Mankiw 6e PowerPoints

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Banking

In this section, you will learn:


the types of banks


about securitization of bank loans


the kinds of risks banks face and how they
manage these risks


what causes bank runs and bank panics


how deposit insurance reduces bank runs but
increases moral hazard


about the regulation of banks


Types of banks


Commercial banks


largest category, about 7000 in U.S.


Savings institutions
, aka savings and loan
associations (S&Ls)


Originally,
mutual banks

(owned by depositors),
focused on savings deposits & mortgage loans


Over time, became corporations, branched into
other types of deposit accounts and loans



Types of banks


Credit unions


nonprofit, owned by their depositors

(“members”)


each restricts membership to a specific group,

e.g
. teachers, veterans


Finance companies


raise funds by issuing bonds and borrowing from
banks


do not accept deposits, therefore less regulated


many specialize in a specific type of loan,

e.g.

car loans, subprime mortgages

Loans and Deposits by Type of Bank
, 12/31/2009

0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
Commercial
banks
Savings
institutions
Credit unions
Finance
companies (do
not accept
deposits)
Deposits
Loans
Billions of dollars

Large vs. small banks


Community bank


small, < $1 billion in assets


operates in a small geographic area


they account for 90% of all commercial banks
by number, but account for a small portion of
total bank assets


have a niche in small business lending


Large banks


capable of making huge loans to corporations


enjoy
economies of scale


Subprime lenders


Subprime lenders

specialize in high
-
risk loans,
charge (sometimes astronomically) high rates


Subprime finance companies


introduction of credit scoring fueled rapid
growth, esp. subprime mortgages


Payday lenders


make small short
-
term loans


charge high fees, commonly equivalent to

400
-
500% APR


controversial

Subprime lenders


Pawnshops


Small, short
-
term loans using borrowers’
property as collateral


Loan sharks


illegal, organized crime


violate usury laws


encourage repayment using threats of violence


in decline due to competition from payday
lenders and pawnshops

Securitization


Securitization
: the process of creating
securities backed by pools of loans with similar
characteristics


Mortgage
-
backed securities

(MBS)


the most prevalent type of securitized asset


more liquid than the underlying loans


MBS backed by subprime mortgages played
important role in the recent economic crisis

The securitization process


Borrowers take out loans from commercial banks
or finance companies.


The lenders sell their loans to the
securitizer
, a
large financial institution.


The
securitizer

gathers a large pool of similar
loans,
e.g.

$100 million of subprime mortgages.


The
securitizer

issues new securities that entitle
their owners to a share of the payments the
original borrowers make on the underlying loans.


The securities are bought by financial institutions
and traded in secondary markets.

Fannie and Freddie


Federal National Mortgage Association (FNMA,
or
Fannie Mae
), created in 1938


Federal Home Loan Corporation (
Freddie Mac
),
created in 1970


both created to increase supply of mortgage
loans, help more people achieve “the American
dream”


Fannie and Freddie are the largest
securitizers

of mortgages

Fannie and Freddie


Fannie and Freddie are
government sponsored
enterprises

(GSEs), private corporations linked
to the government.


Perceived to have implicit
govt

backing,
therefore can borrow funds at lower cost than
other financial institutions can.


Suffered huge losses on subprime mortgages in
2007
-
2008.


To prevent bankruptcy, federal government put
Fannie and Freddie under
conservatorship.

NOW YOU TRY:

Benefits of securitization


List all the parties involved in the securitization
of prime mortgages (
e.g
. by Fannie or Freddie).


For each, name at least one benefit they
receive.

ANSWERS:

Benefits of securitization


Homebuyers/borrowers


Easier to get loans, lower interest rates

because securitization increases the pool of
funds available for making home loans


Banks


profit from selling loans for more than they
lent, can use proceeds to make more loans


achieve geographic diversification: sell loans
made in their community, buy MBS backed by
loans throughout the country, thus protected
from local shocks

ANSWERS:

Benefits of securitization


Securitizers


Earn income from securitizing mortgages and
selling MBS


Buyers of MBS


get assets that are (usually) safe and very
liquid

The subprime mortgage fiasco


The housing bubble. House prices…


rose 71% during 2002
-
2006


fell 33% during 2006
-
2009


Risky lending


Subprime lenders lowered standards regarding
borrowers income, credit


Zero down payment loans, adjustable rate
mortgages with low initial “teaser rates”


Lenders resold loans, so less concerned with
default risk


The subprime mortgage fiasco


The crash


Falling house prices put many homeowners
“underwater”


market value of house less than
amount owed on mortgage


Homeowners couldn’t afford payments, couldn’t
borrow more


Rising delinquencies and foreclosures


Change in U.S. house price index

and rate of new foreclosures,
1999
-
2009

0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
1999
2001
2003
2005
2007
2009
New foreclosure starts

(% of total mortgages)

Percent change in house prices

(from 4 quarters earlier)

