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The economics of money, Banking, and financial markeTs B u s i n e s s s c h o o l e d i T i o n

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The economics of money, Banking, and financial markeTs B u s i n e s s s c h o o l e d i T i o n

Fourth Edition

Frederic S. Mishkin Columbia University

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Library of Congress Cataloging-in-Publication Data

Mishkin, Frederic S. The economics of money, banking, and financial markets / Frederic S. Mishkin, Columbia University. – Business School Edition, Fourth Edition. pages cm Includes index. ISBN 978-0-13-385980-5 1. Finance. 2. Money. 3. Banks and banking. I. Title. HG173.M632 2014 332–dc23 2014042183 10 9 8 7 6 5 4 3 2 1

ISBN 10: 0-13-385980-0 ISBN 13: 978-0-13-385980-5

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To Sally

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viivii

ParT 1 INTRODUCTION 1 1 Why Study Money, Banking, and Financial Markets? ............................................................2 2 An Overview of the Financial System ...................................................................................... 22 3 What Is Money? .............................................................................................................................. 49

ParT 2 FINANCIAL MARKETS 63 4 The Meaning of Interest Rates ................................................................................................... 64 5 The Behavior of Interest Rates ................................................................................................... 85 6 The Risk and Term Structure of Interest Rates ....................................................................116 7 The Stock Market, the Theory of Rational Expectations, and the Efficient

Market Hypothesis .......................................................................................................................140

ParT 3 Financial Institutions 161 8 An Economic Analysis of Financial Structure .......................................................................162 9 Banking and the Management of Financial Institutions ....................................................186 10 Economic Analysis of Financial Regulation ...........................................................................215 11 Banking Industry: Structure and Competition ....................................................................234 12 Financial Crises ..............................................................................................................................267 13 Nonbank Finance ..........................................................................................................................291 14 Financial Derivatives ....................................................................................................................315 15 Conflicts of Interest in the Financial Industry ......................................................................341

ParT 4 Central Banking and the Conduct of Monetary Policy 359 16 Central Banks and the Federal Reserve System ..................................................................360 17 The Money Supply Process .......................................................................................................384 18 Tools of Monetary Policy ...........................................................................................................409 19 The Conduct of Monetary Policy: Strategy and Tactics ...................................................434

ParT 5 International Finance and Monetary Policy 467 20 The Foreign Exchange Market ..................................................................................................468 21 The International Financial System .........................................................................................495

ParT 6 Monetary Theory 523 22 Quantity Theory, Inflation, and the Demand for Money ................................................524 23 Aggregate Demand and Supply Analysis .............................................................................543 24 Monetary Policy Theory ............................................................................................................587 25 Transmission Mechanisms of Monetary Policy ....................................................................616

Brief Contents

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viii Brief Contents

Chapters on the Web 1 Financial Crises in Emerging Market Economies 2 The IS Curve 3 The Monetary Policy and Aggregate Demand Curves 4 The Role of Expectations in Monetary Policy 5 The ISLM Model

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ixix

ParT 1 Introduction 1

c h a P Te r 1 Why Study Money, Banking, and Financial Markets? 2 Why Study Financial Markets? ...............................................................................................................2

The Bond Market and Interest Rates ....................................................................................... 3 The Stock Market ................................................................................................................... 3

Why Study Financial Institutions and Banking? ................................................................................5 Structure of the Financial System ........................................................................................... 6 Banks and Other Financial Institutions ................................................................................... 6 Financial Innovation .............................................................................................................. 6 Financial Crises ...................................................................................................................... 7

Why Study Money and Monetary Policy? .........................................................................................7 Money and Business Cycles .................................................................................................... 7 Money and Inflation ............................................................................................................... 8 Money and Interest Rates ..................................................................................................... 10 Conduct of Monetary Policy ................................................................................................. 10 Fiscal Policy and Monetary Policy ........................................................................................ 11

Why Study International Finance? ..................................................................................................... 12 The Foreign Exchange Market .............................................................................................. 12 The International Financial System ...................................................................................... 14

How We Will Study Money, Banking, and Financial Markets .................................................... 14 Exploring the Web ............................................................................................................... 15

Concluding Remarks............................................................................................................................... 15 Summary  15   •   Key Terms  16   •   Questions  16   •   Applied Problems  17   •  

Data Analysis Problems  17   •   Web Exercises  18   •   Web References  18

a P P e n d i X To c h a P Te r 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 19 Aggregate Output and Income .......................................................................................................... 19 Real Versus Nominal Magnitudes ....................................................................................................... 19 Aggregate Price Level ............................................................................................................................ 20 Growth Rates and the Inflation Rate ................................................................................................. 21

c h a P Te r 2 An Overview of the Financial System 22 Function of Financial Markets .............................................................................................................. 22 Structure of Financial Markets ............................................................................................................. 25

Debt and Equity Markets ...................................................................................................... 25 Primary and Secondary Markets ........................................................................................... 25 Exchanges and Over-the-Counter Markets ........................................................................... 26 Money and Capital Markets .................................................................................................. 27

Contents in Detail

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x Contents in Detail

Financial Market Instruments ............................................................................................................... 27 Money Market Instruments .................................................................................................. 27

following the financial news Money Market Rates 28

Capital Market Instruments .................................................................................................. 29

following the financial news Capital Market Interest Rates 30

Internationalization of Financial Markets ......................................................................................... 31

global Are U.S. Capital Markets Losing Their Edge? 32

International Bond Market, Eurobonds, and Eurocurrencies ................................................ 32 World Stock Markets ............................................................................................................ 33

Function of Financial Intermediaries: Indirect Finance ................................................................ 33

following the financial news Foreign Stock Market Indexes 34

Transaction Costs ................................................................................................................. 34

global The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 35

Risk Sharing ......................................................................................................................... 36 Asymmetric Information: Adverse Selection and Moral Hazard ............................................ 36 Economies of Scope and Conflicts of Interest ....................................................................... 38

Types of Financial Intermediaries ...................................................................................................... 38 Depository Institutions ......................................................................................................... 38 Contractual Savings Institutions ........................................................................................... 40 Investment Intermediaries .................................................................................................... 41

Regulation of the Financial System ..................................................................................................... 42 Increasing Information Available to Investors ....................................................................... 42 Ensuring the Soundness of Financial Intermediaries ............................................................. 43 Financial Regulation Abroad................................................................................................. 45 Summary  45   •   Key Terms  46   •   Questions  46   •   Applied Problems  47   •  

Data Analysis Problems  48   •   Web Exercises  48   •   Web References  48

c h a P Te r 3 What Is Money? 49 Meaning of Money ................................................................................................................................. 49 Functions of Money ................................................................................................................................ 50

Medium of Exchange ............................................................................................................ 50 Unit of Account .................................................................................................................... 51 Store of Value ....................................................................................................................... 52

Evolution of the Payments System ..................................................................................................... 53 Commodity Money .............................................................................................................. 53 Fiat Money ........................................................................................................................... 53 Checks ................................................................................................................................. 53 Electronic Payment ............................................................................................................... 54 E-Money .............................................................................................................................. 54

fyi Are We Headed for a Cashless Society? 55

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Contents in Detail xi

APPLICATION Will Bitcoin Become the Money of the Future? ................................55

Measuring Money ................................................................................................................................... 56 The Federal Reserve’s Monetary Aggregates .......................................................................... 56

following the financial news The Monetary Aggregates 57

fyi Where Are All the U.S. Dollars? 58

Summary  59   •   Key Terms  60   •   Questions  60   •   Applied Problems  61   •   Data Analysis Problems  62   •   Web Exercises  62   •   Web References  62

ParT 2 Financial Markets 63

c h a P Te r 4 The Meaning of Interest Rates 64 Measuring Interest Rates ....................................................................................................................... 64

Present Value ........................................................................................................................ 64

APPLICATION Simple Present Value .........................................................................66

APPLICATION How Much Is That Jackpot Worth? ...................................................66 Four Types of Credit Market Instruments ............................................................................. 67 Yield to Maturity .................................................................................................................. 68

APPLICATION Yield to Maturity on a Simple Loan ...................................................68

APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan ..................................................................................70

APPLICATION Yield to Maturity and Bond Price for a Coupon Bond ......................71

APPLICATION Yield to Maturity on a Perpetuity ......................................................73

APPLICATION Yield to Maturity on a Discount Bond ...............................................74

The Distinction Between Interest Rates and Returns................................................................... 75 Maturity and the Volatility of Bond Returns: Interest-Rate Risk ............................................. 78 Summary .............................................................................................................................. 79

The Distinction Between Real and Nominal Interest Rates ........................................................ 79

APPLICATION Calculating Real Interest Rates ..........................................................80 Summary  82   •   Key Terms  82   •   Questions  82   •   Applied Problems  83   •  

Data Analysis Problems  84   •   Web Exercises  84   •   Web References  84

c h a P Te r 4 W e B a P P e n d i X Measuring Interest-Rate Risk: Duration Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 5 The Behavior of Interest Rates 85 Determinants of Asset Demand .......................................................................................................... 85

Wealth .................................................................................................................................. 86

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xii Contents in Detail

Expected Returns ................................................................................................................. 86 Risk ...................................................................................................................................... 86 Liquidity .............................................................................................................................. 87 Theory of Portfolio Choice ................................................................................................... 87

Supply and Demand in the Bond Market ........................................................................................ 88 Demand Curve ..................................................................................................................... 88 Supply Curve ....................................................................................................................... 89 Market Equilibrium .............................................................................................................. 90 Supply and Demand Analysis ............................................................................................... 91

Changes in Equilibrium Interest Rates .............................................................................................. 91 Shifts in the Demand for Bonds ............................................................................................ 92 Shifts in the Supply of Bonds................................................................................................ 95

APPLICATION Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect ................................................................................................97

APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion .................................................................................................99

APPLICATION Explaining Low Japanese Interest Rates ..........................................100

Supply and Demand in the Market for Money: The Liquidity Preference Framework ....................................................................................101

Changes in Equilibrium Interest Rates in the Liquidity Preference Framework.................104 Shifts in the Demand for Money ......................................................................................... 104 Shifts in the Supply of Money............................................................................................. 104

APPLICATION Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply .............................105

Changes in Income ............................................................................................................. 106 Changes in the Price Level .................................................................................................. 106 Changes in the Money Supply ............................................................................................ 106

Money and Interest Rates ...................................................................................................................107

APPLICATION Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? .......................................................................................109

Summary  112   •   Key Terms  112   •   Questions  112   •   Applied Problems  113   •   Data Analysis Problems  114   •   Web Exercises  115   •   Web References  115

c h a P Te r 5 W e B a P P e n d i X 1 Models of Asset Pricing Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 5 W e B a P P e n d i X 2 Applying the Asset Market Approach to a Commodity Market: The Case of Gold Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 5 W e B a P P e n d i X 3 Loanable Funds Framework Go to the Companion Website, http://www.pearsonhighered.com/mishkin

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Contents in Detail xiii

c h a P Te r 6 The Risk and Term Structure of Interest Rates 116 Risk Structure of Interest Rates .........................................................................................................116

Default Risk ........................................................................................................................ 116

fyi Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis 120

APPLICATION The Global Financial Crisis and the Baa-Treasury Spread ..............121 Liquidity ............................................................................................................................ 121 Income Tax Considerations ................................................................................................ 122 Summary ............................................................................................................................ 123

APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates .............123

Term Structure of Interest Rates .......................................................................................................124

following the financial news Yield Curves 124

Expectations Theory ........................................................................................................... 126 Segmented Markets Theory ................................................................................................ 129 Liquidity Premium and Preferred Habitat Theories ............................................................. 130 Evidence on the Term Structure ......................................................................................... 133

fyi The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 134

Summary ............................................................................................................................ 134

APPLICATION Interpreting Yield Curves, 1980–2014 ............................................134 Summary  136   •   Key Terms  136   •   Questions  136   •   Applied Problems  138   •  

Data Analysis Problems  138   •   Web Exercises  139   •   Web References  139

c h a P Te r 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 140 Computing the Price of Common Stock ........................................................................................140

The One-Period Valuation Model ....................................................................................... 141 The Generalized Dividend Valuation Model ........................................................................ 142 The Gordon Growth Model ................................................................................................ 142

How the Market Sets Stock Prices ....................................................................................................143

APPLICATION Monetary Policy and Stock Prices ...................................................145

APPLICATION The Global Financial Crisis and the Stock Market .........................145

The Theory of Rational Expectations .............................................................................................145 Formal Statement of the Theory ......................................................................................... 147 Rationale Behind the Theory .............................................................................................. 147 Implications of the Theory ................................................................................................. 148

The Efficient Market Hypothesis: Rational Expectations in Financial Markets ...................149 Rationale Behind the Hypothesis ........................................................................................ 150 Random-Walk Behavior of Stock Prices .............................................................................. 151

global Should Foreign Exchange Rates Follow a Random Walk? 152

APPLICATION Practical Guide to Investing in the Stock Market ...........................152

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xiv Contents in Detail

How Valuable Are Reports Published by Investment Advisers? ........................................... 152 Should You Be Skeptical of Hot Tips? ................................................................................. 153

fyi Should You Hire an Ape as Your Investment Adviser? 154

Do Stock Prices Always Rise When There Is Good News? .................................................. 154 Efficient Market Prescription for the Investor ..................................................................... 154

Why the Efficient Market Hypothesis Does Not Imply That Financial Markets are Efficient ........................................................................................155

APPLICATION What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis and the Efficiency of Financial Markets? ..........................156

Behavioral Finance ................................................................................................................................156 Summary  157   •   Key Terms  158   •   Questions  158   •   Applied Problems  159   •  

Data Analysis Problems  160   •   Web Exercises  160   •   Web References  160

c h a P Te r 7 W e B a P P e n d i X Evidence on the Efficient Market Hypothesis Go to the Companion Website, http://www.pearsonhighered.com/mishkin

ParT 3 Financial Institutions 161

c h a P Te r 8 An Economic Analysis of Financial Structure 162 Basic Facts About Financial Structure Throughout the World ................................................162 Transaction Costs ..................................................................................................................................165

How Transaction Costs Influence Financial Structure ......................................................... 165 How Financial Intermediaries Reduce Transaction Costs .................................................... 166

Asymmetric Information: Adverse Selection and Moral Hazard ...........................................167 The Lemons Problem: How Adverse Selection Influences Financial Structure .................167

Lemons in the Stock and Bond Markets.............................................................................. 168 Tools to Help Solve Adverse Selection Problems ................................................................. 168

fyi The Enron Implosion 170

How Moral Hazard Affects the Choice Between Debt and Equity Contracts ...................................................................................................................173

Moral Hazard in Equity Contracts: The Principal–Agent Problem ....................................... 173 Tools to Help Solve the Principal–Agent Problem ............................................................... 174

How Moral Hazard Influences Financial Structure in Debt Markets .....................................176 Tools to Help Solve Moral Hazard in Debt Contracts .......................................................... 176 Summary ............................................................................................................................ 178

APPLICATION Financial Development and Economic Growth ..............................179

fyi The Tyranny of Collateral 180

APPLICATION Is China a Counterexample to the Importance of Financial Development? ...............................................................................181

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Contents in Detail xv

Summary  182   •   Key Terms  183   •   Questions  183   •   Applied Problems  184   •   Data Analysis Problems  185   •   Web Exercises  185   •   Web References  185

C H A P TE R 9 Banking and the Management of Financial Institutions 186 The Bank Balance Sheet ......................................................................................................................186

Liabilities ............................................................................................................................ 186 Assets ................................................................................................................................. 189

Basic Banking ...........................................................................................................................................190 General Principles of Bank Management .......................................................................................193

Liquidity Management and the Role of Reserves .................................................................193 Asset Management .............................................................................................................. 196 Liability Management ......................................................................................................... 197 Capital Adequacy Management .......................................................................................... 198

APPLICATION Strategies for Managing Bank Capital .............................................200

APPLICATION How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis ...............................................................................201

Managing Credit Risk ...........................................................................................................................201 Screening and Monitoring .................................................................................................. 202 Long-Term Customer Relationships ....................................................................................203 Loan Commitments ............................................................................................................204 Collateral and Compensating Balances ...............................................................................204 Credit Rationing .................................................................................................................205

Managing Interest-Rate Risk...............................................................................................................205 Gap and Duration Analysis ................................................................................................. 206

APPLICATION Strategies for Managing Interest-Rate Risk ......................................207

Off-Balance-Sheet Activities ..............................................................................................................208 Loan Sales .......................................................................................................................... 208 Generation of Fee Income .................................................................................................. 208 Trading Activities and Risk Management Techniques .......................................................... 209

Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase:  Rogue Traders and the Principal–Agent Problem  210

Summary  211   •   Key Terms  212   •   Questions  212   •   Applied Problems  213   •   Data Analysis Problems  213   •   Web Exercises  214   •   Web References  214

C H A P TE R 9 W E b A P P E n d i x 1 Duration Gap Analysis Go to the Companion Website, http://www.pearsonhighered.com/mishkin

C H A P TE R 9 W E b A P P E n d i x 2 Measuring Bank Performance Go to the Companion Website, http://www.pearsonhighered.com/mishkin

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xvi Contents in Detail

c h a P Te r 1 0 Economic Analysis of Financial Regulation 215 Asymmetric Information as a Rationale for Financial Regulation ...........................................215

Government Safety Net ...................................................................................................... 215

global The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 217

Drawbacks of the Government Safety Net .......................................................................... 218

Types of Financial Regulation ............................................................................................................220 Restrictions on Asset Holdings ........................................................................................... 220 Capital Requirements ......................................................................................................... 220 Prompt Corrective Action ................................................................................................... 221

global Where Is the Basel Accord Heading After the Global Financial Crisis? 222

Financial Supervision: Chartering and Examination ........................................................... 223 Assessment of Risk Management ........................................................................................ 224 Disclosure Requirements .................................................................................................... 225

fyi Mark-to-Market Accounting and the Global Financial Crisis 226

Consumer Protection .......................................................................................................... 226 Restrictions on Competition ............................................................................................... 227 Summary ............................................................................................................................ 227

global International Financial Regulation 228

Summary  231   •   Key Terms  231   •   Questions  231   •   Applied Problems  232   •   Data Analysis Problems  232   •   Web Exercises  233   •   Web References  233

c h a P Te r 1 0 W e B a P P e n d i X 1 The 1980s Banking and Savings and Loan Crisis Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 0 W e B a P P e n d i X 2 Banking Crises Throughout the World Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 1 Banking Industry: Structure and Competition 234 Historical Development of the Banking System...........................................................................234

Multiple Regulatory Agencies ............................................................................................. 236

Financial Innovation and the Growth of the “Shadow Banking System” ..............................237 Responses to Changes in Demand Conditions: Interest-Rate Volatility ................................ 238 Responses to Changes in Supply Conditions: Information Technology ............................... 239

fyi Will “Clicks” Dominate “Bricks” in the Banking Industry? 241

Securitization and the Shadow Banking System .................................................................. 242 Avoidance of Existing Regulations ...................................................................................... 243

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fyi Bruce Bent and the Money Market Mutual Fund Panic of 2008 245

Financial Innovation and the Decline of Traditional Banking .............................................. 246

Structure of the U.S. Commercial Banking Industry ...................................................................249 Restrictions on Branching ................................................................................................... 250 Response to Branching Restrictions .................................................................................... 251

Bank Consolidation and Nationwide Banking ..............................................................................252 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 .......................... 253 What Will the Structure of the U.S. Banking Industry Look Like in the Future? ................. 254 Are Bank Consolidation and Nationwide Banking Good Things? ........................................ 254

global Comparison of Banking Structure in the United States and Abroad 255

Separation of Banking and Other Financial Service Industries ...............................................256 Erosion of Glass-Steagall ..................................................................................................... 256 The Gramm-Leach-Bliley Financial Services Modernization

Act of 1999: Repeal of Glass-Steagall ............................................................................. 256 Implications for Financial Consolidation ............................................................................ 257

fyi The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks 257

Separation of Banking and Other Financial Services Industries Throughout the World....... 258

Thrift Industry: Regulation and Structure......................................................................................258 Savings and Loan Associations ........................................................................................... 258 Mutual Savings Banks ......................................................................................................... 259 Credit Unions ..................................................................................................................... 259

International Banking ...........................................................................................................................260 Eurodollar Market .............................................................................................................. 260

global Ironic Birth of the Eurodollar Market 261

Structure of U.S. Banking Overseas .................................................................................... 261 Foreign Banks in the United States ..................................................................................... 262 Summary  263   •   Key Terms  264   •   Questions  264   •   Data Analysis 

Problems  265   •   Web Exercises  266   •   Web References  266

c h a P Te r 1 2 Financial Crises 267 What Is a Financial Crisis? ...................................................................................................................267 Dynamics of Financial Crises ..............................................................................................................268

Stage One: Initial Phase ...................................................................................................... 268 Stage Two: Banking Crisis ................................................................................................... 269 Stage Three: Debt Deflation ................................................................................................ 271

APPLICATION The Mother of All Financial Crises: The Great Depression ............272 Stock Market Crash ............................................................................................................ 272 Bank Panics ........................................................................................................................ 272 Continuing Decline in Stock Prices .................................................................................... 273 Debt Deflation .................................................................................................................... 273 International Dimensions ................................................................................................... 274

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The Global Financial Crisis of 2007–2009 ....................................................................................274 Causes of the 2007–2009 Financial Crisis .......................................................................... 274

fyi Collateralized Debt Obligations (CDOs) 275

Effects of the 2007–2009 Financial Crisis ........................................................................... 276

inside the fed Was the Fed to Blame for the Housing Price Bubble? 277

global The European Sovereign Debt Crisis 280

Height of the 2007–2009 Financial Crisis .......................................................................... 281 Government Intervention and the Recovery ....................................................................... 282

global Worldwide Government Bailouts During the 2007–2009 Financial Crisis 283

Response of Financial Regulation .....................................................................................................283 Macroprudential Versus Microprudential Supervision ........................................................ 283 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ............................. 284

Too-Big-to-Fail and Future Regulation ...........................................................................................285 What Can Be Done About the Too-Big-to-Fail Problem? ..................................................... 285 Other Issues for Future Regulation ..................................................................................... 286 Summary  287   •   Key Terms  288   •   Questions  288   •   Data Analysis 

Problems  289   •   Web Exercises  290   •   Web References  290

c h a P Te r 1 3 Nonbank Finance 291 Insurance ..................................................................................................................................................291

Life Insurance ..................................................................................................................... 291 Property and Casualty Insurance ........................................................................................ 292 The Competitive Threat from the Banking Industry............................................................ 294 Credit Insurance ................................................................................................................. 294

fyi The AIG Blowup 295

fyi The Global Financial Crisis and the Monoline Insurers 296

APPLICATION Insurance Management ...................................................................296 Screening ........................................................................................................................... 297 Risk-Based Premiums ......................................................................................................... 297 Restrictive Provisions .......................................................................................................... 297 Prevention of Fraud ............................................................................................................ 298 Cancellation of Insurance ................................................................................................... 298 Deductibles ........................................................................................................................ 298 Coinsurance ....................................................................................................................... 298 Limits on the Amount of Insurance .................................................................................... 298 Summary ............................................................................................................................ 299

Pension Funds .........................................................................................................................................299 Private Pension Plans .......................................................................................................... 300 Public Pension Plans .......................................................................................................... 301

fyi Should Social Security Be Privatized? 301 Finance Companies ...............................................................................................................................302

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Securities Market Operations ...........................................................................................................303 Investment Banking ............................................................................................................ 303 Securities Brokers and Dealers ............................................................................................ 304 Organized Exchanges ......................................................................................................... 304

Mutual Funds ..........................................................................................................................................305

fyi Sovereign Wealth Funds: Are They a Danger? 306

Money Market Mutual Funds ............................................................................................. 307

Hedge Funds ...........................................................................................................................................307 Private Equity and Venture Capital Funds .....................................................................................308 Government Financial Intermediation ............................................................................................309

Federal Credit Agencies ...................................................................................................... 309

fyi The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac 310

Summary  311   •   Key Terms  312   •   Questions  312   •   Applied Problems  313   •   Data Analysis Problems  313   •   Web Exercises  314   •   Web References  314

c h a P Te r 1 4 Financial Derivatives 315 Hedging ....................................................................................................................................................315 Interest-Rate Forward Contracts ......................................................................................................316

APPLICATION Hedging with Interest-Rate Forward Contracts ..............................316 Pros and Cons of Forward Contracts .................................................................................. 317

Financial Futures Contracts and Markets .......................................................................................318

APPLICATION Hedging with Financial Futures ......................................................319 Organization of Trading in Financial Futures Markets ........................................................ 321 The Globalization of Financial Futures Markets .................................................................. 322 Explaining the Success of Futures Markets ......................................................................... 322

APPLICATION Hedging Foreign Exchange Risk .....................................................324 Hedging Foreign Exchange Risk with Forward Contracts ................................................... 324 Hedging Foreign Exchange Risk with Futures Contracts .................................................... 324

Options ....................................................................................................................................................325 Option Contracts ................................................................................................................ 326 Profits and Losses on Option and Futures Contracts .......................................................... 326

APPLICATION Hedging with Future Options .........................................................329 Factors Affecting Option Premiums .................................................................................... 330 Summary ............................................................................................................................ 331

Swaps.........................................................................................................................................................332 Interest-Rate Swap Contracts .............................................................................................. 332

APPLICATION Hedging with Interest-Rate Swaps ..................................................333 Advantages of Interest-Rate Swaps ...................................................................................... 333 Disadvantages of Interest-Rate Swaps ................................................................................. 334 Financial Intermediaries in Interest-Rate Swaps .................................................................. 334

Credit Derivatives .................................................................................................................................334

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Credit Options ................................................................................................................... 335 Credit Swaps ...................................................................................................................... 335 Credit-Linked Notes ........................................................................................................... 336

APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Ticking Time Bomb? ............336

Summary  338   •   Key Terms  338   •   Questions  339   •   Applied Problems  339   •   Data Analysis Problems  340   •   Web Exercises  340   •   Web References  340

c h a P Te r 1 5 Conflicts of Interest in the Financial Industry 341 What Are Conflicts of Interest, and Why Are They Important? ...........................................342

Why Do We Care About Conflicts of Interest? .................................................................... 342

Ethics and Conflicts of Interest ..........................................................................................................342 Types of Conflicts of Interest ............................................................................................................343

Underwriting and Research in Investment Banking ............................................................ 343 Auditing and Consulting in Accounting Firms ................................................................... 344 Credit Assessment and Consulting in Credit-Rating Agencies ............................................. 344

fyi The Collapse of Arthur Andersen 345

Universal Banking .............................................................................................................. 345

fyi Why Do Issuers of Securities Pay to Have Their Securities Rated? 346

fyi Banksters 347

Can the Market Limit Exploitations of Conflicts of Interest? ...................................................347 What Has Been Done to Remedy Conflicts of Interest? ...........................................................349

Sarbanes-Oxley Act of 2002 ............................................................................................... 349 Legal Settlement of 2002 .................................................................................................... 350 Dodd-Frank Bill of 2010 .................................................................................................... 351

A Framework for Evaluating Policies to Remedy Conflicts of Interest ..................................351 Approaches to Remedying Conflicts of Interest ................................................................... 352

APPLICATION Evaluating Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill ...................................................................................354

Summary  356   •   Key Terms  357   •   Questions 357   •   Web Exercises  358   •   Web References 358

ParT 4 Central Banking and the Conduct of Monetary Policy 359

c h a P Te r 1 6 Central Banks and the Federal Reserve System 360 Origins of the Federal Reserve System ...........................................................................................360

inside the fed The Political Genius of the Founders of the Federal Reserve System 361

Structure of the Federal Reserve System .......................................................................................361 Federal Reserve Banks ........................................................................................................ 362

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inside the fed The Special Role of the Federal Reserve Bank of New York 364

Member Banks ................................................................................................................... 365 Board of Governors of the Federal Reserve System ............................................................. 366 Federal Open Market Committee (FOMC) ......................................................................... 366

inside the fed The Role of the Research Staff 367

inside the fed The FOMC Meeting 368

inside the fed Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? 369

Why the Chair of the Board of Governors Really Runs the Show ........................................ 369

inside the fed Styles of Federal Reserve Chairs: Bernanke and Yellen Versus Greenspan 370

How Independent Is the Fed? ..........................................................................................................371 Should the Fed Be Independent? ....................................................................................................373

The Case for Independence ................................................................................................ 373 The Case Against Independence ......................................................................................... 374 Central Bank Independence and Macroeconomic Performance Throughout the World....... 375

Explaining Central Bank Behavior .....................................................................................................375

inside the fed The Evolution of the Fed’s Communication Strategy 376

Structure and Independence of the European Central Bank ..................................................377 Differences Between the European System of Central Banks

and the Federal Reserve System ..................................................................................... 377 Governing Council ............................................................................................................. 378 How Independent Is the ECB? ............................................................................................ 379

Structure and Independence of Other Foreign Central Banks ...............................................379 Bank of Canada .................................................................................................................. 379 Bank of England ................................................................................................................. 379 Bank of Japan ..................................................................................................................... 380 The Trend Toward Greater Independence ........................................................................... 381 Summary  381   •   Key Terms  382   •   Questions  382   •   Data Analysis 

Problems  383   •   Web Exercises  383   •   Web References  383

c h a P Te r 1 7 The Money Supply Process 384 Three Players in the Money Supply Process .................................................................................384 The Fed’s Balance Sheet ......................................................................................................................384

Liabilities ............................................................................................................................ 385 Assets ................................................................................................................................. 386

Control of the Monetary Base ...........................................................................................................386 Federal Reserve Open Market Operations........................................................................... 387 Shifts from Deposits into Currency ..................................................................................... 388 Loans to Financial Institutions............................................................................................ 389 Other Factors That Affect the Monetary Base ...................................................................... 389 Overview of the Fed’s Ability to Control the Monetary Base ................................................ 390

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Multiple Deposit Creation: A Simple Model ................................................................................391 Deposit Creation: The Single Bank ..................................................................................... 391 Deposit Creation: The Banking System ............................................................................... 392 Deriving the Formula for Multiple Deposit Creation ........................................................... 395 Critique of the Simple Model ............................................................................................. 396

Factors That Determine the Money Supply .................................................................................397 Changes in the Nonborrowed Monetary Base, MBn ............................................................. 397 Changes in Borrowed Reserves, BR, from the Fed ............................................................... 397 Changes in the Required Reserve Ratio, rr .......................................................................... 398 Changes in Excess Reserves ................................................................................................ 398 Changes in Currency Holdings ........................................................................................... 398

Overview of the Money Supply Process .......................................................................................398 The Money Multiplier..........................................................................................................................399

Deriving the Money Multiplier ........................................................................................... 399 Intuition Behind the Money Multiplier ............................................................................... 401 Money Supply Response to Changes in the Factors ............................................................ 402

APPLICATION Quantitative Easing and the Money Supply, 2007–2014. ................403 Summary  405   •   Key Terms  405   •   Questions  405   •   Applied Problems  406   •  

Data Analysis Problems  407   •   Web Exercises  407   •   Web References  408

c h a P Te r 1 7 W e B a P P e n d i X 1 The Fed’s Balance Sheet and the Monetary Base Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 7 W e B a P P e n d i X 2 The M2 Money Multiplier Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 7 W e B a P P e n d i X 3 Explaining the Behavior of the Currency Ratio Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 7 W e B a P P e n d i X 4 The Great Depression Bank Panics, 1930–1933, and the Money Supply Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 8 Tools of Monetary Policy 409 The Market for Reserves and the Federal Funds Rate...............................................................409

Demand and Supply in the Market for Reserves ................................................................. 410 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate ..................... 411

APPLICATION How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate ...........................................................415

Conventional Monetary Policy Tools ..............................................................................................416 Open Market Operations .................................................................................................... 416

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Discount Policy and the Lender of Last Resort .................................................................... 417

inside the fed A Day at the Trading Desk 418

Reserve Requirements ........................................................................................................ 420

inside the fed Using Discount Policy to Prevent a Financial Panic 421

Interest on Reserves ............................................................................................................ 422 Relative Advantages of the Different Tools .......................................................................... 422

Nonconventional Monetary Policy Tools and Quantitative Easing .......................................423 Liquidity Provision ............................................................................................................. 423 Large-Scale Asset Purchases ................................................................................................ 424

inside the fed Fed Lending Facilities During the Global Financial Crisis 425

Quantitative Easing Versus Credit Easing............................................................................ 426 Forward Guidance and the Commitment to Future Policy Actions ..................................... 428

Monetary Policy Tools of the European Central Bank ...............................................................429 Open Market Operations .................................................................................................... 429 Lending to Banks................................................................................................................ 430 Reserve Requirements ........................................................................................................ 430 Summary  430   •   Key Terms  431   •   Questions  431   •   Applied Problems  432   •  

Data Analysis Problems  433   •   Web Exercises  433   •   Web References  433

c h a P Te r 1 9 The Conduct of Monetary Policy: Strategy and Tactics 434 The Price Stability Goal and the Nominal Anchor ......................................................................434

The Role of a Nominal Anchor ........................................................................................... 435 The Time-Inconsistency Problem ....................................................................................... 435

Other Goals of Monetary Policy .......................................................................................................436 High Employment and Output Stability ............................................................................. 436 Economic Growth .............................................................................................................. 437 Stability of Financial Markets ............................................................................................. 437 Interest-Rate Stability ......................................................................................................... 437 Stability in Foreign Exchange Markets ................................................................................ 438

Should Price Stability Be the Primary Goal of Monetary Policy? ...........................................438 Hierarchical Versus Dual Mandates ..................................................................................... 438 Price Stability as the Primary, Long-Run Goal of Monetary Policy ....................................... 439

Inflation Targeting .................................................................................................................................439 Inflation Targeting in New Zealand, Canada, and the United Kingdom .............................. 440 Advantages of Inflation Targeting ....................................................................................... 442 Disadvantages of Inflation Targeting ................................................................................... 444

The Evolution of the Federal Reserve’s Monetary Policy Strategy ........................................445 The Fed’s “Just Do It” Monetary Policy Strategy .................................................................. 445 The Long Road to Inflation Targeting ................................................................................. 447

inside the fed Ben Bernanke’s Advocacy of Inflation Targeting 447

global The European Central Bank’s Monetary Policy Strategy 448

Lessons for Monetary Policy Strategy from the Global Financial Crisis ...............................449

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Implications for Inflation Targeting .................................................................................... 450

Should Central Banks Try to Stop Asset-Price Bubbles? ..........................................................451 Two Types of Asset-Price Bubbles ....................................................................................... 451 The Debate Over Whether Central Banks Should Try to Pop Bubbles ................................. 452

Tactics: Choosing the Policy Instrument .........................................................................................455 Criteria for Choosing the Policy Instrument ....................................................................... 457

Tactics: The Taylor Rule .......................................................................................................................458

inside the fed The Fed’s Use of the Taylor Rule 461

inside the fed Fed Watchers 461

Summary  462   •   Key Terms  462   •   Questions  463   •   Applied Problems  464   •   Data Analysis Problems  464   •   Web Exercises  465   •   Web References  466

c h a P Te r 1 9 W e B a P P e n d i X 1 Monetary Targeting Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 1 9 W e B a P P e n d i X 2 A Brief History of Federal Reserve Policymaking Go to the Companion Website, http://www.pearsonhighered.com/mishkin

ParT 5 International Finance and Monetary Policy 467

c h a P Te r 2 0 The Foreign Exchange Market 468 Foreign Exchange Market ....................................................................................................................468

What Are Foreign Exchange Rates? .................................................................................... 469

following the financial news Foreign Exchange Rates 470

Why Are Exchange Rates Important? .................................................................................. 470 How Is Foreign Exchange Traded? ...................................................................................... 471

Exchange Rates in the Long Run .......................................................................................................471 Law of One Price ................................................................................................................ 471 Theory of Purchasing Power Parity ..................................................................................... 472 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates ........... 473 Factors That Affect Exchange Rates in the Long Run .......................................................... 474

Exchange Rates in the Short Run: A Supply and Demand Analysis .......................................476 Supply Curve for Domestic Assets ...................................................................................... 476 Demand Curve for Domestic Assets .................................................................................... 476 Equilibrium in the Foreign Exchange Market ..................................................................... 477

Explaining Changes in Exchange Rates ...........................................................................................478 Shifts in the Demand for Domestic Assets........................................................................... 478 Recap: Factors That Change the Exchange Rate .................................................................. 481

APPLICATION Effects of Changes in Interest Rates on the Equilibrium Exchange Rate ..............................................................................483

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APPLICATION Why Are Exchange Rates So Volatile?.............................................484

APPLICATION The Dollar and Interest Rates ..........................................................485

APPLICATION The Global Financial Crisis and the Dollar ....................................486 Summary  487   •   Key Terms  487   •   Questions  487   •   Applied Problems  488   •  

Data Analysis Problems  489   •   Web Exercises  489   •   Web References  490

a P P e n d i X To c h a P Te r 2 0 The Interest Parity Condition 491 Comparing Expected Returns on Domestic and Foreign Assets ............................................491 Interest Parity Condition .....................................................................................................................493

c h a P Te r 2 1 The International Financial System 495 Intervention in the Foreign Exchange Market ..............................................................................495

Foreign Exchange Intervention and the Money Supply ....................................................... 495

inside the fed A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk 496

Unsterilized Intervention .................................................................................................... 498 Sterilized Intervention ........................................................................................................ 499

Balance of Payments .............................................................................................................................499

global Why the Large U.S. Current Account Deficit Worries Economists 501

Exchange Rate Regimes in the International Financial System.................................................501 Gold Standard .................................................................................................................... 501 The Bretton Woods System ................................................................................................. 502 How a Fixed Exchange Rate Regime Works ........................................................................ 503 Speculative Attacks ............................................................................................................. 504

APPLICATION The Foreign Exchange Crisis of September 1992 ...........................505 The Policy Trilemma ........................................................................................................... 506

APPLICATION How Did China Accumulate $4 Trillion of International Reserves? ................................................................................507

Monetary Unions ................................................................................................................ 508

global Will the Euro Survive? 509

Managed Float .................................................................................................................... 509

Capital Controls .....................................................................................................................................510 Controls on Capital Outflows ............................................................................................. 510 Controls on Capital Inflows ................................................................................................ 510

The Role of the IMF ..............................................................................................................................511 Should the IMF Act as an International Lender of Last Resort? ........................................... 511

International Considerations and Monetary Policy ....................................................................512 Direct Effects of the Foreign Exchange Market on Monetary Policy .................................... 512 Balance-of-Payments Considerations .................................................................................. 512 Exchange Rate Considerations ............................................................................................ 513

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To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative Monetary Policy Strategy .............................................................................................513

Advantages of Exchange-Rate Targeting .............................................................................. 513 Disadvantages of Exchange-Rate Targeting ......................................................................... 514 When Is Exchange-Rate Targeting Desirable for Industrialized Countries? .......................... 516 When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? .................... 517 Currency Boards ................................................................................................................. 517

global Argentina’s Currency Board 518

Dollarization ...................................................................................................................... 519 Summary  519   •   Key Terms  520   •   Questions  520   •   Applied Problems  521   •  

Data Analysis Problems  522   •   Web Exercises  522   •   Web References  522

ParT 6 Monetary Theory 523

c h a P Te r 2 2 Quantity Theory, Inflation, and the Demand for Money 524 Quantity Theory of Money ...............................................................................................................524

Velocity of Money and Equation of Exchange ..................................................................... 524 From the Equation of Exchange to the Quantity Theory of Money ..................................... 526 Quantity Theory and the Price Level .................................................................................. 527 Quantity Theory and Inflation ............................................................................................ 527

APPLICATION Testing the Quantity Theory of Money ...........................................528

Budget Deficits and Inflation .............................................................................................................530 Government Budget Constraint .......................................................................................... 530 Hyperinflation .................................................................................................................... 532

APPLICATION The Zimbabwean Hyperinflation ....................................................532

Keynesian Theories of Money Demand ........................................................................................533 Transactions Motive ............................................................................................................ 533 Precautionary Motive.......................................................................................................... 533 Speculative Motive ............................................................................................................. 533 Putting the Three Motives Together .................................................................................... 533

Portfolio Theories of Money Demand ...........................................................................................534 Theory of Portfolio Choice and Keynesian Liquidity Preference .......................................... 535 Other Factors That Affect the Demand for Money .............................................................. 535 Summary ............................................................................................................................ 536

Empirical Evidence for the Demand for Money ..........................................................................536 Interest Rates and Money Demand ..................................................................................... 536 Stability of Money Demand ................................................................................................ 537 Summary  538   •   Key Terms  538   •   Questions  538   •   Applied Problems  540   •  

Data Analysis Problems  540   •   Web Exercises  541   •   Web References  541

c h a P Te r 2 2 W e B a P P e n d i X 1 The Baumol-Tobin and Tobin Mean-Variance Model Go to the Companion Website, http://www.pearsonhighered.com/mishkin

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c h a P Te r 2 2 W e B a P P e n d i X 2 Empirical Evidence for the Demand for Money Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 2 3 Aggregate Demand and Supply Analysis 543 Aggregate Demand ..............................................................................................................................543

following the financial news Aggregate Output, Unemployment, and Inflation 544

Deriving the Aggregate Demand Curve ............................................................................... 544 Factors That Shift the Aggregate Demand Curve................................................................. 545

fyi What Does Autonomous Mean? 546

Aggregate Supply .................................................................................................................................549 Long-Run Aggregate Supply Curve ..................................................................................... 549 Short-Run Aggregate Supply Curve .................................................................................... 549 Price Stickiness and the Short-Run Aggregate Supply Curve ............................................... 551

Shifts in the Aggregate Supply Curves ...........................................................................................551 Shifts in the Long-Run Aggregate Supply Curve ................................................................. 551 Shifts in the Short-Run Aggregate Supply Curve ................................................................. 552

Equilibrium in Aggregate Demand and Supply Analysis ..........................................................555 Short-Run Equilibrium ....................................................................................................... 556 How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time ............... 556 Self-Correcting Mechanism ................................................................................................ 559

Changes in Equilibrium: Aggregate Demand Shocks .................................................................559

APPLICATION The Volcker Disinflation, 1980–1986 .............................................560

APPLICATION Negative Demand Shocks, 2001–2004 ............................................562

Changes in Equilibrium: Aggregate Supply (Inflation) Shocks ................................................562 Temporary Supply Shocks .................................................................................................. 562

APPLICATION Negative Supply Shocks, 1973–1975 and 1978–1980 ....................565 Permanent Supply Shocks and Real Business Cycle Theory ................................................ 565

APPLICATION Positive Supply Shocks, 1995–1999 ................................................568 Conclusions ....................................................................................................................... 569

APPLICATION Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis ..............................................................................570

AD/AS Analysis of Foreign Business Cycle Episodes ...................................................................570

APPLICATION The United Kingdom and the 2007–2009 Financial Crisis ............572

APPLICATION China and the 2007–2009 Financial Crisis .....................................573 Summary  574   •   Key Terms  575   •   Questions  575   •   Applied Problems  576   •  

Data Analysis Problems  576   •   Web Exercises  577   •   Web References  577

a P P e n d i X To c h a P Te r 2 3 The Phillips Curve and the Short-Run Aggregate Supply Curve 578 The Phillips Curve .................................................................................................................................578

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Phillips Curve Analysis in the 1960s .................................................................................. 578

fyi The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s 580

The Friedman-Phelps Phillips Curve Analysis .................................................................... 580 The Phillips Curve After the 1960s ..................................................................................... 582 The Modern Phillips Curve ................................................................................................ 582 The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations .................... 583

The Short-Run Aggregate Supply Curve ......................................................................................584

c h a P Te r 2 3 W e B a P P e n d i X 1 The Effects of Macroeconomic Shocks on Asset Prices Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 2 3 W e B a P P e n d i X 2 Aggregate Demand and Supply: A Numerical Example Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 2 3 W e B a P P e n d i X 3 The Algebra of the Aggregate Demand and Supply Model Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 2 3 W e B a P P e n d i X 4 The Taylor Principle and Inflation Stability Go to the Companion Website, http://www.pearsonhighered.com/mishkin

c h a P Te r 2 4 Monetary Policy Theory 587 Response of Monetary Policy to Shocks ........................................................................................587

Response to an Aggregate Demand Shock .......................................................................... 588 Response to a Permanent Supply Shock ............................................................................. 590 Response to a Temporary Supply Shock ............................................................................. 592 The Bottom Line: The Relationship Between Stabilizing Inflation and

Stabilizing Economic Activity ........................................................................................ 595

How Actively Should Policymakers Try to Stabilize Economic Activity? .............................595 Lags and Policy Implementation ......................................................................................... 595

Inflation: Always and Everywhere a Monetary Phenomenon .................................................596

fyi The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package 597

Causes of Inflationary Monetary Policy ..........................................................................................597 High Employment Targets and Inflation ............................................................................. 597

APPLICATION The Great Inflation ..........................................................................601

Monetary Policy at the Zero Lower Bound ...................................................................................603 Deriving the Aggregate Demand Curve with the Zero Lower Bound ................................... 603 The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound ................. 605

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APPLICATION Nonconventional Monetary Policy and Quantitative Easing ..........606 Liquidity Provision ............................................................................................................. 607 Asset Purchases and Quantitative Easing ............................................................................ 608 Management of Expectations .............................................................................................. 609

APPLICATION Abenomics and the Shift in Japanese Monetary Policy in 2013 .........610 Summary  612   •   Key Terms  612   •   Questions  613   •   Applied Problems  614   •  

Data Analysis Problems  614   •   Web Exercises  615   •   Web References  615

c h a P Te r 2 5 Transmission Mechanisms of Monetary Policy 616 Transmission Mechanisms of Monetary Policy .............................................................................616

Traditional Interest-Rate Channels ...................................................................................... 617 Other Asset Price Channels ................................................................................................ 618 Credit View ........................................................................................................................ 621

fyi Consumers’ Balance Sheets and the Great Depression 623

Why Are Credit Channels Likely to Be Important? ............................................................. 624

APPLICATION The Great Recession ........................................................................625

Lessons for Monetary Policy ..............................................................................................................625

APPLICATION Applying the Monetary Policy Lessons to Japan’s Two Lost Decades .............................................................................627

Summary  628   •   Key Terms  628   •   Questions  628   •   Applied Problems  629 Data Analysis Problems  630   •   Web Exercises  630   •   Web References  631

c h a P Te r 2 5 W e B a P P e n d i X Evaluating Empirical Evidence: The Debate Over the Importance of Money in Economic Fluctuations Go to the Companion Website, http://www.pearsonhighered.com/mishkin

Glossary ..........................................................................................................................G-1

Index ..................................................................................................................................I-1

Contents on the Web The following chapters are available on our Companion Website at http://www.pearsonhighered.com/mishkin.

