This outline is based on Cowen and Tabarrok (2011). Saving income that is not spent on consumption goods

Transcription

1 Chapter 9 Financial System This outline is based on Cowen and Tabarrok (2011). 9.1 Supply of Savings Saving income that is not spent on consumption goods Investment purchase of new capital goods (business fixed investment, inventories, new houses) What motivates people to save? 1. We save in order to smooth consumption Example: we save during working years for our retirement 1

2 2. People tend to be impatient the higher a person s time preference (impatience for wanting stuff NOW), the less he or she will save. Time Preference a desire to have goods sooner rather than later. The strength of this desire varies from person to person. It is is often expressed as a rate. The higher your rate of time preference, the stronger your desire to have stuff now rather than later. 3. Marketing works people tend to save more if offered as a default choice rather than opt in. 4. Saving pays: Interest rates the interest rate is what you get paid in order to not consume (save) now. The higher the rate, the more it pays to wait for consumption. This is related to your time preferences which accounts for our tendency to express the strength of this desire as a rate. Those with high rates of time preference have to be offered high interest rates in order to save. You have to pay these people a lot in order to forgo consumption today. 9.2 Demand to Borrow 1. Smooth consumption Borrowing helps to smooth consumption over our lifetimes. Drive now, pay later. School 2

3 Figure 9.1: Savings vs. the interest rate. 3

4 now, higher earnings and repayment later (we hope). Life Cycle Hypothesis The lifecycle theory of savings proposed by Nobel Laureate Franco Modigliani, puts the demand to borrow and save together. The lifecycle theory is illustrated in Figure Borrowing is required to pay for very expensive items. It would take a very long time to save enough to pay for your education. In the meantime, you would be earning less. So, it makes sense to borrow today and repay over a long period of time. Same idea for highways, firms that require large network costs (cell carriers, FedEx, etc.) 3. Interest Rates The interest rate is the price you pay to borrow. The price you pay to have it now rather than to wait for enough of your savings to build to purchase what you want. The lower the rate, the more willing you are to borrow. 9.3 Market for Loanable Funds 1. Equilibrium in the LF market The interest rate adjusts to equalize savings and borrowing in the same way and for the same reasons that the price of oil adjusts to balance the supply and demand for 4

5 Figure 9.2: Modigliani s life cycle hypothesis shows how borrowing and saving are used to smooth out consumption over a person s lifetime. 5

6 Figure 9.3: Demand of for loanable funds. 6

7 oil. If the interest rate were higher than 8%, the quantity of savings supplied would exceed the quantity of savings demanded, creating a surplus of savings. With a surplus of savings, suppliers will bid the interest rate down as they compete to lend. If the interest rate were lower than 8%, the quantity of savings demanded would exceed the quantity of savings supplied, a shortage. With a shortage of savings, demanders would bid the interest rate up as they compete to borrow. (Cowen and Tabarrok, 2011, p. 181) 2. Shifts in Supply and Demand Increases in supply of loanable funds Supply of LF shifts right. Interest rates fall and the quantity of LF demanded rises. Decrease in supply of loanable funds Supply of LF shifts left. Interest rates rise as LF become relative more scarce. Demanders bid up the prices (interest rate) and the quantity of LF demanded falls. Demand for Loanable funds decreases Demand of LF shifts left. Interest rates fall (because fewer people are willing to pay for your savings) and the quantity of LF supplied falls. Demand for Loanable funds increases Demand of LF shifts right. Interest rates rise (because more people are competing to use your savings) and the quantity 7

8 Figure 9.4: Market for Loanable Funds. 8

9 of LF supplied rises. 9.4 Financial Intermediaries and the ways savers and investors coordinate actions Financial Intermediary acts as a middleman between savers and borrowers. Financial intermediaries collect savings and organize loans from the saved funds. These include banks, bond markets, and stock markets, hedge-funds, insurance companies and many others in our economy. Like middlemen in general, financial intermediaries reduce the costs of moving savings from savers to borrowers and investors. They are motivated by profits which can only occur to the extent that they reduce transactions costs of the borrowers and savers. If they could create no value, then they would not exist in a free market trading society Banks In their role as financial intermediary, banks receive savings from many individuals, pay them interest, and then loan these funds to borrowers or investors, charging them interest. Banks seek to earn profit by charging more for their loans than they pay 9