US house price index
New foreclosures
The subprime mortgage fiasco


Consequences: huge losses for


Subprime lenders


investment banks and other institutions holding
MBS


Contributed to the worst recession in decades


The business of banking


A bank’s
balance sheet

summarizes its
financial condition at a point in time. It lists


assets
: what the bank owns,

including securities, loans, and reserves


reserves
: the portion of deposits not lent out


liabilities
: what the bank owes others,

including deposits and borrowings (from other
banks or the Federal Reserve)


Net worth

= assets


liabilities


Net worth is also called
equity

or
capital


Balance sheet for “Duckworth Bank”

Assets

(uses of funds)

Liabilities and Net Worth

(sources

of funds)

Reserves

$ 10

Deposits

$ 70

Securities

$ 10

Borrowings

$ 20

Loans

$ 80

Net Worth

$ 10

TOTAL

$100

TOTAL

$100

Measuring bank profits


Return on assets (ROA)

= profits/assets


Return on equity (ROE)

= profits/capital


Example:


Suppose Duckworth Bank’s profits = $2


Recall from Duckworth’s balance sheet:

assets = $100, net worth = capital = $10


So, ROA = $2/$100 = 2%


and ROE = $2/$10 = 10%


ROE is what the stockholders care about

Managing liabilities and assets


Banks get most of their funds from deposits,
which generally cost less than borrowings


On the asset side:


loans generate income but are not liquid


reserves are liquid but generate no income


Liquidity management
: how banks handle the
tradeoff between liquidity and income


Federal Funds
: short
-
term interbank loans
banks take out when they need extra liquidity


Managing credit risk


Credit risk (default risk)
: the risk that borrowers
will not repay their loans


Banks reduce credit risk by requiring
collateral
,
an asset of the borrower that banks can seize if
borrower defaults. Requiring collateral reduces…


adverse selection
: risky borrowers less likely to
take out loans


moral hazard
: after taking out a loan, borrower
has incentive to use the funds responsibly


Banks can also reduce credit risk by selling some
of their loans

Managing interest rate risk


Interest rate risk
: the uncertainty in bank
profits arising from changes in interest rates


maturity mismatch between liabilities and
assets



depositors can withdraw funds at any
time, but many loans don’t mature for years


liabilities more rate
-
sensitive than assets
:

e.g.
, an increase in rates increases cost of
borrowings more than income from loans

Managing interest rate risk


To manage interest rate risk, banks can:


sell loans to reduce their exposure to rate
changes


make loans with
floating interest rates


(also called adjustable rates), so an increase in
interest rates increases income as well as costs


trade derivatives to hedge against interest rate
changes


Equity and insolvency risk


Insolvency
: when assets < liabilities


A wave of defaults can cause insolvency.


Banks can protect themselves by holding more
capital.


Equity ratio (ER)

= capital/assets


ER is related to return on equity:



ROE

= profit/capital




= (profit/assets)/(assets/capital)




= ROA/ER

NOW YOU TRY:

Balance Sheet Analysis

a
.

Fill in the blank spaces on each balance sheet.

b
.

Compute ROA, ROE, and ER for each bank,

assuming each

bank has

$1200 profit.

c
.

Which bank

would you

rather own,

and why?

Balance

sheet for Apple Bank

Assets

Liabilities

Reserves

$2,000

Deposits

$10,000

Securities

$10,000

Borrowings

$6,000

Loans

$8,000

Net Worth

???

Balance

sheet for Orange Bank

Assets

Liabilities

Reserves

$2,000

Deposits

$8,000

Securities

$10,000

Borrowings

???

Loans

$8,000

Net Worth

$6,000

ANSWERS:

Balance Sheet Analysis

Apple & Orange have same ROA = 1200/20000 = 6%

Apple ROE = 1200/4000 = 30%

Orange ROE =

1200/6000 = 20%

Apple ER =

4000/20000 = 20%

Orange ER =

6000/20000 = 30%

Balance

sheet for Apple Bank

Assets

Liabilities

Reserves

$2,000

Deposits

$10,000

Securities

$10,000

Borrowings

$6,000

Loans

$8,000

Net Worth

$4,000

Balance

sheet for Orange Bank

Assets

Liabilities

Reserves

$2,000

Deposits

$8,000

Securities

$10,000

Borrowings

$6,000

Loans

$8,000

Net Worth

$6,000

Reason to choose Apple:


higher ROE, so more profitable for
owners


Reason to choose Orange:


higher ER, so less risk of
insolvency in the event assets lose
value

CASE STUDY

The banking crisis of the 1980s

0
50
100
150
200
250
300
350
1980
1985
1990
1995
Number of failures

bank failures

S&L failures

CASE STUDY

The banking crisis of the 1980s


Huge surge in bank, S&L failures during 1980s


One cause: rising interest rates


Most S&Ls had huge maturity mismatch
between rate
-
sensitive liabilities and long
-
term
loans