W e B c h a P Te r 1 Financial Crises in Emerging Market Economies W-1 Dynamics of Financial Crises in Emerging Market Economies ................................................W-1

Stage One: Initial Phase ..................................................................................................... W-1 Stage Two: Currency Crisis ................................................................................................ W-5 Stage Three: Full-Fledged Financial Crisis ......................................................................... W-6

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xxx Contents in Detail

APPLICATION Crisis in South Korea, 1997–1998.................................................. W-7 Financial Liberalization and Globalization Mismanaged .................................................... W-8 Perversion of the Financial Liberalization and Globalization Process: Chaebols

and the South Korean Crisis ......................................................................................... W-9 Stock Market Decline and Failure of Firms Increase Uncertainty ..................................... W-10 Adverse Selection and Moral Hazard Problems Worsen, and the Economy Contracts ...... W-11 Currency Crisis Ensues .................................................................................................... W-11 Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis .................................. W-11 Recovery Commences ..................................................................................................... W-13

APPLICATION The Argentine Financial Crisis, 2001–2002................................. W-13 Severe Fiscal Imbalances ................................................................................................. W-13 Adverse Selection and Moral Hazard Problems Worsen ................................................... W-13 Bank Panic Begins ........................................................................................................... W-14 Currency Crisis Ensues .................................................................................................... W-14 Currency Crisis Triggers Full-Fledged Financial Crisis ..................................................... W-15 Recovery Begins .............................................................................................................. W-17

global When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 W-18

Preventing Emerging Market Financial Crises ........................................................................... W-18 Beef Up Prudential Regulation and Supervision of Banks................................................. W-18 Encourage Disclosure and Market-Based Discipline ......................................................... W-19 Limit Currency Mismatch ................................................................................................ W-19 Sequence Financial Liberalization .................................................................................... W-20 Summary  W-20   •   Key Terms  W-20   •   Questions  W-21

W e B c h a P Te r 2 The IS Curve W-1 Planned Expenditure and Aggregate Demand ...........................................................................W-1 The Components of Aggregate Demand.....................................................................................W-2

Consumption Expenditure ................................................................................................ W-2

fyi Meaning of the Word Investment W-3

Planned Investment Spending ........................................................................................... W-3 Net Exports ....................................................................................................................... W-5 Government Purchases and Taxes ...................................................................................... W-6

Goods Market Equilibrium ................................................................................................................W-7 Solving for Goods Market Equilibrium .............................................................................. W-7 Deriving the IS Curve ........................................................................................................ W-8

Understanding the IS Curve .............................................................................................................W-8 What the IS Curve Tells Us: Intuition ................................................................................ W-8 What the IS Curve Tells Us: Numerical Example ............................................................... W-8 Why the Economy Heads Toward Equilibrium ................................................................ W-10

Factors That Shift the IS Curve ...................................................................................................... W-10 Changes in Government Purchases .................................................................................. W-10

APPLICATION The Vietnam War Buildup, 1964–1969 ........................................ W-11 Changes in Taxes ............................................................................................................. W-12

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APPLICATION The Fiscal Stimulus Package of 2009 ........................................... W-13 Changes in Autonomous Spending .................................................................................. W-14 Changes in Financial Frictions ........................................................................................ W-16 Summary of Factors That Shift the IS Curve .................................................................... W-16 Summary  W-16   •   Key Terms  W-16   •   Questions  W-17   •   Applied Problems  W-18   •  

Data Analysis Problems W-19   •   Web Exercises  W-20   •   Web References  W-20

W e B c h a P Te r 3 The Monetary Policy and Aggregate Demand Curves W-1 The Federal Reserve and Monetary Policy ..................................................................................W-1 The Monetary Policy Curve ..............................................................................................................W-2

The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope .......................................................................................................... W-2

Shifts in the MP Curve....................................................................................................... W-4 Movements Along Versus Shifts In the MP Curve .............................................................. W-5

APPLICATION Movement Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 ................................................................................... W-5

APPLICATION Shift in the MP Curve: Autonomous Monetary Easing at the Onset of the Global Financial Crisis ..................................................... W-5

The Aggregate Demand Curve .......................................................................................................W-6 Deriving the Aggregate Demand Curve Graphically ........................................................... W-6 Factors That Shift the Aggregate Demand Curve................................................................ W-8

fyi Deriving the Aggregate Demand Curve Algebraically W-8

Summary  W-12   •   Key Terms  W-12   •   Questions  W-12   •   Applied Problems  W-13   •   Data Analysis Problems  W-14   •   Web Exercises  W-15   •   Web References  W-15

W e B c h a P Te r 4 The Role of Expectations in Monetary Policy W-1 Lucas Critique of Policy Evaluation .................................................................................................W-1

Econometric Policy Evaluation .......................................................................................... W-2

APPLICATION The Term Structure of Interest Rates .............................................. W-2

Policy Conduct: Rules or Discretion? .............................................................................................W-3 Discretion and the Time-Inconsistency Problem ................................................................ W-3 Types of Rules .................................................................................................................... W-4 The Case for Rules ............................................................................................................. W-4

fyi The Political Business Cycle and Richard Nixon W-5

The Case for Discretion ..................................................................................................... W-5 Constrained Discretion ...................................................................................................... W-6

global The Demise of Monetary Targeting in Switzerland W-6

The Role of Credibility and a Nominal Anchor ..........................................................................W-7 Benefits of a Credible Nominal Anchor .............................................................................. W-7 Credibility and Aggregate Demand Shocks ........................................................................ W-8 Credibility and Aggregate Supply Shocks ........................................................................ W-10

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APPLICATION A Tale of Three Oil Price Shocks .................................................. W-11 Credibility and Anti-Inflation Policy ................................................................................ W-13

global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program W-14

APPLICATION Credibility and the Reagan Budget Deficits .................................. W-15

Approaches to Establishing Central Bank Credibility ............................................................ W-16 Nominal GDP Targeting .................................................................................................. W-16

inside the fed The Appointment of Paul Volcker, Anti-Inflation Hawk W-17

Appoint “Conservative” Central Bankers .......................................................................... W-17 Summary  W-18   •   Key Terms  W-18   •   Questions  W-18   •   Applied 

Problems  W-19   •   Data Analysis Problems  W-20   •   Web Exercises  W-20

W e B c h a P Te r 5 The ISLM Model W-1 Keynes’s Fixed Price Level Assumption and the IS Curve ........................................................W-1

The LM Curve ................................................................................................................... W-1 Equilibrium in the Market for Money: The LM Curve ........................................................ W-2

ISLM Approach to Aggregate Output and Interest Rates .......................................................W-4 Factors That Cause the LM Curve to Shift ....................................................................................W-5 Changes in Equilibrium Level of the Interest Rate and Aggregate Output .......................W-7

Response to a Change in Monetary Policy ......................................................................... W-7 Response to a Change in Fiscal Policy ............................................................................... W-8

APPLICATION The Economic Stimulus Act of 2008 .............................................. W-9

Effectiveness of Monetary Versus Fiscal Policy ......................................................................... W-11 Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out .................... W-11

APPLICATION Targeting Money Supply Versus Interest Rates ............................ W-13

ISLM Model in the Long Run.......................................................................................................... W-16 Summary W-18   •   Key Terms  W-19   •   Questions and Applied Problems  W-19   •  

Web Exercises  W-19   •   Web References  W-20

a P P e n d i X To W e B c h a P Te r 5 Algebra of the ISLM Model W-24 Basic Closed-Economy ISLM Model ............................................................................................ W-21

IS and LM Curves ............................................................................................................ W-22 Solution of the Model ...................................................................................................... W-22 Implications .................................................................................................................... W-22

Open-Economy ISLM Model ......................................................................................................... W-23 Implications ......................................................................................................................................... W-24

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HALLMARkS Although this text has undergone a major revision, it retains the basic hallmarks that have made it the best-selling textbook on money and banking since its inception over thirty-years ago:

•  A unifying,  analytic  framework  that  uses  a  few basic  economic principles  to  or- ganize students’ thinking about the structure of financial markets, the foreign ex- change markets, financial institution management, and the role of monetary policy in the economy

• A careful, step-by-step development of economic models (the approach used in the best principles of economics textbooks), which makes it easier for students to learn

• The complete integration of an international perspective throughout the text • A thoroughly up-to-date treatment of the latest developments in monetary theory • A special feature called “Following the Financial News,” included to encourage

reading of a financial newspaper • An applications-oriented perspective with numerous applications and special-topic

boxes that increase students’ interest by showing them how to apply theory to real- world examples

WHAT’S NEW IN THE FOuRTH EDITION In addition to the expected updating of all data through 2014 whenever possible, there is major new material in every part of the text.

Enhanced Pearson e-text with Mini-Lecture Videos: A New Way of Learning

Preface

xxxiii

MyEconLab

The Enhanced Pearson e-text in MyEconLab for the fourth edition is available online from MyEconLab textbook resources. Instructors and students can highlight the text, bookmark, search the glossary, and take notes. More importantly, the enhanced Pearson e-text provides a new way of learning that is particularly geared to today’s students. Not only will students be able to read the material in the textbook, but by a simple click on an icon they will be able to watch over 120 mini-lecture videos presented by the author, one for every figure in the text. For analytic figures, these mini-lectures build each graph step-by-step and explain the intuition necessary to fully understand the theory behind the graph. For data figures, the mini-lectures highlight the key data points that are of greatest interest. The mini-lectures are an invaluable study tool for students who typically learn better when they see and hear economic analysis rather than read it.

Real-Time Data A high percentage of the in-text data figures are labeled MyEconLab Real-Time Data. For these figures, students can see the latest data in the enhanced Pearson e-text, using the Federal Reserve Bank of St. Louis’s FRED database. In addition, the new edition of

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xxxiv Preface

the text has a whole new class of problems that involve real-time data analysis. These problems, marked with , ask the students to download data from the Federal Reserve Bank of St. Louis FRED website and then use the data to answer questions about current issues in macroeconomics.

In MyEconLab, these easy-to-assign and automatically-graded Real-Time Data Analysis Problems communicate directly with the FRED site, so that students see updated data every time new data is posted by FRED. Thus the Real-Time Data Analysis Problems offer a no-fuss solution for instructors who wish to make the most current data a central part of their macroeconomics course. These exercises will not only help students understand mac- roeconomics better, but will also enable them to see the real-world relevance of their studies.

The Business School Edition: A More Finance-Oriented Approach I am pleased to continue providing two versions of The Economics of Money, Banking, and Financial Markets. While both versions contain the core chapters that all professors want to cover, The Economics of Money, Banking, and Financial Markets, Business School Edition, presents a more finance-oriented approach—an approach more commonly taught in business schools, but also one that some professors in economics departments prefer when teaching their money and banking courses. The Business School Edition includes chapters on nonbank finance, financial derivatives, and conflicts of interest in the financial industry. The Business School Edition omits the chapters on the IS curve and the monetary policy and aggregate demand curves, as well as the chapter on the role of expectations in monetary policy. The Economics of Money, Banking, and Financial Markets, Business School Edition, more closely fits the needs of those professors whose courses have less of an emphasis on monetary theory.

For professors who desire a comprehensive discussion of monetary theory and monetary policy, The Economics of Money, Banking, and Financial Markets, Eleventh Edition, contains all of the chapters on monetary theory. Professors who do want this coverage are often hard-pressed to cover all of the finance and institutions chapters. To that end, the Eleventh Edition omits the chapters on nonbank finance, financial derivatives, and conflicts of interest. The Companion Website at http://www.pearsonhighered .com/mishkin provides the omitted chapters, making them readily available for those who wish to utilize them in their courses.

Reorganization of Part 3, Financial Institutions The global financial crisis of 2007–2009 has become a central topic in the teaching of money and banking. When I teach this material, I find that students understand the dynamics of the crisis more deeply if they are taught about bank management, financial regulation, and the shadow banking system before they delve into the details of the global financial crisis. For this reason, I have moved the chapter titled “Financial Crises” so that it follows the three chapters titled “Banking and the Management of Financial Institutions,” “Economic Analysis of Financial Regulation,” and “Banking Industry: Structure and Competition.”

In addition, I have added the following new material to Part 3 of the text:

• A new FYI box on the tyranny of collateral (Chapter 8) • A new section that provides more detail on securitization and the shadow banking

system (Chapter 11)

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Preface xxxv

• A new section on the response of financial regulation to the global financial crisis (Chapter 12)

• A new section exploring what can be done about the too-big-to-fail problem (Chapter 12)

Nonconventional Monetary Policy and the Zero Lower Bound Monetary policy entered a brave new world when policymakers were forced to resort to nonconventional measures when the policy interest rate—the federal funds rate in the United States—hit a floor of zero, the so-called “zero lower bound.” Because the policy rate cannot be driven lower than zero, under this condition conventional monetary policy becomes infeasible. Nonconventional monetary policy at the zero lower bound, such as quantitative easing, has become a very controversial topic that stimulates a lot of student interest. The Fourth Edition contains extensive discussion of this topic, includ- ing the following new material:

• A new application on quantitative easing and the money supply from 2007 to 2014 (Chapter 17)

• An updated section on forward guidance and the commitment to future policy actions (Chapter 18)

• A new section on monetary policy at the zero lower bound that uses the aggregate demand and aggregate supply models to explain how the zero lower bound affects the conduct of monetary policy (Chapter 24)

• A new application on nonconventional monetary policy and quantitative easing (Chapter 24)

• A new application on Abenomics and the shift in Japanese monetary policy in 2013 (Chapter 24)

The Euro Crisis The Euro crisis has been a continuing drama since 2010, and so this edition includes the following new material:

• A new global box on the European sovereign debt crisis (Chapter 12) • A new section on monetary unions (Chapter 21) • A new global box on whether the Euro will survive (Chapter 21)

Additional New Material New developments in the money and banking field have prompted me to add the fol- lowing new material to keep the text current:

• A new application on whether Bitcoin will become the money of the future (Chapter 3)

• A new application on the effects of the Obama tax increase on bond interest rates (Chapter 6)

• An updated section on the evolution of the Fed’s communication strategy (Chapter 16)

• A new FYI box that describes the meaning of the word autonomous (Chapter 23) • A new section on nominal GDP targeting (Chapter 24)

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Chapters and Appendices on the Web The Companion Website for the book, http://www.pearsonhighered.com/mishkin, is an essential resource for additional content.

The web chapters for the Fourth Edition of The Economics of Money, Banking, and Financial Markets include the chapters that are unique to the Eleventh Edition, along with web chapters on financial crises in emerging market economies and the ISLM model. These chapters are numbered as follows:

Web Chapter 1: Financial Crises in Emerging Market Economies Web Chapter 2: The IS Curve Web Chapter 3: The Monetary Policy and Aggregate Demand Curves Web Chapter 4: The Role of Expectations in Monetary Policy Web Chapter 5: The ISLM Model

The web appendices include:

Appendix to Chapter 4: Measuring Interest-Rate Risk: Duration Appendix 1 to Chapter 5: Models of Asset Pricing Appendix 2 to Chapter 5: Applying the Asset Market Approach to a

Commodity Market: The Case of Gold Appendix 3 to Chapter 5: Loanable Funds Framework Appendix to Chapter 7: Evidence on the Efficient Market Hypothesis Appendix 1 to Chapter 9: Duration Gap Analysis Appendix 2 to Chapter 9: Measuring Bank Performance Appendix 1 to Chapter 10: The 1980s Banking and Savings and Loan Crisis Appendix 2 to Chapter 10: Banking Crises Throughout the World Appendix 1 to Chapter 17: The Fed’s Balance Sheet and the Monetary Base Appendix 2 to Chapter 17: The M2 Money Multiplier Appendix 3 to Chapter 17: Explaining the Behavior of the Currency Ratio Appendix 4 to Chapter 17: The Great Depression Bank Panics, 1930–1933,

and the Money Supply Appendix 1 to Chapter 19: Monetary Targeting Appendix 2 to Chapter 19: A Brief History of Federal Reserve Policymaking Appendix 1 to Chapter 22: The Baumol-Tobin and Tobin Mean-Variance Models

of the Demand for Money Appendix 2 to Chapter 22: Empirical Evidence on the Demand for Money Appendix 1 to Chapter 23: The Effects of Macroeconomic Shocks on Asset

Prices Appendix 2 to Chapter 23: Aggregate Demand and Supply: A Numerical

Example Appendix 3 to Chapter 23: The Algebra of the Aggregate Demand and Supply

Model Appendix 4 to Chapter 23: The Taylor Principle and Inflation Stability Appendix to Chapter 25: Evaluating Empirical Evidence: The Debate Over

the Importance of Money in Economic Fluctuations

Instructors can either use these web chapters and appendices in class to supplement the material in the textbook or recommend them to students who want to expand their knowledge of the money and banking field.

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Preface xxxvii

FLExIBILITy AND MODuLARITy In using previous editions, adopters, reviewers, and survey respondents have continu- ally praised this text’s flexibility and modularity—that is, the option to pick and choose which chapters to cover and in what order to cover them. Flexibility and modularity are especially important in the money and banking course because there are as many ways to teach this course as there are instructors. To satisfy the diverse needs of instructors, the text achieves flexibility as follows:

• Core chapters provide the basic analysis used throughout the book, and other chap- ters or sections of chapters can be used or omitted according to instructor prefer- ences. For example, Chapter 2 introduces the financial system and basic concepts such as transaction costs, adverse selection, and moral hazard. After covering Chap- ter 2, the instructor may decide to give more detailed coverage of financial structure by assigning Chapter 8, or may choose to skip Chapter 8 and take any of a number of different paths through the book.

• Part 6 on monetary theory can easily be taught before Part 4 of the text if the in- structor wishes to give students a deeper understanding of the rationale behind monetary policy.

• Chapter 25 on the transmission mechanisms of monetary policy can be taught at many different points in the course—either with Part 4, when monetary policy is discussed, or with Chapter 23, when the concept of aggregate demand is developed. Transmission mechanisms of monetary policy can also be taught as a special topic at the end of the course.

• The international approach of the text, accomplished through marked international sections within chapters as well as separate chapters on the foreign exchange market and the international monetary system, is comprehensive yet flexible. Although many instructors will teach all of the international material, others will not. Instructors who wish to put less emphasis on international topics can easily skip Chapter 20 on the foreign exchange market and Chapter 21 on the international financial system and monetary policy. The international sections within chapters are self-contained and can be omitted with little loss of continuity.

To illustrate how this book can be used for courses with varying emphases, several course outlines are suggested for a one-semester teaching schedule. More detailed information about how the text can be used flexibly in your course is available in the Instructor’s Manual.

• General Money and Banking Course: Chapters 1–5, 9-11, 16, 18, 23–24, with a choice of 7 of the remaining 13 chapters

• General Money and Banking Course with an International Emphasis: Chapters 1–5, 9-11, 16, 18–21, 23–24, with a choice of 4 of the remaining 10 chapters

• Financial Markets and Institutions Course: Chapters 1–12, with a choice of 7 of the remaining 13 chapters

PEDAGOGICAL AIDS Whether teaching theory or its applications, a textbook must be a solid motivational tool. To this end, I have incorporated a wide variety of pedagogical features that will make the material easy to learn:

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xxxviii Preface

1. Previews at the beginning of each chapter tell students where the chapter is head- ing, why specific topics are important, and how these topics relate to other topics discussed in the book.

2. Applications, numbering over 50, demonstrate how the analysis presented in the book can be used to explain many important real-world situations.

3. Following the Financial News boxes introduce students to relevant news articles and data that are reported daily in the press, and teach students how to interpret these data.

4. Inside the Fed boxes give students a feel for the operation and structure of the Federal Reserve System.

5. Global boxes present interesting material with an international focus. 6. FYI boxes highlight dramatic historical episodes, interesting ideas, and intriguing

facts related to the subject matter. 7. Summary tables provide a useful study aid for reviewing material. 8. Key statements are important points set in boldface italic type so that students can

easily find them for later reference. 9. Graphs with captions, numbering more than 120, help students clearly understand

the interrelationships among the plotted variables and the principles of analysis. 10. A Summary at the end of each chapter lists the main points covered in the chapter. 11. Key terms are important words or phrases introduced in the chapter. They are set

in boldface when they are defined for the first time, and they are listed by page number at the end of each chapter.

12. End-of-chapter questions and applied problems, numbering more than 600, help students learn the subject matter by applying economic concepts.

13. Real-Time Data Analysis Problems ask students to apply up-to-the-minute data, taken from the St. Louis Federal Reserve Bank’s FRED database, so that they can understand what is happening in the economy in real time.

14. Web Exercises encourage students to collect information from online sources or use online resources to enhance their learning experience.

15. Web sources report the URL sources of the data used to create the many tables and charts.

16. Web References point the student to websites that provide information or data that supplement the text material.

17. A Glossary at the back of the book provides definitions of all the key terms.

AN EASIER WAy TO TEACH: SuPPLEMENTS TO ACCOMPANy THE FOuRTH EDITION

The Economics of Money, Banking, and Financial Markets, Fourth Edition, includes the most comprehensive program of supplements of any money, banking, and financial markets textbook.

MyEconLab MyEconLab has been designed and refined with a single purpose in mind: to create those moments of understanding that transform the difficult into the clear and obvious. With comprehensive homework, quiz, test, and tutorial options, instructors can man- age all of their assessment needs within one program.

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Preface xxxix

MyEconLab for The Economics of Money, Banking, and Financial Markets offers the following resources for students and instructors:

• All end-of-chapter questions and applied problems from the text are available in MyEconLab.

• Applications from the text are provided, along with assignable questions. • Mini-Lecture Videos provide a step-by-step analysis of all the data and analytic

figures included in the text. The videos can be used in class or viewed by students on their own time.

• A Personal Study Plan is created for each individual student based on his or her performance on assigned and sample exercises.

• Instant tutorial feedback is provided for problems and graphing responses to questions.

• Interactive learning aids, such as Help Me Solve This (a step-by-step tutorial), are designed to help the student exactly when he or she needs support.

• News articles are available for classroom and assignment use. Up-to-date news articles and complimentary discussion questions are posted weekly to bring today’s news into the classroom and course.

• Real-Time Data Analysis Problems allow instructors to assign problems that use up-to-the-minute data. Each RTDA exercise loads the appropriate and most cur- rent data from FRED, a comprehensive and up-to-date data set maintained by the Federal Reserve Bank of St. Louis. Exercises are graded based on the particular data used, and feedback is provided.

• An Enhanced Pearson eText is available within the online course materials and off-line via iPad and Android apps. The enhanced Pearson eText enables instructors and students to highlight, bookmark, and take notes.

• Auto-graded problems and graphs are available for assignments. • A powerful Gradebook, flexible and rich with information, provides data on stu-

dent and class assignment performance and time on task. • Advanced communication tools enable students and instructors to communicate

through email, discussion board, chat, and ClassLive. • Customization options provide new and enhanced ways to share documents, add

content, and rename menu items. • Temporary access. A fourteen-day grace period of temporary access is provided for

students who are awaiting financial aid. • One place for students to access all of their MyLab courses. Students and in-

structors can register, create, and access all of their MyLab courses, regardless of discipline, from one convenient online location: http://www.pearsonmylab.com.

For more information, please visit http://www.myeconlab.com.

Additional Instructor Resources 1. Instructor’s Resource Manual. This online supplement, prepared by me, offers

conventional elements such as sample course outlines, chapter outlines, and answers to questions and problems in the text.

2. PowerPoint® Presentation. This online supplement provides all of the tables and graphs presented in the text, along with very detailed lecture notes for all the course material. The lecture notes are, in fact, based on the notes I use in class, and they should help other instructors prepare their lectures as they have helped me prepare mine. In this edition, Paul Kubik of DePaul University has enhanced the presentation

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by adding additional lecture notes. Instructors who prefer to teach with a blackboard can use these PowerPoint slides as their own class notes; for those who prefer to teach with visual aids, the PowerPoint slides afford them the flexibility to do so. The analytic figures within the PowerPoint slides are completely manipulable by the user so that instructors can custom-design their PowerPoint lectures with step-by- step animations of all key text figures.

3. Test Bank. This online supplement, updated and revised by James Hueng of Western Michigan University and Kathy Kelly of the University of Texas at Arlington, is com- prised of more than 2,500 multiple-choice and essay test items, many with graphs. The authors of the test bank have connected questions to the general knowledge and skill guidelines found in The Association to Advance Collegiate Schools of Business (AACSB) assurance of learning standards. AACSB is a not-for-profit corporation of educational institutions, corporations, and other organizations devoted to the promotion and improvement of higher education in business administration and accounting. One of the criteria for AACSB accreditation is quality of the curriculum. Although no specific courses are required, the AACSB expects a curriculum to include learning experiences in the following areas: Written and oral communication, ethical understanding and reasoning, analytical thinking, information technology, inter- personal relations and teamwork, diverse and multicultural work environments, reflec- tive thinking, and application of knowledge. Questions  that  test  skills  relevant  to  these guidelines are appropriately tagged for easy identification and assessment of student mastery.

4. TestGen. This online supplement enables the instructor to produce exams effi- ciently. This product consists of the multiple-choice and essay questions provided in the online Test Bank, and offers editing capabilities. It is available in Windows and Macintosh versions.

5. Mishkin Companion Website.This online supplement, located at http://www .pearsonhighered.com/mishkin, features appendices on a wide variety of topics (see “Appendices on the Web”), omitted chapters, and links to the URLs that are listed at the ends of the chapters.

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ACkNOWLEDGMENTS As always in so large a project, there are many people to thank. My gratitude goes espe- cially to Donna Battista, Vice President of Business Publishing at Pearson; and Christina Masturzo, my Acquisitions Editor. I would like to thank Alison Kalil, Carolyn Philips, and Kathy Smith for their contributions as well. I also have been assisted by comments from my colleagues at Columbia and from my students.

In addition, I have been guided by the thoughtful commentary of outside reviewers and correspondents, especially Jim Eaton and Aaron Jackson. Their feedback has made this a better book. In particular, I thank the following professors who reviewed the text in preparation for this edition:

Thomas Bernardin, Smith College Diego Escobari, The University of Texas–Pan American Layton W.Franko, Queens College Hyeongwoo Kim, Auburn University Mary H. Lesser, Lenoir–Rhyne University Robin McCutcheon, Marshall University Andrew Nahlik, Illinois College Hiranya K. Nath, Sam Houston State University William R. Parke, University of North Carolina, Chapel Hill Prosper Raynold, Miami University Burak Sungu, Miami University Demetri Tsanacas, Ferrum College and Hollins University Rubina Vohra, New Jersey City University Liping Zheng, Drake University

My special thanks go to the following individuals who analyzed the manuscript in previous editions:

Burt Abrams, University of Delaware Francis W. Ahking, University of Connecticut Mohammed Akacem, Metropolitan State College of Denver Stefania Albanesi, Columbia University Nancy Anderson, Mississippi College Muhammad Anwar, University of Massachusetts Harjit K. Arora, Le Moyne College Bob Barnes, Northern Illinois University Stacie Beck, University of Delaware Larry Belcher, Stetson University Gerry Bialka, University of North Florida Daniel K. Biederman, University of North Dakota John Bishop, East Carolina University Daniel Blake, California State University, Northridge Robert Boatler, Texas Christian University Henning Bohn, University of California, Santa Barbara Michael W. Brandl, University of Texas at Austin Oscar T. Brookins, Northeastern University William Walter Brown, California State University, Northridge James L. Butkiewicz, University of Delaware

A01_MISH9805_4_SE_FM_i-xlvi.indd 41 17/11/14 8:28 PM

xlii Preface

Colleen M. Callahan, Lehigh University Ray Canterbery, Florida State University Mike Carew, Baruch University Tina Carter, University of Florida Sergio Castello, University of Mobile Matthew S. Chambers, Towson University Jen-Chi Cheng, Wichita State University Chi-Young Choi, University of Texas, Arlington Patrick Crowley, Middlebury College Sarah E. Culver, University of Alabama, Birmingham Julie Dahlquist, University of Texas, San Antonio Maria Davis, San Antonio College Ranjit S. Dighe, State University of New York, Oswego Richard Douglas, Bowling Green University Donald H. Dutkowsky, Syracuse University Richard Eichhorn, Colorado State University Paul Emberton, Southwest Texas State University Erick Eschker, Humboldt State University Robert Eyler, Sonoma State University L. S. Fan, Colorado State University Imran Farooqi, University of Iowa Sasan Fayazmanesh, California State University, Fresno Dennis Fixler, George Washington University Gary Fleming, Roanoke College Grant D. Forsyth, Eastern Washington University Timothy Fuerst, Bowling Green State University Marc Fusaro, Arkansas Tech University James Gale, Michigan Technological University Shirley Gedeon, University of Vermont Edgar Ghossoub, University of Texas, San Antonio Mark Gibson, Washington State University Lance Girton, University of Utah Stuart M. Glosser, University of Wisconsin, Whitewater Fred C. Graham, American University Jo Anna Gray, University of Oregon David Gulley, Bentley University Ralph Gunderson, University of Wisconsin Daniel Haak, Stanford University Larbi Hammami, McGill University Bassan Harik, Western Michigan University J. C. Hartline, Rutgers University Scott Hein, Texas Tech Robert Stanley Herren, North Dakota State University Jane Himarios, University of Texas, Arlington Chad Hogan, University of Michigan Linda Hooks, Washington and Lee University James Hueng, Western Michigan University Dar-Yeh Hwang, National Taiwan University Jayvanth Ishwaran, Stephen F. Austin State University Aaron Jackson, Bentley University

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Preface xliii

Jonatan Jelen, Queens College and City College of CUNY U Jin Jhun, State University of New York, Oswego Frederick L. Joutz, George Washington University Ahmed Kalifa, Colorado State University Bryce Kanago, University of Northern Iowa Magda Kandil, International Monetary Fund Theodore Kariotis, Towson University George G. Kaufman, Loyola University Chicago Richard H. Keehn, University of Wisconsin, Parkside Elizabeth Sawyer Kelly, University of Wisconsin, Madison Kathy Kelly, University of Texas, Arlington Michael Kelsay, University of Missouri, Kansas City Paul Kubik, DePaul University Sungkyu Kwak, Washburn University Fritz Laux, Northeastern State University Jim Lee, Fort Hays State University Robert Leeson, University of Western Ontario Tony Lima, California State University, Hayward Fiona Maclachlan, Manhattan College Elham Mafi-Kreft, Indiana University Bernard Malamud, University of Nevada, Las Vegas James Maloy, University of Pittsburgh James Marchand, Mercer University Marvin Margolis, Millersville University Elaine McBeth, College of William and Mary Stephen McCafferty, Ohio State University James McCown, Ohio State University Cheryl McGaughey, Angelo State University W. Douglas McMillin, Louisiana State University William Merrill, Iowa State University Carrie Meyer, George Mason University Stephen M. Miller, University of Connecticut Masoud Moghaddam, Saint Cloud State University Thomas S. Mondschean, DePaul University George Monokroussos, University of Albany Clair Morris, U.S. Naval Academy Jon Nadenichek, California State University, Northridge John Nader, Grand Valley State University Leonce Ndikumana, University of Massachusetts, Amherst Ray Nelson, Brigham Young University Inder P. Nijhawan, Fayetteville State University Nick Noble, Miami University of Ohio Dennis O’Toole, Virginia Commonwealth University Mark J. Perry, University of Michigan, Flint Chung Pham, University of New Mexico Marvin M. Phaup, George Washington University Andy Prevost, Ohio University Ganga P. Ramdas, Lincoln University Ronald A. Ratti, University of Missouri, Columbia Hans Rau, Ball State University

A01_MISH9805_4_SE_FM_i-xlvi.indd 43 17/11/14 8:28 PM

xliv Preface

Prosper Raynold, Miami University Javier Reyes, Texas A&M University Jack Russ, San Diego State University Steve Russell, IUPUI Robert S. Rycroft, Mary Washington College Joe Santos, South Dakota State University Lynn Schneider, Auburn University, Montgomery Walter Schwarm, Colorado State University John Shea, University of Maryland Harinder Singh, Grand Valley State University Rajesh Singh, Iowa State University Richard Stahl, Louisiana State University Larry Taylor, Lehigh University Leigh Tesfatsion, Iowa State University Aditi Thapar, New York University Frederick D. Thum, University of Texas, Austin Robert Tokle, Idaho State University C. Van Marrewijk, Erasmus University Rubina Vohra, New Jersey City University Christopher J. Waller, Indiana University Yongsheng Wang, Washington and Jefferson College Chao Wei, George Washington University Maurice Weinrobe, Clark University James R. Wible, University of New Hampshire Philip R. Wiest, George Mason University William Wilkes, Athens State University Thomas Williams, William Paterson University Elliot Willman, New Mexico State University Donald Wills, University of Washington, Tacoma Laura Wolff, Southern Illinois University, Edwardsville JaeJoon Woo, DePaul University Robert Wright, University of Virginia Ben T. Yu, California State University, Northridge Ky H. Yuhn, Florida Atlantic University Ed Zajicek, Winston-Salem State University David Zalewski, Providence College Jeffrey Zimmerman, Methodist College

Finally, I want to thank my wife, Sally; my son, Matthew; and my daughter, Laura, who provide me with a warm and happy environment that enables me to do my work; and also my father, Sidney, now deceased, who a long time ago put me on the path that led to this book.

Frederic S. MiShkin

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About the Author

Frederic S. Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. He is also a Research Associate at the National Bureau of Economic Research, co-director of the U.S. Monetary Policy Forum, a member of the Squam Lake Working Group on Financial Reform, and past president of the Eastern Economics Association. Since receiving his Ph.D. from the Massachusetts Institute of Technology in 1976, he has taught at the University of Chicago, Northwestern University, Princeton University, and Columbia. He has also received an honorary professorship from the People’s (Renmin) University of China. From 1994 to 1997, he was Executive Vice President and Director of Research at the Federal Reserve Bank of New York and an associate economist of the Federal Open Market Committee of the Federal Reserve System. From September 2006 to August 2008, he was a member (governor) of the Board of Governors of the Federal Reserve System.

Professor Mishkin’s research focuses on monetary policy and its impact on financial markets and the aggregate economy. He is the author of more than twenty books, including Macroeconomics: Policy and Practice, Second

Edition (Pearson, 2015); Financial Markets and Institutions, Eighth Edition (Pearson, 2015); Monetary Policy Strategy (MIT Press, 2007); The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton University Press, 2006); Inflation Targeting: Lessons from the International Experience (Princeton University Press, 1999); Money, Interest Rates, and Inflation (Edward Elgar, 1993); and A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient Markets Models (University of Chicago Press, 1983). In addition, he has published more than 200 articles in such journals as American Economic Review, Journal of Political Economy, Econometrica, Quarterly Journal of Economics, Journal of Finance, and Journal of Monetary Economics.

Professor Mishkin has served on the editorial board of American Economic Review and has been an associate editor at Journal of Business and Economic Statistics, the Journal of Applied Econometrics, Journal of Economic Perspectives, Journal of International Money and Finance, and Journal of Money, Credit and Banking; he also served as the editor of the Federal Reserve Bank of New York’s Economic Policy Review. He is currently an associate editor (member of the editorial board) at five academic journals, including International Finance; Finance India; Review of Development Finance; Borsa Economic Review; and Emerging Markets, Finance and Trade. He has been a consultant to the Board of Governors of the Federal Reserve System, the World Bank, and the International Monetary Fund, as well as to many central banks throughout the world. He was also a member of the International Advisory Board to the Financial Supervisory Service of South Korea and an advisor to the Institute for Monetary and Economic Research at the Bank of Korea. Professor Mishkin was a Senior Fellow at the Federal Deposit Insurance Corporation’s Center for Banking Research and was an academic consultant to and serves on the Economic Advisory Panel of the Federal Reserve Bank of New York.

xlv

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Introduction

Crisis and Response: Global Financial Crisis and Its Aftermath

In August 2007, financial markets began to seize up, and over the next two years the world economy experienced a global financial crisis that was the most severe since the Great Depression years of the 1930s. Housing prices plummeted, the stock market crashed, unemployment skyrocketed, and both businesses and households found they couldn’t get credit. Not only did the central bank of the United States, the Federal Reserve, respond by sharply lowering interest rates and intervening in credit markets to provide them with massive amounts of liquidity, but the federal government also entered into the act with a $700 billion bailout of weakened financial institutions and huge fiscal stimulus packages totaling over $1 trillion. However, even with these aggressive actions aimed at stabilizing the financial system and boosting the economy, seven years after the crisis the U.S. economy was still experiencing an unemployment rate above 6%, with many homeowners losing their homes. The financial systems of many governments throughout the world were also in tatters.

The global financial crisis and its aftermath demonstrate the importance of banks and financial systems to economic well-being, as well as the major role of money in the economy. Part I of this book provides an introduction to the study of money, banking, and financial markets. Chapter 1 outlines a road map of the book and discusses why it is so worthwhile to study money, banking, and financial markets. Chapter 2 provides a general overview of the financial system. Chapter 3 then explains what money is and how it is measured.

1 Part

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1 Preview

You have just heard on the evening news that the Federal Reserve is raising the federal funds rate by 12 of a percentage point. What effect might this have on the interest rate of an automobile loan when you finance your purchase of a sleek new sports car? Does it mean that a house will be more or less affordable in the future? Will it make it easier or harder for you to get a job next year?

This book provides answers to these and other questions by examining how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other insti- tutions) work and by exploring the role of money in the economy. Financial mar- kets and institutions affect not only your everyday life but also the flow of trillions of dollars of funds throughout our economy, which in turn affects business profits, the production of goods and services, and even the economic well-being of coun- tries other than the United States. What happens to financial markets, financial institutions, and money is of great concern to politicians and can have a major impact on elections. The study of money, banking, and financial markets will reward you with an understanding of many exciting issues. In this chapter, we provide a road map of this book by outlining these issues and exploring why they are worth studying.

WhY StudY Financial MarketS? Part 2 of this book focuses on financial markets—markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial markets, such as bond and stock markets, are crucial to pro- moting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Indeed, well-functioning financial markets are a key factor in producing high economic growth, and poorly-performing financial markets are one reason that many countries in the world remain des- perately poor. Activities in financial markets also have a direct effect on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy.

Why Study Money, Banking, and Financial Markets?

learning Objectives • Recognize the impor- tance of financial mar- kets in the economy.

• Describe how financial intermediation and financial innovation affect banking and the economy.

• Identify the basic links among monetary policy, the business cycle, and economic variables.

• Explain the importance of exchange rates in a global economy.

2

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 3

the Bond Market and interest rates A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make periodic payments for a specified period of time.1 The bond market is especially important to economic activity because it enables corporations and governments to borrow money to finance their activities, and because it is where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). Many types of interest rates are found in the economy—mortgage inter- est rates, car loan rates, and interest rates on many different types of bonds.

Interest rates are important on a number of levels. On a personal level, high interest rates might deter you from buying a house or a car because the cost of financing would be high. Conversely, high interest rates might encourage you to save because you can earn more interest income by putting aside some of your earnings as savings. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save, but also businesses’ invest- ment decisions. High interest rates, for example, might cause a corporation to postpone building a new plant that would provide more jobs.

Because changes in interest rates affect individuals, financial institutions, busi- nesses, and the overall economy, it is important to explain substantial fluctuations in interest rates over the past 35 years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate fell to 3% in late 1992 and 1993, rose to above 5% in the mid-to-late 1990s, fell to below 1% in 2004, rose to 5% by 2007, and fell to close to zero from 2008 to 2014.

Because different interest rates have a tendency to move in unison, economists fre- quently lump interest rates together and refer to “the” interest rate. As Figure 1 shows, however, interest rates on several types of bonds can differ substantially. The interest rate on three-month Treasury bills, for example, fluctuates more than the other inter- est rates, and is lower on average. The interest rate on Baa (medium-quality) corporate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became larger in the 1970s, narrowed in the 1990s, rose briefly in the early 2000s, narrowed again, and then rose sharply starting in the summer of 2007. It then began to decline toward the end of 2009, returning to low levels by 2014.

In Chapter 2 we study the role of bond markets in the economy, and in Chapters 4 through 6 we examine what an interest rate is, how the common movements in interest rates come about, and why the interest rates on different bonds vary.

the Stock Market A common stock (typically called simply a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the cor- poration. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The stock market, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial

1The definition of bond used throughout this book is the broad one commonly used in academic settings, which covers both short- and long-term debt instruments. However, some practitioners in financial markets use the word bond to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds.

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4 p a r t 1 Introduction

market in almost every country that has one; that’s why it’s often called simply “the market.” A big swing in the prices of shares in the stock market is always a major story on the evening news. People often speculate on where the market is heading and get very excited when they can brag about their latest “big killing,” but they become depressed when they suffer a big loss. The attention the market receives can probably be best explained by one simple fact: It is a place where people can get rich—or poor—very quickly.

As Figure 2 indicates, stock prices are extremely volatile. After rising steadily dur- ing the 1980s, the market experienced the worst one-day drop in its entire history on October 19, 1987—“Black Monday”—with the Dow Jones Industrial Average (DJIA) falling by 22%. From then until 2000, the stock market experienced one of the greatest rises (often referred to as a “bull market”) in its history, with the Dow climbing to a peak of over 11,000. With the collapse of the high-tech bubble in 2000, the stock market fell sharply, dropping by over 30% by late 2002. It then rose to an all-time high above the 14,000 level in 2007, only to fall by over 50% of its value to a low below 7,000 in 2009. Another bull market then began, with the Dow reaching new highs of 17,000 by 2014. These considerable fluctuations in stock prices affect the size of people’s wealth and, as a result, their willingness to spend.

