Financial Crises & Regulation
January 14, 2016
Balance Sheet Basics:
• Assets have to add up to Liabilities + equity. Equity is a function of what the assets and liabilities are.
Money you owe others
Stuff (land, etc.)
Residual claims (equity)
Money other people owe you
Good if your assets are liquid, your liabilities are illiquid
• Banks serve two purposes
◦ Intermediary (not unique to banks…insurance for example)
◦ Transactional services
• Mutual Funds: Provide demandable equity. You are promised the value, not what you put in.
• With banks there is a first mover advantage. Not true about mutual funds.
Liquidity: For something to be liquid, there can’t be informational asymmetries.
Why Banks are Special?
Maturity: payments are due.
Maturity transformation: Starts with a maturity mismatch (you raise money by issuing short term claims like deposits), and then they take that money and make long term loans.
Banks have to keep 10% of deposits on deposit with the federal reserve.
Savings and Loans Crisis:
Market rates can change, while the 30 year fixed interest rate stays the same. So if you have a bunch of mortgages, but are borrowing money at market rates, you are in trouble.
Prices and yields on bonds move in opposite directions. And the magnitude of the drop in value, will correspond with the length until it matures.
• If interest rates jump, If the bond is short term and you can get your money back quickly and reinvest it at a higher rate, then you would lose very little from the jump in rates.
• Short term loans have very little interest rate risk.
• This basically happened in the savings and loans problem. When interest rates went up, the value of the mortgages that they held went way down.
Banks are the most highly leveraged institutions in the american economy.
If you are highly leveraged, you basically have to have a really good return, because if you don’t, you have to pay the interest on the money that you borrowe
• Subtle hazards that concerned congress when it passed glass-steagal:
Problems with banks involve significant externalities (costs to third parties who don’t have anything to do with the bank themselves). Contagion effects..
Banks Balance Sheets:
• Limits on bank powers
• Deposit insurance (helps to stop bank runs)
• Capital requirements
• Financial Stability Oversight Council (Created by Dodd Frank): Composed of heads of major financial regulating bodies (Fed, FCC, FDIC, etc.). Coordinates policy, and mainly designates systemically important financial institutions which are not banks that need regulation by the federal reserve.
• Banking regulators focus especially on trying to insure that banks don’t take risks that increase the probability of failure.