10 for the savings. To earn this money, they must provide useful middleman services by evaluating investments and spreading risk. 1. They specialize in evaluating risk (so that you don t have to). 2. They spread risk across many lenders. This increases more lending and investment. 3. They process payments, making it easy to write checks, use ATMs, etc. which involve many different banks Shadow Banking: What exactly is it? So-called shadow banking or banks perform essential financing functions in our economy. These entities are neither shadowy nor banks per se. The term is an unfortunate name for an otherwise reputable and essential set of financial intermediaries. Tony James (president and chief operating officer of Blackstone, a global investment and advisory firm.) in WSJ 3/3/14: Shadow banking or more accurately, market-based financing is simply the provision of capital by loans or investments to some companies by other companies that are not banks. Examples include insurance companies, credit investment funds, 10

11 hedge funds, private-equity funds, and broker dealers. These institutions do not operate in the dark. Market-based finance in the U.S. amounts to trillions of dollars and is significantly larger than the country s entire banking system Bonds These are loans made directly by savers to the users of those funds, i.e., investors. A bond is an IOU. What is a bond? A promise to repay. Essentially a contract that specifies how much is to be repaid, when, and to whom. They may involve periodic payments (coupon payments) or not (discount loans). One of the advantages of bond finance is that large sums of money can be raised now and invested in long-lived assets such as railroad track. The money can then be paid back over a long period of time. Bonds involve risk since the borrower may not be able to make the coupon payments or to make the final payment when the bond matures (when it is due to be repaid in full). The more risky the bond, the higher the interest offered the lender (bond holder). Crowding out the decrease in private consumption and 11

12 investment that occurs when government borrows more. When government borrows the demand for loanable funds shifts to the right. Interest rates rise. Two things happen as a consequence: 1. The increase in interest rates increases savings (which means consumption falls). This decreases GDP. 2. The higher interest rate discourages investment. This is shown in Figure 9.5. Bond prices and interest rates Bond prices are often expressed in terms of interest rates. Zero-coupon bond a bond that has no coupon payments Discount Bond a zero-coupon bond that is bought at a discount that is repaid at face value at the maturity date. Suppose you buy a bond that promises to repay you $1000 in a year. You agree to pay $950 for this bond, which will earn you a $50 when the bond matures. $1000 $950 $ = 5.26% The interest implicit in this discount bond is 5.26%. 12

13 Figure 9.5: Crowding out. When government borrows more, private consumption and investment is displaced. 13

14 Now suppose that you only have to pay $909 for it. $1000 $909 $ = 10% This shows that the lower the bond s price, the higher the interest rate. Or, the higher the interest rate, the lower the price of the bond. Bond prices and interest rates are inversely related. Price vs Interest B P 100 = i% P where B=Bond s value at maturity, P=price paid for the bond, and i=interest rate. Rearrange, first multiply both sides by P: Add P to both sides: B P = P i% 100 B = (P i% 100 ) + P Factor out P: B = P (1 + i% 100 ) Divide both sides by (1+i%/100) P = B 1 + i%

15 So, for a $1000 bond with a nominal interest rate of 5%, the price paid is: If the interest rate goes to 6%: P = $ /100 = $ = $952 P = $ /100 = $ = $ Stock Markets A stock is a certificate of ownership in a corporation. Owners are referred to as shareholders. Shareholders have a claim to the firms profits. Since profit is revenue minus costs, the shareholder only benefits when the firms earn profits. Everyone else creditors, bond holders, suppliers, and employees get paid before the shareholders. IPO when a firm issues new certificates for sale to the public. This is a way of financing firm s activities (like bonds and bank loans). Secondary Markets: NYSE and Nasdaq Once a stock is owned by the initial buyer, it can be resold in what are called secondary markets. NYSE and NASDAQ being examples. 15

16 Being able to sell shares easily (increased liquidity) makes buying stocks more attractive. Indirectly, this makes IPOs more valuable and able to generate more initial interest in the firms stock. 9.5 What happens when a financial intermediary fails? Economic growth cannot occur without savings and those savings must be processed and intermediated through banks, bond markets, stock markets, and so on. Countries without these institutions have smaller markets for loans, use their savings less effectively, and make fewer good investments. Bank Run happens to an individual bank when a large number of customers withdraw deposits because they think the bank may become insolvent. Insolvency means they could lose all or part of their deposits. Banking Panic A panic is when there are runs on several banks at once. Historically, panics can be local, regional or national. It has been estimated that the banking panics that preceded the Great Depression caused a significant decline in GDP. 1 Panics can be very costly. The Panic of 1907 led 1 Jalil (2012) 16