The stock market is also an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm’s shares means that the firm can raise a larger amount of funds, which it can then use to buy production facilities and equipment.

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FIgure 1 interest rates on Selected Bonds, 1950–2014

MyEconLab Mini-lecture MyEconLab Real-time data

Although different interest rates have a tendency to move in unison, they often differ substantially, and the spreads between them fluctuate.

Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 5

In Chapter 2 we examine the role that the stock market plays in the financial sys- tem, and in Chapter 7 we return to the issue of how stock prices behave and respond to information in the marketplace.

WhY StudY Financial inStitutiOnS and Banking? Part 3 of this book focuses on financial institutions and the business of banking. Banks and other financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. Thus financial institutions play a crucial role in the economy.

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FIgure 2 Stock Prices as Measured by the dow Jones industrial average, 1950–2014 Stock prices are extremely volatile. Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

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6 p a r t 1 Introduction

Structure of the Financial System The financial system is complex, comprising many different types of private sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks, all of which are heavily regulated by the govern- ment. If an individual wanted to make a loan to IBM or General Motors, for example, he or she would not go directly to the president of the company and offer a loan. Instead, he or she would lend to such a company indirectly through financial intermediaries, which are institutions that borrow funds from people who have saved and in turn make loans to people who need funds.

Why are financial intermediaries so crucial to well-functioning financial markets? Why do they extend credit to one party but not to another? Why do they usually write complicated legal documents when they extend loans? Why are they the most heavily regulated businesses in the economy?

We answer these questions in Chapter 8 by developing a coherent framework for analyzing financial structure in the United States and in the rest of the world.

Banks and Other Financial institutions Banks are financial institutions that accept deposits and make loans. The term banks includes firms such as commercial banks, savings and loan associations, mutual sav- ings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs a loan to buy a house or a car usually obtains it from a local bank. Most Americans keep a large portion of their financial wealth in banks in the form of checking accounts, savings accounts, or other types of bank deposits. Because banks are the largest financial intermediaries in our economy, they deserve the most careful study. However, banks are not the only important financial institutions. Indeed, in recent years, other financial institutions, such as insurance companies, finance companies, pension funds, mutual funds, and investment banks, have been growing at the expense of banks, so we need to study them as well.

In Chapter 9, we examine how banks and other financial institutions manage their assets and liabilities to make profits. In Chapter 10, we extend the economic analysis in Chapter 8 to understand why financial regulation takes the form it does and what can go wrong in the regulatory process. In Chapter 11, we look at the banking industry and examine how the competitive environment has changed this industry. We also learn why some financial institutions have been growing at the expense of others.

Financial innovation In Chapter 11, we study financial innovation, the development of new financial products and services. We will see why and how financial innovation takes place, with particular emphasis on how the dramatic improvements in information technology have led to new financial products and the ability to deliver financial services electroni- cally through what has become known as e-finance. We also study financial innovation because it shows us how creative thinking on the part of financial institutions can lead to higher profits but can also sometimes result in financial disasters. By studying how financial institutions have been creative in the past, we obtain a better grasp of how they may be creative in the future. This knowledge provides us with useful clues about how the financial system may change over time.

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 7

Financial crises At times, the financial system seizes up and produces financial crises, which are major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been a feature of capitalist economies for hundreds of years, and are typically followed by severe business cycle downturns. Starting in August 2007, the U.S. economy was hit by the worst financial crisis since the Great Depression. Defaults in subprime residential mortgages led to major losses in financial institutions, producing not only numerous bank failures but also the demise of Bear Stearns and Lehman Brothers, two of the largest investment banks in the United States. The crisis produced the worst economic downturn since the Great Depression, and as a result, it is now referred to as the “Great Recession.”

We discuss why these crises occur and why they do so much damage to the economy in Chapter 12.

WhY StudY MOneY and MOnetarY POlicY? Money, also referred to as the money supply, is defined as anything that is generally accepted as payment for goods or services or in the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important to the health of the economy. The final two parts of this book examine the role of money in the economy.

Money and Business cycles During 1981–1982, the total production of goods and services (called aggregate output) in the U.S. economy fell and the unemployment rate (the percentage of the available labor force unemployed) rose to over 10%. After 1982, the economy began to expand rapidly, and by 1989, the unemployment rate had declined to 5%. In 1990, the eight-year expansion came to an end, with the unemployment rate rising to above 7%. The economy bottomed out in 1991, and the subsequent recovery was the longest in U.S. history, with the unemployment rate falling to around 4%. A mild economic downturn began in March 2001, with unemployment rising to 6%; the economy began to recover in November 2001, with unemployment eventually declining to a low of 4.4%. Starting in December 2007, the economy went into a steep economic downturn and unemployment rose to over 10% before the economy slowly began to recover in June 2009.

Why did the economy undergo such pronounced fluctuations? Evidence suggests that money plays an important role in generating business cycles, the upward and downward movement of aggregate output produced in the economy. Business cycles affect all of us in immediate and important ways. When output is rising, for example, it is easier to find a good job; when output is falling, finding a good job might be difficult. Figure 3 shows the movements of the rate of growth of the money supply over the 1950–2014 period, with the shaded areas representing recessions, or periods of declining aggregate output. We see that the rate of money growth declined before most recessions, indicating that changes in money growth might be a driving force behind business cycle fluctuations. However, declines in the rate of money growth are often not followed by a recession.

We explore how money and monetary policy might affect aggregate output in Chapters 22 through 25 (Part 6) of this book, where we study monetary theory, the theory that relates the quantity of money and monetary policy to changes in aggregate economic activity and inflation.

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8 p a r t 1 Introduction

Money and inflation The movie you paid $10 to see last week would have set you back only a dollar or two thirty years ago. In fact, for $10, you probably could have had dinner, seen the movie, and bought yourself a big bucket of hot buttered popcorn. As shown in Figure 4, which illus- trates the movement of average prices in the U.S. economy from 1950 to 2014, the prices of most items are quite a bit higher now than they were then. The average price of goods and services in an economy is called the aggregate price level or, more simply, the price level (a more precise definition is found in the appendix to this chapter). From 1950 to 2014, the price level has increased more than sevenfold. Inflation, a continual increase in the price level, affects individuals, businesses, and the government. It is generally regarded as an important problem to be solved and is often at the top of political and policymaking agendas. To solve the inflation problem, we need to know something about its causes.

What explains inflation? One clue to answering this question is found in Figure 4, which plots the money supply versus the price level. As we can see, the price level and the money supply generally rise together. These data seem to indicate that a continuing increase in the money supply might be an important factor in causing the continuing increase in the price level that we call inflation.

Further evidence that inflation may be tied to continuing increases in the money supply is found in Figure 5, which plots the average inflation rate (the rate of change of the price level, usually measured as a percentage change per year) for a number of countries over the ten-year period 2003–2013 against the average rate of money growth

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FIgure 3 Money growth (M2 annual rate) and the Business cycle in the united States, 1950–2014 Although money growth has declined before almost every recession, not every decline in the rate

of money growth is followed by a recession. Shaded areas represent recessions. Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 9

over the same period. As you can see, a positive association exists between inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates. Turkey, Ukraine, and Zambia, for example, experienced high inflation during this period, and their rates of money growth were high. By contrast, Sweden and the United States experienced low inflation rates over the same period, and their rates of money growth were low. Such evidence led Milton Friedman, a Nobel laureate in economics, to make the famous statement, “Inflation is always and everywhere a monetary phenomenon.”2 We look at the quantity of money and monetary policy’s role in creating inflation in Chapters 22 and 24.

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FIgure 4 aggregate Price level and the Money Supply in the united States, 1950–2014 From 1950 to 2014, the price level has increased more than tenfold. Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

2Milton Friedman, Dollars and Deficits (Upper Saddle River, NJ: Prentice Hall, 1968), p. 39.

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10 p a r t 1 Introduction

Money and interest rates In addition to other factors, money plays an important role in interest-rate fluctuations, which are of great concern to businesses and consumers. Figure 6 shows changes in the interest rate on long-term Treasury bonds and the rate of money growth from 1950 to 2014. As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the relationship between money growth and interest rates has been less clear-cut since 1980. We analyze the relationship between money growth and interest rates when we examine the behavior of interest rates in Chapter 5.

conduct of Monetary Policy Because money affects many economic variables that are important to the well-being of our economy, politicians and policymakers throughout the world care about the conduct of monetary policy, the management of money and interest rates. The orga- nization responsible for the conduct of a nation’s monetary policy is the central bank. The United States’ central bank is the Federal Reserve System (also called simply “the Fed”). In Chapters 16 through 19 (Part 4), we study how central banks such as

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FIgure 5 average inflation rate Versus average rate of Money growth for Selected countries, 2003–2013

A positive association can be seen between the ten-year averages of inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates.

Source: International Financial Statistics. http://www.imf.org/external/data.htm

MyEconLab Mini-lecture

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 11

the Federal Reserve System can affect the quantity of money and interest rates in the economy, and then we look at how monetary policy is actually conducted in the United States and elsewhere.

Fiscal Policy and Monetary Policy Fiscal policy involves decisions about government spending and taxation. A budget deficit is an excess of government expenditures with respect to tax revenues for a par- ticular time period, typically a year, while a budget surplus arises when tax revenues exceed government expenditures. The government must finance any budget deficit by borrowing, whereas a budget surplus leads to a lower government debt burden. As Figure 7 shows, the budget deficit, relative to the size of the U.S. economy, peaked in 1983 at 6% of national output (as calculated by the gross domestic product, or GDP, a measure of aggregate output described in the appendix to this chapter). Since then, the budget deficit at first declined to less than 3% of GDP, rose again to 5% of GDP by the early 1990s, and fell subsequently, leading to budget surpluses from 1999 to 2001. In the aftermath of the terrorist attacks of September 11, 2001, the war in Iraq that began in March 2003, and the 2007–2009 financial crisis, the budget swung back into deficit, with deficits at one point exceeding 10% of GDP and then falling substantially thereafter. What to do about budget deficits has been the subject of legislation and the source of bitter battles between the president and Congress in recent years.

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1950 1955 1960 1965 1970 1975 1980 1985 1990

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FIgure 6 Money growth (M2 annual rate) and interest rates (long-term u.S. treasury Bonds), 1950–2014

As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the relationship between money growth and interest rates has been less clear-cut since 1980.

Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

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12 p a r t 1 Introduction

You may have read statements in newspapers or heard on TV that budget surpluses are a good thing, while deficits are undesirable. In Chapter 22, we examine why deficits might result in a higher rate of money growth, a higher rate of inflation, and higher interest rates.

WhY StudY internatiOnal Finance? The globalization of financial markets has accelerated at a rapid pace in recent years. Financial markets have become increasingly integrated throughout the world. American companies often borrow in foreign financial markets, and foreign companies borrow in U.S. financial markets. Banks and other financial institutions, such as JP Morgan Chase, Citigroup, UBS, and Deutschebank, have become increasingly international, with operations in many countries throughout the world. Part 5 of this book explores the foreign exchange market and the international financial system.

the Foreign exchange Market For funds to be transferred from one country to another, they have to be converted from the currency of the country of origin (say, dollars) into the currency of the country

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1950 1955 1960 1965 1970 1975 1980 1985 1990 2000 2005 20101995

Percent of GDP

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FIgure 7 government Budget Surplus or deficit as a Percentage of gross domestic Product, 1950–2013

The budget deficit, relative to the size of the U.S. economy, has fluctuated substantially over the years. It rose to 6% of GDP in 1983 and then fell, eventually leading to budget surpluses from 1999 to 2001. Subsequently, budget deficits climbed, peaking at over 10% of GDP in 2009 and falling substantially thereafter.

Source: economic report of the president, table B79 at http://www.gpoaccess.gov/eop/tables09.html

MyEconLab Mini-lecture

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 13

they are going to (say, euros). The foreign exchange market is where this conversion takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, or the price of one country’s currency in terms of another’s, is determined.

Figure 8 shows the exchange rate for the U.S. dollar from 1970 to 2014 (measured as the value of the U.S. dollar in terms of a basket of major foreign currencies). The fluctuations in prices in this market have been substantial: The dollar’s value weakened considerably from 1971 to 1973, rose slightly until 1976, and then reached a low point in the 1978–1980 period. From 1980 to early 1985, the dollar’s value appreciated dra- matically, and then declined again, reaching another low in 1995. From 2000 to 2014, the dollar depreciated substantially, with only a temporary upturn in 2008 and 2009.

What have these fluctuations in the exchange rate meant to the American public and businesses? A change in the exchange rate has a direct effect on American consum- ers because it affects the cost of imports. In 2001, when the euro was worth around 85 cents, 100 euros of European goods (say, French wine) cost $85. When the dollar subsequently weakened, raising the cost of one euro to a peak of nearly $1.50, the same 100 euros of wine now cost $150. Thus a weaker dollar leads to more expensive foreign goods, makes vacationing abroad more expensive, and raises the cost of indulging your desire for imported delicacies. When the value of the dollar drops, Americans decrease their purchases of foreign goods and increase their consumption of domestic goods (such as travel within the United States or American-made wine).

Conversely, a strong dollar means that U.S. goods exported abroad will cost more in foreign countries, and hence foreigners will buy fewer of them. Exports of steel, for example, declined sharply when the dollar strengthened during the 1980–1985 and 1995–2001 periods. A strong dollar benefited American consumers by making foreign goods cheaper, but hurt American businesses and eliminated some jobs by cutting both domestic and foreign sales of the businesses’ products. The decline in the value of the dollar from 1985 to 1995 and from 2001 to 2014 had the opposite effect: It made foreign

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

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FIgure 8 exchange rate of the u.S. dollar, 1970–2014 The value of the U.S. dollar relative to other currencies has fluctuated substantially over the years. Source: Federal reserve Bank of St. Louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

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14 p a r t 1 Introduction

goods more expensive but made American businesses more competitive. Fluctuations in the foreign exchange markets have major consequences for the American economy.

In Chapter 20, we study how exchange rates are determined in the foreign exchange market, in which dollars are bought and sold for foreign currencies.

the international Financial System The tremendous increase in capital flows among countries has heightened the inter- national financial system’s impact on domestic economies. Issues we will explore in Chapter 21 include:

• How does a country’s decision to fix its exchange rate to that of another nation shape the conduct of monetary policy?

• What is the impact of capital controls that restrict mobility of capital across national borders on domestic financial systems and the performance of the economy?

• What role should international financial institutions, such as the International Monetary Fund, play in the international financial system?

hOW We Will StudY MOneY, Banking, and Financial MarketS

This textbook stresses the “economic way of thinking” by developing a unifying frame- work in which you will study money, banking, and financial markets. This analytic framework uses a few basic economic concepts to organize your thinking about the determination of asset prices, the structure of financial markets, bank management, and the role of money in the economy. It encompasses the following basic concepts:

• A simplified approach to the demand for assets • The concept of equilibrium • Basic supply and demand analysis to explain behavior of financial markets • The search for profits • An approach to financial structure based on transaction costs and asymmetric

information • Aggregate supply and demand analysis

The unifying framework used in this book will keep your knowledge from becom- ing obsolete and make the material more interesting. It will enable you to learn what really matters without having to memorize a mass of dull facts that you will forget soon after the final exam. This framework will also provide you with the tools you need to understand trends in the financial marketplace and in variables such as interest rates, exchange rates, inflation, and aggregate output.

To help you understand and apply the unifying analytic framework, simple models are constructed in which the variables held constant are carefully delineated. Each step in the derivation of the model is clearly and carefully laid out, and the models are then used to explain various phenomena by focusing on changes in one variable at a time, holding all other variables constant.

To reinforce the models’ usefulness, this text uses case studies, applications, and special-interest boxes to present evidence that supports or casts doubts on the theories being discussed. This exposure to real-life events and empirical data should dissuade you from thinking that all economists make abstract assumptions and develop theories that have little to do with actual behavior.

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 15

To function better financially in the real world outside the classroom, you must have the tools with which to follow the financial news that is reported in leading financial pub- lications and on the Web. To help and encourage you to read the financial news, this book contains special boxed inserts titled “Following the Financial News” that provide detailed information and definitions to help you evaluate data that are discussed frequently in the media. This book also contains over 700 end-of-chapter questions and applied problems that ask you to apply the analytic concepts you have learned to real-world issues.

exploring the Web The World Wide Web has become an extremely valuable and convenient resource for financial research. This book emphasizes the importance of this tool in several ways. First, you can view the most current data for a high percentage of the in-text data figures by using eText to access the Federal Reserve Bank of St. Louis’s FRED database. Figures for which you can do this are labeled MyEconLab Real-Time Data. Second, at the end of almost every chapter there are several real-time data analysis problems, which ask you to download the most recent data from the Federal Reserve Bank of St. Louis’s FRED data- base and then use these data to answer interesting questions. Third, there are additional Web exercises at the end of many chapters that prompt you to visit sites related to the chapter and use them to learn more about macroeconomic issues. Web references are also supplied at the end of each chapter; these list the URLs of sites related to the material being discussed. You can visit these sites to further explore a topic you find of particular interest. Note: Website URLs are subject to frequent change. We have tried to select stable sites, but we realize that even government URLs change. The publisher’s website (http:// www.myeconlab.com) will maintain an updated list of current URLs for your reference.

cOncluding reMarkS The study of money, banking, and financial markets is an exciting field that directly affects your life. Interest rates influence the earnings you make on your savings and the payments on loans you may seek for a car or a house, and monetary policy may affect your job pros- pects and the prices you will pay for goods in the future. Your study of money, banking, and financial markets will introduce you to many of the controversies related to economic policy that are hotly debated in the political arena, and will help you gain a clearer under- standing of the economic phenomena you hear about in the news media. The knowledge you gain will stay with you and benefit you long after this course is over.

SuMMarY

1. Activities in financial markets directly affect individuals’ wealth, the behavior of businesses, and the efficiency of our economy. Three financial markets deserve par- ticular attention: the bond market (where interest rates are determined), the stock market (which has a major effect on people’s wealth and on firms’ investment decisions), and the foreign exchange market (because fluctuations in the foreign exchange rate have major consequences for the U.S. economy).

2. Banks and other financial institutions channel funds from people who might not put them to productive use to peo- ple who can do so, and thus play a crucial role in improv- ing the efficiency of the economy. When the financial system seizes up and produces a financial crisis, financial firms fail, which causes severe damage to the economy.

3. Money and monetary policy appear to have a major influence on inflation, business cycles, and inter- est rates. Because these economic variables are so

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16 p a r t 1 Introduction

keY terMS

aggregate income, p. 19 aggregate output, p. 7 aggregate price level,

p. 8 asset, p. 3 banks, p. 6 bond, p. 3 budget deficit, p. 11 budget surplus, p. 11 business cycles, p. 7 central bank, p. 10

common stock, p. 3 e-finance, p. 6 Federal Reserve System (the Fed),

p. 10 financial crises, p. 7 financial innovation, p. 6 financial intermediaries, p. 6 financial markets, p. 2 fiscal policy, p. 11 foreign exchange market, p. 13 foreign exchange rate, p. 13

gross domestic product (GDP), p. 11 inflation, p. 8 inflation rate, p. 8 interest rate, p. 3 monetary policy, p. 10 monetary theory, p. 7 money (money supply), p. 7 recession, p. 7 security, p. 3 stock, p. 3 unemployment rate, p. 7

QueStiOnS

All questions are available in MyEconLab at http://www.myeconlab.com.

1. What is the typical relationship among interest rates on three-month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?

2. What effect might a fall in stock prices have on busi- ness investment?

3. What effect might a rise in stock prices have on con- sumers’ decisions to spend?

4. Why are financial markets important to the health of the economy?

5. What was the main cause of the recession that began in 2007?

6. What is the basic activity of banks?

7. What are the other important financial intermediaries in the economy, besides banks?

8. Can you think of any financial innovation in the past ten years that has affected you personally? Has it made you better off or worse off? Why?

9. Has the inflation rate in the United States increased or decreased in the past few years? What about interest rates?

10. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to

a. real output?

b. the inflation rate?

c. interest rates?

11. When interest rates decrease, how might businesses and consumers change their economic behavior?

12. Is everybody worse off when interest rates rise?

13. Why do managers of financial institutions care so much about the activities of the Federal Reserve System?

14. How does the current size of the U.S. budget deficit compare to the historical budget deficit or surplus for the time period since 1950?

15. How would a fall in the value of the pound sterling affect British consumers?

16. How would an increase in the value of the pound ster- ling affect American businesses?

17. How can changes in foreign exchange rates affect the profitability of financial institutions?

18. According to Figure 8, in which years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London?

19. When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American- made or foreign-made jeans? Are U.S. companies that

important to the health of the economy, we need to understand how monetary policy is and should be con- ducted. We also need to study government fiscal policy because it can be an influential factor in the conduct of monetary policy.

4. This textbook stresses the “economic way of thinking” by developing a unifying analytic framework in which to study money, banking, and financial markets, using a few basic economic principles. This textbook also emphasizes the interaction of theoretical analysis and empirical data.

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C h a p t e r 1 Why Study Money, Banking, and Financial Markets? 17

All applied problems are available in MyEconLab at http://www.myeconlab.com.

21. The following table lists foreign exchange rates between U.S. dollars and British pounds (GBP) during April.

Which day would have been the best for converting $200 into British pounds? Which day would have been the worst? What would be the difference in pounds?

Applied problems

Date U.S. Dollars per GBP

4/1 1.9564 4/4 1.9293 4/5 1.914 4/6 1.9374 4/7 1.961 4/8 1.8925 4/11 1.8822 4/12 1.8558 4/13 1.796 4/14 1.7902 4/15 1.7785 4/18 1.7504 4/19 1.7255 4/20 1.6914 4/21 1.672 4/22 1.6684 4/25 1.6674 4/26 1.6857 4/27 1.6925 4/28 1.7201 4/29 1.7512

manufacture jeans happier when the dollar is strong or when it is weak? What about an American company that is in the business of importing jeans into the United States?

20. Much of the U.S. government debt is held by foreign investors as treasury bonds and bills. How do fluctua- tions in the dollar exchange rate affect the value of that debt held by foreigners?

dAtA AnAlysis problems

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database and find data on the three-month treasury bill rate (TB3MS), the three-month AA nonfinancial com- mercial paper rate (CPN3M), the 30-year treasury

bond rate (GS30), the 30-year conventional mortgage rate (MORTG), and the NBER recession indicators (USREC).

a. In general, how do these interest rates behave during recessions and during expansionary periods?

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18 p a r t 1 Introduction

WeB exerciSeS

1. In this exercise, we will practice collecting data from the Web and graphing it using Excel. Go to http:// www.forecasts.org/data/index.htm, click on Stock Index Data at the top of the page, and choose the U.S. Stock Indices—Monthly option. Finally, choose the Dow Jones Industrial Average option.

a. Move the data into an Excel spreadsheet. b. Using the data from part (a), prepare a graph. Use

the Excel Chart Wizard to properly label your axes.

2. In Web Exercise 1, you collected data on and then graphed the Dow Jones Industrial Average (DJIA). This same site reports forecast values of the DJIA. Go to http:// www.forecasts.org/data/index.htm, and click on FFC Home at the top of the page. Click on the Dow Jones Industrial link under Forecasts in the far-left column.

a. What is the Dow forecast to be in six months? b. What percentage increase is forecast for the next six

months?

WeB reFerenceS

http://www.federalreserve.gov/releases/

Daily, weekly, monthly, quarterly, and annual releases and historical data for selected interest rates, foreign exchange rates, and so on.

http://stockcharts.com/charts/historical/

Historical charts of various stock indexes over differing time periods.

http://www.federalreserve.gov

General information, monetary policy, banking system, research, and economic data of the Federal Reserve.

http://www.bls.gov/data/inflation_calculator.htm

This calculator lets you compute how the dollar’s buying power has changed since 1913.

http://www.kowaldesign.com/budget/

This site reports the current federal budget deficit or sur- plus and how it has changed since the 1950s. It also reports how the federal budget is spent.

http://www.brillig.com/debt_clock/

National debt clock. This site reports the exact national debt at each point in time.

b. In general, how do the three-month rates com- pare to the 30-year rates? How do the treasury rates compare to the respective commercial paper and mortgage rates?

c. For the most recent available month of data, take the average of each of the three-month rates and compare it to the average of the three-month rates from January 2000. How do the averages compare?

d. For the most recent available month of data, take the average of each of the 30-year rates and com- pare it to the average of the 30-year rates from January 2000. How do the averages compare?

2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 money supply (M1SL) and the 10-year treasury bond rate (GS10). Add the two

series into a single graph by using the “Add Data Series” feature. Transform the M1 money supply variable into the M1 growth rate by adjusting the units for the M1 money supply to “Percent Change from Year Ago.”

a. In general, how have the growth rate of the M1 money supply and the 10-year treasury bond rate behaved during recessions and during expansionary periods since the year 2000?

b. In general, is there an obvious, stable relation- ship between money growth and the 10-year interest rate since the year 2000?

c. Compare the money growth rate and the 10-year interest rate for the most recent month available to the rates for January 2000. How do the rates compare?

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Appendix to ChApter

Because these terms are used so frequently throughout the text, we need to have a clear understanding of the definitions of aggregate output, income, the price level, and the inflation rate. AggregAte Output And IncOme

The most commonly reported measure of aggregate output, the gross domestic prod- uct (GDP), is the market value of all final goods and services produced in a country during the course of a year. This measure excludes two sets of items that at first glance you might think it would include. Purchases of goods that have been produced in the past, whether a Rembrandt painting or a house built twenty years ago, are not counted as part of GDP; nor are purchases of stocks or bonds. Neither of these categories enters into the GDP because these categories do not include goods and services produced dur- ing the course of the year. Intermediate goods, which are used up in producing final goods and services, such as the sugar in a candy bar or the energy used to produce steel, are also not counted separately as part of the GDP. Because the value of the final goods already includes the value of the intermediate goods, to count them separately would be to count them twice.

Aggregate income, the total income of factors of production (land, labor, and capi- tal) from producing goods and services in the economy during the course of the year, is best thought of as being equal to aggregate output. Because the payments for final goods and services must eventually flow back to the owners of the factors of produc- tion as income, income payments must equal payments for final goods and services. For example, if the economy has an aggregate output of $10 trillion, total income payments in the economy (aggregate income) are also $10 trillion.

reAl Versus nOmInAl mAgnItudes When the total value of final goods and services is calculated using current prices, the resulting GDP measure is referred to as nominal GDP. The word nominal indicates that values are measured using current prices. If all prices doubled but actual production of goods and services remained the same, nominal GDP would double, even though people would not enjoy the benefits of twice as many goods and services. As a result, nominal variables can be misleading measures of economic well-being.

Defining Aggregate Output, Income, the Price Level, and the Inflation Rate

Appendix to ChApter

1

19

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20 p a r t 1 Introduction

A more reliable measure of economic production expresses values in terms of prices for an arbitrary base year, currently 2005. GDP measured with constant prices is referred to as real GDP, the word real indicating that values are measured in terms of fixed prices. Real variables thus measure the quantities of goods and services and do not change because prices have changed, but rather only if actual quantities have changed.

A brief example will make the distinction clearer. Suppose that you have a nominal income of $30,000 in 2016 and that your nominal income was $15,000 in 2005. If all prices doubled between 2005 and 2016, are you better off? The answer is no: Although your income has doubled, your $30,000 buys you only the same amount of goods because prices have also doubled. A real income measure indicates that your income in terms of the goods it can buy is the same. Measured in 2005 prices, the $30,000 of nominal income in 2016 turns out to be only $15,000 of real income. Because your real income is actually the same for the two years, you are no better or worse off in 2016 than you were in 2005.

Because real variables measure quantities in terms of real goods and services, they are typically of more interest than nominal variables. In this text, discussion of aggre- gate output or aggregate income always refers to real measures (such as real GDP).

aggregate Price leVel In this chapter, we defined the aggregate price level as a measure of average prices in the economy. Three measures of the aggregate price level are commonly encountered in economic data. The first is the GDP deflator, which is defined as nominal GDP divided by real GDP. Thus, if 2016 nominal GDP is $10 trillion but 2016 real GDP in 2005 prices is $9 trillion,

GDP deflator = $10 trillion

$9 trillion = 1.11

The GDP deflator equation indicates that, on average, prices have risen 11% since 2005. Typically, measures of the price level are presented in the form of a price index, which expresses the price level for the base year (in our example, 2005) as 100. Thus the GDP deflator for 2016 would be 111.

Another popular measure of the aggregate price level (which officials in the Fed frequently focus on) is the PCE deflator, which is similar to the GDP deflator and is defined as nominal personal consumption expenditures (PCE) divided by real PCE.

The measure of the aggregate price level that is most frequently reported in the press is the consumer price index (CPI). The CPI is measured by pricing a “basket” of goods and services bought by a typical urban household. If, over the course of the year, the cost of this basket of goods and services rises from $500 to $600, the CPI has risen by 20%. The CPI is also expressed as a price index with the base year equal to 100.

The CPI, the PCE deflator, and the GDP deflator measures of the price level can be used to convert or deflate a nominal magnitude into a real magnitude. This is accomplished by dividing the nominal magnitude by the price index. In our example, in which the GDP deflator for 2016 is 1.11 (expressed as an index value of 111), real GDP for 2016 equals

$10 trillion

1.11 = $9 trillion in 2005 prices

which corresponds to the real GDP figure for 2016 assumed earlier.

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C h a p t e r 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 21

grOWth rateS and the inFlatiOn rate The media often talk about the economy’s growth rate, and particularly the growth rate of real GDP. A growth rate is defined as the percentage change in a variable, i.e.,

growth rate of x = xt - xt - 1

xt - 1 * 100

where t indicates today and t - 1 indicates a year earlier. For example, if real GDP grew from $9 trillion in 2016 to $9.5 trillion in 2017,

then the GDP growth rate for 2017 would be 5.6%:

GDP growth rate = $9.5 trillion - $9 trillion

$9 trillion * 100 = 5.6%

The inflation rate is defined as the growth rate of the aggregate price level. Thus, if the GDP deflator rose from 111 in 2016 to 113 in 2017, the inflation rate using the GDP deflator would be 1.8%:

inflation rate = 113 - 111

111 * 100 = 1.8%

If the growth rate is for a period of less than one year, it is usually reported on an annualized basis; that is, it is converted to the growth rate over a year’s time, assuming that the growth rate remains constant. For GDP, which is reported quarterly, the annu- alized growth rate would be approximately four times the percentage change in GDP from the previous quarter. For example, if GDP rose 12% from the first quarter of 2016 to the second quarter of 2016, then the annualized GDP growth rate for the second quarter of 2016 would be reported as 2%1= 4 * 12%2. (A more accurate calculation would be 2.02%, because a precise quarterly growth rate should be compounded on a quarterly basis.)

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Learning Objectives • Compare and contrast direct and indirect finance.

• Identify the structure and components of financial markets.

• List and describe the different types of financial market instruments.

• Recognize the interna- tional dimensions of financial markets.

• Summarize the roles of transaction costs, risk sharing, and information costs as they relate to financial intermediaries.

• List and describe the different types of financial intermediaries.

• Identify the reasons for and list the types of financial market regulations.

2 Preview

Inez the Inventor has designed a low-cost robot that cleans the house (even does the windows!), washes the car, and mows the lawn, but she has no funds to put her wonderful invention into production. Walter the Widower has plenty of savings, which he and his wife accumulated over the years. If Inez and Walter could get together so that Walter could provide funds to Inez, Inez’s robot would see the light of day, and the economy would be better off: We would have cleaner houses, shinier cars, and more beautiful lawns.

Financial markets (bond and stock markets) and financial intermediaries (such as banks, insurance companies, and pension funds) serve the basic function of getting people like Inez and Walter together so that funds can move from those who have a surplus of funds (Walter) to those who have a shortage of funds (Inez). More realistically, when Apple invents a better iPod, it may need funds to bring its new product to market. Similarly, when a local government needs to build a road or a school, it may require more funds than local property taxes provide. Well- functioning financial markets and financial intermediaries are crucial to economic health.

To study the effects of financial markets and financial intermediaries on the economy, we need to acquire an understanding of their general structure and operation. In this chapter, we learn about the major financial intermediaries and the instruments that are traded in financial markets, as well as how these markets are regulated.

This chapter presents an overview of the fascinating study of financial markets and institutions. We return to a more detailed treatment of the regulation, structure, and evolution of the financial system in Chapters 8 through 12.

FunctIOn OF FInancIaL Markets Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. This function is shown schematically in Figure 1. Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the borrower-spenders, are at the right. The

An Overview of the Financial System

22

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C h a p t e r 2 An Overview of the Financial System 23

principal lender-savers are households, but business enterprises and the government (particularly state and local government), as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out. The most important borrower-spenders are businesses and the government (particularly the fed- eral government), but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes.

In direct finance (the route at the bottom of Figure 1), borrowers borrow funds directly from lenders in financial markets by selling the lenders securities (also called financial instruments), which are claims on the borrower’s future income or assets. Secu- rities are assets for the person who buys them but liabilities (IOUs or debts) for the individual or firm that sells (issues) them. For example, if Ford needs to borrow funds to pay for a new factory to manufacture electric cars, it might borrow the funds from savers by selling them a bond, a debt security that promises to make periodic payments for a specified period of time, or a stock, a security that entitles the owner to a share of the company’s profits and assets.

INDIRECT FINANCE

Financial Intermediaries

F U

N D

S

FUNDS FUNDS Financial Markets

Borrower-Spenders 1. Business firms 2. Government 3. Households 4. Foreigners

Lender-Savers 1. Households 2. Business firms 3. Government 4. Foreigners

DIRECT FINANCE

FUNDS FUNDS

Figure 1 Flows of Funds through the Financial system The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct finance,

in which borrowers borrow funds directly from financial markets by selling securities, and indirect finance, in which a financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrower-spenders.

MyEconLab Mini-lecture

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24 p a r t 1 Introduction

Why is this channeling of funds from savers to spenders so important to the economy? The answer is that the people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs. Let’s first think about this on a personal level. Suppose that you have saved $1,000 this year, but no borrowing or lending is possible because no financial markets are available. If you do not have an investment opportunity that will permit you to earn income with your savings, you will just hold on to the $1,000 and it will earn no interest. However, Carl the Carpenter has a productive use for your $1,000: He can use it to purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra $200 per year. If you could get in touch with Carl, you could lend him the $1,000 at a rental fee (interest) of $100 per year, and both of you would be better off. You would earn $100 per year on your $1,000, instead of the zero amount that you would earn otherwise, while Carl would earn $100 more income per year (the $200 extra earnings per year minus the $100 rental fee for the use of the funds).

In the absence of financial markets, you and Carl the Carpenter might never get together. You would both be stuck with the status quo, and both of you would be worse off. Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to one who has them. Financial markets are thus essential to promoting economic efficiency.

The existence of financial markets is beneficial even if someone borrows for a purpose other than increasing production in a business. Say that you are recently married, have a good job, and want to buy a house. You earn a good salary, but because you have just started to work, you have not saved much. Over time, you would have no problem saving enough to buy the house of your dreams, but by then you would be too old to get full enjoyment from it. Without financial mar- kets, you are stuck; you cannot buy the house and must continue to live in your tiny apartment.

If a financial market were set up so that people who had built up savings could lend you the funds to buy the house, you would be more than happy to pay them some interest so that you could own a home while you are still young enough to enjoy it. Then, over time, you would pay back your loan. If this loan could occur, you would be better off, as would the persons who made you the loan. They would now earn some interest, whereas they would not if the financial market did not exist.

Now we can see why financial markets have such an important function in the economy. They allow funds to move from people who lack productive investment opportunities to people who have such opportunities. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy. Indeed, as we will explore in Chapter 12, when financial markets break down during financial crises, as they did during the recent global financial crisis, severe economic hardship results, which can sometimes lead to dangerous political instability.

Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. They provide funds to young people to buy what they need (and will eventually be able to afford) without forcing them to wait until they have saved up the entire purchase price. Financial markets that are operating efficiently improve the economic welfare of everyone in the society.

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C h a p t e r 2 An Overview of the Financial System 25

structure OF FInancIaL Markets Now that we understand the basic function of financial markets, let’s look at their structure. The following descriptions of several categories of financial markets illustrate essential features of these markets.

Debt and equity Markets A firm or an individual can obtain funds in a financial market in two ways. The most common method is through the issuance of a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until that instrument’s expiration date. A debt instrument is short-term if its maturity term is less than a year and long- term if its maturity term is ten years or longer. Debt instruments with a maturity term between one and ten years are said to be intermediate-term.

The second method of raising funds is through the issuance of equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. If you own one share of common stock in a company that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. Equities often make peri- odic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. In addition, owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors.

The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit, because their dollar payments are fixed. We examine the pros and cons of debt versus equity instruments in more detail in Chapter 8, which provides an economic analysis of financial structure.

The total value of equities in the United States has fluctuated between $4 and $25 trillion since the early 1990s, depending on the prices of shares. Although the average person is more aware of the stock market than of any other financial market, the size of the debt market is often substantially larger than the size of the equities market: At the end of 2013, the value of debt instruments was $42 trillion, while the value of equities was $21.3 trillion.

Primary and secondary Markets A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued can be resold.

The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. An important financial institution that assists in the initial sale of securities in the primary market is

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26 p a r t 1 Introduction

the investment bank. The investment bank does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public.

The New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation System), in which previously issued stocks are traded, are the best-known examples of secondary markets, although the bond markets, in which previously-issued bonds of major corporations and the U.S. government are bought and sold, actually have a larger trading volume. Other examples of secondary markets are foreign exchange markets, futures markets, and options markets. Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices.

When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Second, secondary markets determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher the price the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. For this reason, books like this one, which deal with financial markets, focus on the behavior of secondary markets rather than that of primary markets.

exchanges and Over-the-counter Markets Secondary markets can be organized in two ways. One method is through exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York Stock Exchange for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges.

The other forum for a secondary market is an over-the-counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices. Because over-the-counter dealers are in contact via computers and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.

Many common stocks are traded over-the-counter, although a majority of the largest corporations have their shares traded at organized stock exchanges. The U.S. government bond market, with a larger trading volume than the New York Stock Exchange, by contrast, is set up as an over-the-counter market. Forty or so dealers establish a “market” in these securities by standing ready to buy and sell U.S. govern- ment bonds. Other over-the-counter markets include those that trade other types of financial instruments, such as negotiable certificates of deposit, federal funds, and foreign exchange instruments.

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C h a p t e r 2 An Overview of the Financial System 27

Money and capital Markets Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity terms of less than one year) are traded; the capital market is the market in which longer- term debt instruments (generally those with original maturity terms of one year or greater) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. In addition, as we will see in Chapter 4, short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long- term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.

FInancIaL Market InstruMents To complete our understanding of how financial markets perform the important role of channeling funds from lender-savers to borrower-spenders, we need to examine the securities (instruments) traded in financial markets. We first focus on the instruments traded in the money market and then turn to those traded in the capital market.

Money Market Instruments Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments. The money market has undergone great changes in the past three decades, with the amounts of some financial instruments growing at a far more rapid rate than others.

The principal money market instruments are listed in Table 1, along with the amount at the end of 1980, 1990, 2000, and 2013. The Following the Financial News box discusses the money market interest rates most frequently reported in the media.

Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov

Amount ($ billions, end of year)

Type of Instrument 1980 1990 2000 2013

U.S. Treasury bills 216 527 647 1,591

Negotiable bank certificates of deposit (large denominations)

317 543 1,053 1,762

Commercial paper 122 557 1,619 951

Federal funds and security repurchase agreements

64 388 768 1,919

table 1 Principal Money Market Instruments

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28 p a r t 1 Introduction

u.s. treasury Bills These short-term debt instruments of the U.S. government are issued in one-, three-, and six-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount—that is, at a price lower than the set amount paid at maturity. For instance, in May 2016, you might buy a six-month Treasury bill for $9,000 that can be redeemed in November 2016 for $10,000.

U.S. Treasury bills are the most liquid of all money market instruments because they are the most actively traded. They are also the safest money market instrument because there is a low probability of default, a situation in which the party issuing the debt instrument (the federal government, in this case) is unable to make interest payments or pay off the amount owed when the instrument matures. The federal government can always meet its debt obligations because it can raise taxes or issue currency (paper money or coins) to pay off its debts. Treasury bills are held mainly by banks, although small amounts are held by households, corporations, and other financial intermediaries.

negotiable Bank certificates of Deposit A certificate of deposit (CD) is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. Negotiable CDs are those sold in sec- ondary markets, with the amount outstanding currently around $1.8 trillion. Negotiable CDs are an extremely important source of funds for commercial banks from corpora- tions, money market mutual funds, charitable institutions, and government agencies.

commercial Paper Commercial paper is a short-term debt instrument issued by large banks and well-known corporations, such as Microsoft and General Motors. Growth of the commercial paper market has been substantial: The amount of commer- cial paper outstanding has increased by over 700% (from $122 billion to $951 billion) in the period 1980–2013. We will discuss why the commercial paper market has had such tremendous growth in Chapter 11.

repurchase agreements Repurchase agreements (repos) are effectively short-term loans (usually with a maturity term of less than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the

Following the Financial News Money Market Rates

The four money market interest rates discussed most frequently in the media are:

Prime rate: The base interest rate on corporate bank loans, an indicator of the cost of businesses borrow- ing from banks

Federal funds rate: The interest rate charged on over- night loans in the federal funds market, a sensitive indicator of the cost to banks of borrowing funds from other banks and the stance of monetary policy

Treasury bill rate: The interest rate on U.S. Treasury bills, an indicator of general interest-rate movements

Libor rate: The British Banker’s Association average of interbank rates for dollar deposits in the London market

The data for these interest rates are reported daily in newspapers and on Internet sites such as http:// www.bankrate.com.

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C h a p t e r 2 An Overview of the Financial System 29

loan. Repos are made as follows: A large corporation, such as Microsoft, may have some idle funds in its bank account, say $1 million, which it would like to lend for a week. Microsoft uses this excess $1 million to buy Treasury bills from a bank, which agrees to repurchase them the next week at a price slightly above Microsoft’s purchase price. The net effect of this agreement is that Microsoft makes a loan of $1 million to the bank and holds $1 million of the bank’s Treasury bills until the bank repurchases the bills to pay off the loan. Repurchase agreements are now an important source of bank funds (over $493 billion). The most important lenders in this market are large corporations.

Federal (Fed) Funds These instruments are typically overnight loans between banks of their deposits at the Federal Reserve. The federal funds designation is somewhat confusing because these loans are not made by the federal government or by the Federal Reserve but rather by banks to other banks. One reason why a bank might borrow in the federal funds market is that it might find it does not have enough funds in its deposit accounts at the Fed to meet the amount required by regulators. It can then borrow these funds from another bank, which transfers them to the borrowing bank using the Fed’s wire transfer system. This market is very sensitive to the credit needs of the banks, so the interest rate on these loans, called the federal funds rate, is a closely watched barom- eter of the tightness of credit market conditions in the banking system and the stance of monetary policy. When high, the federal funds rate indicates that banks are strapped for funds; when low, it indicates that banks’ credit needs are low.

capital Market Instruments Capital market instruments are debt and equity instruments with maturities of greater than one year. They have far wider price fluctuations than money market instruments and are considered to be fairly risky investments. The principal capital market instru- ments are listed in Table 2, which shows the amount at the end of 1980, 1990, 2000,

Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov.

Amount ($ billions, end of year)

Type of Instrument 1980 1990 2000 2013

Corporate stocks (market value) 1,601 4,146 17,627 21,363

Residential mortgages 1,106 2,886 5,463 9,863

Corporate bonds 366 1,008 2,230 6,436

U.S. government securities (marketable long-term)

407 1,653 2,184 4,359

U.S. government agency securities 193 435 1,616 6,199

State and local government bonds 310 870 1,192 2,925

Bank commercial loans 459 818 1,091 1,175

Consumer loans 355 813 536 679

Commercial and farm mortgages 352 829 1,214 2,463

table 2 Principal capital Market Instruments

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30 p a r t 1 Introduction

and 2013. The Following the Financial News box discusses the capital market interest rates most frequently reported in the media.

stocks Stocks are equity claims on the net income and assets of a corporation. Their value of $21 trillion at the end of 2013 exceeds that of any other type of security in the capital market. However, the amount of new stock issues in any given year is typically quite small, less than 1% of the total value of shares outstanding. Individuals hold around half of the value of stocks; the rest is held by pension funds, mutual funds, and insurance companies.

