households rely on borrowing money from banks to purchase “big ticket items. such as savings and loans. savings banks.

forcing them to borrow from pawn shops. defaults by households and firms increased dramatically. •  Loan losses during 2007–2009 were by far the largest since the Great Depression of the 1930s. banks loosened lending requirements. •  Many banks cut small businesses off from credit. Publishing as Prentice Hall 16 of 38 . Key Components of the Financial System © 2012 Pearson Education.Making the Connection Pawn Shop Finance: What Happens to Small Businesses When Bank Lending Dries Up? •  Pawn shops typically make small loans at high interest rates. During the crisis. Inc. •  Before the financial crisis of 2007-2009. family. or friends to operate.

Publishing as Prentice Hall 17 of 38 .Making the Connection Pawn Shop Finance: What Happens to Small Businesses When Bank Lending Dries Up? Key Components of the Financial System © 2012 Pearson Education. Inc.

Publishing as Prentice Hall 18 of 38 . Key Components of the Financial System © 2012 Pearson Education. and mortgages to earn the money necessary to make pension benefit payments. bonds. Inc.Nonbank Financial Intermediaries •  Insurance companies Insurance companies collect premiums from customers then invest the premiums to obtain the funds necessary to pay claims and other costs. •  Pension funds Pension funds invest contributions from workers and firms in stocks.

Key Components of the Financial System © 2012 Pearson Education. Publishing as Prentice Hall 19 of 38 . such as stocks and bonds. Portfolio A collection of assets. Inc.Nonbank Financial Intermediaries •  Mutual funds A mutual fund obtains money by selling shares to investors and invests the money in a portfolio of financial assets. •  Hedge funds Hedge funds are similar to mutual funds but typically have no more than 99 wealthy investors and make riskier investments. •  Investment banks Investment banks concentrate on providing advice to firms issuing stocks and bonds or considering mergers with other firms.

Key Components of the Financial System © 2012 Pearson Education. Primary market A financial market in which stocks. Inc. Secondary market A financial market in which investors buy and sell existing securities. bonds. most securities trading takes place electronically between dealers linked by computers and is referred to as “over-the-counter” trading. and other securities are sold for the first time. and other securities. bonds. Today.Financial Markets Financial markets are places or channels for buying and selling stocks. Publishing as Prentice Hall 20 of 38 .

Making the Connection What Do People Do With Their Savings? Key Components of the Financial System © 2012 Pearson Education. Publishing as Prentice Hall 21 of 38 . Inc.

The Federal Reserve and Other Financial Regulators Federal agencies that regulate the financial system: • Securities and Exchange Commission (SEC) • The Federal Deposit Insurance Corporation (FDIC) • Office of the Comptroller of the Currency • The Federal Reserve System (the focus of this book) Key Components of the Financial System © 2012 Pearson Education. Publishing as Prentice Hall 22 of 38 . Inc.

Publishing as Prentice Hall 23 of 38 . Inc. Key Components of the Financial System © 2012 Pearson Education. usually referred to as “the Fed. •  Original role: Serve as a lender of last resort.What Is the Federal Reserve? •  The Federal Reserve is the central bank of the United States.” •  Established by Congress in 1913 to deal with banking problems.

•  Chair. •  The FOMC meets eight times per year. During these meetings. Key Components of the Financial System © 2012 Pearson Education. Inc. the Fed decides on a target for the federal funds rate.What Does the Federal Reserve Do? •  The Fed is responsible for monetary policy. •  The Fed is divided into 12 districts (See Figure 1. Publishing as Prentice Hall 24 of 38 . Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. •  The main policymaking body of the Fed is the Federal Open Market Committee (FOMC).2). Federal funds rate The interest rate that banks charge each other on shortterm loans. Ben Bernanke from 2006 – present.

• Key Components of the Financial System © 2012 Pearson Education.2 The Federal Reserve System The Federal Reserve System is divided into 12 districts. each of which has a District Bank located in the city shown on the map. Inc.Figure 1. Publishing as Prentice Hall 25 of 38 .

Publishing as Prentice Hall 26 of 38 .What Does the Financial System Do? The financial system provides three services to savers and borrowers: risk sharing. Risk Sharing Risk is the chance that the value of financial assets will change relative to what you expect. Inc. and information. Risk sharing A service the financial system provides that allows savers to spread and transfer risk. liquidity. Key Components of the Financial System © 2012 Pearson Education. Diversification Splitting wealth among many different assets to reduce risk.

and other securities. Financial markets and intermediaries help make financial assets more liquid. Publishing as Prentice Hall 27 of 38 .Liquidity Liquidity The ease with which an asset can be exchanged for money. bonds. Financial markets convey information to both savers and borrowers by determining the prices of stocks. Key Components of the Financial System © 2012 Pearson Education. Inc. Information Information Facts about borrowers and about expectations of returns on financial assets.