17 to establishment of the FED. What disrupts the efficiency of the financial markets? 1. Insecure property rights can cause intermediation to break down. Dependable legal systems, honest government, trust among parties all contribute to the willingness of people to hand savings over to others for investment. 2. Price controls on interest rates discourage trading in the LF markets. 3. Politicization of intermediaries can lead banks to make loans to the parties that will squander the scarce supply of savings. 4. Systematic problems in the banking system usually lead to large-scale economic crises. Bank failures and bank panics. Penn Square Bank Failure Note: On July 5, 1982 the Penn Square Bank in OKC failed. For a very interesting history (Federal Deposit Insurance Corporation, 1998), from the FDIC s point of view, see fdic.gov/bank/historical/managing/history2-03.pdf. Deposit insurance provided by FDIC is in place to prevent bank 17

18 runs. However, that is cold comfort to those with deposit amounts above the maximum insurable amounts. Penn Square Bank was a small commercial bank located in a area familiar to most Oklahomans: Penn Square Shopping Center in Oklahoma City. At the time it failed, it was the largest bank failure in FDIC history in which uninsured depositors lost money. The bank was something of a high flyer. The Office of the Controller of the Currency (OCC) audits banks and OCC examinations in April 1980 and March 1981 found low capital, excessive low-quality loans, inadequate liquidity, inexperienced staff, increasing problem loans, and management problems. It was already clear to anyone who was paying close attention that the bank was in trouble and needed to clean up its act. In May 1982, rumors of problems at Penn Square began circulating, which caused a deposit runoff that forced the bank to rely increasingly on brokered funds. Brokered deposits are large deposits placed by deposit brokers on behalf of their customers. Because of their size, brokered deposits typically earn higher interest rates, from which the broker deducts a fee before passing the interest to the customer. Continental Bank in Illinois, which was also about to fail, brokered a lot of these (it was profitable for them, but large deposits aren t insured so if Penn Square 18

19 folds... Thus, in order to maintain deposits Penn Square was having to pay dearly. To strengthen the banks balance sheet, the OCC asked Penn Square to raise more capital and to write off a large chunk of bad loans it had made (trading valuable assets investor s capital, for worthless ones bad loans). But, who wants to invest in a poorly run bank? By June 28 it was clear that the bank was going to fail. Efforts to find a bank to acquire Penn Square (the preferred way of dealing with bank failures) was unsuccessful. In the first days of July it was clear that the bank was insolvent. It had to be closed. It shuttered on July 5 and reopened on the following day as what is called a Deposit Insurance National Bank (DINB). A DINB operates like a regular bank. You can write checks, interest bearing accounts pay the stated rates, and everything operates more or less normally at least for those with insured deposits. This is designed to prevent a further run on the bank. The problem with Penn Square is that the books were a mess. Separating insured deposits from uninsured ones proved to be difficult. The FDIC had 3 days to review over 24,000 accounts totalling $470 million to determine who was eligible to withdraw funds. When the bank reopened as a DINB on July 6th, the lines stretched as far as you could see. An reporter described the 19

20 scene: Hundreds of depositors seeking their money crowded the former Penn Square Bank on Tuesday as the federal government began liquidating the 21st bank to fail in the United States this year... Many of the bank s customers paid little heed to [FDIC Chairman] Isaac s assurances that depositors with accounts of less than $100,000 will get their money back through FDIC insurance. Nearly 100 people stood outside the bank s doors at noon, waiting to enter the lobby jammed with depositors. A continuous line of cars wound through the drive-in lanes. Bank workers handed out glasses of iced water to those waiting outdoors in the 90 degree heat. (Federal Deposit Insurance Corporation, 1998, p. 534) Also from the chapter: Reflecting on the long lines of Penn Square customers, FDIC attorney Donald McKinley said, I ll never forget... [they were] lined up as far as you could see in a hot July sun out in the parking lot of this little... shopping center... lined up all the way out in the parking lot forever, waiting to get their deposits, not withstanding all the advertising from the FDIC that through the DINB, you could draw your checks... (Federal Deposit Insurance Corporation, 1998, p. 533) The Penn Square Bank failure s dubious record as the largest on record didn t last long. Thanks in part to its involvement with Penn Square, Continental Illinois (once the 7th largest in 20

21 the U.S.) failed in 1984 again, precipitated by a run on the bank by depositors. Many of the assets it had purchased from Penn Square had substantially diminished in value, which contributed to its insolvency. Light shed on Penn Squares shaky loan portfolio during its failure illuminated Continental s problems. Continental Illinois held the failure record until 2008, when Washington Mutual failed. WaMu, as it was called, was 7 times bigger than Continental Illinois. 9.6 Financial Crisis of Without effective financial intermediation, an economy will end up adrift. Insecure property rights, inflation, politicized lending, and bank failures and panics can all contribute to the breakdown of financial intermediation. The crisis was brought about by high leverage and falling asset prices that created a panic in the shadow banking system that sharply reduced the amount of lending in the economy. The resulting decline in activity demonstrates how important financial intermediaries are to the economy, both when they operate well and when they do not. Owner Equity The value of assets minus debt 21