Mortgages and Mortgage-Backed securities Mortgages are loans to house- holds or firms to purchase land, housing, or other real structures, in which the structure or land itself serves as collateral for the loans. The mortgage market is the largest debt market in the United States, with the amount of residential mortgages (used to purchase residential housing) outstanding more than quadruple the amount of commercial and farm mortgages. Mortgages are provided by financial institutions such as savings and loan associations, mutual savings banks, commercial banks, and insurance companies. However, in recent years a growing amount of the funds for mortgages have been pro- vided by mortgage-backed securities, bond-like debt instruments backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holders of the security. As we will see in Chapter 12, mortgage-backed securities and more complicated variants (CDOs) have become notorious because they played a key role in promoting the recent global financial crisis. The federal government plays an active role in the mortgage market via the three government agencies—the Federal National Mortgage Association (FNMA, “Fannie Mae”), the Government National Mortgage Association (GNMA, “Ginnie Mae”), and the Federal Home Loan Mortgage Corporation (FHLMC, “Freddie Mac”)—that provide funds to the mortgage market by selling bonds and using the proceeds to buy mortgages.

Following the Financial News Capital Market Interest Rates

The five interest rates on capital market instruments discussed most frequently in the media are:

30-year mortgage rate: The interest rate on a 30-year, fixed-rate residential mortgage that is less than $417,000 ($625,500 in high-cost areas) in amount and is guaranteed by the Federal Housing Admin- istration (FHA).

Jumbo mortgage rate: The interest rate on a 30-year, fixed-rate residential mortgage for prime customers that is in excess of $417,000 ($625,500 in high-cost areas) in amount.

Five-year adjustable rate mortgage (ARM) rate: The inter- est rate for the first five years on a residential mortgage that adjusts after five years for prime customers.

New-car loan rate: The interest rate on a four-year, fixed-rate new-car loan.

10-year Treasury rate: The interest rate on U.S. Trea- sury bonds maturing in ten years.

The data for these interest rates are reported daily in newspapers and on Internet sites such as http:// www.bankrate.com and http://www.finance.yahoo .com.

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C h a p t e r 2 An Overview of the Financial System 31

corporate Bonds These long-term bonds are issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some corporate bonds, called convert- ible bonds, have the additional feature of allowing the holder to convert them into a speci- fied number of shares of stock at any time up to the maturity date. This feature makes these convertible bonds more desirable to prospective purchasers than bonds without it, and it allows the corporation to reduce its interest payments because the bonds can increase in value if the price of the stock appreciates sufficiently. Because the outstanding amount of both convertible and nonconvertible bonds for any given corporation is small, corporate bonds are not nearly as liquid as other securities such as U.S. government bonds.

Although the size of the corporate bond market is substantially smaller than that of the stock market, with the amount of corporate bonds outstanding less than one- third that of stocks, the volume of new corporate bonds issued each year is substan- tially greater than the volume of new stock issues. Thus the behavior of the corporate bond market is probably far more important to a firm’s financing decisions than is the behavior of the stock market. The principal buyers of corporate bonds are life insurance companies; pension funds and households are other large holders.

u.s. Government securities These long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government. Because they are the most widely traded bonds in the United States (the volume of transactions on average exceeds $500 billion daily), they are the most liquid security traded in the capital mar- ket. They are held by the Federal Reserve, banks, households, and foreigners.

u.s. Government agency securities These long-term bonds are issued by vari- ous government agencies such as Ginnie Mae, the Federal Farm Credit Bank, and the Tennessee Valley Authority to finance such items as mortgages, farm loans, or power- generating equipment. Many of these securities are guaranteed by the federal govern- ment. They function much like U.S. government bonds and are held by similar parties.

state and Local Government Bonds State and local bonds, also called municipal bonds, are long-term debt instruments issued by state and local governments to finance expenditures on schools, roads, and other large programs. An important feature of these bonds is that their interest payments are exempt from federal income tax and generally from state taxes in the issuing state. Commercial banks, with their high income tax rates, are the biggest buyers of these securities, owning over half the total amount outstanding. The next biggest group of holders consists of wealthy individuals in high income-tax brackets, followed by insurance companies.

consumer and Bank commercial Loans These loans to consumers and businesses are made principally by banks but, in the case of consumer loans, also by finance companies.

InternatIOnaLIzatIOn OF FInancIaL Markets The growing internationalization of financial markets has become an important trend. Before the 1980s, U.S. financial markets were much larger than those outside the United States, but in recent years the dominance of U.S. markets has been weakening. (See the Global box “Are U.S. Capital Markets Losing Their Edge?”) The extraordinary growth of

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32 p a r t 1 Introduction

foreign financial markets has been the result of both large increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled foreign markets to expand their activities. American corporations and banks are now more likely to tap international capital markets to raise needed funds, and Ameri- can investors often seek investment opportunities abroad. Similarly, foreign corporations and banks raise funds from Americans, and foreigners have become important investors in the United States. A look at international bond markets and world stock markets will give us a picture of how this globalization of financial markets is taking place.

International Bond Market, eurobonds, and eurocurrencies The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that country’s currency. For example, if the German automaker Porsche sells a bond in the

global Are U.S. Capital Markets Losing Their Edge? Over the past few decades, the United States lost its international dominance in a number of manufactur- ing industries, including automobiles and consumer electronics, as other countries became more competi- tive in global markets. Recent evidence suggests that financial markets now are undergoing a similar trend: Just as Ford and General Motors have lost global market share to Toyota and Honda, U.S. stock and bond markets recently have seen their share of sales of newly-issued corporate securities slip. The London and Hong Kong stock exchanges now handle a larger share of initial public offerings (IPOs) of stock than does the New York Stock Exchange, which had been by far the dominant exchange in terms of IPO value before 2000. Furthermore, the number of stocks listed on U.S. exchanges has been falling, while stock listings abroad have been growing rapidly: Listings outside the United States are now about ten times greater than those in the United States. Likewise, the portion of new corporate bonds issued worldwide that are initially sold in U.S. capital markets has fallen below the share sold in European debt markets.

Why do corporations that issue new securities to raise capital now conduct more of this business in financial markets in Europe and Asia? Among the factors contributing to this trend are quicker adop- tion of technological innovation by foreign financial markets, tighter immigration controls in the United

States following the terrorist attacks of 2001, and perceptions that listing on American exchanges will expose foreign securities issuers to greater risks of lawsuits. Many people see burdensome financial regulation as the main cause, however, and point specifically to the Sarbanes-Oxley Act of 2002. Congress passed this act after a number of account- ing scandals involving U.S. corporations and the accounting firms that audited them came to light. Sarbanes-Oxley aims to strengthen the integrity of the auditing process and the quality of information provided in corporate financial statements. The costs to corporations of complying with the new rules and procedures are high, especially for smaller firms, but largely avoidable if firms choose to issue their securi- ties in financial markets outside the United States. For this reason, there is much support for revising Sarbanes-Oxley to lessen its allegedly harmful effects and induce more securities issuers back to U.S. finan- cial markets. However, evidence is not conclusive to support the view that Sarbanes-Oxley is the main cause of the relative decline of U.S. financial markets and therefore in need of reform.

Discussion of the relative decline of U.S. financial markets and debate about the factors that are contrib- uting to it likely will continue. Chapter 8 provides more detail on the Sarbanes-Oxley Act and its effects on the U.S. financial system.

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C h a p t e r 2 An Overview of the Financial System 33

United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument in the international capital market for cen- turies. In fact, a large percentage of U.S. railroads built in the nineteenth century were financed by sales of foreign bonds in Britain.

A more recent innovation in the international bond market is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold—for example, a bond denominated in U.S. dollars sold in London. Currently, over 80% of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly. As a result, the Eurobond market is now larger than the U.S. corporate bond market.

A variant of the Eurobond is Eurocurrencies, which are foreign currencies depos- ited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds. American banks borrow Eurodollar deposits from other banks or from their own foreign branches, and Eurodollars are now an important source of funds for American banks.

Note that the currency, the euro, can create some confusion about the terms Eurobond, Eurocurrencies, and Eurodollars. A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in banks outside the United States.

World stock Markets Until recently, the U.S. stock market was by far the largest in the world, but foreign stock markets have been growing in importance, with the United States not always number one. The increased interest in foreign stocks has prompted the development in the United States of mutual funds that specialize in trading in foreign stock markets. As the Following the Financial News box indicates, American investors now pay attention not only to the Dow Jones Industrial Average but also to stock price indexes for foreign stock markets, such as the Nikkei 300 Average (Tokyo) and the Financial Times Stock Exchange (FTSE) 100-Share Index (London).

The internationalization of financial markets is having profound effects on the United States. Foreigners, particularly Japanese investors, are not only providing funds to corporations in the United States but are also helping finance the federal government. Without these foreign funds, the U.S. economy would have grown far less rapidly in the past twenty years. The internationalization of financial markets is also leading the way to a more integrated world economy in which flows of goods and technology between countries are more commonplace. In later chapters, we will encounter many examples of the important roles that international factors play in our economy.

FunctIOn OF FInancIaL InterMeDIarIes: InDIrect FInance

As shown in Figure 1 (p. 23), funds can move from lenders to borrowers by a second route, called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from

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34 p a r t 1 Introduction

one to the other. A financial intermediary does this by borrowing funds from lender- savers and then using these funds to make loans to borrower-spenders. For example, a bank might acquire funds by issuing a liability to the public in the form of savings deposits (an asset for the public). It might then use the funds to acquire an asset by making a loan to General Motors or by buying a U.S. Treasury bond in the financial market. The ultimate result is that funds have been transferred from the public (the lender-savers) to General Motors or the U.S. Treasury (the borrower-spender) with the help of the financial intermediary (the bank).

The process of indirect financing using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers. Indeed, although the media focus much of their attention on securities markets, par- ticularly the stock market, financial intermediaries are a far more important source of financing for corporations than securities markets are. This is true not only for the United States but for other industrialized countries as well (see the Global box). Why are financial intermediaries and indirect finance so important in financial markets? To answer this question, we need to understand the roles of transaction costs, risk sharing, and information costs in financial markets.

transaction costs Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. As we have seen, Carl the Carpenter needs $1,000 for his new tool, and you know that it is an excellent investment opportunity. You have the cash and would like to lend him the money, but to protect your investment, you have to hire a lawyer to write up the loan contract that specifies how much interest Carl will pay you, when he will make these interest payments, and when he will repay you the $1,000. Obtaining the contract will cost

Following the Financial News Foreign Stock Market Indexes

Foreign stock market indexes are published daily in newspapers and on Internet sites such as finance .yahoo.com.

The most important of these stock market indexes are:

Dow Jones Industrial Average (DJIA): An index of the 30 largest publicly-traded corporations in the United States, maintained by the Dow Jones Corporation

S&P 500: An index of 500 of the largest companies traded in the United States, maintained by Standard & Poor’s

NASDAQ Composite: An index for all the stocks that trade on the NASDAQ stock market, where most of the technology stocks in the United States are traded

FTSE 100: An index of the 100 most highly capi- talized UK companies listed on the London Stock Exchange

DAX: An index of the 30 largest German companies trading on the Frankfurt Stock Exchange

CAC 40: An index of the 40 largest French companies trading on Euronext Paris

Hang Seng: An index of the largest companies trading on the Hong Kong stock markets

Strait Times: An index of the 30 largest companies trading on the Singapore Exchange

These indexes are reported daily in newspapers and on Internet sites such as http://www.finance .yahoo.com.

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C h a p t e r 2 An Overview of the Financial System 35

you $500. When you figure in this transaction cost for making the loan, you realize that you can’t earn enough from the deal (you spend $500 to make perhaps $100) and reluctantly tell Carl that he will have to look elsewhere.

This example illustrates that small savers like you or potential borrowers like Carl might be frozen out of financial markets and thus be unable to benefit from them. Can anyone come to the rescue? Financial intermediaries can.

Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale, the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases. For example, a bank knows how to find a good lawyer to produce an airtight loan contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Instead of a loan contract (which may not be all that well written) costing $500, a bank can hire a top-flight lawyer for $5,000 to draw up an airtight loan con- tract that can be used for 2,000 loans at a cost of $2.50 per loan. At a cost of $2.50 per loan, it now becomes profitable for the financial intermediary to lend Carl the $1,000.

Because financial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people like Carl with productive investment opportunities. In addition, a financial intermediary’s low trans- action costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. For example, banks provide depositors with checking accounts that enable them to pay their bills easily. In addition, depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.

global The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison

Patterns of financing corporations differ across coun- tries, but one key fact emerges: Studies of the major developed countries, including the United States, Canada, the United Kingdom, Japan, Italy, Germany, and France, show that when businesses go look- ing for funds to finance their activities, they usually obtain them indirectly through financial intermediar- ies and not directly from securities markets.* Even in the United States and Canada, which have the most developed securities markets in the world, loans from financial intermediaries are far more important for cor- porate finance than securities markets are. The coun- tries that have made the least use of securities markets are Germany and Japan; in these two countries, financ- ing from financial intermediaries has been almost ten

times greater than that from securities markets. How- ever, after the deregulation of Japanese securities mar- kets in recent years, the share of corporate financing by financial intermediaries has been declining relative to the use of securities markets.

Although the dominance of financial intermediar- ies over securities markets is clear in all countries, the relative importance of bond versus stock markets differs widely across countries. In the United States, the bond market is far more important as a source of corporate finance: On average, the amount of new financing raised using bonds is ten times the amount raised using stocks. By contrast, countries such as France and Italy make more use of equities markets than of the bond market to raise capital.

*See, for example, Colin Mayer, “Financial Systems, Corporate Finance, and Economic Development,” in Asymmetric Information, Corporate Finance, and Investment, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1990), pp. 307–332.

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36 p a r t 1 Introduction

risk sharing Another benefit made possible by the low transaction costs of financial institutions is that these institutions can help reduce the exposure of investors to risk—that is, uncer- tainty about the returns investors will earn on assets. Financial intermediaries do this through the process known as risk sharing: They create and sell assets with risk char- acteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. Low transaction costs allow financial intermediaries to share risk at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is also sometimes referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors.

Financial intermediaries also promote risk sharing by helping individuals to diver- sify and thereby lower the amount of risk to which they are exposed. Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. (Diversi- fication is just another name for the old adage “You shouldn’t put all your eggs in one basket.”) Low transaction costs allow financial intermediaries to pool a collection of assets into a new asset and then sell it to individuals.

asymmetric Information: adverse selection and Moral Hazard The presence of transaction costs in financial markets explains, in part, why financial intermediaries and indirect finance play such an important role in financial markets. An additional reason is that in financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan usually has better infor- mation about the potential returns and risks associated with the investment projects for which the funds are earmarked than the lender does. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into, and afterward.1

Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans, even though good credit risks exist in the marketplace.

To understand why adverse selection occurs, suppose you have two aunts to whom you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a conservative type who borrows only when she has an investment she is quite sure will pay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come across a get-rich-quick scheme that will make her a millionaire if she can just borrow $1,000 to invest in it. Unfortunately, as with most get-rich-quick schemes, the probability is high that the investment won’t pay off and that Aunt Sheila will lose the $1,000.

1Asymmetric information and the adverse selection and moral hazard concepts are also crucial problems for the insurance industry.

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C h a p t e r 2 An Overview of the Financial System 37

Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of course, because she has so much to gain if the investment pays off. You, however, would not want to make a loan to her because the probability is high that her invest- ment will turn sour and she will be unable to pay you back.

If you know both your aunts very well—that is, if your information is not asymmetric—you won’t have a problem, because you will know that Aunt Sheila is a bad risk and so you will not lend to her. Suppose, though, that you don’t know your aunts well. You will be more likely to lend to Aunt Sheila than to Aunt Louise because Aunt Sheila will be hounding you for the loan. Because of the possibility of adverse selection, you might decide not to lend to either of your aunts, even though there are times when Aunt Louise, who is an excellent credit risk, might need a loan for a worthwhile investment.

Moral hazard is the problem created by asymmetric information after the transac- tion occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan.

As an example of moral hazard, suppose that you made a $1,000 loan to another relative, Uncle Melvin, who needs the money to purchase a computer so that he can set up a business typing students’ term papers. Once you have made the loan, however, Uncle Melvin is more likely to slip off to the track and play the horses than to purchase the computer. If he bets on a 20-to-1 long shot and wins with your money, he is able to pay back your $1,000 and live high-off-the-hog with the remaining $19,000. But if he loses, as is likely, you won’t get paid back, and all he has lost is his reputation as a reliable, upstanding uncle. Uncle Melvin therefore has an incentive to go to the track because his gains ($19,000) if he bets correctly are much greater than the cost to him (his reputation) if he bets incorrectly. If you knew what Uncle Melvin was up to, you would prevent him from going to the track, and he would not be able to increase the moral hazard. However, because it is hard for you to keep informed about his whereabouts—that is, because information is asymmetric—there is a good chance that Uncle Melvin will go to the track and you will not get paid back. The risk of moral hazard might therefore discourage you from making the $1,000 loan to Uncle Melvin, even if you are sure that you will be paid back if he uses it to set up his business.

The problems created by adverse selection and moral hazard are a major impedi- ment to well-functioning financial markets. Again, financial intermediaries can alleviate these problems.

With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary—say, the Honest John Bank—which in turn lends the funds out either by making loans or by buying securities such as stocks or bonds. Successful financial intermediaries have higher earnings on their investments than do small savers, because they are bet- ter equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn a profit.

As we have seen, financial intermediaries play an important role in the economy because they provide liquidity services, promote risk sharing, and solve information problems, thereby allowing small savers and borrowers to benefit from the existence of financial markets. The success of financial intermediaries in performing this role is

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38 p a r t 1 Introduction

evidenced by the fact that most Americans invest their savings with them and obtain loans from them. Financial intermediaries play a key role in improving economic effi- ciency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. Without a well-functioning set of financial intermediaries, it is very hard for an economy to reach its full potential. We will explore further the role of financial intermediaries in the economy in Part 3.

economies of scope and conflicts of Interest Another reason why financial intermediaries play such an important part in the econ- omy is that by providing multiple financial services to their customers, such as offering them bank loans or selling their bonds for them, they can also achieve economies of scope; that is, they can lower the cost of information production for each service by applying one information resource to many different services. A bank, for example, when making a loan to a corporation, can evaluate how good a credit risk the firm is, which then helps the bank decide whether it would be easy to sell the bonds of this corporation to the public.

Although economies of scope may substantially benefit financial institutions, they also create potential costs in terms of conflicts of interest. Conflicts of interest, a type of moral hazard problem, arise when a person or institution has multiple objectives (interests), some of which conflict with each other. Conflicts of interest are especially likely to occur when a financial institution provides multiple services. The potentially competing interests of those services may lead an individual or firm to conceal informa- tion or disseminate misleading information. We care about conflicts of interest because a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient.

tyPes OF FInancIaL InterMeDIarIes We have seen why financial intermediaries have such an important function in the economy. Now we take a look at the principal financial intermediaries and how they perform the intermediation function. Financial intermediaries fall into three categories: depository institutions (banks), contractual savings institutions, and investment inter- mediaries. Table 3 describes the primary liabilities (sources of funds) and assets (uses of funds) of the financial intermediaries in each category. The relative sizes of these intermediaries in the United States are indicated in Table 4, which lists the amounts of their assets at the end of 1980, 1990, 2000, and 2013.

Depository Institutions Depository institutions (for simplicity, we refer to these as banks throughout this text) are financial intermediaries that accept deposits from individuals and institutions and make loans. The study of money and banking focuses special attention on this group of financial institutions because they are involved in the creation of deposits, an important component of the money supply. These institutions include commercial banks and the so-called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions.

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C h a p t e r 2 An Overview of the Financial System 39

commercial Banks These financial intermediaries raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits (depos- its that are payable on demand but do not allow their owners to write checks), and time deposits (deposits with fixed terms to maturity). They then use these funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds. Slightly fewer than 5,700 commercial banks are found in the United States and, as a group, they are the largest financial intermediary and have the most diversified portfolios (collections) of assets.

savings and Loan associations (s&Ls) and Mutual savings Banks These depository institutions, of which there are approximately 900 in the United States, ob- tain funds primarily through savings deposits (often called shares) and time and check- able deposits. In the past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing. Over time, these restrictions have been loosened, so the distinction between these depository institutions and commercial banks has blurred. These intermediaries have become more alike and are now more competitive with each other.

Type of Intermediary

Primary Liabilities (Sources of Funds)

Primary Assets (Uses of Funds)

Depository institutions (banks)

Commercial banks Deposits Business and consumer loans, mortgages, U.S. government securities, and municipal bonds

Savings and loan associations Deposits Mortgages

Mutual savings banks Deposits Mortgages

Credit unions Deposits Consumer loans

Contractual savings institutions

Life insurance companies Premiums from policies Corporate bonds and mortgages

Fire and casualty insurance companies

Premiums from policies Municipal bonds, corporate bonds and stock, and U.S. government securities

Pension funds, government retirement funds

Employer and employee contributions

Corporate bonds and stock

Investment intermediaries

Finance companies Commercial paper, stocks, bonds

Consumer and business loans

Mutual funds Shares Stocks, bonds

Money market mutual funds Hedge funds

Shares Partnership participation

Money market instruments Stocks, bonds, loans, foreign

currencies, and many other assets

table 3 Primary assets and Liabilities of Financial Intermediaries

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40 p a r t 1 Introduction

credit unions These financial institutions, numbering about 7,000 in the United States, are typically very small cooperative lending institutions organized around a par- ticular group: union members, employees of a particular firm, and so forth. They ac- quire funds from deposits called shares and primarily make consumer loans.

contractual savings Institutions Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to worry as much as deposi- tory institutions about losing funds quickly. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages.

Life Insurance companies Life insurance companies insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages. They also purchase stocks, but are restricted in the amount that they can hold. Currently, with $6 trillion in assets, they are among the largest of the contractual savings institutions.

Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov/releases/Z1/.

Value of Assets ($ billions, end of year)

Type of Intermediary 1980 1990 2000 2013

Depository institutions (banks)

Commercial banks 1,481 3,334 6,469 12,670

Savings and loan associations and mutual savings banks

792 1,365 1,218 2,157

Credit unions 67 215 441 1,005

Contractual savings institutions

Life insurance companies 464 1,367 3,136 6,035

Fire and casualty insurance companies 182 533 862 1,527

Pension funds (private) 504 1,629 4,355 7,966

State and local government retirement funds 197 737 2,293 4,846

Investment intermediaries

Finance companies 205 610 1,140 1,474

Mutual funds 70 654 4,435 11,527

Money market mutual funds 76 498 1,812 2,678

table 4 Primary Financial Intermediaries and Value of their assets

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C h a p t e r 2 An Overview of the Financial System 41

Fire and casualty Insurance companies These companies insure their policy- holders against loss from theft, fire, and accidents. They are very much like life insur- ance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if major disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance companies do. Their largest holding of assets consists of municipal bonds; they also hold corporate bonds and stocks and U.S. government securities.

Pension Funds and Government retirement Funds Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically de- ducted from their paychecks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks. The establishment of pension funds has been actively encouraged by the federal government, both through legislation requiring pension plans and through tax incentives to encourage contributions.

Investment Intermediaries This category of financial intermediary includes finance companies, mutual funds, money market mutual funds, and hedge funds.

Finance companies Finance companies raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers, who use them to purchase such items as furniture, automobiles, and home improvements, and to small businesses. Some finance companies are organized by a parent corporation to help sell its product. For example, Ford Motor Credit Company makes loans to consumers who purchase Ford automobiles.

Mutual Funds These financial intermediaries acquire funds by selling shares to many individuals and then using the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition, mutual funds allow shareholders to hold more diversified portfolios than they otherwise would. Shareholders can sell (redeem) shares at any time, but the value of these shares will be determined by the value of the mutual fund’s holdings of securi- ties. Because these fluctuate greatly, the value of mutual fund shares will, too; therefore, investments in mutual funds can be risky.

Money Market Mutual Funds These financial institutions are similar to mutual funds but also function to some extent as depository institutions because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid. The interest on these assets is paid out to the shareholders.

A key feature of these funds is that shareholders can write checks against the value of their shareholdings. In effect, shares in a money market mutual fund function like checking account deposits that pay interest. Money market mutual funds have experi- enced extraordinary growth since 1971, when they first appeared. In 2013, their assets had climbed to $2.7 trillion.

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42 p a r t 1 Introduction

Hedge Funds Hedge funds are a type of mutual fund with special characteristics. Hedge funds are organized as limited partnerships with minimum investments ranging from $100,000 to, more typically, $1 million or more. These limitations mean that hedge funds are subject to much weaker regulation than other mutual funds. Hedge funds invest in many types of assets, with some specializing in stocks, others in bonds, others in foreign currencies, and still others in far more exotic assets.

Investment Banks Despite its name, an investment bank is not a bank or a finan- cial intermediary in the ordinary sense; that is, it does not take in funds and then lend them out. Instead, an investment bank is a different type of intermediary that helps a corporation issue securities. First it advises the corporation on which type of securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. Investment banks also act as deal makers and earn enormous fees by helping corpora- tions acquire other companies through mergers or acquisitions.

reGuLatIOn OF tHe FInancIaL systeM The financial system is among the most heavily regulated sectors of the American econ- omy. The government regulates financial markets for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. We will examine how these two goals have led to the present regulatory environment. As a study aid, the principal regulatory agencies of the U.S. financial system are listed in Table 5.

Increasing Information available to Investors Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Risky firms or outright crooks may be the most eager to sell securities to unwary investors, and the resulting adverse selection problem may keep investors out of financial markets. Furthermore, once an investor has bought a security, thereby lending money to a firm, the borrower may have incentives to engage in risky activi- ties or to commit outright fraud. The presence of this moral hazard problem may also keep investors away from financial markets. Government regulation can reduce adverse selection and moral hazard problems in financial markets and enhance the efficiency of the markets by increasing the amount of information available to investors.

As a result of the stock market crash of 1929 and revelations of widespread fraud in the aftermath, political demands for regulation culminated in the Securities Act of 1933 and the establishment of the Securities and Exchange Commission (SEC) in 1934. The SEC requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public, and restricts trading by the largest stockhold- ers (known as insiders) in the corporation. By requiring disclosure and by discouraging insider trading, which could be used to manipulate security prices, the SEC hopes that investors will be better informed and protected from the types of abuses that occurred in financial markets before 1933. Indeed, in recent years, the SEC has been particularly active in prosecuting people involved in insider trading.

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C h a p t e r 2 An Overview of the Financial System 43

ensuring the soundness of Financial Intermediaries Asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as a financial panic. Because providers of funds to financial intermediar- ies may not be able to assess whether the institutions holding their funds are sound, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions. The possible outcome is a financial panic that produces large losses for the public and causes serious damage to the economy. To protect the public and the economy from financial panics, the govern- ment has implemented six types of regulations.

restrictions on entry State banking and insurance commissions, as well as the Office of the Comptroller of the Currency (an agency of the federal government), have created tight regulations governing who is allowed to set up a financial intermediary. Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government.

Regulatory Agency Subject of Regulation Nature of Regulations

Securities and Exchange Commission (SEC)

Organized exchanges and financial markets

Requires disclosure of information; restricts insider trading

Commodities Futures Trading Commission (CFTC)

Futures market exchanges Regulates procedures for trading in futures markets

Office of the Comptroller of the Currency

Federally-chartered com- mercial banks and thrift institutions

Charters and examines the books of federally-chartered commercial banks and thrift institutions; imposes restrictions on assets they can hold

National Credit Union Administration (NCUA)

Federally-chartered credit unions

Charters and examines the books of federally-chartered credit unions and imposes restrictions on assets they can hold

State banking and insurance commissions

State-chartered depository institutions and insurance companies

Charter and examine the books of state-chartered banks and insurance companies, impose restrictions on assets they can hold, and impose restrictions on branching

Federal Deposit Insurance Corporation (FDIC)

Commercial banks, mutual savings banks, savings and loan associations

Provides insurance of up to $250,000 for each depositor at a bank, examines the books of insured banks, and imposes restrictions on assets they can hold

Federal Reserve System All depository institutions Examines the books of commercial banks and systemically important financial institutions; sets reserve requirements for all banks

table 5 Principal regulatory agencies of the u.s. Financial system

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44 p a r t 1 Introduction

Only upstanding citizens with impeccable credentials and a large amount of initial funds will be given a charter.

Disclosure Reporting requirements for financial intermediaries are stringent. Their bookkeeping must follow certain strict principles, their books are subject to periodic inspection, and they must make certain information available to the public.

restrictions on assets and activities Financial intermediaries are restricted in what they are allowed to do and what assets they can hold. Before you put funds into a bank or similar institution, you will want to know that your funds are safe and that the bank or other financial intermediary will be able to meet its obligations to you. One way of ensuring the trustworthiness of financial intermediaries is to restrict them from engaging in certain risky activities. Legislation passed in 1933 (and repealed in 1999) separated commercial banking from the securities industry so that banks could not engage in risky ventures associated with this industry. Another way to limit a financial intermediary’s behavior is to restrict it from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent. For example, commercial banks and other depository institutions are not allowed to hold common stock because stock prices experience substantial fluctuations. Insurance companies are allowed to hold common stock, but their holdings cannot exceed a certain fraction of their total assets.

Deposit Insurance The government can insure people’s deposits so that they do not suffer great financial loss if the financial intermediary that holds these deposits should fail. The most important government agency that provides this type of insurance is the Federal Deposit Insurance Corporation (FDIC), which insures each depositor at a commercial bank or mutual savings bank up to a loss of $250,000 per account. Premiums paid by these financial institutions go into the FDIC’s Deposit Insurance Fund, which is used to pay off depositors if an institution fails. The FDIC was created in 1934 after the massive bank failures of 1930–1933, in which the savings of many depositors at commercial banks were wiped out. The National Credit Union Share Insurance Fund (NCUSIF) does the same for credit unions.

Limits on competition Politicians have often declared that unbridled competi- tion among financial intermediaries promotes failures that harm the public. Although the evidence that competition does indeed have this effect is extremely weak, state and federal governments at times have imposed restrictions on the opening of ad- ditional locations (branches). In the past, banks were not allowed to open branches in other states, and in some states banks were restricted from opening branches in additional locations.

restrictions on Interest rates Competition has also been inhibited by regula- tions that impose restrictions on interest rates that can be paid on deposits. For decades after 1933, banks were prohibited from paying interest on checking accounts. In addi- tion, until 1986, the Federal Reserve System had the power under Regulation Q to set maximum interest rates that banks could pay on savings deposits. These regulations were instituted because of the widespread belief that unrestricted interest-rate competi- tion helped encourage bank failures during the Great Depression. Later evidence does not seem to support this view, and Regulation Q has been abolished (although there are still restrictions on paying interest on checking accounts held by businesses).

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C h a p t e r 2 An Overview of the Financial System 45

In later chapters, we will look more closely at government regulation of financial markets and explore whether it has improved their functioning.

Financial regulation abroad Not surprisingly, given the similarity of the economic systems here and in Japan, Canada, and the nations of Western Europe, financial regulation in these countries is similar to that in the United States. Provision of information is improved by requiring corporations issuing securities to report details about assets and liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness of intermediaries is ensured by licensing, periodic inspection of financial intermediaries’ books, and provi- sion of deposit insurance (although its coverage is smaller than that in the United States and its existence is often intentionally not advertised).

The major differences between financial regulation in the United States and abroad relate to bank regulation. In the past, the United States was the only industrialized country that subjected banks to restrictions on branching, which limited their size and confined them to certain geographic regions. (These restrictions were abolished by leg- islation in 1994.) U.S. banks are also the most restricted in the range of assets they may hold. Banks abroad frequently hold shares in commercial firms; in Japan and Germany, those stakes can be sizable.

suMMary

1. The basic function of financial markets is to chan- nel funds from savers who have an excess of funds to spenders who have a shortage of funds. Financial mar- kets can do this either through direct finance, in which borrowers borrow funds directly from lenders by sell- ing them securities, or through indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. This channeling of funds improves the economic welfare of everyone in society. Because they allow funds to move from people who have no productive investment opportunities to those who have such opportunities, financial markets contribute to economic efficiency. In addition, chan- neling of funds directly benefits consumers by allowing them to make purchases when they need them most.

2. Financial markets can be classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets.

3. The principal money market instruments (debt instru- ments with maturities of less than one year) are U.S. Treasury bills, negotiable bank certificates of deposit, commercial paper, repurchase agreements, and federal funds. The principal capital market instruments (debt

and equity instruments with maturities greater than one year) are stocks, mortgages, corporate bonds, U.S. government securities, U.S. government agency securi- ties, state and local government bonds, and consumer and bank commercial loans.

4. An important trend in recent years is the growing interna- tionalization of financial markets. Eurobonds, which are denominated in a currency other than that of the country in which they are sold, are now the dominant security in the international bond market and have surpassed U.S. corporate bonds as a source of new funds. Eurodollars, which are U.S. dollars deposited in foreign banks, are an important source of funds for American banks.

5. Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use those funds to acquire assets by purchasing securi- ties or making loans. Financial intermediaries play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral haz- ard. As a result, financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets, thereby increasing the efficiency of the economy. However, the economies of scope that help make financial intermediaries successful can lead

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46 P a r t 1 Introduction

to conflicts of interest that make the financial system less efficient.

6. The principal financial intermediaries fall into three cat- egories: (a) banks—commercial banks, savings and loan associations, mutual savings banks, and credit unions; (b) contractual savings institutions—life insurance com- panies, fire and casualty insurance companies, and pen- sion funds; and (c) investment intermediaries—finance companies, mutual funds, money market mutual funds and hedge funds.

7. The government regulates financial markets and financial intermediaries for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. Regulations include requiring disclosure of information to the public, restrictions on who can set up a financial intermediary, restrictions on what assets financial intermediaries can hold, the provision of deposit insurance, limits on competition, and restric- tions on interest rates.

Key Terms

adverse selection, p. 36 asset transformation, p. 36 asymmetric information, p. 36 brokers, p. 26 capital, p. 24 capital market, p. 27 conflicts of interest, p. 38 currency, p. 28 dealers, p. 26 default, p. 28 diversification, p. 36 dividends, p. 25 economies of scale, p. 35 economies of scope, p. 38 equities, p. 25

Eurobond, p. 33 Eurocurrencies, p. 33 Eurodollars, p. 33 exchanges, p. 26 federal funds rate, p. 29 financial intermediation, p. 34 financial panic, p. 43 foreign bonds, p. 32 intermediate-term, p. 25 investment bank, p. 26 liabilities, p. 23 liquid, p. 26 liquidity services, p. 35 long-term, p. 25 maturity, p. 25

money market, p. 27 moral hazard, p. 37 mortgages, p. 30 mortgage-backed securities, p. 30 over-the-counter (OTC) market, p. 26 portfolio, p. 36 primary market, p. 25 risk, p. 36 risk sharing, p. 36 secondary market, p. 25 short-term, p. 25 thrift institutions (thrifts), p. 38 transaction costs, p. 34 underwrite, p. 42 underwriting, p. 26

QuesTions

All questions are available in MyEconLab at http://www.myeconlab.com.

1. If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next year because it enables me to get a job as a traveling salesman, should I take out a loan from Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan sharking?

2. Some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

3. Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?

4. If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?

5. “Because corporations do not actually raise any funds in secondary markets, secondary markets are less important to the economy than primary markets are.” Is this statement true, false, or uncertain?

6. Describe who issues each of the following money market instruments:

a. Treasury bills

b. Certificates of deposit

c. Commercial paper

d. Repurchase agreement

e. Fed funds

M02_MISH6760_11_SE_Ch02_022-048.indd 46 11/10/14 10:06 AM

C h a p t e r 2 An Overview of the Financial System 47

7. What is the difference between a mortgage and a mortgage- backed security?

8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a railroad system. Why did this make both countries better off?

9. A significant number of European banks held large amounts of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

10. How does risk sharing benefit both financial intermediaries and private investors?

11. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection?

13. Why do loan sharks worry less about moral hazard in connection with their borrowers than some other lenders do?

14. If you are an employer, what kinds of moral hazard problems might you worry about with regard to your employees?

15. If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard prob- lem still exist?

16. “In a world without information costs and transac- tion costs, financial intermediaries would not exist.” Is this statement true, false, or uncertain? Explain your answer.

17. Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate, rather than lend her the funds yourself?

18. How do conflicts of interest make the asymmetric information problem worse?

19. How can the provision of several types of financial ser- vices by one firm be both beneficial and problematic?

20. If you were going to get a loan to purchase a new car, which financial intermediary would you use: a credit union, a pension fund, or an investment bank?

21. Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing market?

22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit on insured losses to bank depositors from $100,000 per account to $250,000 per account. How would this help stabi- lize the financial system?

All applied problems are available in MyEconLab at http://www.myeconlab.com.

23. Suppose you have just inherited $10,000 and are con- sidering the following options for investing the money to maximize your return:

Option 1: Put the money in an interest-bearing checking account that earns 2%. The FDIC insures the account against bank failure.

Option 2: Invest the money in a corporate bond with a stated return of 5%, although there is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friend’s roommates, Mike, at an agreed-upon interest rate of 8%, even though you believe there is a 7% chance that Mike will leave town without repaying you.

Option 4: Hold the money in cash and earn zero return.

a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event.)

b. Suppose Option 3 is your only possibility. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, would you pay the $100? What does this say about the value of better information regarding risk?

aPPLIeD PrOBLeMs

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48 p a r t 1 Introduction

Data anaLysIs PrOBLeMs

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on federal debt held by the Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international and foreign investors (FDHBFIN). Using these series, calculate the total amount held and the percentage held in each of the three categories for the most recent quarter available. Repeat for the first quarter of 2000, and compare the results.

2. Go to the St. Louis Federal Reserve FRED database, and find data on the total assets of all commercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds (MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjusting the Frequency setting to “Quarterly.” Calculate the percent increase in growth of assets for each series, from January 2000 to the most recent quarter available. Which of the two financial intermediaries has experienced the most growth?

WeB exercIses

1. One of the single best sources of information about financial institutions is the U.S. Flow of Funds report, produced by the Federal Reserve. This document contains data on most financial intermediaries. Go to http://www.federalreserve.gov/releases/Z1/ and find the most current release. You may have to get Acrobat Reader if your computer does not already have it; the site has a link for a free download. Go to the Level Tables and answer the following questions.

a. What percentage of assets do commercial banks hold in loans? What percentage of assets is held in mortgage loans?

b. What percentage of assets do savings and loans hold in mortgage loans?

c. What percentage of assets do credit unions hold in mortgage loans and in consumer loans?

2. The most famous financial market in the world is the New York Stock Exchange. Go to http://www.nyse .com.

a. What is the mission of the NYSE?

b. Firms must pay a fee to list their shares for sale on the NYSE. What would be the fee for a firm with five million common shares outstanding?

WeB reFerences

http://stockcharts.com/charts/historical

Contains historical stock index charts for the Dow Jones Industrial Average, S&P 500, NASDAQ, 30-year Treasury Bond, and gold prices.

http://www.nyse.com

New York Stock Exchange. Find listed companies, quotes, company historical data, real-time market indexes, and more.

http://www.nasdaq.com

Detailed market and security information for the NASDAQ OTC stock exchange.

http://finance.yahoo.com

Major world stock indexes, with charts, news, and components.

http://www.sec.gov

The United States Securities and Exchange Commission home page. Contains vast SEC resources, laws and regulations, investor information, and litigation.

M02_MISH6760_11_SE_Ch02_022-048.indd 48 29/09/14 4:59 PM

Learning Objectives • Describe what money is. • List and summarize the functions of money.

• Identify different types of payment systems.

• Compare and contrast the M1 and M2 money supplies.

3 Preview

If you had lived in America before the Revolutionary War, your money might have consisted primarily of Spanish doubloons (silver coins that were also called pieces of eight). Before the Civil War, the principal forms of money in the United States were gold and silver coins and paper notes, called banknotes, issued by private banks. Today, you use as money not only coins and paper bills issued by the government, but also debit cards and checks written on accounts held at banks. Money has taken different forms at different times, but it has always been important to people and to the economy.

To understand the effects of money on the economy, we must understand exactly what money is. In this chapter, we develop precise definitions by exploring the func- tions of money, looking at why and how it promotes economic efficiency, tracing how its forms have evolved over time, and examining how money is currently measured.

MeanIng Of MOney As used in everyday conversation, the word money can mean many things, but to economists it has a very specific meaning. To avoid confusion, we must clarify how economists’ use of the word money differs from conventional usage.

Economists define money (also referred to as the money supply) as anything that is generally accepted as payment for goods or services or in the repayment of debts. Cur- rency, consisting of paper bills and coins, clearly fits this definition and is one type of money. When most people talk about money, they’re talking about currency (paper money and coins). If, for example, someone comes up to you and says, “Your money or your life,” you should quickly hand over all of your currency rather than ask, “What exactly do you mean by ‘money’?”

To define money merely as currency is much too narrow a definition for econo- mists. Because checks are also accepted as payment for purchases, checking account deposits are considered money as well. An even broader definition of money is needed because other items, such as savings deposits, can, in effect, function as money if they can be quickly and easily converted into currency or checking account deposits. As you can see, no single, precise definition of money or the money supply is possible, even for economists.

To complicate matters further, the word money is frequently used synonymously with wealth. When people say, “Joe is rich—he has an awful lot of money,” they probably

What Is Money?

49

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50 P a r t 1 Introduction

mean that Joe not only has a lot of currency and a high balance in his checking account but also has stocks, bonds, four cars, three houses, and a yacht. Thus, while “currency” is too narrow a definition of money, this other popular usage is much too broad. Econo- mists make a distinction between money in the form of currency, demand deposits, and other items that are used to make purchases, and wealth, the total collection of pieces of property that serve to store value. Wealth includes not only money but also other assets such as bonds, common stock, art, land, furniture, cars, and houses.

People also use the word money to describe what economists call income, as in the sentence “Sheila would be a wonderful catch; she has a good job and earns a lot of money.” Income is a flow of earnings per unit of time. Money, by contrast, is a stock: It is a certain amount at a given point in time. If someone tells you that he has an income of $1,000, you cannot tell whether he earns a lot or a little without knowing whether this $1,000 is earned per year, per month, or even per day. But if someone tells you that she has $1,000 in her pocket, you know exactly how much this is.

Keep in mind that the money discussed in this book refers to anything that is gen- erally accepted as payment for goods and services or in the repayment of debts, and is distinct from income and wealth.

functIOns Of MOney Whether money is shells or rocks or gold or paper, it has three primary functions in any economy: as a medium of exchange, as a unit of account, and as a store of value. Of the three functions, its function as a medium of exchange is what distinguishes money from other assets such as stocks, bonds, and houses.

Medium of exchange In almost all market transactions in our economy, money in the form of currency or checks is a medium of exchange; it is used to pay for goods and services. The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services. To see why, let’s look at a barter economy, one without money, in which goods and services are exchanged directly for other goods and services.

Take the case of Ellen the Economics Professor, who can do just one thing well: give brilliant economics lectures. In a barter economy, if Ellen wants to eat, she must find a farmer who not only produces the food she likes but also wants to learn econom- ics. As you might expect, this search will be difficult and time-consuming, and Ellen might spend more time looking for such an economics-hungry farmer than she will teaching. It is even possible that she will have to quit lecturing and go into farming herself. Even so, she may still starve to death.

The time spent trying to exchange goods or services is called a transaction cost. In a barter economy, transaction costs are high because people have to satisfy a “double coincidence of wants”—they have to find someone who has a good or service they want and who also wants the good or service they have to offer.

Let’s see what happens if we introduce money into Ellen the Economics Professor’s world. Ellen can teach anyone who is willing to pay money to hear her lecture. She can then go to any farmer (or his representative at the supermarket) and buy the food she needs with the money she has been paid. The problem of the double coincidence of

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C h a P t e r 3 What Is Money? 51

wants is avoided, and Ellen saves a lot of time, which she may spend doing what she does best: teaching.

