R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 10 The Economics of Banking LEARNING OBJECTIVES After studying this chapter, you should be able to: 10.1 Understand bank balance sheets 10.2 Describe the basic operations of a commercial bank 10.3 Explain how banks manage risk 10.4 Explain the trends in the U.S commercial banking industry © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 10 The Economics of Banking WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY? • In the recovery from the financial crisis of 2007–2009, banks had become extremely cautious in making loans • Banks were turning away borrowers with flawed credit histories and avoiding industries that were hard hit by the recession • As the value of real estate declined, the collateral that small businesses could use to borrow against also declined • An Inside Look at Policy on page 306 discusses how higher interest rates may reduce bank profits © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During and immediately following the 2007–2009 financial crisis, there was a sharp increase in the number of bank failures Question: Is banking a particularly risky business? If so, what types of risks banks face? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 10.1Learning Objective Understand bank balance sheets © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 • The key commercial banking activities are taking in deposits from savers and making loans to households and firms • A bank’s primary sources of funds are deposits, and primary uses of funds are loans, which are summarized in the bank’s balance sheet Balance sheet A statement that shows an individual’s or a firm’s financial position on a particular day • The typical layout of a balance sheet is based on the following accounting equation: Assets = Liabilities + Shareholders’ equity The Basics of Commercial Banking: The Bank Balance Sheet © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 The Basics of Commercial Banking: The Bank Balance Sheet © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 Asset Something of value that an individual or a firm owns; in particular, a financial claim Liability Something that an individual or a firm owes, particularly a financial claim on an individual or a firm Bank capital The difference between the value of a bank’s assets and the value of its liabilities; also called shareholders’ equity The Basics of Commercial Banking: The Bank Balance Sheet © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 Bank Liabilities Checkable Deposits Checkable deposits Accounts against which depositors can write checks, also called transaction deposits • Demand deposits are checkable deposits on which banks not pay interest • NOW (negotiable order of withdrawal) accounts are checking accounts that pay interest • Checkable deposits are liabilities to banks and assets to households and firms The Basics of Commercial Banking: The Bank Balance Sheet © 2012 Pearson Education, Inc Publishing as Prentice Hall of 55 Nontransaction Deposits • The most important types of nontransaction deposits are savings accounts, money market deposit accounts (MMDAs), and time deposits, or certificates of deposit (CDs) • Checkable deposits and small-denomination time deposits are covered by federal deposit insurance • CDs of less than $100,000 are called small-denomination time deposits CDs of $100,000 or more are called large-denomination time deposits CDs worth $100,000 or more are negotiable, which means that investors can buy and sell them in secondary markets prior to maturity Federal deposit insurance A government guarantee of deposit account balances up to $250,000 The Basics of Commercial Banking: The Bank Balance Sheet © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 55 Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation • The Federal Reserve plays the role of a lender of last resort by making discount loans to banks suffering from temporary liquidity problems • Before the Fed existed, banks were subject to bank runs • If many banks simultaneously experienced runs, the result would be a bank panic, which often resulted in banks being unable to return depositors’ money and having to temporarily close their doors • Bank panics typically resulted in recessions After the severe bank panic of 1907, Congress passed the Federal Reserve Act in 1913 • The Great Depression led to bank panics, and Congress responded with the creation of the Federal Deposit Insurance Corporation (FDIC), established in 1934 Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 55 Figure 10.2 Commercial Bank Failures in the United States, 1980–2010 Bank failures in the United States were at low levels from 1960 until the savings and loan crisis of the mid-1980s By the mid-1990s, bank failures had returned to low levels, where they remained until the beginning of the financial crisis in 2007 Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 55 The Rise of Nationwide Banking • In the early 1900s, banks were prohibited from crossing state lines Unit banking meant that banks were kept small, serving the local area • In 1900, of the 12,427 commercial banks in the United States, only 87 had any branches • The U.S system of many small, geographically limited banks failed to take advantage of economies of scale in banking • Restrictions on branching within the state loosened after the mid1970s, and in 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed for the phased removal of restrictions on interstate banking • These changes led to rapid consolidation of banks, from 14,384 in 1975 to only 6,839 by 2009 In 2010, concerns about bank size and banks “too big to fail” were discussed in Congress, but no limits on size were finally enacted Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 55 Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 55 Expanding the Boundaries of Banking • Between 1960 and 2010, banks increased their funds and borrowings; they relied less on C&I and consumer loans, and more on real estate loans; they expanded into nontraditional lending activities and activities generating revenue from fees instead of interest Off-Balance-Sheet Activities Off-balance-sheet activities Activities that not affect a bank’s balance sheet because they not increase either the bank’s assets or its liabilities Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 55 Off-Balance-Sheet Activities Four important off-balance-sheet activities that banks have come to rely on to earn fee income include: Standby letters of credit Standby letter of credit A promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures Loan commitments Loan commitment An agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 55 Off-Balance-Sheet Activities Four important off-balance-sheet activities that banks have come to rely on to earn fee income include: Loan sales Loan sale A financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party Trading activities • Banks earn fees from trading in the multibillion-dollar markets for futures, options, and interest-rate swaps • Bank losses from trading in securities became a concern during the financial crisis of 2007-2009 Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 55 Electronic Banking • The first important development in electronic banking was the spread of automatic teller machines (ATMs) • By the mid-1990s, virtual banks, or banks that carry out all their banking activities online, began to appear • By the mid-2000s, most traditional banks had also begun providing online services • Check clearing is now done electronically Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 55 Making the Connection Can Electronic Banking Save Somalia’s Economy? • For a market economy to function, a government needs to maintain a minimum level of order • Banks are particularly vulnerable to robberies Not surprisingly, brickand-mortar banks are scarce in Somalia, which has been subjected to incessant civil wars and rampant violence • But for the past three years, Somali GDP has been growing, and entrepreneurs have realized that they can provide virtual banking services through cell phones and Internet access • Somalis are now able to keep deposits online, transfer money, and obtain credit • While electronic banking appears to have contributed to the welcome economic progress, the country’s other problems present significant obstacles to maintaining that growth Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 55 The Financial Crisis, TARP, and Partial Government Ownership of Banks • As the financial crisis unfolded, residential real estate mortgages began to decline in value • The market for mortgage-backed securities froze, meaning that buying and selling of these securities largely stopped, making it very difficult to determine their market prices These securities became known as “toxic assets.” • Evaluating balance sheets and determining the true value of bank capital was difficult • Banks responded to their worsening balance sheets by tightening credit standards for consumer and commercial loans The resulting credit crunch helped bring on the recession that started in December 2007, as households and firms had increased difficulty funding their spending Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 55 Troubled Asset Relief Program (TARP) A government program under which the U.S Treasury purchased stock in hundreds of banks to increase the banks’ capital Another initiative to inject capital into banks, called the Capital Purchase Program (CPP), also relied on the U.S Treasury to purchase stock in hundreds of troubled banks Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 51 of 55 Making the Connection Small Businesses: Key Victims of the Credit Crunch • Small businesses play a key role in the economy Businesses with fewer than 500 employees generate most of the jobs in the economy • During the financial crisis, banks were building their reserves and tightening lending requirements, so it became increasingly difficult for small firms to fund their operations • As commercial real estate values declined, borrowing against the value of stores or factories became more difficult • Banks worried that the severity of the recession would increase adverse selection and moral hazard Pressure from government regulators to avoid making risky loans and credit limits on credit cards also limited the borrowing ability of small businesses • The large employment losses during the recession came in part from the difficulty of small businesses to obtain loans Trends in the U.S Commercial Banking Industry © 2012 Pearson Education, Inc Publishing as Prentice Hall 52 of 55 Answering the Key Question At the beginning of this chapter, we asked the question: “Is banking a particularly risky business? If so, what types of risks banks face?” In a market system, businesses of all types face risks, and many fail Economists and policymakers are particularly concerned about the risk and potential for failure that banks face because they play a vital role in the financial system In this chapter, we have seen that the basic business of commercial banking—borrowing money short term from depositors and lending it long term to households and firms—entails several types of risks: liquidity risk, credit risk, and interest-rate risk © 2012 Pearson Education, Inc Publishing as Prentice Hall 53 of 55 AN INSIDE LOOK AT POLICY Interest-Rate Hikes Threaten Bank Profits REUTERS, U.S Regulators Warn Banks on Interest Rate Risk Key Points in the Article • In early 2010, the Federal Financial Institutions Examination Council (FFIEC) urged commercial banks to protect themselves against a likely increase in interest rates • Banks had profited by borrowing funds at low rates and purchasing assets such as Treasury securities that had higher yields • Some institutions are expecting interest rates to remain at historic lows, but it is unlikely that the Fed will keep rates near zero forever • As interest rates rise, banks relying heavily on short-term funds could see their funding costs accelerate Longer-term assets may no longer be profitable to own, forcing banks to sell securities en masse and potentially weakening the financial sector again © 2012 Pearson Education, Inc Publishing as Prentice Hall 54 of 55 AN INSIDE LOOK AT POLICY Evidence of U.S banks’ profits can be found in their balance sheets Bank capital as a percentage of assets was lower when interest rates were higher prior to the financial crisis © 2012 Pearson Education, Inc Publishing as Prentice Hall 55 of 55 .. .CHAPTER 10 The Economics of Banking LEARNING OBJECTIVES After studying this chapter, you should be able to: 10. 1 Understand bank balance sheets 10. 2 Describe the basic operations... bank 10. 3 Explain how banks manage risk 10. 4 Explain the trends in the U.S commercial banking industry © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 10 The Economics of Banking. .. acquired by banks with the funds they receive from depositors, with funds they borrow, with funds they acquired initially from their shareholders, and with profits they retain from their operations