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Business in Action 7e Bovée/Thill The Money Supply and Banking Systems Chapter 20 Business in Action 7e Bovée/Thill Learning Objectives 1. List the four financial functions of money and 2. 3. define two key measures of the money supply Explain the major functions of the Federal Reserve System and identify other key federal financial institutions Distinguish investment banks from commercial banks and identify the three major types of investment banks Copyright © 2015 Pearson Education, Inc. 20-3 Learning Objectives 4. Identify the major types of commercial banks 5. 6. and outline the impact of banking deregulation over the past three decades Identify the two major sets of economic forces that triggered the meltdown of 2008 and sent the economy into a global recession Outline the efforts to reform the banking industry in the wake of the subprime crisis Copyright © 2015 Pearson Education, Inc. 20-4 The Meaning of Money • Money Anything generally accepted as a means of paying for goods and services serves as a medium of exchange, a unit of accounting, a store of value, and a standard of deferred value Copyright © 2015 Pearson Education, Inc. 20-5 The Money Supply • Money Supply The amount of money in circulation at any given point in time Copyright © 2015 Pearson Education, Inc. 20-6 Exhibit 20.1 Trends in the Money Supply Copyright © 2015 Pearson Education, Inc. 20-7 The Federal Reserve System • Federal Reserve System The central banking system of the United States Responsible for regulating banks and implementing monetary policy Copyright © 2015 Pearson Education, Inc. 20-8 The Federal Reserve System (cont.) • Federal Funds Rate The interest rate that member banks charge each other to borrow money overnight from the funds they keep in the Federal Reserve accounts Copyright © 2015 Pearson Education, Inc. 20-9 The Federal Reserve System (cont.) • Discount rate The interest rate that member banks pay when they borrow funds from the Fed. • Prime rate The interest rate a bank charges its best loan customers. Copyright © 2015 Pearson Education, Inc. 20-10 Other Government Banking Agencies and Institutions • Federal Deposit Insurance Corporation (FDIC) The federal agency responsible for protecting money in customer accounts and managing the transition of assets whenever a bank fails Guarantee amount: $250,000 per account. Copyright © 2015 Pearson Education, Inc. 20-11 Other Government Banking Agencies and Institutions • Fannie Mae The government-sponsored enterprise responsible for guaranteeing and funding home mortgages • Secondary Mortgage Market The financial market in which mortgages are bought and sold, providing much of the funds that are loaned to home buyers Copyright © 2015 Pearson Education, Inc. 20-12 Other Government Banking Agencies and Institutions • Freddie Mac A secondary mortgage institution similar to Fannie Mae. Copyright © 2015 Pearson Education, Inc. 20-13 Investment Banking • Investment banks Firms that offer a variety of services related to initial public stock offerings, mergers and acquisitions, and other investment matters. Copyright © 2015 Pearson Education, Inc. 20-14 Commercial Banking and Other Financial Services • Commercial Banks Financial institutions that accept deposits, offer various types of checking and savings accounts, and provide loans • Retail Banks Banks that provide financial services to consumers Copyright © 2015 Pearson Education, Inc. 20-15 Commercial Banking and Other Financial Services • Merchant Banks Banks that provide financial services to businesses can also refer to private equity management • Thrift Banks Banking institutions that offer deposit accounts and focus on offering home mortgage loans Copyright © 2015 Pearson Education, Inc. 20-16 Commercial Banking and Other Financial Services • Credit Unions Not-for-profit, member-owned cooperatives that offer deposit accounts and lending services to consumers and small businesses • Private Banking Banking services for wealthy individuals and families Copyright © 2015 Pearson Education, Inc. 20-17 Other Financial Services • Independent Mortgage Companies Nonbank companies that use their own funds to offer mortgages • Mortgage Brokers Nonbank companies that initiate loans on behalf of a mortgage lender in exchange for a fee Copyright © 2015 Pearson Education, Inc. 20-18 Other Financial Services • Finance Companies Nonbank institutions that lend money to consumers and businesses for cars and other vehicles, home improvements, expansion, purchases, and other purposes • Credit Rating Agencies Companies that offer opinions about the creditworthiness of borrowers and of specific investments Copyright © 2015 Pearson Education, Inc. 20-19 Banking and Financial Bubbles • Bubble A market situation in which frenzied demand for an asset pushes the price of that asset far beyond its true economic value Copyright © 2015 Pearson Education, Inc. 20-20 Exhibit 20.2 The Housing Bubble Copyright © 2015 Pearson Education, Inc. 20-21 The Housing Bubble • Subprime mortgages Home loans for borrowers with low credit scores • Loan-to-Value (LTV) The percentage of an asset’s market value that a lender is willing to finance when offering a loan the rest of the purchase price has to be paid by the buyer as a down payment Copyright © 2015 Pearson Education, Inc. 20-22 Exhibit 20.3 Subprime Lending Copyright © 2015 Pearson Education, Inc. 20-23 Changing the Rules in Mortgage Lending • Adjustable Rate Mortgage (ARM) A mortgage that features variable interest rates over the life of the loan • Option ARM A type of ARM that lets borrowers choose from several repayment options Copyright © 2015 Pearson Education, Inc. 20-24 The Securitization of Debt • Securitization A process in which debts such as mortgages are pooled together and transformed into investments • Mortgage-Backed Securities (MBSs) Credit derivatives based on home mortgages Copyright © 2015 Pearson Education, Inc. 20-25 The Meltdown of 2008 • Defaults Situations in which borrowers stop making payments on their loans. • Foreclosures Situations in which lenders take possession of homes after borrowers default on their mortgage payments. Copyright © 2015 Pearson Education, Inc. 20-26 The Meltdown of 2008 • Liquidity Crisis A severe shortage of liquidity throughout a sector of the economy or the entire economy, during which companies can’t get enough cash to meet their operating needs • Credit Freeze A situation in which credit has become so scarce that it is virtually unavailable, at any cost, to most potential borrowers Copyright © 2015 Pearson Education, Inc. 20-27 Lessons to Learn from the Subprime Meltdown • Transferring risk does not reduce or eliminate the risk—and sometimes it can even increase risk. • Decoupling risk from responsibility leads to risky and irresponsible behavior. • Individual short-term incentives can overpower logic and collective long-term consequences. Copyright © 2015 Pearson Education, Inc. 20-28 Lessons to Learn from the Subprime Meltdown • Unregulated private contracts can have damaging public consequences. • If something seems too good to be true, it is. • Innovation can be dangerous if it outpaces our ability to understand it or control it. Copyright © 2015 Pearson Education, Inc. 20-29 Lessons to Learn from the Subprime Meltdown • Leverage can be dangerous, and massive • • • leverage can be deadly. The past is not always a reliable guide to the future. Computer models and quantitative analysis must support experience and common sense, not replace them. Investors must understand the quality of the information they use to make investment decisions. Copyright © 2015 Pearson Education, Inc. 20-30 Efforts to Prevent another Banking Crisis • Dodd-Frank Act Legislation passed in 2010 aimed at reforming the banking industry and offering consumers greater protection Copyright © 2015 Pearson Education, Inc. 20-31 Dodd-Frank Act Points of Emphasis • • • • Monitoring for systemic risk Protecting consumers Closer scrutiny of the derivatives market Ending taxpayer bailouts of companies deemed “too big to fail.” • Tougher regulation of credit rating agencies THE END Copyright © 2015 Pearson Education, Inc. 20-32