As this example shows, money promotes economic efficiency by eliminating much of the time spent exchanging goods and services. It also promotes efficiency by allowing people to specialize in what they do best. Money is therefore essential in an economy: It is a lubricant that allows the economy to run more smoothly by lowering transaction costs, thereby encouraging specialization and division of labor.

The need for money is so strong that almost every society beyond the most primi- tive invents it. For a commodity to function effectively as money, it has to meet several criteria: (1) It must be easily standardized, making it simple to ascertain its value; (2) it must be widely accepted; (3) it must be divisible, so that it is easy to “make change”; (4) it must be easy to carry; and (5) it must not deteriorate quickly. Objects that have satisfied these criteria have taken many unusual forms throughout human history, ranging from wampum (strings of beads) used by Native Americans; to tobacco and whiskey, used by the early American colonists; to cigarettes, used in prisoner-of-war camps during World War II.1 The diverse forms of money that have been developed over the years are as much a testament to the inventiveness of the human race as are the developments of tools and language.

unit of account The second role of money is to provide a unit of account; that is, money is used to measure value in an economy. We measure the value of goods and services in terms of money, just as we measure weight in terms of pounds or distance in terms of miles. To see why this function is important, let’s look again at a barter economy, in which money does not perform this function. If the economy has only three goods—say, peaches, economics lectures, and movies—then we need to know only three prices to tell us how to exchange one for another: the price of peaches in terms of economics lectures (that is, how many economics lectures you have to pay for a peach), the price of peaches in terms of movies, and the price of economics lectures in terms of movies. If there were 10 goods, we would need to know 45 prices in order to exchange one good for another; with 100 goods, we would need 4,950 prices; and with 1,000 goods, we would need 499,500 prices.2

Imagine how hard it would be in a barter economy to shop at a supermarket with 1,000 different items on its shelves and be faced with deciding whether chicken or fish is a better buy if the price of a pound of chicken were quoted as 4 pounds of butter and the price of a pound of fish as 8 pounds of tomatoes. To make it possible to compare prices, the tag on each item would have to list up to 999 different prices, and the time spent reading them would result in very high transaction costs.

1An extremely entertaining article on the development of money in a prisoner-of-war camp during World War II is R. A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica 12 (November 1945): 189–201. 2The formula for telling us the number of prices we need when we have N goods is the same formula that tells us the number of pairs when there are N items. It is

N1N - 12

2

In the case of ten goods, for example, we would need

10110 - 12

2 =

90

2 = 45 prices.

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52 P a r t 1 Introduction

The solution to the problem is to introduce money into the economy and have all prices quoted in terms of units of that money, enabling us to quote the price of econom- ics lectures, peaches, and movies in terms of, say, dollars. If there were only three goods in the economy, this would not be a great advantage over the barter system, because we would still need three prices to conduct transactions. But for 10 goods we would need only 10 prices; for 100 goods, 100 prices; and so on. At the 1,000-goods supermarket, now only 1,000 prices need to beconsidered, not 499,500!

We can see that using money as a unit of account lowers transaction costs in an economy by reducing the number of prices that need to be considered. The benefits of this function of money grow as the economy becomes more complex.

store of Value Money also functions as a store of value; it is a repository of purchasing power avail- able over time. A store of value is used to save purchasing power from the time income is received until the time it is spent. This function of money is useful because most of us do not want to spend our income immediately upon receiving it, but rather prefer to wait until we have the time or the desire to shop.

Money is not unique as a store of value; any asset—whether money, stocks, bonds, land, houses, art, or jewelry—can be used to store wealth. Many such assets have advantages over money as a store of value: They often pay the owner a higher interest rate than money, experience price appreciation, and deliver services such as providing a roof over one’s head. If these assets are a more desirable store of value than money, why do people hold money at all?

The answer to this question relates to the important economic concept of liquidity, the relative ease and speed with which an asset can be converted into a medium of exchange. Liquidity is highly desirable. Money is the most liquid asset of all because it is the medium of exchange; it does not have to be converted into anything else to make purchases. Other assets involve transaction costs when they are converted into money. When you sell your house, for example, you have to pay a brokerage commission (usually 4–6% of the sales price), and if you need cash immediately to pay some pressing bills, you might have to settle for a lower price if you want to sell the house quickly. Because money is the most liquid asset, people are willing to hold it even if it is not the most attractive store of value.

How good a store of value money is depends on the price level. A doubling of all prices, for example, means that the value of money has dropped by half; conversely, a halving of all prices means that the value of money has doubled. During times of infla- tion, when the price level is increasing rapidly, money loses value rapidly, and people become more reluctant to hold their wealth in this form. This is especially true during periods of extreme inflation, known as hyperinflation, in which the inflation rate exceeds 50% per month.

Hyperinflation occurred in Germany after World War I, with inflation rates sometimes exceeding 1,000% per month. By the end of the hyperinflation of 1923, the price level had risen to more than 30 billion times what it had been just two years before. The quantity of money needed to purchase even the most basic items became excessive. There are sto- ries, for example, that near the end of the hyperinflation, a wheelbarrow of cash would be required to pay for a loaf of bread. Money was losing its value so rapidly that workers were paid and then given time off on several occasions during the day to spend their wages before the money became worthless. No one wanted to hold on to money, so the use of money to carry out transactions declined, and barter became more and more dominant. Transaction costs skyrocketed and, as we would expect, output in the economy fell sharply.

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C h a P t e r 3 What Is Money? 53

eVOLutIOn Of the PayMents systeM We can obtain a better picture of the functions of money and the forms it has taken over time by looking at the evolution of the payments system, the method of conducting transactions in the economy. The payments system has been evolving over centuries, and with it the form of money. At one point, precious metals such as gold were used as the principal means of payment and were the main form of money. Later, paper assets such as checks and currency began to be used in the payments system and viewed as money. Where the payments system is heading has an important bearing on how money will be defined in the future.

commodity Money To obtain perspective on where the payments system is heading, it’s worth exploring how it has evolved. For any object to function as money, it must be universally accept- able; everyone must be willing to take it in payment for goods and services. An object that clearly has value to everyone is a likely candidate to serve as money, and a natural choice is a precious metal such as gold or silver. Money made up of precious metals or another valuable commodity is called commodity money, and from ancient times until several hundred years ago, commodity money functioned as the medium of exchange in all but the most primitive societies. The problem with a payments system based exclusively on precious metals is that such a form of money is very heavy and is hard to transport from one place to another. Imagine the holes you’d wear in your pockets if you had to buy things only with coins! Indeed, for a large purchase such as a house, you’d have to rent a truck to transport the money payment.

fiat Money The next development in the payments system was paper currency (pieces of paper that function as a medium of exchange). Initially, paper currency carried a guarantee that it was convertible into coins or into a fixed quantity of precious metal. However, currency has evolved into fiat money, paper currency decreed by governments as legal tender (meaning that it must be accepted as legal payment for debts) but not convertible into coins or pre- cious metal. Paper currency has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is some trust in the authorities who issue it and if printing has reached a sufficiently advanced stage that coun- terfeiting is extremely difficult. Because paper currency has evolved into a legal arrangement, countries can change the currency they use at will. Indeed, this is what many European countries did when they abandoned their currencies for the euro in 2002.

Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive to transport in large amounts because of their bulk. To combat this problem, another step in the evolution of the payments system occurred with the devel- opment of modern banking: the invention of checks.

checks A check is an instruction from you to your bank to transfer money from your account to someone else’s account when she deposits the check. Checks allow transactions to take place without the need to carry around large amounts of currency. The introduction of checks was a major innovation that improved the efficiency of the payments system. Frequently, payments made back and forth cancel each other; without checks, this

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54 P a r t 1 Introduction

would involve the movement of a lot of currency. With checks, payments that cancel each other can be settled by canceling the checks, and no currency need be moved. The use of checks thus reduces the transportation costs associated with the payments system and improves economic efficiency. Another advantage of checks is that they can be written for any amount up to the balance in the account, making transactions for large amounts much easier. Checks are also advantageous in that loss from theft is greatly reduced and because they provide convenient receipts for purchases.

Two problems arise, however, with a payments system based on checks. First, it takes time to get checks from one place to another, a particularly serious problem if you are paying someone in a different location who needs to be paid quickly. In addition, if you have a checking account, you know that it often takes several business days before a bank will allow you to make use of the funds from a check you have deposited. If your need for cash is urgent, this feature of paying by check can be frustrating. Second, the paper shuffling required to process checks is costly; currently, the cost of processing all checks written in the United States is estimated at over $10 billion per year.

electronic Payment The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills electronically. In the past, you had to pay a bill by mailing a check, but now banks provide websites at which you just log on, make a few clicks, and thereby trans- mit your payment electronically. Not only do you save the cost of the stamp, but paying bills becomes (almost) a pleasure, requiring little effort. Electronic payment systems pro- vided by banks now even spare you the step of logging on to pay the bill. Instead, recur- ring bills can be automatically deducted from your bank account. Estimated cost savings when a bill is paid electronically rather than by a check exceed one dollar per transaction. Electronic payment is thus becoming more and more common in the United States.

e-Money Electronic payments technology can substitute not only for checks but also for cash, in the form of electronic money (or e-money)—money that exists only in electronic form. The first form of e-money was the debit card. Debit cards, which look like credit cards, enable consumers to purchase goods and services by electronically transferring funds directly from their bank accounts to a merchant’s account. Debit cards are used in many of the same places that accept credit cards and are now often faster to use than cash. At most supermarkets, for example, you can swipe your debit card through the card reader at the checkout station, press a button, and the amount of your purchase is deducted from your bank account. Most banks, as well as companies such as Visa and MasterCard, issue debit cards, and your ATM card typically can function as a debit card.

A more advanced form of e-money is the stored-value card. The simplest form of stored-value card is purchased for a preset dollar amount that the consumer pays up front, like a prepaid phone card. The more sophisticated stored-value card is known as a smart card. It contains a computer chip that allows it to be loaded with digital cash from the owner’s bank account whenever needed. In Asian countries, such as Japan and Korea, cell phones now have a smart card feature that raises the expression “pay by phone” to a new level. Smart cards can be loaded from ATM machines, personal computers with a smart card reader, or specially equipped telephones.

A third form of electronic money, often referred to as e-cash, is used on the Inter- net to purchase goods or services. A consumer gets e-cash by setting up an account with

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C h a P t e r 3 What Is Money? 55

FYI Are We Headed for a Cashless Society?

Predictions of a cashless society have been around for decades, but they have not come to fruition. For exam- ple, Business Week predicted in 1975 that electronic means of payment “would soon revolutionize the very concept of money itself,” only to reverse its view sev- eral years later. In recent years, pilot projects aimed at converting consumers to the use of e-money in the form of smart cards have not been a success. Mondex, which was launched in Great Britain in 1995 and was one of the first widely-touted stored-value cards, is now used only on a few British university campuses. In Germany and Belgium, millions of people carry bank cards with computer chips embedded in them that enable them to make use of e-money, but very few people actually use them. Why has the movement to a cashless society been so slow in coming?

Although e-money might be more convenient and efficient than a payments system based on paper, several factors work against the disappearance of the paper system. First, it is very expensive to set up the computer, card reader, and telecommunications networks necessary to make electronic money the

dominant form of payment. Second, electronic means of payment raise security and privacy concerns. We often hear media reports of an unauthorized hacker who has been able to access a computer database and alter the information stored there. Because this is not an uncommon occurrence, unscrupulous persons might be able to access bank accounts in electronic payments systems and steal funds by moving them from someone else’s accounts into their own. The prevention of this type of fraud is no easy task, and a whole new field of computer science has developed to cope with such security issues. A further concern is that the use of electronic means of payment leaves an electronic trail that contains a large amount of personal data on buying habits. There are worries that govern- ment agencies, employers, and marketers might be able to access these data, thereby enabling them to encroach on our privacy if they choose to do so.

In conclusion, although the use of e-money will surely increase in the future, to paraphrase Mark Twain, “the reports of cash’s death are greatly exaggerated.”

a bank that has links to the Internet and then transferring the e-cash to her PC. When she wants to buy something with e-cash, she surfs to a store on the Web and clicks the “buy” option for a particular item, whereupon the e-cash is automatically transferred from her computer to the merchant’s computer. The merchant can then have the funds transferred from the consumer’s bank account to his own before the goods are shipped.

Given the convenience of e-money, you might think that we would move quickly to a cashless society in which all payments are made electronically. However, this hasn’t happened, as discussed in the FYI box, “Are We Headed for a Cashless Society?”

A p p lI c At I o n Will Bitcoin Become the Money of the Future? Bitcoin is a new type of electronic money created by software developer Satoshi Nakamoto in 2009. Bitcoin is not controlled by a single entity like a central bank, but rather is cre- ated in a decentralized fashion by users who generate new bitcoins when they use their computing power to verify and process Bitcoin transactions, a process referred to as “mining.” Some tech enthusiasts have characterized Bitcoin as the money of the future. But does Bitcoin satisfy the three key functions of money that we discussed earlier? That is, does it function as a medium of exchange, a unit of account, and a store of value?

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56 P a r t 1 Introduction

Bitcoin certainly functions well as a medium of exchange. It has two features that make it attractive for conducting transactions. First, the fees for conducting transactions with bitcoins are substantially lower than those associated with credit cards and debit cards. Second, transactions made with bitcoins can be made anonymously, which is very attractive to those who want to preserve their privacy.

Bitcoin, however, does not do well with regard to the other two functions of money— as a unit of account and a store of value. The price of Bitcoin has been extremely volatile, with its volatility estimated to be over seven times that of the price of gold and over eight times that of stock market indexes such as the S&P 500. For example, in 2011, the price of a bitcoin fluctuated between 30 cents and $32. It then rose to a peak of $255 on April 10, 2013, only to fall back down to $55 on April 17. On November 30, 2013, the price of a bitcoin peaked at $1125, but it then fell to below the $500 level by May of 2014.

The high volatility of the value of the bitcoin means that it does not function well as a store of value; it is just too risky. Because of this volatility, the Bitcoin has not become a unit of account: Almost no one quotes the prices of their products in terms of bitcoins.

Despite the hype, Bitcoin does not satisfy two of the three key functions of money and thus its use as money is likely to be quite limited. Furthermore, governments are con- cerned about the use of Bitcoin to conduct drug transactions and money laundering. The Department of Homeland Security seized Bitcoin assets from the Mt. Gox exchange when the FBI shut down the Silk Road drug website in May of 2013. Countries such as China have outlawed the use of Bitcoin as a currency. There also have been high-profile thefts of Bitcoin, with Mt. Gox, one of the largest Bitcoin exchanges, experiencing a theft of almost $500 million worth of Bitcoin in February of 2014, leading Mt. Gox to file for bankruptcy.

Our understanding of the functions of money strongly suggests that Bitcoin will not be the money of the future. However, some of its technology, which enables users to conduct electronic transactions cheaply, may become a feature of future electronic payments systems. ◆

MeasurIng MOney The definition of money as anything that is generally accepted as payment for goods and services tells us that money is defined by people’s behavior. An asset is considered money only if people believe it will be accepted by others when making payment. As we have seen, many different assets have performed this role over the centuries, ranging from gold to paper currency to checking accounts. For this reason, a behavioral definition does not tell us which assets in our economy should be considered money. To measure money, we need a precise definition that tells us exactly which assets should be included.

the federal reserve’s Monetary aggregates The Federal Reserve System (the Fed), the central banking authority responsible for mon- etary policy in the United States, has conducted many studies on how to measure money. The problem of measuring money has recently become especially crucial because exten- sive financial innovation has produced new types of assets that might properly belong in a measure of money. Since 1980, the Fed has modified its measures of money several times and has settled on the following measures of the money supply, which are also referred to as monetary aggregates (see Table 1 and the Following the Financial News box).

The narrowest measure of money reported by the Fed is M1, which includes the most liquid assets: currency, checking account deposits, and traveler’s checks. The

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C h a P t e r 3 What Is Money? 57

components of M1 are shown in Table 1. The currency component of M1 includes only paper money and coins in the hands of the nonbank public and does not include cash held in ATMs or bank vaults. Surprisingly, more than $4,000 cash is in circu- lation for each person in the United States (see the FYI box). The traveler’s checks component of M1 includes only traveler’s checks not issued by banks. The demand deposits component includes business checking accounts that do not pay interest, as well as traveler’s checks issued by banks. The other checkable deposits item includes all other checkable deposits, particularly interest-bearing checking accounts held by households. These assets are clearly money because they can be used directly as a medium of exchange.

Until the mid-1970s, only commercial banks were permitted to establish checking accounts, and they were not allowed to pay interest on them. With the advent of financial innovation (discussed more extensively in Chapter 11), regulations have changed so that other types of banks, such as savings and loan associations, mutual savings banks, and credit unions, can also offer checking accounts. In addition, banking institutions can offer other checkable deposits, such as NOW (negotiated order of withdrawal) accounts and ATS (automatic transfer from savings) accounts, that do pay interest on their balances.

Source: http://www.federalreserve.gov/releases/h6/hist.

Value as of August 18, 2014, ($ billions)

M1 = Currency 1,206.1 + Traveler’s checks 3.3 + Demand deposits 1,089.9 + Other checkable deposits 477.4

Total M1 2,776.7

M2 = M1 + Small-denomination time deposits 533.0 + Savings deposits and money market deposit accounts 7,338.2 + Money market mutual fund shares (retail) 642.5

Total M2 11,290.4

table 1 Measures of the Monetary aggregates

Following the Financial News The Monetary Aggregates

Every week on Thursday, the Federal Reserve publishes the data for M1 and M2 in its H.6 release. These num- bers are often reported on in the media. The H.6 release

can be found at http://www.federalreserve.gov/releases/ h6/current/h6.htm.

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58 P a r t 1 Introduction

The M2 monetary aggregate adds to M1 other assets that are not quite as liquid as those included in M1: assets that have check-writing features (money market deposit accounts and money market mutual fund shares) and other assets (savings deposits and small-denomination time deposits) that can be turned into cash quickly and at very little cost. Small-denomination time deposits are certificates of deposit with a denomination of less than $100,000 that can be redeemed without a penalty only at a fixed maturity date. Savings deposits are nontransaction deposits that can be added to or taken out at any time. Money market deposit accounts are similar to money market mutual funds but are issued by banks. The money market mutual fund shares are retail accounts on which households can write checks.

Because economists and policymakers cannot be sure which of the monetary aggregates is the best measure of money, it is logical to wonder if the movements of M1 and M2 closely parallel one another. If they do, then using one monetary aggregate to predict future eco- nomic performance and to conduct policy will be the same as using the other, and it does not much matter that we are not sure of the appropriate definition of money for a given policy decision. However, if the monetary aggregates do not move together, then what one monetary aggregate tells us is happening to the money supply might be quite different from what the other monetary aggregate would tell us. Conflicting information would present a confusing picture, making it hard for policymakers to decide on the right course of action.

Figure 1 plots the growth rates of M1 and M2 from 1960 to 2014. The growth rates of these two monetary aggregates do tend to move together; the timing of their rise and fall is roughly similar until the 1990s, and they both show a higher growth rate, on average, in the 1970s than in the 1960s.

Yet some glaring discrepancies exist between the movements of these aggregates. Contrast M1’s high rates of growth from 1992 to 1994 with the much lower growth rates of M2. Also notice that from 2004 to 2007, M2’s growth rate increased slightly, while M1’s growth rate decelerated sharply and became negative. In 2009 and 2011, M1 growth surged to over 15% from near zero the year before, while M2 growth rose

FYI Where Are All the U.S. Dollars?

The almost $4,000 of U.S. currency held per person in the United States is a surprisingly large number. U.S. currency is bulky, can be easily sto- len, and pays no interest, so it doesn’t make sense for most of us to keep a lot of it. Do you know anyone who carries $4,000 in his or her pockets? We have a puzzle: Where are all these dollars, and who is holding them?

Criminals are one group that holds a lot of dollars. If you were engaged in illegal activity, you would not conduct your transactions with checks because they are traceable and therefore a potentially powerful piece of evidence against you. That explains why gangsters like Tony Soprano have so much cash buried in their

backyards. Some businesses like to retain a lot of cash because, if they operate as a cash business, it makes their transactions less traceable; thus they can avoid declaring income on which they would otherwise have to pay taxes.

Foreigners are the other group that routinely holds U.S. dollars. In many countries, people do not trust their own currency because their country often expe- riences high inflation, which erodes the value of that currency; these people hold U.S. dollars as a hedge against this inflation risk. Lack of trust in the ruble, for example, has led Russians to hoard enormous amounts of U.S. dollars. More than half of U.S. dollars are held abroad.

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C h a P t e r 3 What Is Money? 59

less dramatically. Thus, the different measures of money tell a very different story about the results of monetary policy in recent years.

From the data in Figure 1, you can see that obtaining a single, precise, and correct measure of money does seem to matter, and that it does make a difference which monetary aggregate policymakers and economists choose as the best measure of money.

5%

20%

15%

25%

10%

–5%

–10%

0%

1965 19751960 1970 1985 1990 1995 20052000 2010 20151980

Year

M on

ey G

ro w

th (

pe rc

en t c

ha ng

e ye

ar -o

ve r-

ye ar

)

M1 M2

M1 M2

Figure 1 growth rates of the M1 and M2 aggregates, 1960–2014 The timing of the rise and fall of growth rates is roughly similar for both M1 and M2. There were periods,

however, such as 1992–1994 and 2004–2007, during which M1 and M2 moved in opposite directions, leading to conflicting recommendations about the best course of monetary policy.

Source: Federal reserve bank of St. louis, FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

suMMary

1. To economists, the word money has a different meaning than income or wealth. Money is anything that is gener- ally accepted as payment for goods or services or in the repayment of debts.

2. Money serves three primary functions: as a medium of exchange, as a unit of account, and as a store of value. Money as a medium of exchange helps an economy avoid the problem of double coincidence of wants that arises in a barter economy, and thus lowers transaction costs and

encourages specialization and the division of labor. Money as a unit of account reduces the number of prices needed in an economy, which also reduces transaction costs. Money also functions as a store of value, but performs this role poorly if it is rapidly losing value due to inflation.

3. The payments system has evolved over time. Until several hundred years ago, the payments systems in all but the most primitive societies were based primarily on precious metals. The introduction of paper currency lowered the

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60 P a r t 1 Introduction

Key terMs

commodity money, p. 53 currency, p. 49 e-cash, p. 54 electronic money (e-money), p. 54 fiat money, p. 53 hyperinflation, p. 52

income, p. 50 liquidity, p. 52 M1, p. 56 M2, p. 58 medium of exchange, p. 50 monetary aggregates, p. 56

payments system, p. 53 smart card, p. 54 store of value, p. 52 unit of account, p. 51 wealth, p. 50

QuestIOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Why is simply counting currency an inadequate mea- sure of money?

2. In prison, cigarettes are sometimes used among inmates as a form of payment. How is it possible for cigarettes to solve the “double coincidence of wants” problem, even if a prisoner does not smoke?

3. Three goods are produced in an economy by three individuals:

Good Producer

Apples Orchard owner

Bananas Banana grower

Chocolate Chocolatier

If the orchard owner likes only bananas, the banana grower likes only chocolate, and the choco- latier likes only apples, will any trade between these three persons take place in a barter economy? How will introducing money into the economy benefit these three producers?

4. Why did cavemen not need money?

5. Most of the time it is quite difficult to separate the three functions of money. Money performs its three functions at all times, but sometimes we can stress one

in particular. For each of the following situations, iden- tify which function of money is emphasized.

a. Brooke accepts money in exchange for performing her daily tasks at her office, since she knows she can use that money to buy goods and services.

b. Tim wants to calculate the relative value of oranges and apples, and therefore checks the price per pound of each of these goods as quoted in currency units.

c. Maria is currently pregnant. She expects her expen- ditures to increase in the future and decides to increase the balance in her savings account.

6. In Brazil, a country that underwent a rapid inflation before 1994, many transactions were conducted in dol- lars rather than in reals, the domestic currency. Why?

7. Was money a better store of value in the United States in the 1950s than in the 1970s? Why or why not? In which period would you have been more willing to hold money?

8. Why have some economists described money during a hyperinflation as a “hot potato” that is quickly passed from one person to another?

9. Why were people in the United States in the nineteenth century sometimes willing to be paid by check rather than with gold, even though they knew there was a possibility that the check might bounce?

cost of transporting money. The next major advance was the introduction of checks, which lowered transaction costs still further. We are currently moving toward an electronic payments system in which paper is eliminated and all transactions are handled by computers. Despite the potential efficiency of such a system, obstacles are slowing the movement to a checkless society and the development of new forms of electronic money.

4. The Federal Reserve System has defined two different measures of the money supply—M1 and M2. These measures are not equivalent and do not always move together, so they cannot be used interchangeably by policymakers. Obtaining the precise, correct measure of money does seem to matter and has implications for the conduct of monetary policy.

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C h a P t e r 3 What Is Money? 61

a. Currency

b. Money market mutual funds

c. Small-denomination time deposits

d. Checkable deposits

16. Assume that you are interested in earning some return on the idle balances you usually keep in your checking account and decide to buy some money market mutual funds shares by writing a check. Comment on the effect of your action (with everything else the same) on M1 and M2.

17. In April 2009, the growth rate of M1 fell to 6.1%, while the growth rate of M2 rose to 10.3%. In September 2013, the year-over-year growth rate of the M1 money supply was 6.5%, while the growth rate of the M2 money supply was about 8.3%. How should Federal Reserve policymakers interpret these changes in the growth rates of M1 and M2?

18. Suppose a researcher discovers that a measure of the total amount of debt in the U.S. economy over the past twenty years was a better predictor of inflation and the business cycle than M1 or M2. Does this discovery mean that we should define money as equal to the total amount of debt in the economy?

10. In ancient Greece, why was gold a more likely candi- date for use as money than wine?

11. If you use an online payment system such as PayPal to purchase goods or services on the Internet, does this affect the M1 money supply, the M2 money supply, both, or neither? Explain.

12. Rank the following assets from most liquid to least liquid:

a. Checking account deposits

b. Houses

c. Currency

d. Automobiles

e. Savings deposits

f. Common stock

13. Which of the Federal Reserve’s measures of the mon- etary aggregates—M1 or M2—is composed of the most liquid assets? Which is the larger measure?

14. It is not unusual to find a business that displays a sign saying “no personal checks, please.” On the basis of this observation, comment on the relative degree of liquidity of a checking account versus currency.

15. For each of the following assets, indicate which of the monetary aggregates (M1 and M2) includes them:

2015 2016 2017 2018

A. Currency 900 920 925 931

B. Money market mutual fund shares 680 681 679 688

C. Saving account deposits 5,500 5,780 5,968 6,105

D. Money market deposit accounts 1,214 1,245 1,274 1,329

E. Demand and checkable deposits 1,000 972 980 993

F. Small denomination time deposits 830 861 1,123 1,566

G. Traveler’s checks 4 4 3 2

H. 3-month treasury bills 1,986 2,374 2,436 2,502

All applied problems are available in MyEconLab at http://www.myeconlab.com.

19. The table below shows hypothetical values, in billions of dollars, of different forms of money.

a. Use the table to calculate the M1 and M2 money sup- plies for each year, as well as the growth rates of the M1 and M2 money supplies from the previous year.

b. Why are the growth rates of M1 and M2 so different? Explain.

aPPLIed PrObLeMs

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62 P a r t 1 Introduction

Web exercIses

1. Go to http://www.federalreserve.gov/releases/h6/Current/.

a. What have been the growth rates of M1 and M2 over the past twelve months?

b. From what you know about the state of the economy, do these growth rates seem expansionary or restrictive?

data anaLysIs PrObLeMs

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on currency (CURRSL), traveler’s checks (TVCKSSL), demand deposits (DEMDEPSL), and other checkable deposits (OCDSL). Calculate the M1 money supply, and calculate the percentage change in M1 and in each of the four components of M1 from the most recent month of data available to the same time one year prior. Which component has the highest growth rate? The lowest growth rate? Repeat the calculations using the data from January 2000 to the most recent month of data available, and compare your results.

2. Go to the St. Louis Federal Reserve FRED database, and find data on small-denomination time deposits (STDSL), savings deposits and money market deposit accounts (SAVINGSL), and retail money market funds (RMFSL). Calculate the percentage change of each of these three components of M2 (not included in M1) from the most recent month of data available to the same time one year prior. Which component has the highest growth rate? The lowest growth rate? Repeat the calculations using the data from January 2000 to the most recent month of data available, and compare your results. Use your answers from question 1 to determine which grew faster: the non-M1 components of M2, or the M1 money supply.

Web references

http://www.federalreserve.gov/paymentsystems/default.htm

This site reports on the Federal Reserve’s policies regarding payments systems.

http://www.federalreserve.gov/releases/h6/Current/

The Federal Reserve reports the current levels of M1 and M2 on this website.

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Financial Markets

Crisis and Response: Credit Market Turmoil and the Stock Market Crash of October 2008

The financial crisis that started during the summer of 2007 began to snowball as the value of mortgage-backed securities on financial institutions’ balance sheets plummeted. When the House of Representatives, fearing the wrath of constituents who were angry about proposals to bail out Wall Street, voted down a $700 billion bailout package proposed by the Bush administration on Monday, September 29, 2008, the financial crisis took an even more virulent turn, despite the bailout package that was passed four days later.

A “flight to quality” drove three-month Treasury bill rates down to almost zero, rates not seen since the Great Depression of the 1930s. Credit spreads—an indicator of risk—shot through the roof, with the gap between Eurodollar and Treasury bill rates (the TED spread) going from around 40 basis points (0.40 percentage point) before the financial crisis began to over 450 basis points in mid-October, the highest value in its history. After earlier sharp declines, the stock market crashed further, with the week beginning on October 6, 2008, showing the worst weekly decline in U.S. history.

The recent financial crisis illustrates how volatile financial markets can be. This volatility hit financial consumers directly, leading to difficulty in getting loans, falling home values, and declining retirement account values, and putting jobs in jeopardy. How can policy respond to disruptions in financial markets? We begin addressing this question by examining the inner workings of financial markets, particularly interest rate dynamics. Chapter 4 explains what an interest rate is, as well as the relationships among interest rates, bond prices, and returns. Chapter 5 examines how the overall level of interest rates is determined. In Chapter 6, we extend the analysis of the bond market to explain changes in credit spreads and the relationship of long-term to short-term interest rates. Chapter 7 looks at the role of expectations in the stock market and explores what drives stock prices.

2 Part

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Preview

Interest rates are among the most closely watched variables in the economy. Their movements are reported almost daily by the news media because they directly affect our everyday lives and have important consequences for the health of the economy. They influence personal decisions such as whether to consume or save, whether to buy a house, and whether to purchase bonds or put funds into a savings account. Interest rates also affect the economic decisions of businesses and households, such as whether to use their funds to invest in new equipment for factories or to save rather than spend their money.

Before we can go on with the study of money, banking, and financial markets, we must understand exactly what the phrase interest rates means. In this chapter, we see that a concept known as the yield to maturity is the most accurate measure of interest rates; the yield to maturity is what economists mean when they use the term interest rate. We’ll discuss how the yield to maturity is measured. We’ll also see that a bond’s interest rate does not necessarily indicate how good an investment the bond is, because what the bond earns (its rate of return) does not necessarily equal its interest rate. Finally, we’ll explore the distinction between real interest rates, which are adjusted for inflation, and nominal interest rates, which are not.

Although learning definitions is not always the most exciting of pursuits, it is important to read carefully and understand the concepts presented in this chapter. Not only are they used continually throughout the remainder of this text, but a firm grasp of these terms will give you a clearer understanding of the role that interest rates play in your life as well as in the general economy.

MeasurIng Interest rates Different debt instruments have very different streams of cash payments (known as cash flows) to the holder, with very different timing. Thus we first need to understand how we can compare the value of one kind of debt instrument with the value of another before we see how interest rates are measured. To do this, we make use of the concept of present value.

Present Value The concept of present value (or present discounted value) is based on the com- monsense notion that a dollar paid to you one year from now is less valuable than a dollar paid to you today. This notion is true because you can deposit a dollar today in a

4 The Meaning of Interest Rates Learning Objectives • Calculate the present value of future cash flows and the yield to maturity on the four types of credit market instruments.

• Recognize the distinc- tions among yield to maturity, current yield, rate of return, and rate of capital gain.

• Interpret the distinc- tion between real and nominal interest rates.

64

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C h a p t e r 4 The Meaning of Interest Rates 65

savings account that earns interest and have more than a dollar in one year. Economists use a more formal definition, as explained in this section.

Let’s look at the simplest kind of debt instrument, which we will call a simple loan. In this loan, the lender provides the borrower with an amount of funds (called the principal) that must be repaid to the lender at the maturity date, along with an addi- tional payment for the interest. For example, if you made your friend, Jane, a simple loan of $100 for one year, you would require her to repay the principal of $100 in one year’s time, along with an additional payment for interest—say, $10. In the case of a simple loan like this one, the interest payment divided by the amount of the loan is a natural and sensible way to measure the interest rate. This measure of the so-called simple interest rate, i, is

i = $10

$100 = 0.10 = 10%

If you make this $100 loan, at the end of the year you will have $110, which can be rewritten as

$100 * 11 + 0.102 = $110 If you then lent out the $110 at the same interest rate, at the end of the second

year you would have

$110 * 11 + 0.102 = $121 or, equivalently,

$100 * (1 + 0.10) * (1 + 0.10) = $100 * 11 + 0.1022 = $121 Continuing with the loan again, at the end of the third year you would have

$121 * 11 + 0.102 = $100 * 11 + 0.1023 = $133 Generalizing, we can see that at the end of n years, your $100 would turn into

$100 * 11 + i2n The amounts you would have at the end of each year by making the $100 loan

today can be seen in the following timeline:

$100 3 (1 1 0.10)n

Year n

Today 0

$100 $110

Year 1

$121

Year 2

$133

Year 3

This timeline clearly indicates that you are just as happy having $100 today as you will be having $110 a year from now (of course, as long as you are sure that Jane will pay you back). You are also just as happy having $100 today as you will be having $121 two years from now, or $133 three years from now, or 100 * 11 + 0.102n dollars n years from now. The timeline indicates that we can also work backward from future amounts to the present. For example, $133 = $100 * 11 + 0.1023 three years from now is worth $100 today, so

$100 = $133

11 + 0.1023

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66 P a r t 2 Financial Markets

The process of calculating today’s value of dollars received in the future, as we have done above, is called discounting the future. We can generalize this process by writing today’s (present) value of $100 as PV and the future cash flow (payment) of $133 as CF, and then replacing 0.10 (the 10% interest rate) by i. This leads to the following formula:

PV = CF

(1 + i)n (1)

Intuitively, Equation 1 tells us that if you are promised $1 of cash flow, for cer- tain, ten years from now, this dollar would not be as valuable to you as $1 is today because, if you had the $1 today, you could invest it and end up with more than $1 in ten years.

The concept of present value is extremely useful, because it allows us to figure out today’s value (price) of a credit (debt) market instrument at a given simple interest rate i by just adding up the individual present values of all the future payments received. This information enables us to compare the values of two or more instruments that have very different timing of their payments.

A p p li c At i o n Simple Present Value What is the present value of $250 to be paid in two years if the interest rate is 15%?

Solution The present value would be $189.04. We find this value by using Equation 1,

PV = CF

11 + i2n

where CF = cash flow in two years = 250 i = annual interest rate = 0.15 n = number of years = 2

Thus

PV = $250

11 + 0.1522 = $250

1.3225 = $189.04

Today 0

$250

$189.04

Year 1

Year 2

A p p li c At i o n How Much Is That Jackpot Worth? Assume that you just hit the $20 million jackpot in the New York State Lottery, which promises you a payment of $1 million every year for the next twenty years. You are clearly excited, but have you really won $20 million?

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C h a p t e r 4 The Meaning of Interest Rates 67

Solution No, not in the present value sense. In today’s dollars, that $20 million is worth a lot less. If we assume an interest rate of 10% as in the earlier examples, the first payment of $1 million is clearly worth $1 million today, but the second payment next year is worth only $1 million> 11 + 0.102 = $909,090, a lot less than $1 million. The fol- lowing year, the payment is worth $1 million> 11 + 0.1022 = $826,446 in today’s dollars, and so on. When you add up all these amounts, they total $9.4 million. You are still pretty excited (who wouldn’t be?), but because you understand the concept of present value, you recognize that you are the victim of false advertising. In present- value terms, you didn’t really win $20 million, but instead won less than half that amount. ◆

Four types of Credit Market Instruments In terms of the timing of their cash flow payments, there are four basic types of credit market instruments.

1. A simple loan, which we have already discussed, in which the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with an additional payment for the interest. Many money market instru- ments are of this type—for example, commercial loans to businesses.

2. A fixed-payment loan (also called a fully amortized loan) in which the lender provides the borrower with an amount of funds that the borrower must repay by making the same payment, consisting of part of the principal and interest, every period (such as a month) for a set number of years. For example, if you borrow $1,000, a fixed-payment loan might require you to pay $126 every year for 25 years. Installment loans (such as auto loans) and mortgages are frequently of the fixed- payment type.

3. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. (The coupon payment is so named be- cause in the past, the bondholder obtained payment by clipping a coupon off the bond and sending it to the bond issuer, who then sent the payment to the holder. Today, it is no longer necessary to send in coupons to receive pay- ments.) A coupon bond with $1,000 face value, for example, might pay you a coupon payment of $100 per year for ten years, and then repay you the face value amount of $1,000 at the maturity date. (The face value of a bond is usu- ally in $1,000 increments.)

A coupon bond is identified by four pieces of information: First is the bond’s face value; second is the corporation or government agency that issues the bond; third is the maturity date of the bond; and fourth is the bond’s coupon rate, which is the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond. In our example, the coupon bond has a yearly coupon payment of $100 and a face value of $1,000. The coupon rate is then $100>$1,000 = 0.10, or 10%. Capital market instruments such as U.S. Treasury bonds and notes and corporate bonds are examples of coupon bonds.

4. A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a

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68 p a r t 2 Financial Markets

coupon bond, a discount bond does not make any interest payments; it just pays off the face value. For example, a one-year discount bond with a face value of $1,000 might be bought for $900; in a year’s time, the owner would be repaid the face value of $1,000. U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds are examples of discount bonds.

These four types of instruments make payments at different times: Simple loans and discount bonds make payments only at their maturity dates, whereas fixed-pay- ment loans and coupon bonds make payments periodically until maturity. How can you decide which of these instruments will provide you with the most income? They all seem so different because they make payments at different times. To solve this problem, we use the concept of present value, explained earlier, to provide us with a procedure for measuring interest rates on these different types of instruments.

Yield to Maturity Of the several common ways of calculating interest rates, the most important is the yield to maturity, which is the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.1 Because the concept behind the calculation of the yield to maturity makes good economic sense, economists consider it the most accurate measure of interest rates.

To better understand the yield to maturity, we now look at how it is calculated for the four types of credit market instruments. In all of these examples, the key to understanding the calculation of the yield to maturity is realizing that we are equating today’s value of the debt instrument with the present value of all of its future cash flow payments.

simple Loan Using the concept of present value, the yield to maturity on a simple loan is easy to calculate. For the one-year loan we discussed, today’s value is $100, and the pay- ments in one year’s time would be $110 (the repayment of $100 plus the interest payment of $10). We can use this information to solve for the yield to maturity i by recognizing that the present value of the future payments must equal today’s value of the loan.

a P P li c at i o n Yield to Maturity on a Simple Loan If Pete borrows $100 from his sister and next year she wants $110 back from him, what is the yield to maturity on this loan?

Solution

The yield to maturity on the loan is 10%.

PV = CF

11 + i2n

where PV = amount borrowed = $100 CF = cash flow in one year = $110 n = number of years = 1

1In other contexts, the yield to maturity is also called the internal rate of return.

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C h a p t e r 4 The Meaning of Interest Rates 69

Today 0

$100 $110 i 5 10%

Year 1

Thus

$100 = $110

11 + i2 11 + i2$100 = $110

11 + i2 = $110 $100

i = 1.10 - 1 = 0.10 = 10%

This calculation of the yield to maturity should look familiar because it equals the interest payment of $10 divided by the loan amount of $100; that is, it equals the sim- ple interest rate on the loan. An important point to recognize is that for simple loans, the simple interest rate equals the yield to maturity. Hence the same term i is used to denote both the yield to maturity and the simple interest rate.

Fixed-Payment Loan Recall that this type of loan has the same cash flow payment every period throughout the life of the loan. On a fixed-rate mortgage, for example, the borrower makes the same payment to the bank every month until the maturity date, at which time the loan will be completely paid off. To calculate the yield to maturity for a fixed-payment loan, we follow the same strategy that we used for the simple loan—we equate today’s value of the loan with its present value. Because the fixed-payment loan involves more than one cash flow payment, the present value of the fixed-payment loan is calculated (using Equation 1) as the sum of the present values of all cash flow payments.

In the case of our earlier example, the loan is $1,000 and the yearly payment is $126 for the next 25 years. The present value (PV) is calculated as follows: At the end of one year, there is a $126 payment with a PV of $126> 11 + i2; at the end of two years, there is another $126 payment with a PV of $126> 11 + i22; and so on until, at the end of the twenty-fifth year, the last payment of $126 with a PV of $126> 11 + i225 is made. Setting today’s value of the loan ($1,000) equal to the sum of the present values of all the yearly payments gives us

$1,000 = $126

1 + i +

$126

11 + i22 + $126

11 + i23 + c + $126

11 + i225 More generally, for any fixed-payment loan,

LV = FP

11 + i2 + FP

11 + i22 + FP

11 + i23 + c + FP

11 + i2n (2)

◆

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70 p a r t 2 Financial Markets

where LV = loan value FP = fixed yearly payment n = number of years until maturity

For a fixed-payment loan, the loan value, the fixed yearly payment, and the num- ber of years until maturity are known quantities, and only the yield to maturity is not. So we can solve this equation for the yield to maturity i. Because this calculation is not easy, many financial calculators have programs that enable you to find i given the loan’s numbers for LV, FP, and n. For example, in the case of a 25-year $1,000 loan with yearly payments of $85.81, the yield to maturity that results from solv- ing Equation 2 is 7%. Real estate brokers always have a financial calculator that can solve such equations handy, so that they can immediately tell the prospective house buyer exactly what the yearly (or monthly) payments will be if the house purchase is financed by a mortgage.

a P P li c at i o n Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan You decide to purchase a new home and need a $100,000 mortgage. You take out a loan from the bank that has an interest rate of 7%. What is the yearly payment to the bank if you wish to pay off the loan in twenty years?

Solution

The yearly payment to the bank is $9,439.29.

LV = FP

11 + i2 + FP

11 + i22 + FP

11 + i23 + c + FP

11 + i2n

where LV = loan value amount = 100,000 i = annual interest rate = 0.07 n = number of years = 20

Thus

$100,000 = FP

11 + 0.072 + FP

11 + 0.0722 + FP

11 + 0.0723 + c + FP

11 + 0.07220

To find the monthly payment for the loan using a financial calculator:

n = number of years = 20 PV = amount of the loan 1LV2 = 100,000 FV = amount of the loan after 20 years = 0 i = annual interest rate = 0.07

Then push the PMT button to get the fixed yearly payment 1FP2 = $9,439.29. ◆

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C h a p t e r 4 The Meaning of Interest Rates 71

Coupon Bond To calculate the yield to maturity for a coupon bond, follow the same strategy used for the fixed-payment loan: Equate today’s value of the bond with its present value. Because coupon bonds also have more than one cash flow payment, the present value of the bond is calculated as the sum of the present values of all the coupon payments plus the present value of the final payment of the face value of the bond.

