How are banks like a manufacturing business Manufacturer financials instruments CDs saving/checking accounts & loans Banks buy money (take deposits) and then resell it at a higher price (making loans/selling securities) so in effect banks manufacture money and their raw material money, like selling a used car, buy it at a low price clean it up and sell it higher. Liabilities of banks is their source of funds, and their assets are the way they use the funds. P 214 Repurchase agreements
SOS In its simplest form, a repurchase agreement is a collateralized loan, involving a contractual arrangement between two parties, whereby one agrees to sell a security at a specified price with a commitment to buy the security back at a later date for another specified price. In essence, this makes a repurchase agreement much like a short-term interest-bearing loan against specific collateral. Both parties, the borrower and lender, are able to meet their investment goals of secured funding and liquidity.
Repurchase agreements are used by money market funds to invest surplus funds on a short term basis and by dealers as a key source of secured funding. Securities dealers use these deals to manage their liquidity and finance their inventories. While repurchase agreements are commonly found within money market funds as short term, mostly overnight investments, the cash investor might look to invest cash for a more customized period of time to fulfill a specific investment need. As these transactions are short term and considered relatively safe due to the secured collateral, market liquidity and rates remain competitive for all investors.
The differences between brokers/dealers & what it means for their risk levels 1. A broker is a person who executes the trade on behalf of others, whereas a dealer is a person who trades business on their own behalf. 2. A dealer is a person who will buy and sell securities on their account. On the other hand, a broker is one who will buy and sell securities for their clients. 3. While dealers have all the rights and freedom regarding the buying and selling of securities, brokers seldom have this freedom and these rights. 4.
A broker’s primary service is to buy and sell stocks on an exchange for members of the investing public who wish to own part of a company. When anyone decides to participate in the stock market, a broker is usually the first place they go. An account is set up for the client through which she trades stocks. The broker accepts stock orders from the client and then executes these directly on the exchange. A business that engages solely in broker services interacts with the stock market for its clients only. Every transaction made affects a client’s account.
For this reason, a broker is often referred to as an “agent. 5. A broker (no assets & act as a middleman) is normally paid a commission for transacting the business but not a dealer. Dealers have assets of their own that they sell at a later date. A stock market dealer trades equities under its own name. The business itself maintains stock holdings that are not in the name of any client. The dealer may actually be a client of another broker, so as to trade these stocks for its own account. However, unlike a “trader,” which maintains her own account with a broker that affects no one else, a “dealer” may use its portfolio to offer services to the public.
SOS Risk Since a broker is working for the public or an individual the risk is much higher because your reputation and trade are on the line. If you execute a trade inappropriately then you are putting yourself at risk because you cannot know how happy the customer is going to be. If you were a dealer for example and you made a mistake or mismatched something, you can easily forgive yourself and not lose a client however if you mess up an exchange as a broker you’re less likely to have people use your services in the future.
Every transaction you make as a broker effects your client’s account, which is why I would consider the risk higher than a dealer who is maintaining his or her own account. Investment banks vs. commercial banks SOS The central difference between commercial banks and investment banks centers on their respective dealings with securities. Commercial banks offer a wide variety of services, but they do not deal with securities (be it marketing, selling, brokering, underwriting or otherwise). Investment banks, on the other hand, make securities their primary area of business.
The clients of investment and commercial banks differ as well, with commercial banks offering their services exclusively to businesses and investment banks offering different services to corporate clients, governments and consumers. Lines of credit and how they work A line of credit is a type of financing that businesses or consumers can use to obtain cash for various purposes. A line of credit works similar to a credit card in that it is a revolving line of credit, so when the line is paid down or off it is available for use again.
A line of credit may be secured, requiring the use of a piece of property as collateral, or unsecured, where no collateral is required. They are like loans except you don’t get a large injection of money right away, you just draw on the credit line when you need it like a credit card but the interest rates are low and limits are high. And also opposed to a loan you only pay on the credit you’ve used rather than the whole sum like a loan. – ch. 14 SOS A line of credit works in a similar fashion to a credit card. To access the line of credit, the borrower typically receives a debit card or checks that access the line.
When the borrower needs to cover an expense or make a purchase, they use the debit card or write a check for the amount that they need. Once a month, the borrower receives a bill from the lender. The interest charge and minimum monthly payment is calculated based on the outstanding balance of the line of credit. The line of credit is a revolving line of credit, so as the borrower pays down or pays off the outstanding balance, the line is available for use again. A line of credit can be beneficial to borrowers because if they never use the line, then they do not pay any interest or make any payments on it.
If a borrower does use a line of credit, they only have to use the amount that they need and are only charged interest on the amount that they use. Primary sources of funds for different sized businesses Small businesses: less than $10million, depository institutions are the most important source of credit. Via short-term loan or line of credit. Get credit analysis. Unique features: develop a relationship with bank/borrower. Loans are collateralized, pledging of assets against the loan. Midsize businesses – between $10million and $150million.
