Outline Chapter 5 Commercial Banks How and what do banks do Take in deposits from individuals and small firms make loans mainly to mortgages and small firms Whom do they typically deal with Individuals and small firms What kind of money problems can this cause Mismatched loans timing is mismatched when short term deposits demand Great Depression deposits money to be requested on demand fund long term loans usually mortgages Liquidity problems caused by mismatched loans can lead to bank runs Bank runs contagion If large percent of depositors were to request their money at the same time the bank wouldn t have the funds available because they re invested in long term loans Investors took money out of the banks bec of panic from lack of dollars in circulation Not enough money for banks to supply Adverse select problems Problems from bank runs how do you know if the bank you put your money in is a good safe bank Contagion when a large amount people line up to take money out of one bank because of uncertainty and causes others to panic going to take money out of their bank Can t stop when fear and panic take over Happened in the great depression Moral hazard problems mitigated by monitoring FDIC Federal Deposit Insurance Corporation solution to run on banks and contagion in great depression Guaranteed if bank couldn t cover your deposit government would supply funds to the bank Monitoring government will regulate banks arethe banks to heavily regulated Regulation Limited what they can invest in and limits on the size of the leverage ratio Unintended Consequences Too big to fail If federal government stands behind whatever a bank does will the government ever allow a bad bank to fail There are insolvent banks who were run poorly and took on bad risks couldn t cover their loans with all their assets which is the definition of bankruptcy Banks can make riskier investments if the government backs them no matter what Protection of non bank intermediaries all restrictions on commercial banks helped protect non bank intermediaries Compare contrast with commercial banks Commercial banks take in deposits Investment banks don t Primary sources of money for I Banks are commercial paper and repos purchase agreements both are short term loans Terminology Money markets high quality short term assets these mutual funds went from treasury bills to accepting commercial paper as they received higher interest rates and the companies issuing commercial paper borrowed cheaper Can be found in pension funds and insurance companies 1 Investment Banks Understand activities How investment banking has changed from the past Capital markets Capital where long term debt 30 year t notes or corporate bonds and equity securities are bought and sold 1 year Stock always traded in the capital markets Proprietary trading Repurchase agreements repos similar to commercial paper one bank sells another financial institution three month t bills with the agreement that the seller will rebuy the bills the next day at a slightly higher price the higher price contains interest rate basically an overnight or very short term loan Borrower sells collateral to lender and then buys the collateral back the next day with interest Usually it s safe securities like treasury bills Commercial paper short term unsecured loan issued by a high quality firm looking for short term operational money Risky Maturity of 270 days or less most common maturity of 6 months if exceeds 270 days the company would have to register the loan with the SEC costing them legal fees and so on Mismatched maturities of loans what happened during the housing bubble when the I Banks were selling MBS and CDO s Leaves banks open to runs because the FDIC doesn t insure them Partnerships to publicly traded Started with private partners using their own money Started selling stock Partners no longer make decisions CEO S due Changes in risk taking Principal agent problem A moral hazard between the CEO and the stockholders CEO is trading with investor s money Short term gains are important to managers Leverage Borrowing money to invest using less equity magnifying returns and losses Return on Equity ROE is what is used to measure leverage o ROE Value of Assets how much you actually pay Capital Value of your own money o Leverage Ratio Amount borrowed How much you pay Executive compensation want short term gains to keep shareholders happy and gains mean higher bonuses Proprietary trading When company uses its own money to buy and sell securities Was a result of becoming a public company Financial engineering innovation MBS mortgage backed securities investment banks packed and sold mortgages government created the market fannie mae freddie mac CDOs collateralized debt obligations Selling mortgage backed securities in a large bundle Lacked transparency Large part of investment banking business and income was bundling and selling MBS Repos liquidity problems Were used with leverage to buy MBSand CDO s which opens them up to be run on as all their money was tied up in mortgages with no access to federal reserve money Globalization Spread internationally as a low risk product since house prices will always increase Shadow Banking and the 2007 09 Credit Crisis 2 Size in relation to commercial banking more than half the loans out are from shadow banking Repeal of Glass Steagall and emergence of financial holding companies AIG insurance company credit default swaps Why were they bailed out SKIP from Types of Mutual Funds pp 89 94 Begin again with Insurance Companies p 94 Risk pooling law of large numbers mitigate adverse selection Due statistical analysis to figure out how many events will happen in a large group Risk based premiums Adjusting charges so that the riskier something is the more it must pay eg Person interest rates on a loan security higher return diversification allows for safety in issuing premiums when there are risky and safe premiums written so the odds having a lot at once are mitigated i e male drivers are more risky than females so they charge higher amounts To reduce moral hazrd they have deductibles and co insurance Restricted covenants the insurance company will not cover certain people SKIP deductibles coinsurance restrictive covenants Unintended consequences of Credit Crisis Number of investment banks As a result of being to big to fail there are fewer larger investment banks than before the crisis There are only two major investment banks Too big to fail
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