The present value of a $1,000-face-value bond with ten years to maturity and yearly coupon payments of $100 (a 10% coupon rate) can be calculated as follows: At the end of one year, there is a $100 coupon payment with a PV of $100> 11 + i2; at the end of the second year, there is another $100 coupon payment with a PV of $100> 11 + i22; and so on until, at maturity, there is a $100 coupon payment with a PV of $100> 11 + i210 plus the repayment of the $1,000 face value with a PV of $1,000> 11 + i210. Setting today’s value of the bond (its current price, denoted by P) equal to the sum of the present values of all the cash flow payments for the bond gives

P = $100

1 + i +

$100

11 + i22 + $100

11 + i23 + c + $100

11 + i210 + $1,000

11 + i210 More generally, for any coupon bond,2

P = C

1 + i +

C

11 + i22 + C

11 + i23 + c + C

11 + i2n + F

11 + i2n (3)

where P = price of the coupon bond C = yearly coupon payment F = face value of the bond n = years to maturity date

In Equation 3, the coupon payment, the face value, the years to maturity, and the price of the bond are known quantities, and only the yield to maturity is not. Hence we can solve this equation for the yield to maturity i. As in the case of the fixed-payment loan, this calculation is not easy, so business-oriented software and financial calculators have built-in programs that solve the equation for you.

a P P li c at i o n Yield to Maturity and Bond Price for a Coupon Bond Find the price of a 10% coupon bond with a face value of $1000, a 12.25% yield to maturity, and eight years to maturity.

Solution The price of the bond is $889.20. To solve using a financial calculator:

n = years to maturity = 8 FV = face value of the bond 1F2 = 1,000 i = annual interest rate = 12.25% PMT = yearly coupon payments1C2 = 100

Then push the PV button to get the price of the bond = $889.20.

2Most coupon bonds actually make coupon payments on a semiannual basis rather than once a year as we assumed here. The effect on the calculations is very slight and will be ignored here.

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72 p a r t 2 Financial Markets

Alternatively, you could solve for the yield to maturity given the bond price by entering $889.20 for PV and pushing the i button to get a yield to maturity of 12.25%. ◆

Table 1 shows the yields to maturity calculated for several bond prices. Three interesting facts emerge:

1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.

2. The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the bond falls. As the yield to maturity falls, the price of the bond rises.

3. The yield to maturity is greater than the coupon rate when the bond price is below its face value and is less than the coupon rate when the bond price is above its face value.

These three facts are true for any coupon bond and are really not surprising if you think about the reasoning behind the calculation of the yield to maturity. When you put $1,000 in a bank account with an interest rate of 10%, you can take out $100 every year and you will be left with the $1,000 at the end of ten years. This process is similar to buying the $1,000 bond with a 10% coupon rate analyzed in Table 1, which pays a $100 coupon payment every year and then repays $1,000 at the end of ten years. If the bond is purchased at the par value of $1,000, its yield to maturity must equal 10%, which is also equal to the coupon rate of 10%. The same reasoning applied to any cou- pon bond demonstrates that if the coupon bond is purchased at its par value, the yield to maturity and the coupon rate must be equal.

It is a straightforward process to show that the bond price and the yield to maturity are negatively correlated. As i, the yield to maturity, increases, all denominators in the bond price formula (Equation 3) must necessarily increase, because the rise in i lowers the pres- ent value of all future cash flow payments for this bond. Hence a rise in the interest rate, as measured by the yield to maturity, means that the price of the bond must fall. Another way to explain why the bond price falls when the interest rate rises is to consider that a higher interest rate implies that the future coupon payments and final payment are worth less when discounted back to the present; hence the price of the bond must be lower.

The third fact, that the yield to maturity is greater than the coupon rate when the bond price is below its par value, follows directly from facts 1 and 2. When the yield to maturity equals the coupon rate, then the bond price is at the face value; when the

Price of Bond ($) Yield to Maturity (%)

1,200 7.13

1,100 8.48

1,000 10.00

900 11.75

800 13.81

table 1 Yields to Maturity on a 10%-Coupon-rate Bond Maturing in ten Years (Face Value = $1,000)

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C h a p t e r 4 The Meaning of Interest Rates 73

yield to maturity rises above the coupon rate, the bond price necessarily falls and so must be below the face value of the bond.

One special case of a coupon bond is worth discussing here because its yield to maturity is particularly easy to calculate. This bond is called a consol or a perpetuity; it is a per- petual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever. Consols were first sold by the British Treasury during the Napole- onic Wars and are still traded today; they are quite rare, however, in American capital mar- kets. The formula in Equation 3 for the price of the consol Pc simplifies to the following:3

Pc = C

ic (4)

where Pc = price of the perpetuity 1consol2 C = yearly payment ic = yield to maturity of the perpetuity 1consol2 One nice feature of perpetuities is that you can immediately see that as ic increases, the

price of the bond falls. For example, if a perpetuity pays $100 per year forever and the interest rate is 10%, its price will be $1,000 = $100>0.10. If the interest rate rises to 20%, its price will fall to $500 = $100>0.20. We can rewrite this formula as

ic = C

Pc (5)

a P P li c at i o n Yield to Maturity on a Perpetuity What is the yield to maturity on a bond that has a price of $2,000 and pays $100 of interest annually, forever?

Solution The yield to maturity is 5%.

ic = C

Pc

3The bond price formula for a consol is

P = C

1 + i +

C

11 + i22 + C

11 + i23 + c

which can be written as

P = C1x + x2 + x3 + c2 in which x = 1> 11 + i2. The formula for an infinite sum is

1 + x + x2 + x3 + c = 1 1 - x

for x 6 1

and so

P = Ca 1 1 - x

- 1b = C c 1 1 - 1> 11 + i2 - 1 d

which by suitable algebraic manipulation becomes

P = Ca1 + i i

- i

i b = C

i

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74 p a r t 2 Financial Markets

where C = yearly payment = $100 Pc = price of perpetuity (consol) = $2,000

Thus

ic = $100

$2,000

ic = 0.05 = 5% ◆

The formula given in Equation 5, which describes the calculation of the yield to maturity for a perpetuity, also provides a useful approximation for the yield to maturity on coupon bonds. When a coupon bond has a long term to maturity (say, twenty years or more), it is very much like a perpetuity, which pays coupon payments forever. This is because the cash flows more than twenty years in the future have such small present discounted values that the value of a long-term coupon bond is very close to the value of a perpetuity with the same coupon rate. Thus ic in Equation 5 will be very close to the yield to maturity for any long-term bond. For this reason, ic, the yearly coupon payment divided by the price of the security, has been given the name current yield and is fre- quently used as an approximation to describe interest rates on long-term bonds.

Discount Bond The yield-to-maturity calculation for a discount bond is similar to that for a simple loan. Let’s consider a discount bond such as a one-year U.S. Treasury bill that pays a face value of $1,000 in one year’s time but today has a price of $900.

a P P li c at i o n Yield to Maturity on a Discount Bond What is the yield to maturity on a one-year, $1,000 Treasury bill with a current price of $900?

Solution The yield to maturity is 11.1%.

Using the present value formula,

PV = CF

11 + i2n

and recognizing that the present value (PV) is the current price of $900, the cash flow in one year is $1,000, and the number of years is 1, we can write:

$900 = $1,000

1 + i

Solving for i, we get

11 + i2 * $900 = $1,000 $900 + $900i = $1,000

$900i = $1,000 - $900

i = $1,000 - $900

$900 = 0.111 = 11.1% ◆

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C h a p t e r 4 The Meaning of Interest Rates 75

As we just saw in the preceding application, the yield to maturity for a one-year discount bond equals the increase in price over the year, $1,000 − $900, divided by the initial price, $900. Hence, more generally, for any one-year discount bond, the yield to maturity can be written as

i = F - P

P (6)

where F = face value of the discount bond P = current price of the discount bond

An important feature of this equation is that it indicates that, for a discount bond, the yield to maturity is negatively related to the current bond price. This is the same conclusion that we reached for a coupon bond. Equation 6 shows that a rise in the bond price—say, from $900 to $950—means that the bond will have a smaller increase in its price at maturity and so the yield to maturity will fall, from 11.1% to 5.3% in our example. Similarly, a fall in the yield to maturity means that the current price of the discount bond has risen.

summary The concept of present value tells you that a dollar in the future is not as valuable to you as a dollar today because you can earn interest on a dollar you have today. Specifically, a dollar received n years from now is worth only $1> 11 + i2n today. The present value of a set of future cash flow payments on a debt instrument equals the sum of the present values of each of the future payments. The yield to maturity for an instrument is the interest rate that equates the present value of the future payments on that instrument to its value today. Because the procedure for calculating the yield to maturity is based on sound economic principles, the yield to maturity is the measure that economists think most accurately describes the interest rate.

Our calculations of the yield to maturity for a variety of bonds reveal the important fact that current bond prices and interest rates are negatively related: When the interest rate rises, the price of the bond falls, and vice versa.

the DIstInCtIOn Between Interest rates anD returns

Many people think that the interest rate on a bond tells them all they need to know about how well off they are as a result of owning it. If Irving the Investor thinks he is well off when he owns a long-term bond yielding a 10% interest rate, and the interest rate then rises to 20%, he will have a rude awakening: As we will shortly see, if he has to sell the bond, Irving will lose his shirt! How well a person does financially by holding a bond or any other security over a particular time period is accurately measured by the security’s return, or, in more precise terminology, the rate of return. We will use the concept of return continually throughout this book: Understanding this concept will make the material presented later in the book easier to follow.

For any security, the rate of return is defined as the amount of each payment to the owner plus the change in the security’s value, expressed as a fraction of its pur- chase price. To make this definition clearer, let us see what the return would look like for a $1,000-face-value coupon bond with a coupon rate of 10% that is bought

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76 p a r t 2 Financial Markets

for $1,000, held for one year, and then sold for $1,200. The payments to the owner are the yearly coupon payments of $100, and the change in the bond’s value is $1,200 - $1,000 = $200. Adding these values together and expressing them as a fraction of the purchase price of $1,000 gives us the one-year holding-period return for this bond:

$100 + $200 $1,000

= $300

$1,000 = 0.30 = 30%

You may have noticed something quite surprising about the return that we just calculated: It equals 30%, yet as Table 1 indicates, initially the yield to maturity was only 10%. This discrepancy demonstrates that the return on a bond will not necessar- ily equal the yield to maturity on that bond. We now see that the distinction between interest rate and return can be important, although for many securities the two may be closely related.

More generally, the return on a bond held from time t to time t + 1 can be writ- ten as

R = C + Pt + 1 - Pt

Pt (7)

where R = return from holding the bond from time t to time t + 1 Pt = price of the bond at time t Pt + 1 = price of the bond at time t + 1 C = coupon payment

A convenient way to rewrite the return formula in Equation 7 is to recognize that it can be split into two separate terms:

R = C

Pt +

Pt + 1 - Pt Pt

The first term is the current yield ic (the coupon payment over the purchase price):

C

Pt = ic

The second term is the rate of capital gain, or the change in the bond’s price relative to the initial purchase price:

Pt + 1 - Pt Pt

= g

where g is the rate of capital gain. Equation 7 can then be rewritten as

R = ic + g (8)

which shows that the return on a bond is the current yield ic plus the rate of capital gain g. This rewritten formula illustrates the point we just discovered: Even for a bond for which the current yield ic is an accurate measure of the yield to maturity, the return can differ substantially from the interest rate. Returns will differ substantially from the interest rate if the price of the bond experiences sizable fluctuations that produce sub- stantial capital gains or losses.

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C h a p t e r 4 The Meaning of Interest Rates 77

To explore this point even further, let’s look at what happens to the returns on bonds of different maturities when interest rates rise. Table 2 calculates the one-year returns, using Equation 8 above, on several 10%-coupon-rate bonds, all purchased at par, when interest rates on all these bonds rise from 10% to 20%. Several key findings from this table are generally true of all bonds:

• The only bonds whose returns will equal their initial yields to maturity are those whose times to maturity are the same as their holding periods (see, for example, the last bond in Table 2).

• A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than their holding periods.

• The more distant a bond’s maturity date, the greater the size of the percentage price change associated with an interest rate change.

• The more distant a bond’s maturity date, the lower the rate of return that occurs as a result of an increase in the interest rate.

• Even though a bond may have a substantial initial interest rate, its return can turn out to be negative if interest rates rise.

At first, students are frequently puzzled (as was poor Irving the Investor) that a rise in interest rates can mean that a bond has been a poor investment. The trick to understanding this fact is to recognize Irving has already purchased the bond, so that a rise in the interest rate means that the price of the bond Irving is holding falls and he experiences a capital loss. If this loss is large enough, the bond can be a poor investment indeed. For example, we see in Table 2 that the bond that has 30 years to maturity when purchased has a capital loss of 49.7% when the interest rate rises from 10% to 20%. This loss is so large that it exceeds the current yield of 10%, resulting in a negative return (loss) of –39.7%. If Irving does not sell the bond, his capital loss is often referred to as a “paper loss.” This is a loss nonetheless because if Irving had not bought this bond and had instead put his money in the bank, he would now be able to buy more bonds at their lower price than he presently owns.

*Calculated with a financial calculator, using Equation 3.

(1) Years to Maturity

When Bond Is Purchased

(2) Initial

Current Yield (%)

(3)

Initial Price ($)

(4) Price Next Year* ($)

(5) Rate of Capital

Gain (%)

(6) Rate of Return

[col (2)  col (5)] (%)

30 10 1,000 503 -49.7 -39.7 20 10 1,000 516 -48.4 -38.4 10 10 1,000 597 -40.3 -30.3 5 10 1,000 741 -25.9 -15.9 2 10 1,000 917 -8.3 +1.7 1 10 1,000 1,000 0.0 +10.0

table 2 One-Year returns on Different-Maturity 10%-Coupon-rate Bonds when Interest rates rise from 10% to 20%

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78 p a r t 2 Financial Markets

Maturity and the Volatility of Bond returns: Interest-rate risk The finding that the prices of longer-maturity bonds respond more dramatically to changes in interest rates helps explain an important fact about the behavior of bond markets: Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Price changes of +20% and -20% within a year, with correspond- ing variations in returns, are common for bonds that are more than twenty years away from maturity.

We now see that changes in interest rates make investments in long-term bonds quite risky. Indeed, the risk level associated with an asset’s return that results from interest-rate changes is so important that it has been given a special name, interest- rate risk.4 Dealing with interest-rate risk is a major concern of managers of financial institutions and investors, as we will see in later chapters.

Although long-term debt instruments have substantial interest-rate risk, short-term debt instruments do not. Indeed, bonds with a maturity term that is as short as the hold- ing period have no interest-rate risk.5 We see this for the coupon bond at the bottom of Table 2, which has no uncertainty about the rate of return because it equals the yield to maturity, which is known at the time the bond is purchased. The key to understanding why there is no interest-rate risk for any bond whose time to maturity matches the hold- ing period is to recognize that (in this case) the price at the end of the holding period is already fixed at the face value. A change in interest rates can then have no effect on the price at the end of the holding period for these bonds, and the return will therefore be equal to the yield to maturity, which is known at the time the bond is purchased.6

4Interest-rate risk can be quantitatively measured using the concept of duration. This concept and its calculation are discussed in an appendix to this chapter, which can be found on the Companion Website at http://www .pearsonhighered.com/mishkin. 5The statement that there is no interest-rate risk for any bond whose time to maturity matches the holding period is literally true only for discount (zero-coupon) bonds that make no intermediate cash payments before the holding period is over. A coupon bond that makes an intermediate cash payment before the holding period is over requires that this payment be reinvested. Because the interest rate at which this payment can be reinvested is uncertain, some uncertainty exists about the return on this coupon bond even when the time to maturity equals the holding period. However, the riskiness of the return on a coupon bond from reinvesting the coupon payments is typically quite small, so a coupon bond with a time to maturity equal to its holding period still has very little risk. 6In this text we assume that holding periods on all short-term bonds are equal to the term to maturity, and thus the bonds are not subject to interest-rate risk. However, if the term to maturity of the bond is shorter than an investor’s holding period, the investor is exposed to a type of interest-rate risk called reinvestment risk. Reinvestment risk occurs because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain.

To understand reinvestment risk, suppose that Irving the Investor has a holding period of two years and decides to purchase a $1,000, one-year bond at face value and then another one at the end of the first year. If the initial inter- est rate is 10%, Irving will have $1,100 at the end of the first year. If the interest rate rises to 20%, as in Table 2, Irving will find that buying $1,100 worth of another one-year bond will leave him at the end of the second year with $1,100 * 11 + 0.202 = $1,320. Thus Irving’s two-year return will be 1$1,320 - $,10002 >1,000 = 0.32 = 32%, which equals 14.9% at an annual rate. In this case, Irving has earned more by buying the one-year bonds than he would have if he had initially purchased a two-year bond with an interest rate of 10%. Thus, when Irving has a hold- ing period that is longer than the term to maturity of the bonds he purchases, he benefits from a rise in interest rates. Conversely, if interest rates fall to 5%, Irving will have only $1,155 at the end of two years: $1,100 * 11 + 0.052. His two-year return will be 1$1,555 - $1,0002 >1,000 = 0.155 = 15.5%, which is 7.2% at an annual rate. With a holding period greater than the term to maturity of the bond, Irving now loses from a decline in interest rates.

We have seen that when the holding period is longer than the term to maturity of a bond, the return is uncer- tain because the future interest rate when reinvestment occurs is also uncertain—in short, there is reinvestment risk. We also see that if the holding period is longer than the term to maturity of the bond, the investor benefits from a rise in interest rates and is hurt by a fall in interest rates.

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C h a p t e r 4 The Meaning of Interest Rates 79

summary The return on a bond, which tells you how good an investment it has been over the holding period, is equal to the yield to maturity in only one special case—when the holding period and the term to maturity of the bond are identical. Bonds whose terms to maturity are longer than their holding periods are subject to interest-rate risk: Changes in interest rates lead to capital gains and losses that produce substantial differ- ences between the return and the yield to maturity known at the time the bond is pur- chased. Interest-rate risk is especially important for long-term bonds, on which capital gains and losses can be substantial. This is why long-term bonds are not considered safe assets with a sure return over short holding periods.

the DIstInCtIOn Between reaL anD nOMInaL Interest rates

So far in our discussion of interest rates, we have ignored the effects of inflation on the cost of borrowing. What we up to this point have been calling the interest rate makes no allowance for inflation, and it is more precisely referred to as the nominal interest rate. We must distinguish the nominal interest rate from the real interest rate, which is the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. This interest rate is more precisely referred to as the ex ante real interest rate because it is adjusted for expected changes in the price level. The ex ante real interest rate is veryimportant to economic decisions, and typically it is what economists mean when they make refer- ence to the “real” interest rate. The interest rate that is adjusted for actual changes in the price level is called the ex post real interest rate. It describes how well a lender has done in real terms after the fact.

The real interest rate is more accurately defined from the Fisher equation, named for Irving Fisher, one of the great monetary economists of the twentieth century. The Fisher equation states that the nominal interest rate i equals the real interest rate r plus the expected rate of inflation πe:7

i = r + πe (9)

Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the expected inflation rate:

r = i - πe (10)

To see why this definition makes sense, let’s first consider a situation in which you have made a simple one-year loan with a 5% interest rate 1i = 5%2, and you expect the price level to rise by 3% over the course of the year 1πe = 3%2. As a result of making

7A more precise formulation of the Fisher equation is

i = r + πe + 1r * πe2 because

1 + i = 11 + r211 + πe2 = 1 + r + πe + 1r * πe2 and subtracting 1 from both sides gives us the first equation. For small values of r and πe, the term r * πe is so small that we ignore it, as in the text.

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80 P a r t 2 Financial Markets

the loan, at the end of the year you expect to have 2% more in real terms—that is, in terms of real goods and services you can buy. In this case, the interest rate you expect to earn in terms of real goods and services is 2%:

r = 5% - 3% = 2%

as indicated by Equation 10.8

A p p li c At i o n Calculating Real Interest Rates What is the real interest rate if the nominal interest rate is 8% and the expected infla- tion rate is 10% over the course of a year?

Solution The real interest rate is -2%. Although you will be receiving 8% more dollars at the end of the year, you will be paying 10% more for goods. The result is that you will be able to buy 2% fewer goods at the end of the year, and you will be 2% worse off in real terms. Mathematically,

r = i - πe

where i = nominal interest rate = 0.08 πe = expected inflation rate = 0.10

Thus

r = 0.08 - 0.10 = -0.02 = -2% ◆

As a lender, you are clearly less eager to make a loan in this case, because in terms of real goods and services you have actually earned a negative interest rate of 2%. By contrast, as a borrower, you fare quite well because at the end of the year, the amounts you will have to pay back will be worth 2% less in terms of goods and services—you

8Because most interest income in the United States is subject to federal income taxes, the true earnings in real terms from holding a debt instrument are not reflected by the real interest rate defined by the Fisher equation but rather by the after-tax real interest rate, which equals the nominal interest rate after income tax payments have been subtracted, minus the expected inflation rate. For a person facing a 30% tax rate, the after-tax interest rate earned on a bond yielding 10% is only 7% because 30% of the interest income must be paid to the Internal Revenue Service. Thus the after-tax real interest rate on this bond when expected inflation is 5% equals 2%1=7% - 5%2. More generally, the after-tax real interest rate can be expressed as

i11 - τ2 - πe where τ = the income tax rate.

This formula for the after-tax real interest rate also provides a better measure of the effective cost of borrowing for many corporations and homeowners in the United States because, in calculating income taxes, they can deduct interest payments on loans from their income. Thus, if you face a 30% tax rate and take out a mortgage loan with a 10% interest rate, you are able to deduct the 10% interest payment and lower your taxes by 30% of this amount. Your after-tax nominal cost of borrowing is then 7% (10% minus 30% of the 10% interest payment), and when the expected inflation rate is 5%, the effective cost of borrowing in real terms is again 2%1=7% - 5%2.

As the example (and the formula) indicates, after-tax real interest rates are always below the real interest rate defined by the Fisher equation. For a further discussion of measures of after-tax real interest rates, see Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200.

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C h a p t e r 4 The Meaning of Interest Rates 81

as the borrower will be ahead by 2% in real terms. When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.

A similar distinction can be made between nominal returns and real returns. Nomi- nal returns, which do not allow for inflation, are what we have been referring to as simply “returns.” When inflation is subtracted from a nominal return, we have the real return, which indicates the amount of extra goods and services that we can purchase as a result of holding the security.

The distinction between real and nominal interest rates is important because the real interest rate, which reflects the real cost of borrowing, is likely to be a better indica- tor of the incentives to borrow and lend. It appears to be a better guide to how people will respond to what is happening in credit markets. Figure 1, which presents estimates from 1953 to 2014 of the real and nominal interest rates on three-month U.S. Treasury bills, shows us that nominal and real rates usually move together but do not always do so. (This is also true for nominal and real interest rates in the rest of the world.) In par- ticular, when nominal rates in the United States were high in the 1970s, real rates were actually extremely low—often negative. By the standard of nominal interest rates, you would have thought that credit market conditions were tight during this period because it was expensive to borrow. However, the estimates of the real rates indicate that you would have been mistaken. In real terms, the cost of borrowing was actually quite low.

16

12

8

4

0

–4

1955 1960 1970 1990 2000

Interest Rate (% annual rate)

2005 2010 201519801965 1975 19951985

Nominal Rate

Estimated Real Rate

Figure 1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2014 Nominal and real interest rates often do not move together. When U.S. nominal rates were high in the

1970s, real rates were actually extremely low—often negative. Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/. The real rate is

constructed using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function of past inter- est rates, inflation, and time trends, and then subtracting the expected inflation measure from the nominal interest rate.

MyEconLab Mini-lecture MyEconLab Real-time data

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82 p a r t 2 Financial Markets

suMMarY

1. The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that equates the present value of future payments of a debt instrument with the instrument’s value today. Application of this principle reveals that bond prices and interest rates are negatively correlated: When the interest rate rises, the price of the bond must fall, and vice versa.

2. The return on a security, which tells you how well you have done by holding the security over a stated period of time, can differ substantially from the interest rate

as measured by the yield to maturity. Long-term bond prices experience substantial fluctuations when inter- est rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large, which is why long-term bonds are not considered safe assets with a sure return.

3. The real interest rate is defined as the nominal inter- est rate minus the expected rate of inflation. It is both a better measure of the incentives to borrow and lend and a more accurate indicator of the tightness of credit market conditions than is the nominal interest rate.

KeY terMs

cash flows, p. 64 consol or perpetuity, p. 73 coupon bond, p. 67 coupon rate, p. 67 current yield, p. 74 discount bond (zero-coupon

bond), p. 67

face value (par value), p. 67 fixed-payment loan (fully amortized

loan), p. 67 interest-rate risk, p. 78 nominal interest rate, p. 79 present value (present discounted

value), p. 64

rate of capital gain, p. 76 real interest rate, p. 79 real terms, p. 80 return (rate of return), p. 75 simple loan, p. 65 yield to maturity, p. 68

QuestIOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%?

2. Write down the formula that is used to calculate the yield to maturity on a twenty-year 10% coupon bond with a $1,000 face value that sells for $2,000.

3. To help pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don’t have to start making these payments until you graduate from college two years from now. Why is the yield to maturity nec- essarily less than 12%? (This is the yield to maturity on a normal $1,000 fixed-payment loan on which you pay $126 per year for 25 years.)

4. Do bondholders fare better when the yield to maturity increases or when it decreases? Why?

5. A financial adviser has just given you the follow- ing advice: “Long-term bonds are a great investment

because their interest rate is over 20%.” Is the financial adviser necessarily right?

6. If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

7. When is the current yield a good approximation of the yield to maturity?

8. Why would a government choose to issue a perpetuity, which requires payments forever, instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?

9. Under what conditions will a discount bond have a nega- tive nominal interest rate? Is it possible for a coupon bond or a perpetuity to have a negative nominal interest rate?

10. True or False: With a discount bond, the return on the bond is equal to the rate of capital gain.

11. If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

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C h a p t e r 4 The Meaning of Interest Rates 83

13. Retired persons often have much of their wealth placed in savings accounts and other interest-bearing invest- ments, and complain whenever interest rates are low. Do they have a valid complaint?

12. Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have commented that real interest rates were actually much higher in the mid-1980s than in the late 1970s. Does this make sense? Do you think that these economists are right?

All applied problems are available in MyEconLab at http://www.myeconlab.com.

14. If the interest rate is 10%, what is the present value of a security that pays you $1,100 next year, $1,210 the year after, and $1,331 the year after that?

15. Calculate the present value of a $1,000 discount bond with five years to maturity if the yield to maturity is 6%.

16. A lottery claims its grand prize is $10 million, payable over 5 years at $2,000,000 per year. If the first pay- ment is made immediately, what is this grand prize really worth? Use an interest rate of 6%.

17. What is the yield to maturity on a $1,000-face-value discount bond maturing in one year that sells for $800?

18. What is the yield to maturity on a simple loan for $1 million that requires a repayment of $2 million in five years’ time?

19. Which $1,000 bond has the higher yield to maturity, a twenty-year bond selling for $800 with a current yield of 15% or a one-year bond selling for $800 with a cur- rent yield of 5%?

20. Consider a bond with a 4% annual coupon and a face value of $1,000. Complete the following table. What relationships do you observe between years to matu- rity, yield to maturity, and the current price?

21. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently sell- ing for $1,044.89 and has two years to maturity. What is the bond’s yield to maturity?

22. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%? If the yield to maturity doubles, what will happen to the perpetuity’s price?

23. Property taxes in a particular district are 4% of the purchase price of a home every year. If you just pur- chased a $250,000 home, what is the present value of all the future property tax payments? Assume that the house remains worth $250,000 forever, property tax rates never change, and a 6% interest rate is used for discounting.

24. A $1000-face-value bond has a 10% coupon rate, its current price is $960, and its price is expected to increase to $980 next year. Calculate the current yield, the expected rate of capital gain, and the expected rate of return.

25. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year. What nominal rate would you require from the bank over the next year? How much money will you have at the end of one year? If you are saving to buy a fancy bicycle that currently sells for $1,050, will you have enough money to buy it?

aPPLIeD PrOBLeMs

Years to Maturity

Yield to Maturity

Current Price

2 2%  

2 4%  

3 4%  

5 2%  

5 6%  

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84 p a r t 2 Financial Markets

Data anaLYsIs PrOBLeMs

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the interest rate on a four-year auto loan (TERMCBAUTO48NS). Assume that you borrow $20,000 to purchase a new automobile and that you finance it with a four-year loan at the most recent interest rate given in the database. If you make one payment per year for four years, what will the yearly payment be? What is the total amount that will be paid out on the $20,000 loan?

2. The U.S. Treasury issues some bonds as Treasury Inflation Indexed Securities, or TIIS, which are bonds

adjusted for inflation; hence the yields can be roughly interpreted as real interest rates. Go to the St. Louis Federal Reserve FRED database, and find data on the following TIIS bonds and their nominal counterparts. Then answer the questions below.

• 5 year U.S. treasury (DGS5) and 5 year TIIS (DFII5)

• 7 year U.S. treasury (DGS7) and 7 year TIIS (DFII7)

• 10 year U.S. treasury (DGS10) and 10 year TIIS (DFII10)

• 20 year U.S. treasury (DGS20) and 20 year TIIS (DFII20)

• 30 year U.S. treasury (DGS30) and 30 year TIIS (DFII30)

a. Following the Great Recession of 2008–2009, the 5, 7, 10, and even the 20 year TIIS yields became negative for a period of time. How is this possible?

b. Using the most recent data available, calculate the difference between the yields for each of the pairs of bonds (DGS5 – DFII5, etc.) listed above. What does this difference represent?

c. Based on your answer to part (b), are there significant variations among the differences in the bond-pair yields? Interpret the magni- tude of the variation in differences among the pairs.

weB exerCIses

weB aPPenDICes

1. In this chapter, we discussed long-term bonds as if there were only one type, coupon bonds. In fact, inves- tors can also purchase long-term discount bonds. A discount bond is sold at a low price, and the whole return comes in the form of a price appreciation. You can easily compute the current price of a discount

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read the Web appendix to Chapter 4.

bond by using the financial calculator at http://www .treasurydirect.gov/indiv/tools/tools_savingsbondcalc.htm.

To compute the values for savings bonds, read the instructions on the page and click on Get Started. Fill in the information (you do not need to fill in the Bond Serial Number field) and click on Calculate.

Appendix 1: Measuring Interest-Rate Risk: Duration

weB reFerenCes

http://www.bloomberg.com/markets/

Under Rates & Bonds, you can access information on key interest rates, U.S. Treasuries, government bonds, and municipal bonds.

http://www.teachmefinance.com

A review of the key financial concepts: time value of money, annuities, perpetuities, and so on.

M04_MISH6760_11_SE_Ch04_063-084.indd 84 29/09/14 4:59 PM

Learning Objectives • Identify the factors that affect the demand for assets.

• Draw the demand and supply curves for the bond market, and identify the equilibrium interest rate.

• List and describe the factors that affect the equilibrium interest rate in the bond market.

• Describe the connec- tion between the bond market and the money market through the liquidity preference framework.

• List and describe the factors that affect the money market and the equilibrium interest rate.

• Identify and illustrate the effects on the interest rate of changes in money growth over time.

5 Preview

In the early 1950s, nominal interest rates on three-month Treasury bills were about 1% at an annual rate; by 1981, they had reached over 15%. They fell below 1% in 2003, rose to 5% in 2007, and then fell to close to zero in 2008 and for many years afterward. What explains these substantial fluctuations in interest rates? One reason why we study money, banking, and financial markets is to provide some answers to this question.

In this chapter, we examine how the overall level of nominal interest rates (which we refer to simply as “interest rates”) is determined and which factors influence their behavior. We learned in Chapter 4 that interest rates are negatively related to the price of bonds, so if we can explain why bond prices change, we can also explain why interest rates fluctuate. We make use of supply and demand analysis for bond markets and markets for money to examine how interest rates change.

To derive a demand curve for assets such as money or bonds, the first step in our analysis, we must first understand what determines the demand for these assets. We do this by examining portfolio theory, an economic theory that outlines criteria that are important when deciding how much of an asset to buy. Armed with this theory, we can then go on to derive the demand curve for bonds or money. After deriving supply curves for these assets, we develop the concept of market equilibrium, which is defined as the point at which the quantity supplied equals the quantity demanded. Then we use this model to explain changes in equilibrium interest rates.

Because interest rates on different securities tend to move together, in this chapter we will proceed as if there were only one type of security and one interest rate in the entire economy. In the following chapter, we expand our analysis to look at why interest rates on different types of securities differ.

DetermInants Of asset DemanD Before going on to our supply and demand analysis of the bond market and the market for money, we must first understand what determines the quantity demanded of an asset. Recall that an asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing machinery are all

The Behavior of Interest Rates

85

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86 P a r t 2 Financial Markets

assets. Faced with the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:

1. Wealth, the total resources owned by the individual, including all assets 2. Expected return (the return expected over the next period) on one asset relative to

alternative assets 3. Risk (the degree of uncertainty associated with the return) on one asset relative to

alternative assets 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative

to alternative assets

Wealth When we find that our wealth has increased, we have more resources available with which to purchase assets, and so, not surprisingly, the quantity of assets we demand increases. Therefore, the effect of changes in wealth on the quantity demanded of an asset can be summarized as follows: Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.

expected returns In Chapter 4, we saw that the return on an asset (such as a bond) measures how much we gain from holding that asset. When we make a decision to buy an asset, we are influenced by what we expect the return on that asset to be. If an ExxonMobil bond, for example, has a return of 15% half the time and 5% the other half, its expected return (which you can think of as the average return) is 10%1=0.5 * 15% + 0.5 * 5%2.1 If the expected return on the ExxonMobil bond rises relative to expected returns on alternative assets, then, holding everything else constant, it becomes more desirable to purchase the Exx- onMobil bond, and the quantity demanded increases. This can occur in either of two ways: (1) when the expected return on the ExxonMobil bond rises while the return on an alternative asset—say, stock in Google—remains unchanged or (2) when the return on the alternative asset, the Google stock, falls while the return on the ExxonMobil bond remains unchanged. To summarize, an increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset.

risk The degree of risk or uncertainty of an asset’s returns also affects demand for the asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half the time and 5% the other half, making its expected return 10%, while Feet-on-the-Ground stock has a fixed return of 10%. Fly-by-Night stock has uncertainty associated with its returns and so has greater risk than Feet-on-the-Ground stock, whose return is a sure thing.

1If you are interested in finding out more information on how to calculate expected returns, as well as standard deviations of returns that measure risk, the Companion Website at http://www.pearsonhighered.com/mishkin contains an appendix to this chapter describing models of asset pricing. This appendix also describes how diver- sification lowers the overall risk of a portfolio and includes a discussion of systematic risk and basic asset pricing models, such as the capital asset pricing model and the arbitrage pricing theory.

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C h a P t e r 5 The Behavior of Interest Rates 87

response of the Quantity of an asset Demanded to Changes in Wealth, expected returns, risk, and Liquidity

Variable Change in Variable Change in Quantity Demanded

Wealth c c Expected return relative to other assets c c Risk relative to other assets c T Liquidity relative to other assets c c

Note: Only increases in the variables are shown. The effects of decreases in the variables on the quantity demanded would be the opposite of those indicated in the rightmost column.

summary table 1

A risk-averse person prefers stock in Feet-on-the-Ground (the sure thing) to Fly-by- Night stock (the riskier asset), even though the stocks have the same expected return, 10%. By contrast, a person who prefers risk is a risk preferrer or risk lover. Most people are risk-averse, especially in their financial decisions: Everything else being equal, they prefer to hold the less risky asset. Hence, holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.

Liquidity Another factor that affects the demand for an asset is how quickly it can be converted into cash at low costs—its liquidity. An asset is liquid if the market in which it is traded has depth and breadth, that is, if the market has many buyers and sellers. A house is not a very liquid asset because it may be hard to find a buyer quickly; if a house must be sold to pay off bills, it might have to be sold for a much lower price. And the transac- tion costs associated with selling a house (broker’s commissions, lawyer’s fees, and so on) are substantial. A U.S. Treasury bill, by contrast, is a highly liquid asset. It can be sold in a well-organized market with many buyers, and so it can be sold quickly at low cost. The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is and the greater the quantity demanded will be.

theory of Portfolio Choice All the determining factors we have just discussed can be assembled into the theory of portfolio choice, which tells us how much of an asset people will want to hold in their portfolios. It states that, holding all other factors constant:

1. The quantity demanded of an asset is positively related to wealth. 2. The quantity demanded of an asset is positively related to its expected return relative

to alternative assets. 3. The quantity demanded of an asset is negatively related to the risk of its returns

relative to alternative assets. 4. The quantity demanded of an asset is positively related to its liquidity relative to

alternative assets.

These results are summarized in Table 1.

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88 P a r t 2 Financial Markets

suPPLy anD DemanD In the BOnD market Our first approach to the analysis of interest-rate determination looks at supply and demand in the bond market so that we can better understand how the prices of bonds are determined. Thanks to our knowledge from Chapter 4 of how interest rates are measured, we know that each bond price is associated with a particular level of the interest rate. Specifically, the negative relationship between bond prices and interest rates means that when a bond’s price rises, its interest rate falls, and vice versa.

The first step in our analysis is to obtain a bond demand curve, which shows the relationship between the quantity demanded and the price when all other economic variables are held constant (that is, values of other variables are taken as given). You may recall from previous economics courses that the assumption that all other eco- nomic variables are held constant is called ceteris paribus, which means “other things being equal” in Latin.

Demand Curve To clarify and simplify our analysis, let’s consider the demand for one-year discount bonds, which make no coupon payments but pay the owner the $1,000 face value in a year. If the holding period is one year, then, as we saw in Chapter 4, the return on the bonds is known absolutely and is equal to the interest rate as measured by the yield to maturity. This means that the expected return on this bond is equal to the interest rate i, which, using Equation 6 in Chapter 4, is

i = Re = F - P

P

where i = interest rate = yield to maturity Re = expected return F = face value of the discount bond P = initial purchase price of the discount bond

This formula shows that a particular value of the interest rate corresponds to each bond price. If the bond sells for $950, the interest rate and expected return are

$1,000 - $950 $950

= 0.053 = 5.3%

At this 5.3% interest rate and expected return corresponding to a bond price of $950, let us assume that the quantity of bonds demanded is $100 billion, which is plotted as point A in Figure 1.

At a price of $900, the interest rate and expected return are

$1,000 - $900 $900

= 0.111 = 11.1%

Because the expected return is higher, with all other economic variables (such as income, expected returns on other assets, risk, and liquidity) held constant, the quan- tity demanded of these bonds will be higher, as predicted by portfolio theory. Point B in Figure 1 shows that the quantity of bonds demanded at the price of $900 has risen to $200 billion. Continuing with this reasoning, we see that if the bond price is $850 (interest rate and expected return = 17.6%), the quantity of bonds demanded (point C)

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C h a p t e r 5 The Behavior of Interest Rates 89

will be greater than at point B. Similarly, at the even lower prices of $800 (interest rate = 25%) and $750 (interest rate = 33.3%), the quantity of bonds demanded will be even higher (points D and E). The curve Bd, which connects these points, is the demand curve for bonds. It has the usual downward slope, indicating that at lower prices of the bond (everything else being equal), the quantity demanded is higher.2

Supply Curve An important assumption behind the demand curve for bonds in Figure 1 is that all other economic variables besides the bond’s price and interest rate are held constant. We use the same assumption in deriving a supply curve, which shows the relation- ship between the quantity supplied and the price when all other economic variables are held constant.

In Figure 1, when the price of the bonds is $750 (interest rate = 33.3%), point F shows that the quantity of bonds supplied is $100 billion for the example we are con- sidering. If the price is $800, the interest rate is the lower rate of 25%. Because at this

2Although our analysis indicates that the demand curve is downward-sloping, it does not imply that the curve is a straight line. For ease of exposition, however, we will draw demand curves and supply curves as straight lines.

MyEconLab Mini-lecture

100 200 300 400 500

750 (i = 33.0%)

800 (i = 25.0%)

P * = 850 (i * = 17.6%)

900 (i = 11.1%)

950 (i = 5.3%)

1,000 (i = 0%)

Quantity of Bonds, B ($ billions)

A

B

C

D

EF

G

H

I

Bs

Bd

Price of Bonds, P ($)

With excess supply, the bond price falls to P *

With excess demand, the bond price rises to P *

Figure 1 Supply and Demand for Bonds Equilibrium in the bond market occurs at point C, the intersection of the demand curve Bd and the bond supply curve Bs. The equilibrium price is P* = $850, and the equilibrium interest rate is i* = 17.6%.

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90 P a r t 2 Financial Markets

interest rate it is now less costly to borrow by issuing bonds, firms will be willing to borrow more through bond issues, and the quantity of bonds supplied is at the higher level of $200 billion (point G). An even higher price of $850, corresponding to a lower interest rate of 17.6%, results in a larger quantity of bonds supplied of $300 billion (point C). Higher prices of $900 and $950 result in even lower interest rates and even greater quantities of bonds supplied (points H and I). The Bs curve, which connects these points, is the supply curve for bonds. It has the usual upward slope found in supply curves, indicating that as the price increases (everything else being equal), the quantity supplied increases.

market equilibrium In economics, market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied:

Bd = Bs (1)

In Figure 1, equilibrium occurs at point C, where the demand and supply curves intersect at a bond price of $850 (interest rate of 17.6%) and a quantity of bonds of $300 billion. The price of P* = 850, where the quantity demanded equals the quantity supplied, is called the equilibrium or market-clearing price. Similarly, the interest rate of i* = 17.6% that corresponds to this price is called the equilibrium or market-clearing interest rate.

The concepts of market equilibrium and equilibrium price or interest rate are use- ful because the market tends to head toward them. We can see this in Figure 1 by first looking at what happens when we have a bond price that is above the equilibrium price. When the price of bonds is set too high, at, say, $950, the quantity of bonds supplied at point I is greater than the quantity of bonds demanded at point A. A situation like this, in which the quantity of bonds supplied exceeds the quantity of bonds demanded, is called a condition of excess supply. Because people want to sell more bonds than others want to buy, the price of the bonds will fall, as shown by the downward arrow in the figure at the bond price of $950. As long as the bond price remains above the equilibrium price, an excess supply of bonds will continue to be available, and the price of bonds will continue to fall. This decline will stop only when the price has reached the equilibrium price of $850, the price at which the excess supply of bonds has been eliminated.

Now let’s look at what happens when the price of bonds is below the equilibrium price. If the price of the bonds is set too low, at, say, $750, the quantity demanded at point E is greater than the quantity supplied at point F. This is called a condition of excess demand. People now want to buy more bonds than others are willing to sell, so the price of bonds will be driven up, as illustrated by the upward arrow in the figure at the bond price of $750. Only when the excess demand for bonds is eliminated by the bond price rising to the equilibrium level of $850 is there no further tendency for the price to rise.

We can see that the concept of equilibrium price is a useful one because it indi- cates where the market will settle. Because each price on the vertical axis of Figure 1 corresponds to a particular value of the interest rate, the same diagram also shows that the interest rate will head toward the equilibrium interest rate of 17.6%. When the

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C h a P t e r 5 The Behavior of Interest Rates 91

interest rate is below the equilibrium interest rate, as it is when it is at 5.3%, the price of the bond is above the equilibrium price, and an excess supply of bonds results. The price of the bond then falls, leading to a rise in the interest rate toward the equilibrium level. Similarly, when the interest rate is above the equilibrium level, as it is when it is at 33.3%, an excess demand for bonds occurs, and the bond price rises, driving the interest rate back down to the equilibrium level of 17.6%.

supply and Demand analysis Our Figure 1 is a conventional supply and demand diagram with price on the vertical axis and quantity on the horizontal axis. Because the interest rate that corresponds to each bond price is also marked on the vertical axis, this diagram allows us to read the equilibrium interest rate, giving us a model that describes the determination of interest rates. It is important to recognize that a supply and demand diagram like Figure 1 can be drawn for any type of bond because the interest rate and price of a bond are always negatively related for all kinds of bonds, whether a discount bond or a coupon bond.