No longer bank-dependent but not large enough to issue traded debt in the public bond market. Issue equity traded in the over-the-counter market. Short-term debt financed by commercial banks. Revolving line of credit – longer-term debt financing through their commercial bank that combines an LC w/ intermediate-term loan. Long term debt financed by non-bank institutions. Large businesses – excess of $150million. Can afford the high distribution and underwriting costs of a public issue. Securities underwriting – issuer selects an underwriter (usually an investment bank).
Shelf registration – permits issuer of a public bond to register a dollar capacity with SEC. Draw down on this capacity at any time. Good credit ratings tend to rely on commercial paper market for short term debt. Asymmetric information & how the theory relates to firms maximizing profits Information Asymmetry can lead to two main problems: 1. Adverse selection- immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not be in optimal health may be more inclined to purchase life insurance than someone who feels fine. . Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance. SOS Ex: Car Company, asymmetric information exists if the buyer or seller (one party) has superior information than the other group. Why? A car salesman tends to have better information concerning the quality of the used car than the buyer. A firm like a car company can maximize their profits by making their cars sound better than their competitors.
If people believe they have the best-used cars for the price and the lack of problems associated with the vehicle they will more than likely sell more cars than their competitors. They will be taking advantage of the buyers’ lack of knowledge about the car facts therefore maximizing profits because they may not have sold the car otherwise. Another reason why it increases profit is because the value of the vehicle more than likely doesn’t coincide with the price, so instead of taking a loss or lowering the price closer to the value asymmetric information allows that seller to gain more compensation than they should have.
Free-rider problem In economics, the free rider problem refers to a situation where some individuals in a population either consume more than their fair share of a common resource, or pay less than their fair share of the cost of a common resource. A commonly used example of the economic notion of the free rider problem is found in national defense. All citizens of a country benefit from being defended; however, individuals who evade taxes are still protected by the same common resource of national defense, even though they did not pay for their fair share of the resource.
A client can profit from a stock trade without actually using any of his or her own capital. Purchases shares without actually paying for them and then selling them for a profit. The Fed Reserve check clearing process. How/why non-member banks are involved in this and why they are also subject to reserve requirements 1. When a bank receives a check for deposit, it credits the account of the check depositor and later collects the funds from the bank upon which the check is drawn. Depository institutions transfer many of their checks to Federal Reserve Banks for collection.
In turn, Reserve Banks pay the depositing banks for the total amount of the checks, and then collect the funds from the banks on which the checks are drawn. When a Reserve Bank receives checks from a bank, it credits that institution’s reserve account for the amount of the checks funds. A Reserve Bank gives credit for most checks the same or the next business day, and within two days for almost all others. However, the bank on which the check is drawn does not pay the Reserve Bank until the check is presented to it.
SOS This affects their reserves because the money appears in two depository institutions for a period of time. Since they have to have 10% of their reserves at all times, there is a connection between the required reserve amount and the amount of money a bank can lend. If the reserve requirement is raised, then banks have less money to loan and this will have a restraining effect on the money supply. If the reserve requirement is lowered, then banks have more money to loan. Member and nonmember banks have to be involved in this process because it helps determine the unexpected cash flows.
If someone writes a check to a bank for a large amount of money and nonmember banks are not subject to reserve requirements than that bank is less likely to be able to give you your money on demand than a member bank. Thus why they all have to work together in order to ensure the money supply that enters and exits is stable. Otherwise the economy will undergo major changes. Accomplished by adding/subtracting reserves held on deposit by the bank at its regional Federal Reserve bank. Demand deposits in Bank A in crease with a corresponding increase in assets.
When the check clears through Fed, Fed increases A’s deposits in Fed by amount of check. There is a corresponding decrease in the deposits of B. Therefore reserves neither gain or lose deposits. * Non-member banks are involved so that people can send money to any bank. IF not in the Fed system they have clearing account which permits transfer of reserves between regions. The effect of deposit expansion as banks change their reserve amounts SOS If banks change their reserves from 10% to 5% then you’re going to see fewer reserves in the bank. For example if you have $1000 in the bank and you have to keep 10% of it you’ll have $100 in reserves.
If your reserves go down to 5% then you only have to keep $50 in reserves. Deposit expansion ties in because it allows banks to keep only a small fraction of the money people deposit as cash or by the Fed. The rest of the depositors money is loaned out, meaning you kept 100$ for your reserves and loan out 900$ if you reserve requirement was 10%. Banks are required to keep a certain percentage to fulfill the withdraw requests from their depositors, however deposit expansion allows them to make even more money off of “x” amount that was deposited by loaning out the amount left after the reserve requirement was calculated.
If inflation is on the horizon what would the Fed do with its tools to control the situation The fed could raise the reserve requirement so that banks had to hold more money in the vault/Fed and it contracts the money supply. * Raise the discount rate (Fed charges for temp. loan) less borrowing, decrease money supply * Open market operations – sell securities to contract reserves Could the Fed have prevented the banking collapse that occurred in the 1930s? SOSBanks are subject to crisis when their depositors are no longer confident that their bank holds enough reserves to satisfy withdrawal demands.
