Lecture 1: Money, Banking & Financial Markets

Why Study Financial Markets?

1. Channel funds from savers to investors, thereby promoting economic efficiency

2. Affect personal wealth and behavior of business firms

Bond Market

- where corporations and governments borrow funds

- where interest rates are determined

- affects consumers willingness to spend & save

- affects business spending decisions

Stock Market

- affects personal wealth

- affects business investment decisions

Foreign Exchange Market

- used for transfer of funds between countries

- affects costs of imports & exports for domestic and foreign consumers

- affects competitiveness of domestic versus foreign businesses

Number of Bank Failures Per Year

411

3 40 3

25

140

157

92

51

2418

00

25

50

75

100

125

150

175

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: FDIC

The Circular Flow Diagram

Financial System

Flow of FundsLenders/Savers

•Firms

•Households

•Government

•Foreigners

Financial Intermediaries

•Banks

•S&Ls

•CUs

Financial Markets

•Stock Market

•Bond Market

•FX Market

Borrowers/Spenders

•Firms

•Households

•Government

•Foreigners

$$

$$

Deposits

Securities

Securities

Securities

$$

$$

Direct Finance

Indirect Finance

Profit search is to money

what gravity is to water

The Heart Vs Bank AnalogyHow the Heart Works: Blood Flow Diagram

How Blood Flows Through a Healthy Heart.

Interest Rates and Recessions 1988-2016

0

1

2

3

4

5

6

7

8

9

10

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18

0

1

2

3

4

5

6

7

8

9

10

Recession Baa Fed Funds 10-yr Treas Forecast

S&P 500 Stock Index

(monthly average)

0

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

1700

1800

1900

2000

2100

2200

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

0

1

2

3

4

5

6

7

8

9

10

Nominal Index Recession

Fed Funds Rate (RHS) Real Index

U.S. Dollar Versus Euro

Exchange Rate

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

Euro/$

Euro/$$/Euro

$/Euro

U.S. Economic Output(Real GDP - Quarterly Growth Rate)

1.7

3.9

2.72.5

-1.5

0.8

4.6

2.7

1.9

0.5

0.1

2.8

0.8

3.1

4.0

-1.2

4.0

5.0

2.32.0

2.6

2.0

0.90.8

1.2

2.52.52.52.52.52.5

2.9

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

10:1 11:01 12:01 13:01 14:01 15:01 16:01 17:01

GDP Growth

2.5% Maximum Sustainable Growth Rate

Source: Department of Commerce.

GDP Output Gap

vs.

Federal Funds Rate

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%Recession

Output Gap (Left Axis)

Federal Funds Rate (Right Axis)

Source: CBO & Federal Reserve.

2.5% Target

Consumer Price Index

1970 to Present

5.6

3.33.4

8.7

12.3

6.9

4.9

6.7

9.0

12.5

8.9

3.83.84.04.44.4

4.7

6.1

3.12.92.72.72.5

3.3

1.71.6

2.6

3.4

1.6

2.41.9

3.33.5

2.5

4.1

-0.1

2.8

1.6

3.1

2.11.51.6

0.1

1.6

3.8

1.1

13.3

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

Federal Reserve Balance Sheet

(August 2014 vs January 2010 vs July 2009 vs July 2008)

($ Billions, H.4.1 Release, Table 10)

Assets Liabilities + Capital

T-Bills (0/18/18/22) Federal Reserve Notes (1,444/879/870/793)

T-Notes/Bonds (2,321/708/618/402)

TIPS (97/47/48/40)

Depository Institution Deposits (2,778/1,135/809/23)

Federal Agency Debt (41/161/102/0)

Mortgage-Backed Securities (1,678/969/526/0)

Repurchase Agreements (0/0/0/117) Reverse Repurchase Agreements (282/64/66/43)

Term Auction Credit (0/76/274/150) U.S. Treasury, General Account (29/124/65/4)

Primary Credit (1/18/34/14) U.S. Treasury, Supplementary Financing (0/5/200/0)

Secondary Credit (0/1/0/0)

Seasonal Credit (1/0/1/1)

Asset-backed CP MMMF Liquidity Facility (0/0/8/0) Interest on Federal Reserve Notes due to U.S. Treasury (2)

AIG Credit (0/25/43/0)

Term Asset-back Security loan Facility (1/298/26/0) Foreign Official Deposits (6/3/2/2)

Commercial Paper Funding LLC (0/14/111/0)

Money Market Investor Funding (0/0/0/0)

Maiden Lane I, II, III LLC (2/64/60/29) Capital Paid In (28/26/25/5)

Surplus (28/25/21/3)

Central Bank Liquidity Swaps (1/6/112/62) Other Capital (0/1/4/1)

Total Assets (4,413/2,295/2,074/913) Total Liabilities & Capital (4,413/2,295/2,074/913)

Italicized accounts represent new policy tools

M1, Monetary Base and

Money Multiplier

0200400600800

1,0001,2001,4001,6001,8002,0002,2002,4002,6002,8003,0003,2003,4003,6003,8004,0004,200