An important feature of the analysis here is that supply and demand are always described in terms of stocks (amounts at a given point in time) of assets, not in terms of flows. The asset market approach for understanding behavior in financial markets— which emphasizes stocks of assets, rather than flows, in determining asset prices—is the dominant methodology used by economists, because correctly conducting analyses in terms of flows is very tricky, especially when we encounter inflation.3

Changes In eQuILIBrIum Interest rates We will now use the supply and demand framework for bonds to analyze why inter- est rates change. To avoid confusion, it is important to make the distinction between movements along a demand (or supply) curve and shifts in a demand (or supply) curve. When quantity demanded (or supplied) changes as a result of a change in the price of the bond (or, equivalently, a change in the interest rate), we have a movement along the demand (or supply) curve. The change in the quantity demanded when we move from point A to B to C in Figure 1, for example, is a movement along a demand curve. A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded (or supplied) changes at each given price (or interest rate) of the bond in response to a change in some other factor besides the bond’s price or interest rate. When one of these factors changes, causing a shift in the demand or supply curve, there will be a new equilibrium value for the interest rate.

In the following pages, we will look at how the supply and demand curves shift in response to changes in variables, such as expected inflation and wealth, and what effects these changes have on the equilibrium value of interest rates.

3The asset market approach developed in the text is useful in understanding not only how interest rates behave but also how any asset price is determined. A second appendix to this chapter, which is on the Companion Website at http://www.pearsonhighered.com/mishkin, shows how the asset market approach can be applied to understanding the behavior of commodity markets—in particular, the gold market. The analysis of the bond market that we have developed here has another interpretation that uses a different terminology and framework involving the supply and demand for loanable funds. This loanable funds framework is discussed in a third appendix to this chapter, which is also available on the book’s website.

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Shifts in the Demand for Bonds The theory of portfolio choice, which we developed at the beginning of the chapter, provides a framework for deciding which factors will cause the demand curve for bonds to shift. These factors include changes in the following four parameters:

1. Wealth 2. Expected returns on bonds relative to alternative assets 3. Risk of bonds relative to alternative assets 4. Liquidity of bonds relative to alternative assets

To see how a change in each of these factors (holding all other factors constant) can shift the demand curve, let’s look at some examples. (As a study aid, Table 2 sum- marizes the effects of changes in these factors on the bond demand curve.)

Wealth When the economy is growing rapidly in a business cycle expansion and wealth is increasing, the quantity of bonds demanded at each bond price (or interest rate) increases, as shown in Figure 2. To see how this works, consider point B on the ini- tial demand curve for bonds, Bd1. With higher wealth, the quantity of bonds demanded at the same price must rise, to point B′. Similarly, for point D, the higher wealth causes the quantity demanded at the same bond price to rise to point D′. Continuing with this reasoning for every point on the initial demand curve Bd1, we can see that the demand curve shifts to the right from Bd1 to B

d 2, as indicated by the arrows.

We can conclude that in a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. Applying the same reasoning, in a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left.

A

B

C

D

E

A′

B′

C′

D′

E′

Quantity of Bonds, B

Bd1 Bd2

Price of Bonds, P

An increase in the demand for bonds shifts the bond demand curve rightward.

Figure 2 Shift in the Demand Curve for Bonds When the demand for bonds increases, the demand curve shifts to the right as shown.

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C h a P t e r 5 The Behavior of Interest Rates 93

Factors That Shift the Demand Curve for Bonds

Variable

Change in Variable

Change in Quantity Demanded at Each Bond Price

Shift in Demand Curve

Wealth c c

Expected interest rate c T  

Expected inflation c T  

Riskiness of bonds relative to other assets

c T  

Liquidity of bonds relative to other assets

c c  

Note: Only increases in the variables are shown. The effects of decreases in the variables on demand would be the opposite of those indicated in the remaining columns.

Summary table 2

Bd1B d 2

P

P

P

P

B

B

B

B

Bd1B d 2

Bd1B d 2

Bd1 B d 2

P

B

Bd1 B d 2

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Another factor that affects wealth is the public’s propensity to save. If households save more, wealth increases and, as we have seen, the demand for bonds rises and the demand curve for bonds shifts to the right. Conversely, if people save less, wealth and the demand for bonds fall, and the demand curve shifts to the left.

expected returns For a one-year discount bond and a one-year holding period, the expected return and the interest rate are identical, so nothing other than today’s interest rate affects the expected return.

For bonds with maturities of greater than one year, the expected return may differ from the interest rate. For example, we saw in Chapter 4, Table 2, that a rise in the interest rate on a long-term bond from 10% to 20% would lead to a sharp decline in price and a very large negative return. Hence, if people began to think that interest rates would be higher next year than they had originally anticipated, the expected return today on long-term bonds would fall, and the quantity demanded would fall at each interest rate. Higher expected future interest rates lower the expected return for long- term bonds, decrease the demand, and shift the demand curve to the left.

By contrast, an expectation of lower future interest rates would mean that long- term bond prices would be expected to rise more than originally anticipated, and the resulting higher expected return today would raise the quantity demanded at each bond price and interest rate. Lower expected future interest rates increase the demand for long-term bonds and shift the demand curve to the right (as in Figure 2).

Changes in expected returns on other assets can also shift the demand curve for bonds. If people suddenly become more optimistic about the stock market and begin to expect higher stock prices in the future, both expected capital gains and expected returns on stocks will rise. With the expected return on bonds held constant, the expected return on bonds today relative to stocks will fall, lowering the demand for bonds and shifting the demand curve to the left. An increase in expected return on alternative assets lowers the demand for bonds and shifts the demand curve to the left.

A change in expected inflation is likely to alter expected returns on physical assets (also called real assets), such as automobiles and houses, which affect the demand for bonds. An increase in expected inflation from, say, 5% to 10% will lead to higher prices on cars and houses in the future and hence higher nominal capital gains. The resulting rise in the expected returns today on these real assets will lead to a fall in the expected return on bonds relative to the expected return on real assets today and thus cause the demand for bonds to fall. Alternatively, we can think of the rise in expected inflation as lowering the real interest rate on bonds, and thus the resulting decline in the relative expected return on bonds will cause the demand for bonds to fall. An increase in the expected rate of inflation lowers the expected return on bonds, causing their demand to decline and the demand curve to shift to the left.

risk If prices in the bond market become more volatile, the risk associated with bonds increases, and bonds become a less attractive asset. An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left.

Conversely, an increase in the volatility of prices in another asset market, such as the stock market, would make bonds more attractive. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right (as in Figure 2).

Liquidity If more people started trading in the bond market, and as a result it be- came easier to sell bonds quickly, the increase in their liquidity would cause the quan- tity of bonds demanded at each interest rate to rise. Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right (see Figure 2).

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C h a p t e r 5 The Behavior of Interest Rates 95

Similarly, increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left. The reduction of brokerage commissions for trading common stocks that occurred when the fixed-rate commission structure was abolished in 1975, for example, increased the liquidity of stocks relative to bonds, and the result- ing lower demand for bonds shifted the demand curve to the left.

Shifts in the Supply of Bonds Certain factors can cause the supply curve for bonds to shift. Among these factors are:

1. Expected profitability of investment opportunities 2. Expected inflation 3. Government budget deficits

We will look at how the supply curve shifts when each of these factors changes (all others remaining constant). (As a study aid, Table 3 summarizes the effects of changes in these factors on the bond supply curve.)

Factors That Shift the Supply of Bonds

Variable

Change in Variable

Change in Quantity Supplied at Each Bond Price

Shift in Supply Curve

Profitability of investments c c

Expected inflation c c  

Government deficit c c  

Note: Only increases in the variables are shown. The effects of decreases in the variables on the supply would be the opposite of those indicated in the remaining columns.

Summary table 3

Bs2 Bs1

B

P

Bs2 Bs1

B

P

Bs2 Bs1

B

P

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Expected Profitability of Investment Opportunities When opportunities for profitable plant and equipment investments are plentiful, firms are more willing to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profit- able abound, and the quantity of bonds supplied at any given bond price increases (see Figure 3). Therefore, in a business cycle expansion, the supply of bonds increases and the supply curve shifts to the right. Likewise, in a recession, when far fewer profitable investment opportunities are expected, the supply of bonds falls and the supply curve shifts to the left.

Expected Inflation As we saw in Chapter 4, the real cost of borrowing is most accurately measured by the real interest rate, which equals the (nominal) interest rate minus the expected inflation rate. For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence, the quantity of bonds supplied increases at any given bond price. An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right (see Figure 3) and a decrease in expected inflation causes the supply of bonds to decrease and the supply curve to shift to the left.

Government Budget Deficits The activities of the government can influence the supply of bonds in several ways. The U.S. Treasury issues bonds to finance government deficits, caused by gaps between the government’s expenditures and its revenues. When these deficits are large, the Treasury sells more bonds, and the quantity of bonds sup- plied at each bond price increases. Higher government deficits increase the supply of bonds and shift the supply curve to the right (see Figure 3). On the other hand, govern- ment surpluses, as occurred in the late 1990s, decrease the supply of bonds and shift the supply curve to the left.

F′

Quantity of Bonds, B

Price of Bonds, P

I

H

C

G

F

I′

H′

C′

G′

Bs1 B s 2

An increase in the supply of bonds shifts the bond supply curve rightward.

Figure 3 Shift in the Supply Curve for Bonds When the supply of bonds increases, the supply curve shifts to the right.

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C h a p t e r 5 The Behavior of Interest Rates 97

State and local governments and other government agencies also issue bonds to finance their expenditures, and this can affect the supply of bonds as well. We will see in later chapters that the conduct of monetary policy involves the purchase and sale of bonds, which in turn influences the supply of bonds.

We now can use our knowledge of how supply and demand curves shift to analyze how the equilibrium interest rate can change. The best way to do this is to pursue several applications that are particularly relevant to our understanding of how monetary policy affects interest rates. In studying these applications, keep two things in mind:

1. When we examine the effect of a variable change, remember we are assuming that all other variables are unchanged; that is, we are making use of the ceteris paribus assumption.

2. Remember that the interest rate is negatively related to the bond price, so when the equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.

A p p li c At i o n Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect We have already done most of the work necessary to evaluate how a change in expected inflation affects the nominal interest rate, in that we have already analyzed how a change in expected inflation shifts the supply and demand curves. Figure 4 shows the effect on the equilibrium interest rate of an increase in expected inflation.

1

2

Bd1Bd2

P1

P2

Price of Bonds, P

Quantity of Bonds, B

Bs1

Bs2

Step 2. and shifts the bond supply curve rightward . . .

Step 1. A rise in expected in�ation shifts the bond demand curve leftward . . .

Step 3. causing the price of bonds to fall and the equilibrium interest rate to rise.

Figure 4 Response to a Change in Expected Inflation When expected inflation rises, the supply curve shifts from Bs1 to B

s 2, and the

demand curve shifts from Bd1 to B

d 2. The

equilibrium moves from point 1 to point 2, causing the equi- librium bond price to fall from P1 to P2 and the equilibrium interest rate to rise.

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98 p a r t 2 Financial Markets

Suppose that expected inflation is initially 5% and the initial supply and demand curves Bs1 and B

d 1 intersect at point 1, where the equilibrium bond price is P1. If

expected inflation rises to 10%, the expected return on bonds relative to real assets falls for any given bond price and interest rate. As a result, the demand for bonds falls, and the demand curve shifts to the left from Bd1 to B

d 2. The rise in expected inflation

also shifts the supply curve. At any given bond price and interest rate, the real cost of borrowing declines, causing the quantity of bonds supplied to increase and the supply curve to shift to the right, from Bs1 to B

s 2.

When the demand and supply curves shift in response to the change in expected inflation, the equilibrium moves from point 1 to point 2, at the intersection of Bd2 and B

s 2.

The equilibrium bond price falls from P1 to P2 and, because the bond price is negatively related to the interest rate, this means that the interest rate rises. Note that Figure 4 has been drawn so that the equilibrium quantity of bonds remains the same at both point 1 and point 2. However, depending on the size of the shifts in the supply and demand curves, the equilibrium quantity of bonds can either rise or fall when expected inflation rises.

Our supply and demand analysis has led us to an important observation: When expected inflation rises, interest rates will rise. This result has been named the Fisher effect, after Irving Fisher, the economist who first pointed out the relationship of expected inflation to interest rates. The accuracy of this prediction is shown in Figure 5. The interest rate on three-month Treasury bills has usually moved along with the expected inflation rate. Consequently, many economists recommend that inflation must be kept low if we want to keep nominal interest rates low.

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20102005

20

16

12

8

4

0

Annual Rate (%)

2015

Interest Rate

Expected Inflation

Figure 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2014 The interest rate on three-month Treasury bills and the expected inflation rate generally move together, as

the Fisher effect predicts. Sources: Federal reserve bank of St. louis FreD database: http://research.stlouisfed.org/fred2/. Expected inflation calculated using

procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends.

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C h a p t e r 5 The Behavior of Interest Rates 99

A p p li c At i o n Changes in the Interest Rate Due to a Business Cycle Expansion Figure 6 analyzes the effects of a business cycle expansion on interest rates. In a business cycle expansion, the amounts of goods and services being produced in the economy increase, so national income rises. When this occurs, businesses are more willing to borrow because they are likely to have many profitable investment oppor- tunities for which they need financing. Hence, at a given bond price, the quantity of bonds that firms want to sell (that is, the supply of bonds) will increase. This means that during a business cycle expansion, the supply curve for bonds shifts to the right (see Figure 6) from Bs1 to B

s 2.

Expansion in the economy also affects the demand for bonds. As the economy expands, wealth is likely to increase, and the theory of portfolio choice tells us that the demand for bonds will rise as well. We see this in Figure 6, where the demand curve has shifted to the right, from Bd1 to B

d 2.

Given that both the supply and demand curves have shifted to the right, we know that the new equilibrium reached at the intersection of Bd2 and B

s 2 must also move to the

right. However, depending on whether the supply curve shifts more than the demand curve or vice versa, the new equilibrium interest rate can either rise or fall.

Price of Bonds, P

Quantity of Bonds, B

1

2

Bd1 Bd2

P1

P2

Bs1

Bs2

Step 1. A business cycle expansion shifts the bond supply curve rightward . . .

Step 2. and shifts the bond demand curve rightward, but by a lesser amount . . .

Step 3. so the price of bonds falls and the equilibrium interest rate rises.

Figure 6 Response to a Business Cycle Expansion In a business cycle expansion, when income and wealth are rising, the demand curve shifts rightward from

Bd1 to B d 2. If the supply curve shifts to the right more than the demand curve, as in this figure, the equilibrium

bond price moves down from P1 to P2 and the equilibrium interest rate rises.

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100 p a r t 2 Financial Markets

The supply and demand analysis used here gives us an ambiguous answer to the question of what happens to interest rates in a business cycle expansion. Figure 6 has been drawn so that the shift in the supply curve is greater than the shift in the demand curve, causing the equilibrium bond price to fall to P2 and the equilibrium interest rate to rise. The reason the figure has been drawn such that a business cycle expansion and a rise in income lead to a higher interest rate is that this is the outcome we actually see in the data. Figure 7 plots the movement of the interest rate on three-month U.S. Treasury bills from 1951 to 2014 and indicates when the business cycle went through recessions (shaded areas). As you can see, the interest rate tends to rise during business cycle expansions and fall during recessions, as indicated by the supply and demand diagram in Figure 6.

A p p li c At i o n Explaining Low Japanese Interest Rates In the 1990s and early 2000s, Japanese interest rates became the lowest in the world. Indeed, in November 1998, an extraordinary event occurred: Interest rates on Japanese six-month Treasury bills even turned slightly negative! Why did Japanese interest rates drop to such low levels?

16

14

18

12

10

8

6

4

2

0 1950 1960 1970 1980 1990

Interest Rate (% annual rate)

2000 2005 2010 20151955 1965 1975 1985 1995

Interest Rate

Figure 7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2014 Shaded areas indicate periods of recession. The interest rate tends to rise during business cycle expansions

and fall during recessions. Source: Federal reserve bank of St. louis FreD database: http://research.stlouisfed.org/fred2/

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C h a P t e r 5 The Behavior of Interest Rates 101

In the late 1990s and early 2000s, Japan experienced a prolonged recession, which was accompanied by deflation (a negative inflation rate). We can use these facts, along with an analysis similar to that used in the preceding applications, to explain the low Japanese interest rates.

Negative inflation caused the demand for bonds to rise because the expected return on real assets fell, thereby raising the relative expected return on bonds and in turn causing the demand curve to shift to the right. Negative inflation also raised the real interest rate and therefore the real cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift to the left. The outcome was then exactly the opposite of that graphed in Figure 4: The rightward shift of the demand curve and leftward shift of the supply curve led to a rise in the bond price and a fall in interest rates.

The business cycle contraction and the resulting lack of profitable investment opportunities in Japan also led to lower interest rates by decreasing the supply of bonds and shifting the supply curve to the left. Although the demand curve also shifted to the left because wealth decreased during the business cycle contraction, the demand curve shifted less than the supply curve, just as we saw in the preceding application. Thus, the bond price rose and interest rates fell (the opposite outcome of that in Figure 6).

Usually we think that low interest rates are a good thing because they make it cheap to borrow. But the Japanese example shows that just as a fallacy is present in the adage “You can never be too rich or too thin” (maybe you can’t be too rich, but you can certainly be too thin and thereby damage your health), a fallacy is present in always thinking that lower interest rates are better. In Japan, the low and even negative interest rates were a sign that the country was in real trouble, with falling prices and a contracting economy. Only when the Japanese economy returns to health will interest rates rise back to more normal levels. ◆

suPPLy anD DemanD In the market fOr mOney: the LIQuIDIty PreferenCe frameWOrk

An alternative model for determining the equilibrium interest rate, developed by John Maynard Keynes, is known as the liquidity preference framework. This framework determines the equilibrium interest rate in terms of the supply of and demand for money rather than the supply of and demand for bonds. Although the two frameworks look different, the liquidity preference analysis of the market for money is closely related to the supply and demand framework of the bond market.4

The starting point of Keynes’s analysis is his assumption that people use two main categories of assets to store their wealth: money and bonds. Therefore, total wealth in the economy must equal the total quantity of bonds plus money in the economy, which equals the quantity of bonds supplied (Bs) plus the quantity of money supplied (Ms).

4Note that the term market for money refers to the market for the medium of exchange, money. This market differs from the money market referred to by finance practitioners, which, as discussed in Chapter 2, is the financial market in which short-term debt instruments are traded.

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102 P a r t 2 Financial Markets

The quantity of bonds demanded (Bd) plus the quantity of money demanded (Md) must also equal the total amount of wealth, because people cannot purchase more assets than their available resources allow. Thus the quantity of bonds and money supplied must equal the quantity of bonds and money demanded:

Bs + Ms = Bd + Md (2)

Collecting the bond terms on one side of the equation and the money terms on the other, this equation can be rewritten as

Bs - Bd = Md - Ms (3)

Equation 3 tells us that if the market for money is in equilibrium 1Ms = Md2 , then the right-hand side of the equation equals zero, implying that Bs = Bd, which in turn means the bond market is also in equilibrium.

Thus we arrive at the same result whether we determine the equilibrium inter- est rate by equating the supply and demand for bonds or by equating the supply and demand for money. In this sense, the liquidity preference framework, which analyzes the market for money, is equivalent to a framework analyzing supply and demand in the bond market. In practice, the approaches differ because, by assuming there are only two kinds of assets, money and bonds, the liquidity preference approach implicitly ignores any effects on interest rates that arise from changes in the expected returns on real assets such as automobiles and houses. In most instances, however, both frame- works yield the same predictions.

The reason we approach the determination of interest rates using both frameworks is that the bond supply and demand framework is easier to use when analyzing the effects caused by changes in expected inflation, whereas the liquidity preference frame- work is easier to use when analyzing the effects caused by changes in income, the price level, and the supply of money.

Because the definition of money used by Keynes includes currency (which earns no interest) and checking account deposits (which in his time typically earned little or no interest), he assumed that money has a zero rate of return. Bonds, the only alternative asset to money in Keynes’s framework, have an expected return equal to the interest rate i.5 As this interest rate rises (holding everything else unchanged), the expected return on money falls relative to the expected return on bonds, causing a fall in the quantity of money demanded, as predicted by the theory of portfolio choice.

We can also see that the quantity of money demanded and the interest rate should be negatively related by using the concept of opportunity cost, which is the amount of interest (expected return) sacrificed by not holding the alternative asset—in this case, a bond. As the interest rate on bonds, i, rises, the opportunity cost of holding money rises; thus money is less desirable and the quantity of money demanded falls.

Figure 8 shows the quantity of money demanded at a number of interest rates, with all other economic variables, such as income and the price level, held constant. At an interest rate of 25%, point A shows that the quantity of money demanded is

5Keynes did not actually assume that the expected returns on bonds equaled the interest rate but rather argued that they were closely related. This distinction makes no appreciable difference in our analysis.

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C h a p t e r 5 The Behavior of Interest Rates 103

$100 billion. If the interest rate is at the lower rate of 20%, the opportunity cost of holding money is lower, and the quantity of money demanded rises to $200 billion, as indicated by the move from point A to point B. If the interest rate is even lower, the quantity of money demanded is even higher, as is indicated by points C, D, and E. The curve Md connecting these points is the demand curve for money, and it slopes downward.

At this point in our analysis, we will assume that a central bank controls the amount of money supplied at a fixed quantity of $300 billion, so that the supply curve for money Ms in the figure is a vertical line at $300 billion. The equilibrium at which the quantity of money demanded equals the quantity of money supplied occurs at the intersection of the supply and demand curves at point C, where

Md = Ms (4)

The resulting equilibrium interest rate is i* = 15%. We can again see that there is a tendency to approach this equilibrium rate by first

looking at the relationship of money demand and supply when the interest rate is above the equilibrium interest rate. When the interest rate is 25%, the quantity of money demanded at point A is $100 billion, yet the quantity of money supplied is $300 billion. The excess supply of money means that people are holding more money than they desire, so they will try to get rid of their excess money balances by trying to buy bonds.

5

10

20

25

30

0 200 300 400 600500

i * =15

Quantity of Money, M ($ billions)

M s

Md

100

Interest Rate, i (%)

A

B

C

D

E

With excess supply, the interest rate falls to i *.

With excess demand, the interest rate rises to i *.

Figure 8 Equilibrium in the Market for Money Equilibrium in the market for money occurs at point C, the intersection of the money demand curve Md and the money supply curve Ms. The equilibrium interest rate is i* = 15%.

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104 P a r t 2 Financial Markets

Accordingly, they will bid up the price of bonds. As the bond price rises, the interest rate will fall toward the equilibrium interest rate of 15%. This tendency is shown by the downward arrow drawn at the interest rate of 25%.

Likewise, if the interest rate is 5%, the quantity of money demanded at point E is $500 billion, but the quantity of money supplied is only $300 billion. An excess demand for money now exists because people want to hold more money than they currently have. To try to obtain more money, they will sell their only other asset— bonds—and the price will fall. As the price of bonds falls, the interest rate will rise toward the equilibrium rate of 15%. Only when the interest rate is at its equilibrium value will there be no tendency for it to move further, and so the interest rate will settle at this value.

Changes In eQuILIBrIum Interest rates In the LIQuIDIty PreferenCe frameWOrk

In order to use the liquidity preference framework to analyze how the equilibrium interest rate changes, we must understand what causes the demand and supply curves for money to shift.

shifts in the Demand for money In Keynes’s liquidity preference analysis, two factors cause the demand curve for money to shift: income and the price level.

Income effect In Keynes’s view, there were two reasons why income would affect the demand for money. First, as an economy expands and income rises, wealth increases and people want to hold more money as a store of value. Second, as the economy ex- pands and income rises, people want to carry out more transactions using money as a medium of exchange, and so they also want to hold more money. The conclusion is that a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

Price-Level effect Keynes took the view that people care about the amount of money they hold in real terms—that is, in terms of the goods and services it can buy. When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their holdings of money in real terms to the former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.

shifts in the supply of money We will assume that the supply of money is completely controlled by the central bank, which in the United States is the Federal Reserve. (Actually, the process that determines the money supply is substantially more complicated, involving banks, depositors, and borrowers from banks. We will study it in more detail later in the book.) For now, all we need to know is that an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right.

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C h a p t e r 5 The Behavior of Interest Rates 105

A p p l i c At i o n Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply To see how we can use the liquidity preference framework to analyze the movement of interest rates, we will again look at several applications that will help us evaluate the effect of monetary policy on interest rates. In going through these applications, remember to use the ceteris paribus assumption: When examining the effect of a change in one variable, hold all other variables constant. (As a study aid, Table 4 summarizes the shifts in the demand and supply curves for money.)

Factors That Shift the Demand for and Supply of Money

Variable

Change in Variable

Change in Money Demand (Md) or Supply (Ms) at Each Interest Rate

Change in Interest Rate

Income c Mdc c

Price level c Mdc c  

Money supply c Msc T  

Note: Only increases in the variables are shown. The effects of decreases in the variables on demand and supply would be the opposite of those indicated in the remaining columns.

Summary table 4

i

M

i2

i1

Md1 Md2

Ms

M

i1

i

i2

Ms1 M s 2

Md

i

M

i2

i1

Md1 Md2

Ms

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106 p a r t 2 Financial Markets

Changes in Income We have seen that when income is rising during a business cycle expansion, the demand for money will rise, shown in Figure 9 by the rightward shift in the demand curve from Md1 to M

d 2. The new equilibrium is reached at point 2, at the intersection of

the Md2 curve with the money supply curve M s. As you can see, the equilibrium interest

rate rises from i1 to i2. The liquidity preference framework thus generates the conclu- sion that when income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise. This conclusion is unambiguous, unlike the conclusion we reached using the bond demand and supply framework.

Changes in the Price Level When the price level rises, the value of money in terms of its purchasing power is lower. To restore their money’s purchasing power in real terms to its former level, people will want to hold a greater nominal quantity of money. A higher price level shifts the demand curve for money to the right from Md1 to M

d 2 (see Figure 9). The equilibrium

moves from point 1 to point 2, where the equilibrium interest rate has risen from i1 to i2, illustrating that when the price level increases, with the supply of money and other economic variables held constant, interest rates will rise.

Changes in the Money Supply An increase in the money supply due to expansionary monetary policy by the Federal Reserve implies that the supply curve for money will shift to the right. As shown in Figure 10 by the movement of the supply curve from Ms1 to M

s 2, the equilibrium moves

Md1

Md2

2

1

i2

i1

M

Interest Rate, i

Quantity of Money, M

Ms

Step 1. A rise in income or the price level shifts the money demand curve rightward . . .

Step 2. and the equilibrium interest rate rises.

Figure 9 Response to a Change in Income or the Price Level In a business cycle expansion, when income is rising, or when the price level rises, the demand curve shifts from Md1 to Md2. The supply curve is fixed at Ms = M. The equi- librium interest rate rises from i1 to i2.

MyEconLab Mini-lecture

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C h a p t e r 5 The Behavior of Interest Rates 107

from point 1 down to point 2, where the Ms2 supply curve intersects with the demand curve Md and the equilibrium interest rate has fallen from i1 to i2. When the money supply increases (everything else remaining equal), interest rates will decline.6

Money anD InTeReST RaTeS The liquidity preference analysis in Figure 10 seems to suggest that an increase in the money supply will lower interest rates. This conclusion has important policy implica- tions because it has frequently caused politicians to call for a more rapid growth of the money supply in an effort to drive down interest rates.

But is it correct to conclude that money and interest rates should be negatively related? Might other important factors have been left out of the liquidity preference analysis in Figure 10, factors that would reverse this conclusion? We will provide answers to these questions by applying the supply and demand analysis we used in this chapter to obtain a deeper understanding of the relationship between money and interest rates.

An important criticism of the idea that an increase in the money supply lowers interest rates was raised by Milton Friedman, a Nobel laureate in economics. He acknowledged that the liquidity preference analysis was correct and called the result—that an increase

6This same result can be generated using the bond supply and demand framework. As we will see in Chapter 17, a central bank increases the money supply primarily by buying bonds and thereby decreasing the supply of bonds available to the public. The resulting shift to the left of the supply curve for bonds leads to an increase in the equilibrium price of bonds and a decline in the equilibrium interest rate.

Quantity of Money, M

Ms1 M s 2

2

1

i2

i1

Interest Rate, i

Md

Step 1. An increase in the money supply shifts the money supply curve rightward . . .

Step 2. and the equilibrium interest rate falls.

Figure 10 Response to a Change in the Money Supply When the money supply increases, the supply curve shifts from Ms1 to M

s 2 and

the equilibrium interest rate falls from i1 to i2.

MyEconLab Mini-lecture

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108 P a r t 2 Financial Markets

in the money supply (everything else remaining equal) lowers interest rates—the liquidity effect. However, he viewed the liquidity effect as merely part of the story: An increase in the money supply might not leave “everything else equal” and will have other effects on the economy that may make interest rates rise. If these effects are substantial, it is entirely possible that when the money supply increases, interest rates might also increase.

We have already laid the groundwork for our discussion of these other effects, because we have shown how changes in income, the price level, and expected inflation influence the equilibrium interest rate.

1. Income Effect. An increasing money supply can cause national income and wealth to rise. Both the liquidity preference and bond supply and demand frameworks indicate that interest rates will then rise (see Figures 6 and 9). Thus the income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income.

2. Price-Level Effect. An increase in the money supply can also cause the overall price level in the economy to rise. The liquidity preference framework predicts that this will lead to a rise in interest rates. Thus the price-level effect from an increase in the money supply is a rise in interest rates in response to the rise in price level.

3. Expected-Inflation Effect. The higher inflation rate that can result from an increase in the money supply can also affect interest rates by influencing the expected infla- tion rate. Specifically, an increase in the money supply may lead people to expect a higher price level in the future—and hence the expected inflation rate will be higher. The bond supply and demand framework has shown us that this increase in expected inflation will lead to a higher level of interest rates. Therefore, the expected- inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate.

At first glance it might appear that the price-level effect and the expected-inflation effect are the same thing. They both indicate that increases in the price level induced by an increase in the money supply will raise interest rates. However, there is a subtle difference between the two, and this is why they are discussed as two separate effects.

Suppose that a one-time increase in the money supply today leads to a rise in prices to a permanently higher level by next year. As the price level rises over the course of this year, the interest rate will rise via the price-level effect. Only at the end of the year, when the price level has risen to its peak, will the price-level effect be at a maximum.

The rising price level will also raise interest rates via the expected-inflation effect, because people will expect that inflation will be higher over the course of the year. However, when the price level stops rising next year, inflation and the expected infla- tion rate will return to zero. Any rise in interest rates as a result of the earlier rise in expected inflation will then be reversed. We thus see that in contrast to the price-level effect, which reaches its greatest impact next year, the expected-inflation effect will have its smallest impact (zero impact) next year. The basic difference between the two effects, then, is that the price-level effect remains even after prices have stopped rising, whereas the expected-inflation effect disappears.

An important point is that the expected-inflation effect will persist only as long as the price level continues to rise. As we will see in our discussion of monetary theory in subsequent chapters, a one-time increase in the money supply will not produce a continually rising price level; only a higher rate of money supply growth will. Thus a higher rate of money supply growth is needed if the expected-inflation effect is to persist.

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C h a P t e r 5 The Behavior of Interest Rates 109

A p p li c At i o n Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? We can now put together all the effects we have discussed to help us decide whether our analysis supports the politicians who advocate a greater rate of growth of the money supply when they feel that interest rates are too high. Of all the effects, only the liquidity effect indicates that a higher rate of money growth will cause a decline in interest rates. In contrast, the income, price-level, and expected-inflation effects indi- cate that interest rates will rise when money growth is higher. Which of these effects is largest, and how quickly does each take effect? The answers are critical in deter- mining whether interest rates will rise or fall when money supply growth is increased.

Generally, the liquidity effect from greater money growth takes effect immediately, because the rising money supply leads to an immediate decline in the equilibrium inter- est rate. The income and price-level effects take longer to work because time is needed for the increasing money supply to raise the price level and income, which in turn raise interest rates. The expected-inflation effect, which also raises interest rates, can be slow or fast, depending on whether people adjust their expectations of inflation slowly or quickly when the money growth rate is increased.

Three possibilities are outlined in Figure 11; each shows how interest rates respond over time to an increased rate of money supply growth, starting at time T. Panel (a) shows a case in which the liquidity effect dominates the other effects so that the interest rate falls from i1 at time T to a final level of i2. The liquidity effect operates quickly to lower the interest rate, but as time goes by, the other effects start to reverse some of the decline. Because the liquidity effect is larger than the others, however, the interest rate never rises back to its initial level.

In panel (b), the liquidity effect is smaller than the other effects, with the expected- inflation effect operating slowly because expectations of inflation are slow to adjust upward. Initially, the liquidity effect drives down the interest rate. Then the income, price-level, and expected-inflation effects begin to raise it. Because these effects are dominant, the interest rate eventually rises above its initial level to i2. In the short run, lower interest rates result from increased money growth, but eventually they end up climbing above the initial level.

In panel (c), the expected-inflation effect dominates and operates rapidly because people quickly raise their expectations of inflation when the rate of money growth increases. The expected-inflation effect begins immediately to overpower the liquidity effect, and the interest rate immediately starts to climb. Over time, as the income and price-level effects start to take hold, the interest rate rises even higher, and the eventual outcome is an interest rate that is substantially higher than the initial interest rate. The result shows clearly that increasing money supply growth is not the answer to reducing interest rates; rather, money growth should be reduced to lower interest rates!

An important issue for economic policymakers is deciding which of these three scenarios is closest to reality. If a decline in interest rates is desired, then an increase in money supply growth is called for when the liquidity effect dominates the other effects, as in panel (a). A decrease in money growth is appropriate when the other effects dominate the liquidity effect and expectations of inflation adjust rapidly, as in panel (c). If the other effects dominate the liquidity effect but expectations of inflation adjust only slowly, as in panel (b), then the decision to increase or decrease money growth depends on whether policymakers care more about what happens in the short run or in the long run.

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110 P a r t 2 Financial Markets

Liquidity Effect

Income, Price-Level, and Expected- Inflation Effects

( a ) Liquidity effect larger than other effects

Time

i1 i2

T

Liquidity Effect

Income, Price-Level, and Expected- Inflation Effects

( b ) Liquidity effect smaller than other effects and slow adjustment of expected in�ation

Time

i1

i2

T

Liquidity and Expected- Inflation Effects

Income and Price- Level Effects

( c ) Liquidity effect smaller than other effects and fast adjustment of expected in�ation

Time

i1

i2

T

Interest Rate, i

Interest Rate, i

Interest Rate, i

Figure 11 Response over Time to an Increase in Money Supply Growth Each panel shows how interest rates respond over time to an increased rate of money supply growth,

starting at time T.

MyEconLab Mini-lecture

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C h a P t e r 5 The Behavior of Interest Rates 111

Which scenario is supported by the evidence? The relationship between interest rates and money growth from 1950 to 2014 is plotted in Figure 12. When the rate of money supply growth began to climb in the mid-1960s, interest rates rose, indicating that the liquidity effect was dominated by the price-level, income, and expected-inflation effects. By the 1970s, interest rates reached levels unprecedented in the post–World War II period, as did the rate of money supply growth.

The scenario depicted in panel (a) of Figure 11 seems doubtful, and the case for lowering interest rates by raising the rate of money growth is much weakened. Look- ing back at Figure 5, which shows the relationship between interest rates and expected inflation, you should not find this too surprising. The rise in the rate of money supply growth in the 1960s and 1970s is matched by a large rise in expected inflation, which would lead us to predict that the expected-inflation effect would be dominant. It is the most plausible explanation for why interest rates rose in the face of higher money growth. However, Figure 12 does not really tell us which one of the two scenarios depicted in panels (b) and (c) of Figure 11 is more accurate. It depends critically on how fast people’s expectations about inflation adjust. Research done using more sophis- ticated methods than just looking at a graph like Figure 12 indicates that increased money growth temporarily lowers short-term interest rates and thus conforms to the scenario in panel (b). ◆

0

4

8

12

212

28

24

16

20

22

24

26

28

30

32

Money Growth Rate (M2)

Interest Rate

Interest Rate (% annual rate)

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 20151950

Money Growth Rate (% annual rate)

2 4

22

26 28

24

6 8 10 12 14 16 18 20 22 24 26 28

0

Figure 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2014 When the rate of money supply growth began to climb in the mid-1960s, interest rates rose, indicating that

the liquidity effect was dominated by the price-level, income, and expected-inflation effects. By the 1970s, both interest rates and money growth reached levels unprecedented in the post–World War II period.

Source: Federal reserve Bank of St. Louis FreD database: http://research.stlouisfed.org/fred2/

MyEconLab Mini-lecture MyEconLab Real-time data

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112 P a r t 2 Financial Markets

summary 1. The theory of portfolio choice tells us that the quantity

demanded of an asset is (a) positively related to wealth, (b) positively related to the expected return on the asset relative to alternative assets, (c) negatively related to the riskiness of the asset relative to alternative assets, and (d) positively related to the liquidity of the asset relative to alternative assets.

2. The supply and demand analysis for bonds provides one theory of how interest rates are determined. It predicts that interest rates will change when there is a change in demand caused by changes in income (or wealth), expected returns, risk, or liquidity, or when there is a change in supply caused by changes in the attractiveness of investment opportunities, the real cost of borrowing, or the government budget.

3. An alternative theory of how interest rates are determined is provided by the liquidity preference framework, which analyzes the supply of and demand for money. It shows that interest rates will change when the demand for money changes because of alterations in income or the price level, or when the supply of money changes.

4. There are four possible effects on interest rates of an increase in the money supply: the liquidity effect, the income effect, the price-level effect, and the expected- inflation effect. The liquidity effect indicates that a rise in money supply growth will lead to a decline in interest rates; the other effects work in the opposite direction. The evidence seems to indicate that the income, price- level, and expected-inflation effects dominate the liquid- ity effect such that an increase in money supply growth leads to higher—rather than lower—interest rates.

key terms

asset market approach, p. 91 demand curve, p. 88 excess demand, p. 90 excess supply, p. 90 expected return, p. 86

Fisher effect, p. 98 liquidity, p. 86 liquidity preference framework,

p. 101 market equilibrium, p. 90

opportunity cost, p. 102 risk, p. 86 supply curve, p. 89 theory of portfolio choice, p. 87 wealth, p. 86

QuestIOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:

a. Your wealth falls.

b. You expect the stock to appreciate in value.

c. The bond market becomes more liquid.

d. You expect gold to appreciate in value.

e. Prices in the bond market become more volatile.

2. Explain why you would be more or less willing to buy a house under the following circumstances:

a. You just inherited $100,000.

b. Real estate commissions fall from 6% of the sales price to 5% of the sales price.

c. You expect Microsoft stock to double in value next year.

d. Prices in the stock market become more volatile.

e. You expect housing prices to fall.

3. Explain why you would be more or less willing to buy gold under the following circumstances:

a. Gold again becomes acceptable as a medium of exchange.

b. Prices in the gold market become more volatile.

c. You expect inflation to rise, and gold prices tend to move with the aggregate price level.

d. You expect interest rates to rise.

4. Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances:

a. Trading in these bonds increases, making them easier to sell.

b. You expect a bear market in stocks (stock prices are expected to decline).

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C h a P t e r 5 The Behavior of Interest Rates 113

c. Brokerage commissions on stocks fall.

d. You expect interest rates to rise.

e. Brokerage commissions on bonds fall.

5. What will happen to the demand for Rembrandt paintings if the stock market undergoes a boom? Why?

6. “The more risk-averse people are, the more likely they are to diversify.” Is this statement true, false, or uncer- tain? Explain your answer.

7. “No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquid- ity than another security.” Is this statement true, false, or uncertain? Explain your answer.

8. What effect will a sudden increase in the volatility of gold prices have on interest rates?

9. How might a sudden increase in people’s expectations of future real estate prices affect interest rates?

10. Explain what effect a large federal deficit should have on interest rates.

11. In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for quite some time. Does this make sense? Why or why not?

12. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer.

13. The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.

14. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.

15. Predict what will happen to interest rates if prices in the bond market become more volatile.

16. Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?

17. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed?

18. If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates? Discuss the possible resulting situations.

19. M1 money growth in the U.S. was about 15% in 2011 and 2012, and 10% in 2013. Over the same time period, the yield on 3-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low, rather than increase? What does this say about the income, price-level, and expected-inflation effects?

All applied problems are available in MyEconLab at http://www.myeconlab.com.

20. Suppose you visit with a financial adviser, and you are considering investing some of your wealth in one of three investment portfolios: stocks, bonds, or com- modities. Your financial adviser provides you with the following table, which gives the probabilities of pos- sible returns from each investment:

a. Which investment should you choose to maximize your expected return: stocks, bonds, or commodities?

b. If you are risk-averse and have to choose between the stock and the bond investments, which should you choose? Why?

aPPLIeD PrOBLems

Stocks Bonds Commodities

Probability Return Probability Return Probability Return

0.25 12% 0.6 10% 0.2 20%

0.25 10% 0.4 7.50% 0.25 12%

0.25 8%     0.25 6%

0.25 6%     0.25 4%

        0.05 0%

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114 P a r t 2 Financial Markets

a. What is the expected equilibrium price and quantity of bonds in this market?

b. Given your answer to part (a), what is the expected interest rate in this market?

25. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations:

Bd: Price = -0.6 * Quantity + 1140 Bs: Price = Quantity + 700 Suppose that, as a result of monetary policy actions,

the Federal Reserve sells 80 bonds that it holds. Assume that bond demand and money demand are held constant.

a. How does the Federal Reserve policy affect the bond supply equation?

b. Calculate the effect of the Federal Reserve’s action on the equilibrium interest rate in this market.

21. An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?

22. Using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).

23. Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?

24. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations:

Bd: Price = -0.6 * Quantity + 1140 Bs: Price = Quantity + 700

Data anaLysIs PrOBLems

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on net worth of households and non- profits (HNONWRQ027S) and the 10-year U.S. treasury bond (GS10). For the net worth indicator, adjust the units setting to “Percent Change from Year Ago,” and for the 10-year bond, adjust the frequency setting to “Quarterly.”

a. What is the percent change in net worth over the most recent year of data available? All else being equal, what do you expect should happen to the price and yield on the 10-year treasury bond? Why?

b. What is the change in yield on the 10-year trea- sury bond over the last year of data available? Is this result consistent with your answer to part (a)? Briefly explain.

2. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 money supply (M1SL) and the 10-year U.S. treasury bond rate. For the M1 money supply indicator, adjust the units setting to “Percent Change from Year Ago,” and for the 10-year treasury bond, adjust the frequency setting to “Quarterly.” Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year treasury rate on the vertical axis, from 2000:Q1 to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are sev- eral ways to do this; however, one particular chart layout has this option built in). Based on the fit- ted line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the con- temporaneous money growth rate with the inter- est rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1 with the interest rate from 2001:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected- inflation effects.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1 with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data

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C h a P t e r 5 The Behavior of Interest Rates 115

WeB exerCIses

1. Increasing prices erode the purchasing power of the dollar. It is interesting to compute what goods would have cost at some point in the past after adjusting for inflation. Go to http://minneapolisfed.org/index.cfm. What would a car that costs $22,000 today have cost the year you were born?

2. One of the points made in this chapter is that infla- tion erodes investment returns. Go to http://www

.moneychimp.com/articles/econ/inflation_calculator

.htm and review how changes in inflation alter your real return. What happens to the difference between the adjusted value of an investment and its inflation- adjusted value as

a. inflation increases?

b. the investment horizon lengthens?

c. expected returns increase?

WeB referenCes

http://www.federalreserve.gov/releases/H6/Current

The Federal Reserve reports money supply data at 4:30 p.m. every Thursday.

WeB aPPenDICes

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read the Web appendices to Chapter 5.

Appendix 1: Models of Asset Pricing

Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold

Appendix 3: Loanable Funds Framework

available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11 of this chapter?

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Learning Objectives • Identify and explain the three factors affecting the risk structure of interest rates.

• List and explain the three theories of why interest rates vary across different maturities.

6 Preview

In our supply and demand analysis of interest-rate behavior in Chapter 5, we exam-ined the determination of just one interest rate. Yet we saw earlier that there are enormous numbers of bonds on which the interest rates can and do differ. In this chapter, we complete the interest-rate picture by examining the relationships of the various interest rates to one another. Understanding why interest rates differ from bond to bond can help businesses, banks, insurance companies, and private investors decide which bonds to purchase as investments and which ones to sell.

