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How Banks Work
CHAPTER TWO
The Role of Banks
•
A bank is a financial intermediary that accepts
deposits from savers and makes loans to
borrowers.
•
By making larger loans out of small deposits, banks
provide liquidity for borrowers and lenders.
•
Banks are adept at:
a) pooling funds
b) gathering information about borrowers
Asymmetric Information
• Both borrowers and lenders want to paint the
best possible picture when presenting
themselves to banks
• Asymmetric information is a situation where
one party to a transaction knows more, has
more information, than the other
• Two types of problems result
– Adverse selection
– Moral hazard
Adverse Selection
• Those at more than average risk are also more
likely to enter a contract that is offered to
everyone
• Example: the market for “lemons”…The
salesperson has the advantage
• The least desirable (highest risk) borrowers
are the most likely to accept loans at high
interest rates
Moral Hazard
• The mere existence of a contract can change
people’s behavior, incentivizing them to behave in
ways they otherwise might not
• Example: car insurance…The sense of security
provided may induce people to drive more
recklessly than they would without it
• Borrowers may behave in ways that harm the
bank, taking on more risk in order to get a loan
than they would with their own capital
Solutions to Asymmetric
Information Problems
• Banks have means to minimize the problems posed
by asymmetric information
– Collateral can be accepted from borrowers, reducing
borrowers’ incentive to engage in risky practices
– Borrowers can be required to maintain a minimum net
worth, below which loans must be paid immediately
– Covenants can be inserted in loans to require borrowers to
behave in certain ways
Failures of the Banking System
• The Savings-and-Loan Crisis: Undiversified
portfolios and insecure long-term loans
resulted in high risk of failure. A moral hazard
problem was created by the government with
new loans allowing for additional expansion.
• The Credit Crunch of the 90s: Banks lent less
than normal with greater requirements of
borrowers. Banks scrambled to add other
assets to their portfolios, reducing the
potential for capital investment in the
economy.
Bank Balance Sheets
•
The profit motive guides the bank’s decisions
regarding how much to lend and to whom
Assets = liabilities + equity capital
•
•
•
Assets primarily include reserves, securities,
and loans the bank has made
Loans represent the asset generating the
greatest profit
Liabilities include primarily savers’ deposits and
borrowing on behalf or the bank
Bank Balance Sheets (cont.)
• Banks must balance each side of the balance
sheet, such that assets = liabilities + capital
• Example: A saver’s deposit simultaneously
increases reserves (asset) and transactions
deposits (liability)
• Example: A bank’s purchase of government
securities increases securities (asset) and
decreases reserves (asset)
Reserve Accounting
• Banks manage funds by adjusting the size of
their reserves. By law, banks are required to
maintain a certain amount of reserves
Reserves = vault cash + deposits at the Fed
Excess Reserves
•
Banks often keep more reserves on hand than is
necessary to meet their requirements
•
Excess reserves are the bank’s total reserves minus
its required reserves
•
Excess reserves are used in four ways
1)
2)
3)
4)
Held by the bank
Lent in the federal funds market
Used to buy securities
Used to make new loans
The Federal Funds Market
• The federal funds market is the where banks lend
excess reserves to other banks desiring additional
reserves
• The interest rate charged on these inter-bank
loans is the federal funds rate
• If a bank has any amount in deposit at the Fed, it
will usually loan in the federal funds market
• Small banks often carry excess reserves only as
vault cash, precluding them from this market
Insufficient Reserves
•
When banks cannot make their reserve
requirement, they are faced with five options
1) Borrowing in the federal funds market
2) Borrowing from the Fed at the discount window
(borrowing directly from the Fed at the discount rate)
3) Selling securities owned by the bank
4) Reducing outstanding loans
5) Issuing certificates of deposit
Spread & Bank Profits
• Most profit comes from interest paid to the
bank on loans and securities
• Additional profits are earned through bank
fees and services
• The size of a bank’s profit depends on the
spread, or the difference between the average
interest earned on its assets and the average
interest paid on its liabilities
Banks & Competition
• As in all industries,
competition keeps banks’
prices (i.e., interest rates)
similar across banks
• More competition = smaller
spread
• Banks with large volumes
can take advantage of
economies of scale
Banks & Risk
• Like all businesses, banks’ profits are not guaranteed,
but tempered by risk
– Default risk = the possibility that the bank’s borrowers do
not repay their loans
– Interest rate risk = the risk that changes in market interest
rates decrease the value of the bank’s financial assets
• Risk is reduced through internal controls and audits,
diversification of holdings, and active management
of assets and liabilities
Sweep Accounts
• Sweep accounts “sweep” balances from a
transactions account into an MMDA
periodically (e.g. once a week)
• Used to help banks avoid holding reserves, as
reserves do not pay interest
• Allows banks to earn additional interest on
deposits and remain in compliance with
Federal Reserve regulations
Effects of Sweep Accounts
• Banks have been able to increase profits by
earning interest on reserves to which interest
was previously unavailable
• This gain for banks is a simultaneous loss of
revenue for the government, perhaps making
monetary policy more challenging
• Banks now meet reserve requirements
primarily with vault cash, leaving less on
deposit with the Fed
Contemporaneous vs. Lagged
Reserve Accounting
• The Fed has modified how banks account for
reserves in response to sweeps
• Sweeps made contemporaneous accounting
(counting all deposits over a two week period)
even more volatile, making it difficult to
forecast the demand for reserves
• In lagged reserve accounting, the time period
is increased, giving banks more certainty in
regard to the amount of reserves they need
Required Clearing Balances
• A transition from a system emphasizing
required reserves to a focus on the balances
banks hold at the Fed
• Required clearing balances are those a bank
agrees to hold at the Fed for purposes of
clearing transactions
• Simplifies the reconciliation of inter-bank
transactions, such as check clearing
• These balances help the Fed to know how
much money it needs to supply the economy