Key Components of the Financial System © 2012 Pearson Education. and information.1 The Services Provided by Securitized Loans Briefly discuss the extent to which securitized loans embody the key services of risk sharing. Inc. Publishing as Prentice Hall 28 of 38 .Solved Problem 1. liquidity.

Step 2 Define securitized loans. So. Key Components of the Financial System © 2012 Pearson Education. When loans are securitized. Step 3 Explain whether securitized loans provide risk sharing. investors rely on the bank or other loan originator to have gathered the necessary information. and information. which makes it liquid. Inc. A securitized loan can be resold and so has a secondary market.Solved Problem 1. 1. 2. When a mortgage is bundled together with other mortgage-backed securities. 3. Securitized loans are loans that have been bundled with other loans and resold to investors. Non-securitized loans are financial assets but not financial securities. liquidity. they are both financial assets and financial securities. Publishing as Prentice Hall 29 of 38 . the buyers jointly share the risk of a default.1 The Services Provided by Securitized Loans Solving the Problem Step 1 Review the chapter material. securitized loans provide all three of these key services.

© 2012 Pearson Education. Publishing as Prentice Hall 30 of 38 .2 Learning Objective Provide an overview of the financial crisis of 2007–2009.1. Inc.

sold bonds to investors and used the funds to purchase mortgages from banks. •  Investment banks became significant participants in the mortgage market.Origins of the Financial Crisis Bubble An unsustainable increase in the price of a class of assets. Publishing as Prentice Hall 31 of 38 . the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). The Financial Crisis of 2007–2009 © 2012 Pearson Education. bundling and selling mortgage-backed securities. Inc. •  Overly optimistic expectations. changes in the mortgage market for made it easier for families to borrow money to buy houses. and more importantly. •  Two government-sponsored enterprises (GSEs).

Inc. By 2005. many mortgages were being issued to subprime borrowers with flawed credit histories. Unfortunately. The Financial Crisis of 2007–2009 © 2012 Pearson Education. the decline in housing prices that began in 2006 led to rising defaults and a sharp decline in the value of many mortgage-backed securities.Origins of the Financial Crisis Standards for obtaining loans were greatly loosened. Both borrowers and lenders anticipated higher housing prices. which would reduce the chance of default. Adjustable-rate mortgages allowed borrowers to pay a very low interest rate. Publishing as Prentice Hall 32 of 38 .

• The Financial Crisis of 2007–2009 © 2012 Pearson Education. followed by sharp decreases in sales and prices from early 2006 through early 2009 and then a slow revival. Inc.Origins of the Financial Crisis Figure 1. Publishing as Prentice Hall 33 of 38 . Panel (b) shows that home prices followed a similar pattern to home sales.3 The Housing Bubble Panel (a) shows that housing bubble resulted in rapid increases in both sales of new houses and housing prices between 2000 and 2005.

The Deepening Crisis and the Response of the Fed and Treasury In October 2008. The Financial Crisis of 2007–2009 © 2012 Pearson Education. Congress passed the Troubled Asset Relief Program (TARP). Many policies of the Fed and Treasury during the recession of 2007–2009 were controversial because they involved: •  Partial government ownership of financial firms •  Implicit guarantees to large financial firms that they would not be allowed to go bankrupt •  Unprecedented intervention in financial markets Many feared that the Fed’s actions might reduce its independence. Publishing as Prentice Hall 34 of 38 . Inc. under which the Treasury provided funds to commercial banks in exchange for stock in those banks.

3 Learning Objective Explain the key issues and questions the financial crisis raises. Inc.1. Publishing as Prentice Hall 35 of 38 . © 2012 Pearson Education.

Our brief account of the financial crisis raises a number of questions that we will answer in the following chapters. Inc. Key Issues and Questions from the Financial Crisis © 2012 Pearson Education. The 17 key issues and questions listed on textbook pages 17 – 19 provide a roadmap for the topics in the rest of the book. Publishing as Prentice Hall 36 of 38 .

•  He outlined three other possible options: 1. such as lowering the discount rate. lowering the federal funds rate.  The Fed could lower the interest rate it paid banks on required reserves (from 0.  The Fed could buy additional securities with the proceeds of maturing mortgage securities. 3. © 2012 Pearson Education. Inc.AN INSIDE LOOK AT POLICY Fed Ready to Help Economy. Publishing as Prentice Hall 37 of 38 .25 percent). Bernanke Prepared to Take New Steps Key Points in the Article •  Fed Chairman Ben Bernanke expressed doubts about the effectiveness of the actions the Fed usually takes to spur the economy. 2. or lowering reserve requirements. but Options Are Limited Wall Street Journal.  Announce the Fed’s intention to keep short-term interest rates low.

Publishing as Prentice Hall 38 of 38 . Inc. © 2012 Pearson Education.AN INSIDE LOOK AT POLICY The Fed was very aggressive in using its discount window to pump reserves into the banking system in 2008 and 2009.