Most loans made when interest rates were low


Interest rates rose sharply during 1970s, 1980s.
Treasury Bill rate peaked at 14% in 1981


Result: huge increase in costs without
corresponding increase in income


CASE STUDY

The banking crisis of the 1980s


Another cause: the commercial real estate bust


Early 1980s real estate boom:


surge in demand for comm. real estate loans


banks relaxed lending standards to cash in on boom


Congress allowed S&Ls to make commercial loans,
S&Ls made huge loans to real estate developers


Recession in early 1980s led to defaults


Falling oil prices hurt Texas and Oklahoma


Oversupply of commercial real estate led to
plummeting property prices, increasing defaults


Bank runs


Bank run
: when depositors lose confidence in a
bank and make sudden, large withdrawals


Even if the loss in confidence is not justified, the
sudden withdrawals overwhelm the bank,
deplete its liquid assets


To pay withdrawals, the bank must sell assets
quickly, often at “fire sale” prices


Soon, bank capital is driven below zero

Bank panics


Bank panic
: simultaneous bank runs occurring at
many banks


18 bank panics in U.S. during 1873
-
1933


Early 1930s: bank panics caused 30% of banks to
fail, contributing to the Great Depression


FDR’s “bank holiday” (March 6, 1933):

all banks closed until
govt

declared them solvent,
helped end the bank panic


No bank panics in U.S. since 1933


Deposit insurance


Deposit insurance
: a government program that
compensates depositors when a bank fails


Federal Deposit Insurance Corporation
(FDIC)
:


created in 1933


provides insurance on deposits up to $250,000
(increased from $100,000 in 2008)

DISCUSSION QUESTION:

Deposit Insurance


How can deposit insurance reduce bank runs
and bank panics?


How does deposit insurance affect the
incentives of


depositors?


banks?


Is deposit insurance a good idea?

Effects of deposit insurance


Reduces bank runs/panics: depositors less likely
to withdraw funds since deposits are insured


Eliminates depositors’ incentive to monitor banks
to insure banks are not taking excessive risks


Reduces banks’ incentives to avoid making risky
high
-
interest loans

Deposit insurance exacerbates

moral hazard in banking,

increases chance of future bank failures

Bank regulation


Charter
: a license to operate a bank


Each bank applies for a charter from a state
agency or from the Office of the Comptroller of
the Currency (OCC)


Every bank is regulated by one or more of these:


Federal Reserve


OCC


FDIC


state agencies

Restrictions on balance sheets


Assets


banks can hold government bonds and safe
corporate bonds, not stock or risky corp. bonds


no single loan can be “too large” (15% of bank
capital for nationally chartered banks)


Capital


U.S. requires minimum equity ratio =
5%


1988 Basel Accord requires capital equal 8% of

“risk adjusted assets,” a weighted average of
assets (higher weights for riskier assets)

Bank supervision


Banks required to report info about finances and
activities


Bank examinations
: regulators visit banks at
least annually to examine banks’ records,
interview managers,
etc
.



Closing insolvent banks


When a bank becomes insolvent, its depositors
may not know or care, due to deposit insurance


Moral hazard becomes severe for insolvent
banks: managers figure they have nothing to
lose by making very risky gambles


Result: net worth may become more negative
before bank closes


Thus, regulators try to close insolvent banks
quickly to prevent further losses

Closing insolvent banks


Regulators allowed to close banks when

capital = 2% of assets or less


They may do so, or may allow bank to operate


Forbearance
: a regulator’s decision not to
close an insolvent bank


occurs to avoid the pain and costs of closing
the bank


a gamble that the bank’s finances will improve


exacerbated the S&L crisis because failing
banks were allowed to incur further losses

SECTION SUMMARY


Banks are institutions that accept deposits

and make loans. Types include commercial
banks, savings institutions, and credit unions.
Finance companies make loans but do not accept
deposits. Subprime lenders make loans to people
with low incomes or bad credit.


Many bank loans, especially mortgages, are
securitized. Securitization increases the funds
available for loans and allows banks to reduce
default risk and interest rate risk by selling loans.

SECTION SUMMARY


A bank’s assets include its loans, reserves,

and securities. A bank’s liabilities include

its deposits and borrowings. Net worth or bank
capital is the difference between assets and
liabilities. The balance sheet shows assets on the
left and liabilities and net worth on the right.


Banks try to reduce credit (default) risk by
screening and monitoring borrowers, and by
requiring collateral. Banks reduce interest rate
risk by selling loans, making adjustable rate loans,
and hedging with derivatives.

SECTION SUMMARY


A bank run occurs when depositors lose
confidence and make sudden withdrawals.

They can cause otherwise healthy banks to fail.


Deposit insurance prevents bank runs by
promising to pay off depositors if their bank fails.
Deposit insurance increases the moral hazard that
banks may take on excessive risks.


U.S. banks are regulated by a variety of agencies.
Regulators restrict the riskiness of bank assets
and require minimum levels of capital.