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

$ B

illi

on

0

1

2

3

4

Mo

ney

Mu

ltip

lier

MB Multiplier M1

Money Multiplier = M1/MB = 1 + c = 1+0.76 = 0.73

r + e + c 0.1+1.55+0.76

DM/M + DV/V = DP/P + DY/Y

DM/M + 0 = DP/P + 3.5%

Money Supply Growth, M1&M2

(% change year ago)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

Recession M2 M1

Currency

Checking

Savings

MMA

MMMF

CD

Federal Government Surplus/Deficit(Billions of Dollars)

-74-79-128

-208-185-221

-150-155-153

-221-269-290

-255-203

-164

-107

-22

69

126

236

128

-158

-378-413

-318

-248

-161

-459

-1,400

-1,294-1,296

-1,079

-680

-480

-269-302

-220-196

-258-280-279

-339

-212

-$1,500

-$1,250

-$1,000

-$750

-$500

-$250

$0

$250

$500

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22

Source: Congressional Budget Office.

•Bank stock purchases (TARP)

•Stimulus plan

•Mortgage bailout plan

•Income-support programs

•Recession-induced falling revenues

Function of Financial Intermediaries

Financial Intermediaries

1. Engage in process of indirect finance

• borrow funds from savers, then lend funds to borrowers

• issue liabilities, then acquire assets

• take deposits, then make loans

2. More important source of finance than securities markets

3. Needed because of

• risk sharing

• asymmetric information

• transactions costs

UWCU Balance SheetAssets Liabilities + NW

Cash (13.7%) Deposits (90%)Share Draft (24%)

Investments (14.4%) Regular Share (29%)

MMA (25%)

Loans (65.7%) CDs (8%)

Consumer (26.5%) IRAs (3%)

Mortgage (30%)

Other Loans (9%) Borrowings (0%)

Building (2.9%) Net Worth (8.8%)

YOA - COF = NIM

+ Fee/Other Income

- Operating Expense

- PLL

= Net Income

*Required ROA = Asset Growth Rate x Capital Ratio(dependent variable) (choice variable) (current)

Treasury Yield Curves

0

1

2

3

4

5

6

1 2 3 5 10 15 20 25 30Years to Maturity

Yie

ld t

o M

atu

rit

y

June 2007

July 2016

Yield Curve &

the 3 Components of NIM

6

4

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1 year 2 3 4 5 year 6

Years to Maturity

Perc

en

t

Funding

Spread

Interest Rate

Risk Spread

Credit

Spread

1-year CD

@ 3.0%

5-year loan

@ 7.5%

Asymmetric Information:A situation where one party lacks sufficient information about the

other party to make accurate decisions

Adverse Selection

1. Asymmetric information before transaction occurs

2. Potential borrowers most likely to produce adverse outcomes are ones most

likely to seek loans and be selected

3. Adverse Selection => bankers willingness to lend

Moral Hazard

1. Asymmetric information after transaction occurs

2. Hazard that borrower has incentives to engage in undesirable (immoral)

activities making it more likely that won’t pay loan back

3. Moral hazard => bankers willingness to lend

4. Reputation: Declining social stigma regarding bankruptcy => M.H.

Asymmetric Information

Adverse Selection Moral Hazard

Stopping “bad credit risks” from

becoming borrowers

Stopping borrowers from

becoming “bad credit risks”

Screening process Monitoring process

Loan applicants

Approve

DenyLoan signing

date

Performing

Non-performing

A situation where 1 party

has more info

than the other party

Loan department Collections department

potential bad credit risks are the ones

who most actively seek out loans

the lender runs the risk that the borrower

will engage in risky activities that make

it less likely that the loan will be paid back

“The business of banking

is the business of collecting information”Good C.R.

Bad C.R.

2 types

Financial Intermediaries make Ps by Transactions costs

1. Experts on loan contracts

2. Experts with screening process

3. Experts with monitoring borrowers

4. Develop high level of lending expertise

5. Take advantage of economies of scale (lower average costs)

• number of transactions

(reduce average costs by spreading fixed costs over many transactions)

• scale of transactions

(make a few large loans instead of many small loans => variable costs)

• scope of operations

(offering many products and services => variable costs)

Regulation of the Financial SystemTwo Main Reasons for Regulation

1. Increase information to investors

Decreases adverse selection and moral hazard problems

SEC forces corporations to disclose information

SEC prohibits insider trading

2. Ensuring the soundness of financial intermediaries

Prevents financial panics

Six types of regulation:

1. Chartering – restrictions on entry

2. reporting requirements – disclosure of appropriate financial statements

3. restrictions on assets and activities

4. deposit insurance – up to $250,000 per person

5. anti-competitive measures – limits on branching (abolished by 1994 legislation)

6. Restrictions on interest rates

Econ 330

Homework 1Due Friday, September 16

Chapter 2, pages 46-47.

Questions 2, 4, 6, 7, 11, 14, 15, 17, 20