This can trigger a bank run where depositors attempt to get to the bank before the other depositors in order to withdraw their money before the bank’s limited reserves run out. The problem with bank runs is that when depositors withdraw money and stuff it under their mattresses rather than trust it to other banks, the money supply shrinks. The Fed could have prevented this crisis by carrying out their role as a last resort lender to these banks. If they had lent banks money through loans than the banks would have more money in reserves. Thus able to fulfill withdraw requirements as they came in.
They could have also bought government bonds. That would supply the bank with additional cash to meet the demands of their depositors (also decreases interest rates). That would have ended some bank failures and prevented the banking collapse, so yes I believe the Fed could have taken more action than a “bank holiday” to help put an end to this issue. How do banks use Floats 1. The “float” is that time lapse between when a check is deposited and when the money becomes available. For example, a person gives the landlord a rent check on Tuesday, but the money won’t be in the bank until Friday.
The float time for paper checks is between two and five days. Banks use this time to verify the legitimacy of a check. 2. Float is money in the banking system that is counted twice, for a brief time, because of delays in processing checks. Float distorts the measurement of the money supply and complicates the implementation of monetary policy. When check clearing is delayed, funds in the process of collection appear in the accounts of both the institutions that receive the checks for deposit and the institutions upon which the checks are drawn.
Thus, float inflates, for a brief time, the amount of money in the banking system. SOS float is the time between writing a check and the reserves being taken. Floats temporarily increase total bank reserves because one bank has added to its reserves but it has yet to be taken out of another bank. Banks can maximize on the float if they wish and use the extra reserves to gain money in a short-term area. But floats are diminishing in size and importance due to electronic payment systems.
Does the Fed have an incentive to monetize (convert into or express in the form of currency) the debt eventually SOS Yes but it’s not a good idea because this means to print money in order to repay the national debt. For example, suppose a government is $1 trillion in debt. Theoretically, the government can simply expand the money supply by $1 trillion and reduce the national debt to zero. Some governments monetize their debts, but because it increases the amount of money in circulation, it is considered highly inflationary. For example, the price of strawberries is currently about $4. 0 if we would double our money supply to decrease the debt to zero the price of strawberries would more than double.
That’s because the value of our dollar would decrease so dramatically that it would take “x” more times money to get that $4. 50 crate of strawberries. What the Fed does with the money it earns in interest SOSWhen the Fed buys bonds; it’s not spending the government’s cash. Rather it creates the money itself, basically by electronically crediting the money to banks. The Fed then earns interest on the Treasuries it holds. The Fed earned a $77. billion profit last year, and of that, most was from interest payments. That’s up significantly from the pre-crisis years, when the Fed had a much smaller portfolio, with far fewer bonds. After paying some of its own administrative expenses, the Fed turns most of those profits over to Treasury, which can use them to pay government bills as well as the Consumer Financial Protection Bureau and the Office of Financial Research. Finally the interest is used to reduce the national debt but the number in comparison to the debt is so small its like a drop of water in a bucket.
The FOMC (directive and main components) * SOS The Federal Open Market Committee (FOMC) consists of twelve members. The seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth.
FOMC specifies immediate prescription for implementing longer-term objectives. Outlines its operating targets. Emphasizes monetary and reserve aggregates, but in practice operates on interest rates (Federal Funds Rate). Reviews recent economic and financial developments (prices, unemployment, int. rates, money supply, bal. of pmts, bank credit), make projections for the future, based on anticipated economic conditions, proposes appropriate monetary policy. Releases statement that summarizes directive, gives idea of future policy risks, indicates whether policy risks are weighted toward inflation, economic weakness or both.
Why is the Fed Funds Rate a good target. Pros and cons to using it SOS It’s a good target because the rate adjusts according to the supply and demand for reserves. For example, when the Fed sells securities, it reduces the banks’ supply of reserves and makes interest rates go up. However, when the Fed buys securities, it increases the banks’ supply of reserves and interest rates go down. This is a positive thing because banks can adjust their reserves based off of the demand. If people need more money for loans then they can buy securities to increase the reserve.
Hence more money in reserves = more money to loan out. However, this can be a bad thing for the economy because it could cause too much growth and then inflation. You want businesses and people to take out loans because that helps grow the economy but you don’t want interest rates to become so low that you create too much liquidity in your money supply. Then the value of your dollar will decrease thus costing you more money to purchase everyday items like food for example. Pick the policy that produces less variability in the gross domestic product.
Fed funds rate is good target because interest rates will affect the aggregate demand for good/services, real GDP and inflation rate. And targeting reserves is unrealistic because to have a close relationship between reserves and spending there needs to be stable relationships between reserves and money supply, and the money supply and total spending. Since the link is weak, then there will be a lot of variation in demand for reserves that isn’t related to changes in spending so changes in interest rates would not stabilize economy.