22 Leverage Ratio This is the ratio of debt to equity. Insolvent When firm has liabilities that exceed its assets. Commercial Bank these are funded by deposits (which are insured up to some limit) and they make loans out from those deposits. Regulated by various entities including the FDIC and the FED. Investment Banks these are funded by investors (not depositors), are not federally insured, and also make loans. Shadow banking system collection of investment banks, hedge funds, money market funds, and a host of other nontraditional financial intermediaries. Characterized by less regulation than regular commercial banks. Fannie Mae (from Wikipedia) Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. It is a government-sponsored enterprise (GSE), though it has been a publicly traded company since The corporation s purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS), allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market by reducing the reliance on locally-based savings and loan associations 22

23 (aka thrifts ). Mortgage Backed Security (more Wikipedia) A mortgagebacked security (MBS) is a type of asset-backed security that is secured by a mortgage, or more commonly a collection ( pool ) of sometimes hundreds of mortgages. The mortgages are sold to a financial institution (a government agency or investment bank) that securitizes, or packages, the loans together into a security that can be sold to investors. The mortgages of a MBS may be residential or commercial; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be private-label, issued by structures set up by investment banks. The structure of the MBS may be known as pass-through, where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations (CMOs, often structured as real estate mortgage investment conduits) and collateralized debt obligations (CDOs). Securitization (mostly from Wikipedia) This is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations, and selling these bundles to investors. The cash collected from the mortgages or loans 23

24 underlying the security is paid to the investors that buy these bundles. Securitization can: lower cost of capital, allow investors to diversify, enhance liquidity, etc. However, these instruments are quite complex, making it difficult to evaluate their risk. (Are the houses in the bundle in Oklahoma or Nevada there was a big difference). There are also incentives for sellers and buyers to undervalue risks (e.g., moral hazard). Lehman Brothers was an investment bank that became insolvent at the beginning of the financial crisis of Lehman was the fourth-largest investment bank in the US (behind Goldman Sachs, Morgan Stanley, and Merrill Lynch), doing business in investment banking, equity and fixed-income sales and trading (especially U.S. Treasury securities), research, investment management, private equity, and private banking. Financial Market Meltdown Short story (an a gross oversimplification to be sure). OK. Here is the one minute version: com/watch?v=kvpgcaeksvw 24

25 Or SP747F0A378BC181C7 Housing boom In the mid 2000 s no one thought housing prices would ever fall. Housing prices survived the bursting of the so-called dot com bubble that burst in 1999 (or so). This created overconfidence in the ability of home prices to survive turbulent economic times. Consequently, buyers were willing to make very low down payments, having almost no equity in their homes. Lenders were willing to offer these loans because they too thought the underlying asset values would rise, leaving them with equity if the mortgagee defaulted. Thus, no or low down payments are not a problem if the value rises over time. Besides, banks were not that worried about initiating these loans because they had no intention of holding them anyway. They sell them to Fannie Mae or Freddie Mac, who bundle these loans together and serve a secondary market for these bundled mortgages. This makes mortgages easy to buy and sell (liquidity), which in turn makes mortgages more attractive to hold as investments (supply of LF) and cheaper for consumers than they otherwise would be. Lehman Brothers was a very well respected investment bank. Lehman was heavily invested in these mortgage backed se- 25

26 curities. This seemed like a good idea since the underlying assets were U.S. mortgages (assumed very safe). Based on this incorrect assumption about the assets safety, Lehman was highly leveraged. A very small drop in the value of the assets would cause Lehman to become insolvent. Once insolvent, no one would be willing to invest in their bank. Other investors would flee and the whole institution would collapse. To compound matters, these bundles of securities were often sold, rebundled, and resold. The consequence of this is that no one could tell who owned the underlying properties on which the securities were based. This created vast uncertainty in the financial markets. Who would fail next? Would the government allow them to fail (as they did Lehman)? As the recession hit, home prices fell, these securities lost value and many in the shadow banking segment faced insolvency. Credit markets froze up. No one was lending. This hurt consumption and investment and the recession deepened. 26

27 Bibliography Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of Economics, 2nd edn, Worth, New York. Federal Deposit Insurance Corporation (1998), Managing the Crisis: The FDIC and RTC Experience, chapter Penn Square Bank, N.A., pp Jalil, Andrew (2012), A new history of banking panics in the united states, : Construction and implications, pdf. 27