We first look at why bonds with the same term to maturity have different interest rates. The relationship among these interest rates is called the risk structure of inter- est rates, although risk, liquidity, and income tax rules all play a role in determining the risk structure. A bond’s term to maturity also affects its interest rate, and the rela- tionship among interest rates on bonds with different terms to maturity is called the term structure of interest rates. In this chapter, we examine the sources and causes of fluctuations in interest rates relative to one another, and look at a number of theories that explain these fluctuations.

RIsk stRuctuRe Of InteRest Rates Figure 1 shows the yields to maturity for several categories of long-term bonds from 1919 to 2014. It shows us two important features of interest-rate behavior for bonds of the same maturity: Interest rates on different categories of bonds, although they generally move together, differ from one another in any given year, and the spread (or difference) between the interest rates varies over time. The interest rates on municipal bonds, for example, were higher than those on U.S. government (Treasury) bonds in the late 1930s but lower thereafter. In addition, the spread between the interest rates on Baa corporate bonds (riskier than Aaa corporate bonds) and U.S. government bonds was very large dur- ing the Great Depression years from 1930–1933, was smaller during the 1940s–1960s, and then widened again afterward. Which factors are responsible for these phenomena?

Default Risk One attribute of a bond that influences its interest rate is its risk of default. Default occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. Corporations suffering

The Risk and Term Structure of Interest Rates

116

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 117

big losses, such as the major airline companies like United, Delta, US Airways, and Northwest in the mid-2000s, and then American Airlines in 2011, might be more likely to suspend interest payments on their bonds. The default risk on their bonds would therefore be quite high. By contrast, U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes or print money to pay off its obligations. Bonds like these with no default risk are called default-free bonds. (However, during the budget negotiations in Congress in 2013, which led to a government shutdown, the Republicans threatened to let Treasury bonds default, and this threat had an adverse impact on the bond market.) The spread between interest rates on bonds with default risk and interest rates on default-free bonds, both of the same maturity, is called the risk premium. The risk premium indicates how much additional interest people must earn to be willing to hold the risky bond. Our supply and demand analysis of the bond market in Chapter 5 can be used to explain why a bond with default risk always has a positive risk premium, and why a higher default risk means a larger risk premium.

To examine the effect of default risk on interest rates, let’s look at the supply and demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond markets in Figure 2. To make the diagrams somewhat easier to read, let’s assume that initially corporate bonds have the same default risk as U.S. Treasury bonds. In this case, these two bonds have the same attributes (identical risk and maturity); their equilibrium

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0 1950 1960 1970 1980 1990 2000 2010

State and Local Government (Municipal)

U.S. Government Long-Term Bonds

Annual Yield (%)

Corporate Aaa Bonds

194019301920

Corporate Baa Bonds

Figure 1 Long-Term Bond Yields, 1919–2014 Interest rates on different categories of bonds differ from one another in any given year, and the spread (or

difference) between the interest rates varies over time. Sources: Board of governors of the Federal reserve System, Banking and Monetary Statistics,

1941–1970; Federal reserve Bank of St. Louis FreD database: http://research.stlouisfed.org/fred2.

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118 p a r t 2 Financial Markets

prices and interest rates will initially be equal 1P c1 = PT1 and ic1 = iT12, and the risk premium on corporate bonds 1ic1 - iT12 will be zero.

If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease. In addition, the corporate bond’s return will be more uncertain. The theory of portfolio choice predicts that because the expected return on the corporate bond falls relative to the expected return on the default-free Treasury bond while its relative riskiness rises, the corporate bond is less desirable (holding everything else equal), and demand for it will fall. Another way of thinking about this is that if you were an investor, you would want to hold (demand) a smaller amount of corporate bonds. The demand curve for corporate bonds in panel (a) of Figure 2 then shifts to the left, from Dc1 to D

c 2.

At the same time, the expected return on default-free Treasury bonds increases rela- tive to the expected return on corporate bonds, while their relative riskiness declines. The Treasury bonds thus become more desirable, and demand rises, as shown in panel (b) by the rightward shift in the demand curve for these bonds from DT1 to D

T 2.

As we can see in Figure 2, the equilibrium price for corporate bonds falls from Pc1 to Pc2, and since the bond price is negatively correlated to the interest rate, the equilibrium interest rate on corporate bonds rises to ic2. At the same time, however, the equilibrium price for the Treasury bonds rises from PT1 to P

T 2 and the equilibrium interest rate falls

Quantity of Corporate Bonds Quantity of Treasury Bonds

Price of Bonds, P Price of Bonds, P

(a) Corporate bond market (b) Default-free (U.S. Treasury) bond market

Risk Premium

P c2

S c

D c1D c2

P T2

P T1

i c2

S T

D T1 DT2

i T2

P c1

Step 1. An increase in default risk shifts the demand curve for corporate bonds left . . .

Step 2. and shifts the demand curve for Treasury bonds to the right . . .

Step 3. which raises the price of Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds.

Figure 2 Response to an Increase in Default Risk on Corporate Bonds Initially, Pc1 = PT1, ic1 = iT1, and the risk premium is zero. An increase in default risk on corporate bonds shifts

the demand curve from Dc1 to D c 2; simultaneously, it shifts the demand curve for Treasury bonds from D

T 1 to D

T 2.

The equilibrium price for corporate bonds falls from Pc1 to P c 2, and the equilibrium interest rate on corporate

bonds rises to ic2. In the Treasury market, the equilibrium bond price rises from P T 1 to P

T 2, and the equilibrium

interest rate falls to iT2. The brace indicates the difference between i c 2 and i

T 2, the risk premium on corporate

bonds. (Note that because Pc2 is lower than P T 2, i

c 2 is greater than i

T 2.)

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 119

to iT2. The spread between the interest rates on corporate and default-free bonds—that is, the risk premium on corporate bonds—has risen from zero to ic2 - iT2. We can now conclude that a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.

Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. This information is provided by credit-rating agencies, investment advisory firms that rate the quality of corporate and municipal bonds in terms of their probability of default. Credit-rating agencies have become very controversial in recent years because of the role they played in the global financial crisis of 2007–2009 (see the FYI box, “Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis”). Table 1 provides

Rating Agency

Moody’s S&P Fitch Definitions

Aaa AAA AAA Prime Maximum Safety

Aa1 AA+ AA+ High Grade High Quality Aa2 AA AA  

Aa3 AA- AA-   A1 A+ A+ Upper Medium Grade A2 A A  

A3 A- A-   Baa1 BBB+ BBB+ Lower Medium Grade Baa2 BBB BBB  

Baa3 BBB- BBB-   Ba1 BB+ BB+ Noninvestment Grade Ba2 BB BB Speculative

Ba3 BB- BB-   B1 B- B- Highly Speculative B2 B B  

B3 B- B-   Caa1 CCC+ CCC Substantial Risk Caa2 CCC — In Poor Standing

Caa3 CCC- —   Ca — — Extremely Speculative

C — — May Be in Default

— — DDD Default

— — D  

— D D  

taBLe 1 Bond Ratings by Moody’s, standard and Poor’s, and fitch

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the bond ratings and their descriptions as defined by the three largest credit-rating agencies, Moody’s Investor Service, Standard and Poor’s Corporation, and Fitch Rat- ings. Bonds with relatively low risk of default are called investment-grade securities and have a rating of Baa (or BBB) and above. Bonds with ratings below Baa (or BBB) have higher default risk and have been aptly dubbed speculative-grade or junk bonds. Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as high-yield bonds.

Next let’s look at Figure 1 at the beginning of the chapter and see if we can explain the relationship between interest rates on corporate and those on U.S. Treasury bonds. Corporate bonds always have higher interest rates than U.S. Trea- sury bonds because they always have some risk of default, whereas U.S. Treasury bonds do not. Because Baa-rated corporate bonds have a greater default risk than the higher-rated Aaa bonds, their risk premium is greater, and the Baa rate there- fore always exceeds the Aaa rate. We can use the same analysis to explain the huge jump in the risk premium on Baa corporate bond rates during the Great Depression years of 1930–1933, as well as the rise in the risk premium after 1970 (see Figure 1). The Depression period saw a very high rate of business failures and defaults. As we would expect, these factors led to a substantial increase in the default risk for bonds issued by vulnerable corporations, and the risk premium for Baa bonds reached unprecedentedly high levels. Since 1970, we have again seen higher levels of busi- ness failures and defaults, although they have been well below Great Depression levels. Again, as expected, both default risks and risk premiums for corporate bonds rose, widening the spread between interest rates on corporate bonds and those on Treasury bonds.

FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis

Debt ratings play a major role in the pricing of debt securities and in the regulatory process. Conflicts of interest arose for credit-rating agencies in the years leading up to the global financial crisis when these agencies advised clients on how to structure complex financial instruments that paid out cash flows from subprime mortgages. At the same time, the agencies were rating these identical products, leading to the potential for severe conflicts of interest. Specifically, the large fees they earned from advising clients on how to structure products that the agencies them- selves were rating meant they did not have sufficient incentives to make sure their ratings were accurate.

When housing prices began to fall and subprime mortgages began to default, it became crystal clear that the ratings agencies had done a terrible job of assessing the risk in the subprime products they had helped to structure. Many AAA-rated products had to be downgraded over and over again until they reached junk status. The resulting massive losses on these assets were one reason why so many financial institutions that were holding them got into trouble. Indeed, some commentators have cited credit-rating agencies as among the chief vil- lains that should be blamed for the global financial crisis.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 121

A p p lI c At I o n The Global Financial Crisis and the Baa-Treasury Spread Starting in August 2007, the collapse of the subprime mortgage market led to large losses among financial institutions (which we will discuss more extensively in Chapter 12). As a consequence of the subprime collapse and the subsequent global financial crisis, many investors began to doubt the financial health of corporations with low credit ratings such as Baa and even the reliability of the ratings themselves. The perceived increase in default risk for Baa bonds made them less desirable at any given interest rate, decreased the quan- tity demanded, and shifted the demand curve for Baa bonds to the left. As shown in panel (a) of Figure 2, the interest rate on Baa bonds should have risen, which is indeed what happened. Interest rates on Baa bonds rose by 280 basis points (2.80 percentage points) from 6.63% at the end of July 2007 to 9.43% at the most virulent stage of the global financial crisis in mid-October 2008. But the increase in perceived default risk for Baa bonds in October 2008 made default-free U.S. Treasury bonds relatively more attractive and shifted the demand curve for these securities to the right—an outcome described by some analysts as a “flight to quality.” Just as our analysis in Figure 2 predicts, interest rates on Treasury bonds fell by 80 basis points, from 4.78% at the end of July 2007 to 3.98% in mid-October 2008. The spread between interest rates on Baa and Treasury bonds rose by 360 basis points, from 1.85% before the crisis to 5.45% afterward. ◆

Liquidity Another attribute of a bond that influences its interest rate is its liquidity. As we learned in Chapter 4, a liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (holding every- thing else constant). U.S. Treasury bonds are the most liquid of all long-term bonds; because they are so widely traded, they are the easiest to sell quickly, and the cost of selling them is low. Corporate bonds are not as liquid because fewer bonds for any one corporation are traded; thus it can be costly to sell these bonds in an emergency because it might be hard to find buyers quickly.

How does the reduced liquidity of the corporate bonds affect their interest rates relative to the interest rate on Treasury bonds? We can use supply and demand analysis with the same figure that was used to analyze the effect of default risk, Figure 2, to show that the lower liquidity of corporate bonds relative to Treasury bonds increases the spread between the interest rates on these two bonds. Let’s start the analysis by assum- ing that, initially, corporate and Treasury bonds are equally liquid and all their other attributes are the same. As shown in Figure 2, their equilibrium prices and interest rates will initially be equal: Pc1 = PT1 and ic1 = iT1. If the corporate bond becomes less liquid than the Treasury bond because it is less widely traded, then (as the theory of portfolio choice indicates) demand for it will fall, shifting its demand curve leftward from Dc1 to D

c 2, as in panel (a). The Treasury bond now becomes relatively more liquid

in comparison with the corporate bond, so its demand curve shifts rightward from DT1 to D

T 2, as in panel (b). The shifts in the curves in Figure 2 show that the price of the

less liquid corporate bond falls and its interest rate rises, while the price of the more liquid Treasury bond rises and its interest rate falls.

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122 P a r t 2 Financial Markets

The result is that the spread between the interest rates on the two bond types rises. Therefore, the differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but also its lesser liquidity. This is why a risk premium should more accurately be called a “risk and liquidity premium,” but convention dictates the label risk premium.

Income Tax Considerations Returning to Figure 1, we are still left with one puzzle—the behavior of municipal bond rates. Municipal bonds are certainly not default-free: State and local governments have defaulted on municipal bonds in the past, particularly during the Great Depression, and even more recently in the cases of Detroit, Michigan; San Bernadino, Mammoth Lakes, and Stockton, all in California; Jefferson County, Alabama; Harrisburg, Pennsylvania; Central Falls, Rhode Island; and Boise County, Idaho. Also, municipal bonds are not as liquid as U.S. Treasury bonds.

Why is it, then, that these bonds have had lower interest rates than U.S. Treasury bonds for most of the past 70 years, as indicated in Figure 1? The explanation lies in the fact that interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.

Let’s imagine that your income is high enough to put you in the 40% income tax bracket, where for every extra dollar of income you earn you have to pay 40 cents to the government. If you own a $1,000-face-value U.S. Treasury bond that sells for $1,000 and has a coupon payment of $100, you get to keep only $60 of the payment after taxes. Although the bond has a 10% interest rate, you actually earn only 6.0% after taxes.

Suppose, however, that you put your savings into a $1,000-face-value municipal bond that sells for $1,000 and pays only $80 in coupon payments. Its interest rate is only 8%, but because it is a tax-exempt security, you pay no taxes on the $80 coupon payment, so you earn 8% after taxes. Clearly, you earn more on the municipal bond after taxes, so you are willing to hold the riskier and less liquid municipal bond even though it has a lower interest rate than the U.S. Treasury bond. (This was not true before World War II, when the tax-exempt status of municipal bonds did not convey much of an advantage because income tax rates were extremely low.)

Another way of understanding why municipal bonds have lower interest rates than Treasury bonds is to use the supply and demand analysis depicted in Figure 3. We initially assume that municipal and Treasury bonds have identical attributes and so have the same bond prices as drawn in the figure, Pm1 = PT1, and the same interest rates. Once the municipal bonds are given a tax advantage that raises their after-tax expected return relative to Treasury bonds and makes them more desirable, demand for them rises, and their demand curve shifts to the right, from Dm1 to D

m 2 . Their equi-

librium bond price then rises from Pm1 to P m 2 , and their equilibrium interest rate falls. By

contrast, Treasury bonds have now become less desirable relative to municipal bonds; demand for Treasury bonds decreases, and DT1 shifts to the left to D

T 2. The Treasury

bond price falls from PT1 to P T 2, and the interest rate rises. The resulting lower interest

rates for municipal bonds and higher interest rates for Treasury bonds explain why municipal bonds can have interest rates below those of Treasury bonds.1

1In contrast to corporate bonds, Treasury bonds are exempt from state and local income taxes. Using the analysis in the text, you should be able to show that this feature of Treasury bonds provides an additional reason why interest rates on corporate bonds are higher than those on Treasury bonds.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 123

Summary The risk structure of interest rates (the relationships among interest rates on bonds with the same maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of a bond’s interest payments. As a bond’s default risk increases, the risk premium on that bond (the spread between its interest rate and the interest rate on a default-free Treasury bond) rises. The greater liquidity of Treasury bonds also explains why their interest rates are lower than those on less liquid bonds. If a bond has a favor- able tax treatment, as do municipal bonds, whose interest payments are exempt from federal income taxes, its interest rate will be lower.

A p p li c At i o n Effects of the Obama Tax Increase on Bond Interest Rates In 2013, Congress approved legislation proposed by the Obama administration to increase the income tax rate on high-income taxpayers fom 35% to 39% when it repealed tax cuts implemented under the Bush administration. What was the effect of this income tax increase on interest rates in the municipal bond market relative to those in the Treasury bond market?

Quantity of Treasury BondsQuantity of Municipal Bonds

Price of Bonds, P Price of Bonds, P

(a) Market for municipal bonds (b) Market for Treasury bonds

P m1

P m2

S m

D m1 D m2

P T2

P T1

S T

DT1DT2

Step 2. and shifts the demand for Treasury bonds to the left . . .

Step 1. Tax-free status shifts the demand for municipal bonds to the right . . .

Step 3. with the result that municipal bonds end up with a higher price and a lower interest rate than on Treasury bonds.

Figure 3 Interest Rates on Municipal and Treasury Bonds When a municipal bond is given tax-free status, demand for the municipal bond shifts rightward from

Dm1 to D m 2 , and demand for the Treasury bond shifts leftward from D

T 1 to D

T 2. The equilibrium price of the

municipal bond rises from Pm1 to P m 2 , so its interest rate falls, while the equilibrium price of the Treasury

bond falls from PT1 to P T 2 and its interest rate rises. The result is that municipal bonds end up with lower

interest rates than Treasury bonds.

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124 p a r t 2 Financial Markets

Our supply and demand analysis provides the answer. An increased income tax rate for wealthy people means that the after-tax expected return on tax-free municipal bonds relative to that on Treasury bonds is higher, because the interest on Treasury bonds is now taxed at a higher rate. Because municipal bonds now become more desir- able, their demand increases, shifting the demand curve to the right, as in Figure 3, which raises their price and lowers their interest rate. Conversely, the higher income tax rate makes Treasury bonds less desirable; this change shifts their demand curve to the left, lowers their price, and raises their interest rates.

Our analysis thus shows that the increase in income tax rates for wealthy people helped to lower the interest rates on municipal bonds relative to the interest rate on Treasury bonds. ◆

TeRM STRucTuRe of InTeReST RaTeS We have seen how risk, liquidity, and tax considerations (collectively embedded in the risk structure) can influence interest rates. Another factor that influences the interest rate on a bond is its term to maturity: Bonds with identical risk, liquidity, and tax char- acteristics may have different interest rates because their times remaining to maturity are different. A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as government bonds. The Following the Financial News box shows a yield curve for Treasury securities. Yield

Following the Financial News Yield Curves

Many newspapers and Internet sites such as http:// www.finance.yahoo.com publish a daily plot of the yield curves for Treasury securities. An example for July 7, 2014 is presented here. The numbers on the

vertical axis indicate the interest rate for the Trea- sury security, with the maturity term given on the horizontal axis, with “m” denoting “month” and “y” denoting “year.”

0

1

2

3

4

5

Interest Rate (%)

Maturity 1 m 3 m 6 m 1 y 2 y 3 y 5 y 10 y 20 y 30 y

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 125

curves can be classified as upward-sloping, flat, or downward-sloping (the last sort is often referred to as an inverted yield curve). When yield curves slope upward, which is the most common case, long-term interest rates are above short-term interest rates; when yield curves are flat, short- and long-term interest rates are the same; and when yield curves are inverted, long-term interest rates are below short-term interest rates. Yield curves can also have more complicated shapes in which they first slope up and then down, or vice versa. Why does the yield curve usually slope upward, but sometimes take on other shapes?

In addition to explaining why yield curves take on different shapes at different times, a good theory of the term structure of interest rates must explain the following three important empirical facts:

1. As we see in Figure 4, interest rates on bonds of different maturities move together over time.

2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted.

3. Yield curves almost always slope upward, as appears in the Following the Financial News box.

Three theories have been put forward to explain the term structure of interest rates—that is, the relationships among interest rates on bonds of different maturities reflected in yield curve patterns: (1) the expectations theory, (2) the segmented markets

16

14

12

10

8

6

4

2

0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

20-Year Bond Averages

Three-to Five-Year Averages

Interest Rate (% annual rate)

Three-Month Bills (Short-Term)

2005 2010 2015

Figure 4 Movements over Time of Interest Rates on u.S. Government Bonds with Different Maturities Interest rates on bonds of different maturities move together over time. Source: Federal reserve Bank of St. Louis FreD database: http://research.stlouisfed.org/fred2/

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126 p a r t 2 Financial Markets

theory, and (3) the liquidity premium theory. Each of these theories is described in the following sections. The expectations theory does a good job of explaining the first two facts on our list, but not the third. The segmented markets theory can account for fact 3 but not the other two facts, which are well explained by the expectations theory. Because each theory explains facts that the other cannot, a natural way of seeking a better understanding of the term structure is to combine the features of both theories, which leads us to the liquidity premium theory, a theory that explains all three facts.

If the liquidity premium theory does a better job of explaining the facts and is hence the most widely accepted theory, why do we spend time discussing the other two theories? There are two reasons. First, the ideas in these two theories lay the ground- work for the liquidity premium theory. Second, it is important to see how economists modify theories to improve them when they find that the predicted results are incon- sistent with the empirical evidence.

expectations theory The expectations theory of the term structure states the following commonsense proposition: The interest rate on a long-term bond will equal the average of the short- term interest rates that people expect to occur over the life of the long-term bond. For example, if people expect that short-term interest rates will be 10%, on average, over the coming five years, the expectations theory predicts that the interest rate on bonds with five years to maturity will be 10%, too. If short-term interest rates are expected to rise even higher after this five-year period, so that the average short-term interest rate over the coming 20 years is 11%, then the interest rate on 20-year bonds will equal 11% and will be higher than the interest rate on five-year bonds. Thus the expectations theory predicts that interest rates on bonds of different maturities differ because short- term interest rates are expected to have different values at future dates.

The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds that have this characteristic are said to be perfect substitutes. In practice, this means that if bonds with different maturities are perfect substitutes, then the expected returns on those bonds must be equal.

To see how the assumption that bonds with different maturities are perfect sub- stitutes leads to the expectations theory, let us consider the following two investment strategies:

1. Purchase a one-year bond, and when it matures in one year, purchase another one-year bond.

2. Purchase a two-year bond and hold it until maturity.

Because both strategies must have the same expected return, the interest rate on the two-year bond must equal the average of the two one-year interest rates. For example, let’s say that the current interest rate on the one-year bond is 9%, and you expect the interest rate on the one-year bond next year to be 11%. If you pursue the first strategy of buying the two one-year bonds, the expected return over the two years will average out to be 19% + 11%2 >2 = 10% per year. You will be willing to hold both the one- and two-year bonds only if the expected return per year on the two-year bond equals this return. Therefore, the interest rate on the two-year bond must equal 10%, the average interest rate on the two one-year bonds.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 127

We can make this argument more general. For an investment of $1, consider the choice of holding, for two periods, a two-period bond or two one-period bonds. Using the definitions

it = today’s (time t) interest rate on a one-period bond iet + 1 = interest rate on a one-period bond expected for next period (time t + 1) i2t = today’s (time t) interest rate on the two-period bond

the expected return from investing $1 in the two-period bond and holding it for the two periods can be calculated as

11 + ie2t211 + ie2t2 - 1 = 1 + 2i2t + 1i2t22 - 1 = 2i2t + 1i2t22

After the second period, the $1 investment is worth 11 + i2t211 + i2t2. Subtract- ing the $1 initial investment from this amount and dividing by the initial $1 investment gives the rate of return calculated in the previous equation. Because (i2t)

2 is extremely small—if i2t = 10% = 0.10, then 1i2t22 = 0.01—we can simplify the expected return for holding the two-period bond for the two periods to

2i2t

With the other strategy, in which one-period bonds are bought, the expected return on the $1 investment over the two periods is

11 + it211 + iet + 12 - 1 = 1 + it + iet + 1 + it1iet + 12 - 1 = it + iet + 1 + it1iet + 12

This calculation is derived by recognizing that, after the first period, the $1 investment becomes 1 + it, and this is reinvested in the one-period bond for the next period, yield- ing an amount 11 + it211 + iet + 12. Then, subtracting the $1 initial investment from this amount and dividing by the initial investment of $1 gives the expected return for the strategy of holding one-period bonds for the two periods. Because it1iet + 12 is also extremely small—if it = iet + 1 = 0.10, then it1iet + 12 = 0.01—we can simplify this to

it + iet + 1

Both bonds will be held only if these expected returns are equal—that is, when

2i2t = it + iet + 1

Solving for i2t in terms of the one-period rates, we have

i2t = it + iet + 1

2 (1)

which tells us that the two-period rate must equal the average of the two one-period rates. Graphically, this can be shown as

Today 0

Year 1

Year 2

it i e t11

i 2t 5 it 1 i

e t11

2

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128 p a r t 2 Financial Markets

We can conduct the same steps for bonds with longer maturities so that we can examine the whole term structure of interest rates. By doing so, we find that the interest rate int on an n-period bond must be

int = it + iet + 1 + iet + 2 + c + iet + 1n - 12

n (2)

Equation 2 states that the n-period interest rate equals the average of the one-period interest rates expected to occur over the n-period life of the bond. This is a restatement of the expectations theory, in more precise terms.2

A simple numerical example might help clarify the expectations theory presented in Equation 2. If the one-year interest rates over the next five years are expected to be 5%, 6%, 7%, 8%, and 9%, Equation 2 indicates that the interest rate on the two-year bond will be

5% + 6% 2

= 5.5%

On the five-year bond, it will be

5% + 6% + 7% + 8% + 9% 5

= 7%

By doing similar calculations for the one-, three-, and four-year interest rates, you should be able to verify that the one- to five-year interest rates are 5.0%, 5.5%, 6.0%, 6.5%, and 7.0%, respectively. Thus we see that the rising trend in expected short-term interest rates produces an upward-sloping yield curve along which interest rates rise as maturity lengthens.

The expectations theory is an elegant theory that explains why the term structure of interest rates (as represented by yield curves) changes at different times. When the yield curve is upward-sloping, the expectations theory suggests that short-term interest rates are expected to rise in the future, as we have seen in our numerical example. In this situation, in which the long-term rate is currently higher than the short-term rate, the average of future short-term rates is expected to be higher than the current short- term rate, which can occur only if short-term interest rates are expected to rise. This result is depicted in our numerical example. When the yield curve is inverted (slopes downward), the average of future short-term interest rates is expected to be lower than the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future. Only when the yield curve is flat does the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future.

The expectations theory also explains fact 1, which states that interest rates on bonds with different maturities move together over time. Historically, short-term inter- est rates have shown the following trend: If they increase today, they will tend to be higher in the future. Hence a rise in short-term rates will raise people’s expectations of future higher short-term rates. Because long-term rates are the average of expected future short-term rates, a rise in short-term rates will also raise long-term rates, causing short- and long-term rates to move together.

2The analysis here has been conducted for discount bonds. Formulas for interest rates on coupon bonds would differ slightly from those used here, but would convey the same principle.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 129

The expectations theory also explains fact 2, which states that yield curves tend to have an upward slope when short-term interest rates are low and be inverted when short-term rates are high. When short-term rates are low, people generally expect them to rise to some normal level in the future, and the average of future expected short-term rates is high relative to the current short-term rate. Therefore, long-term interest rates will be substantially higher than current short-term rates, and the yield curve will have an upward slope. Conversely, if short-term rates are high, people usually expect them to come back down. Long-term rates will then drop below short-term rates because the average of expected future short-term rates will be lower than current short-term rates, and the yield curve will slope downward and become inverted.3

The expectations theory is an attractive theory because it provides a simple expla- nation of the behavior of the term structure, but unfortunately it has a major shortcom- ing: It cannot explain fact 3, which states that yield curves usually slope upward. The typical upward slope of yield curves implies that short-term interest rates are usually expected to rise in the future. In practice, short-term interest rates are just as likely to fall as they are to rise, and so the expectations theory suggests that the typical yield curve should be flat rather than upward-sloping.

segmented Markets theory As the name suggests, the segmented markets theory of the term structure sees mar- kets for different-maturity bonds as completely separate and segmented. The interest rate on a bond of a particular maturity is then determined by the supply of and demand for that bond, and is not affected by expected returns on other bonds with other maturities.

The key assumption of the segmented markets theory is that bonds of different maturities are not substitutes at all, and so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity. This theory of the term structure is the opposite extreme of the expectations theory, which assumes that bonds of different maturities are perfect substitutes.

The argument for why bonds of different maturities are not substitutes is that inves- tors have very strong preferences for bonds of one maturity as opposed to another, so they are concerned only with the expected returns on bonds of the maturity they prefer. This might be because they have a particular holding period in mind, and if they match the maturity of the bond to the desired holding period, they can obtain a certain return with no risk at all.4 (We saw in Chapter 4 that if the term to maturity equals the hold- ing period, then the return is known for certain because it equals the yield exactly, and

3The expectations theory explains another important fact about the relationship between short-term and long-term interest rates. As you can see in Figure 4, short-term interest rates are more volatile than long-term rates. If inter- est rates are mean-reverting—that is, if they tend to head back down after they reach unusually high levels or go back up after they fall to unusually low levels—then an average of these short-term rates must necessarily have less volatility than the short-term rates themselves. Because the expectations theory suggests that the long-term rate will be equal to an average of future short-term rates, it implies that the long-term rate will have less volatility than short-term rates. 4The statement that there is no uncertainty about the return if the term to maturity equals the holding period is literally true only for a discount bond. For a coupon bond with a long holding period, some risk exists because coupon payments must be reinvested before the bond matures. Our analysis here is thus being conducted for discount bonds. However, the gist of the analysis remains the same for coupon bonds because the amount of risk from reinvestment is small when coupon bonds have the same term to maturity as the holding period.

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130 p a r t 2 Financial Markets

no interest-rate risk exists.) For example, people who are limited by a short holding period will prefer to hold short-term bonds. Conversely, if you are putting away funds for your young child to go to college in the future, your desired holding period will be much longer, and you will want to hold longer-term bonds.

In the segmented markets theory, differing yield curve patterns are accounted for by supply and demand differences associated with bonds of different maturities. If, as seems sensible, risk-averse investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, the segmented markets theory can explain fact 3, which states that yield curves typically slope upward. Because the demand for long-term bonds is typically relatively lower than that for short- term bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward.

Although the segmented markets theory can explain why yield curves usually tend to slope upward, it has a major flaw in that it cannot explain facts 1 and 2. First, because it views the market for bonds of different maturities as completely segmented, there is no reason that a rise in the interest rate on a bond of one maturity would affect the interest rate on a bond of another maturity. Therefore, the segmented markets theory cannot explain why interest rates on bonds of different maturities tend to move together (fact 1). Second, because it is not clear how the demand for and supply of short- versus long-term bonds change with the level of short-term interest rates, the theory does not explain why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high (fact 2).

Because each of our two theories explains empirical facts that the other cannot, a logical step is to combine the theories, which leads us to the liquidity premium theory.

Liquidity Premium and Preferred Habitat theories The liquidity premium theory of the term structure states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.

The liquidity premium theory’s key assumption is that bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity. However, the theory allows investors to prefer one bond maturity over another. In other words, bonds of different maturi- ties are assumed to be substitutes, but not perfect substitutes. Investors tend to prefer shorter-term bonds because these bonds bear less interest-rate risk. For this reason, investors must be offered a positive liquidity premium to induce them to hold longer- term bonds. Thus the expectations theory is modified by adding a positive liquidity premium to the equation that describes the relationship between long- and short-term interest rates. The liquidity premium theory is written as

int = it + iet + 1 + iet + 2 + c + iet + 1n - 12

n + lnt (3)

where lnt is the liquidity (term) premium for the n-period bond at time t, which is always positive and rises with the term to maturity of the bond, n.

Closely related to the liquidity premium theory is the preferred habitat theory, which takes a somewhat less direct approach to modifying the expectations hypothesis but comes to a similar conclusion. It assumes that investors have a preference for bonds

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 131

of one maturity over bonds of another—a particular bond maturity (“preferred habitat”) in which they prefer to invest. Because they prefer bonds of one maturity over bonds of another, they are willing to buy bonds that do not have the preferred maturity (habitat) only if those bonds earn a somewhat higher expected return. Because risk-averse investors are likely to prefer the habitat of short-term bonds over that of longer-term bonds, they are willing to hold long-term bonds only if they have higher expected returns. This reasoning leads to the same Equation 3 implied by the liquidity premium theory, with a term premium that typically rises with maturity.

The relationship between the expectations theory and the liquidity premium and preferred habitat theories is shown in Figure 5. There we see that because the liquidity premium is always positive and typically grows as the term to maturity increases, the yield curve implied by the liquidity premium theory is always above the yield curve implied by the expectations theory and generally has a steeper slope. (For simplicity, we are assuming that the expectations theory yield curve is flat.)

A simple numerical example, similar to the one we used for the expectations hypothesis, further clarifies the liquidity premium and preferred habitat theories given in Equation 3. Again suppose that the one-year interest rates over the next five years are expected to be 5%, 6%, 7%, 8%, and 9%, while investors’ preferences for holding short-term bonds means that the liquidity premiums for one- to five-year bonds are 0%, 0.25%, 0.5%, 0.75%, and 1.0%, respectively. Equation 3 then indicates that the interest rate on the two-year bond would be

5% + 6% 2

+ 0.25% = 5.75%

302520151050

Years to Maturity, n

Interest Rate, int

Expectations Theory Yield Curve

Liquidity Premium, lnt

Liquidity Premium (Preferred Habitat) Theory Yield Curve

Figure 5 The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory Because the liquidity premium is always positive and grows as the term to maturity increases, the yield

curve implied by the liquidity premium and preferred habitat theories is always above the yield curve implied by the expectations theory and has a steeper slope. For simplicity, the yield curve implied by the expectations theory shown here assumes unchanging future one-year interest rates.

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132 p a r t 2 Financial Markets

For the five-year bond, it would be

5% + 6% + 7% + 8% + 9% 5

+ 1% = 8%

By doing similar calculations for the one-, three-, and four-year interest rates, you should be able to verify that the one- to five-year interest rates are 5.0%, 5.75%, 6.5%, 7.25%, and 8.0%, respectively. Comparing these findings with those for the expecta- tions theory, we see that the liquidity premium and preferred habitat theories produce yield curves that slope more steeply upward because of investors’ preferences for short- term bonds.

Let’s see if the liquidity premium and preferred habitat theories are consistent with all three empirical facts we have discussed. They explain fact 1, which states that interest rates on different-maturity bonds move together over time: A rise in short-term interest rates indicates that short-term interest rates will, on average, be higher in the future, and the first term in Equation 3 then implies that long-term interest rates will rise along with them.

The liquidity and preferred habitat theories also explain why yield curves tend to have an especially steep upward slope when short-term interest rates are low and to be inverted when short-term rates are high (fact 2). Because investors generally expect short-term interest rates to rise to some normal level when they are low, the average of future expected short-term rates will be high relative to the current short-term rate. With the additional boost of a positive liquidity premium, long-term interest rates will be substantially higher than current short-term rates, and the yield curve will have a steep upward slope. Conversely, if short-term rates are high, people usually expect them to come back down. Long-term rates will then drop below short-term rates because the average of expected future short-term rates will be far below cur- rent short-term rates, despite positive liquidity premiums, and so the yield curve will slope downward.

The liquidity premium and preferred habitat theories explain fact 3, which states that yield curves typically slope upward, by recognizing that the liquidity premium rises with a bond’s maturity because of investors’ preferences for short-term bonds. Even if short-term interest rates are expected to stay the same, on average, in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward.

How can the liquidity premium and preferred habitat theories explain the occa- sional appearance of inverted yield curves if the liquidity premium is positive? It must be that, at times, short-term interest rates are expected to fall so much in the future that the average of the expected short-term rates is well below the current short-term rate. Even when the positive liquidity premium is added to this average, the resulting long-term rate is still lower than the current short-term interest rate.

As our discussion indicates, a particularly attractive feature of the liquidity pre- mium and preferred habitat theories is that you can see what the market is predicting about future short-term interest rates just from the slope of the yield curve. A steeply rising yield curve, as in panel (a) of Figure 6, indicates that short-term interest rates are expected to rise in the future. A moderately steep yield curve, as in panel (b), indi- cates that short-term interest rates are not expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future. Finally, an inverted yield curve, as in panel (d), indicates that short-term interest rates are expected to fall sharply in the future.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 133

Evidence on the Term Structure In the 1980s, researchers examining the term structure of interest rates questioned whether the slope of the yield curve provides information about movements of future short-term interest rates. They found that the spread between long- and short-term interest rates does not always help predict future short-term interest rates, a finding that may stem from substantial fluctuations in the liquidity (term) premium for long-term bonds. More recent research using more discriminating tests now favors a different view. It shows that the term structure contains quite a bit of information for the very short run (over the next several months) and the long run (over several years) but is

Term to Maturity

Term to Maturity

Term to Maturity

Term to Maturity

(a) (b)

(c) (d)

Yield to Maturity

Steeply upward- sloping yield curve

Flat yield curve Downward- sloping yield curve

Mildly upward- sloping yield curve

Yield to Maturity

Yield to Maturity

Yield to Maturity

Figure 6 Yield Curves and the Market’s Expectations of Future Short-Term Interest Rates According to the Liquidity Premium (Preferred Habitat) Theory

A steeply rising yield curve, as in panel (a), indicates that short-term interest rates are expected to rise in the future. A moderately steep yield curve, as in panel (b), indicates that short-term interest rates are not expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-term rates are expected to fall moderately in the future. Finally, an inverted yield curve, as in panel (d), indicates that short-term interest rates are expected to fall sharply in the future.

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134 P a r t 2 Financial Markets

unreliable at predicting movements in interest rates over the intermediate term (the time in between). Research also has found that the yield curve can be used to help forecast future inflation and business cycles (see the FYI box).

Summary The liquidity premium and preferred habitat theories are the most widely accepted theories of the term structure of interest rates because they explain the major empirical facts about the term structure so well. They combine the features of both the expecta- tions theory and the segmented markets theory by asserting that a long-term interest rate will be the sum of a liquidity (term) premium and the average of the short-term interest rates that are expected to occur over the life of the bond.

The liquidity premium and preferred habitat theories explain the following facts: (1) Interest rates on bonds of different maturities tend to move together over time; (2) when short-term interest rates are low, yield curves are more likely to have a steep upward slope; (3) yield curves usually slope upward, but when short-term interest rates are high, yield curves are more likely to be inverted.

The theories also help us predict the movement of short-term interest rates in the future. A steep upward slope of the yield curve means that short-term rates are expected to rise, a mild upward slope means that short-term rates are expected to remain the same, a flat slope means that short-term rates are expected to fall moderately, and an inverted yield curve means that short-term rates are expected to fall sharply.

A p p li c At i o n Interpreting Yield Curves, 1980–2014 Figure 7 illustrates several yield curves for U.S. government bonds, for selected dates from 1981 to 2014. What do these yield curves tell us about the public’s expectations of future movements of short-term interest rates?

FYi The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle

Because the yield curve contains information about future expected interest rates, it should have the capacity to help forecast inflation and real output fluc- tuations. To see why, recall from Chapter 5 that rising interest rates are associated with economic booms and falling interest rates with recessions. When the yield curve is either flat or downward-sloping, it suggests that future short-term interest rates are expected to fall because the economy is more likely to enter a reces- sion. Indeed, the yield curve is found to be an accurate predictor of the business cycle.

In Chapter 4, we learned that a nominal interest rate is composed of a real interest rate and expected

inflation, implying that the yield curve contains information about both the future path of nominal interest rates and future inflation. A steep yield curve predicts a future increase in inflation, while a flat or downward-sloping yield curve forecasts a future decline in inflation.

Because the yield curve can be used to forecast business cycles and inflation, the slope of the yield curve is part of the tool kit of many economic fore- casters and is often viewed as a useful indicator of the stance of monetary policy, with a steep yield curve indicating loose policy and a flat or downward- sloping yield curve indicating tight policy.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 135

The steep inverted yield curve that occurred on January 15, 1981, indicated that short-term interest rates were expected to decline sharply in the future. In order for longer-term interest rates, along with their positive liquidity premiums, to be well below short-term interest rates, short-term interest rates must be expected to decline so sharply that their average would be far below the current short-term rate. Indeed, the public’s expectations of sharply lower short-term interest rates evident in the yield curve were realized soon after January 15; by March, three-month Treasury bill rates had declined from the 16% level to 13%.

The steep, upward-sloping yield curves that occurred on March 28, 1985, and July 7, 2014, indicated that short-term interest rates were expected to climb in the future. Long-term interest rates are higher than short-term interest rates when short- term interest rates are expected to rise because their average plus the liquidity premium will be higher than the current short-term rate. The moderately upward-sloping yield curves on May 16, 1980, and March 3, 1997, indicated that short-term interest rates were expected neither to rise nor to fall in the near future. In this case, their average remains the same as the current short-term rate, and the positive liquidity premium for longer-term bonds explains the moderate upward slope of the yield curve. The flat

1 2 3 4 5 5 10 15 20

6

8

10

12

14

16

Terms to Maturity (Years)

Interest Rate (% annual rate)

May 16, 1980

March 28, 1985

January 15, 1981

March 3, 1997

0

4

2

February 6, 2006

July 7, 2014

Figure 7 Yield Curves for U.S. Government Bonds Yield curves for U.S. government bonds for different dates from 1981 to 2014. Sources: Federal reserve Bank of St. Louis; u.S. Financial Data, various issues; Wall Street Journal, various dates.

MyEconLab Mini-lecture

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136 p a r t 2 Financial Markets

yield curve of February 6, 2006, indicated that short-term interest rates were expected to fall slightly. ◆

suMMaRY

1. Bonds with the same maturity will have different inter- est rates because of three factors: default risk, liquidity, and tax considerations. The greater a bond’s default risk, the higher its interest rate relative to the interest rates of other bonds; the greater a bond’s liquidity, the lower its interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity that arises because of these three factors is known as the risk structure of interest rates.

2. Four theories of the term structure provide explana- tions of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond. By contrast, the segmented markets theory treats the determination of interest rates for each bond’s maturity as the outcome of supply and demand in that market only. Neither of these theories by

itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually slope upward.

3. The liquidity premium (preferred habitat) theory combines the features of the other two theories, and by so doing is able to explain the facts just mentioned. The liquidity premium (preferred habitat) theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. The liquidity premium (preferred habitat) theory allows us to infer the market’s expectations about the movement of future short-term interest rates from the yield curve. A steeply upward-sloping curve indicates that future short-term rates are expected to rise; a mildly upward-sloping curve, that short-term rates are expected to stay the same; a flat curve, that short-term rates are expected to decline slightly; and an inverted yield curve, that a substantial decline in short-term rates is expected in the future.

keY teRMs

credit-rating agencies, p. 119 default, p. 116 default-free bonds, p. 117 expectations theory, p. 126 inverted yield curve, p. 125

junk bonds, p. 120 liquidity premium theory, p. 130 preferred habitat theory, p. 130 risk premium, p. 117 risk structure of interest rates, p. 116

segmented markets theory, p. 129 term structure of interest rates, p. 116 yield curve, p. 124

QuestIOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. If junk bonds are “junk,” then why do investors buy them?

2. Which should have the higher risk premium on its interest rates, a corporate bond with a Moody’s Baa rating or a corporate bond with a C rating? Why?

3. Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?

4. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?

5. Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 137

predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds; and (b) the segmented markets theory of the term structure holds.

15. Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%, 6%, and 6%, respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A and B?

16. If a yield curve looks like the one shown in the figure below, what is the market predicting about the move- ment of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?

6. “If bonds of different maturities are close substitutes, their interest rates are more likely to move together.” Is this statement true, false, or uncertain? Explain your answer.

7. The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds?

8. Predict what will happen to interest rates on a corpora- tion’s bonds if the federal government guarantees today that it will pay creditors if the corporation goes bank- rupt in the future. What will happen to the interest rates on Treasury securities?

9. Predict what will happen to the risk premiums on cor- porate bonds if brokerage commissions are lowered in the corporate bond market.

10. During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated nonfinancial com- mercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. What explains this sudden increase?

11. If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

12. Prior to 2008, mortgage lenders required a house inspection to assess a home’s value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre-2008 scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

13. “According to the expectations theory of the term structure, it is better to invest in one-year bonds, rein- vested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years.” Is this statement true, false, or uncertain?

14. If bond investors decide that 30-year bonds are no lon- ger as desirable an investment as they were previously,

Mishkin Economics of Money. . . Second proof: 1/13/00

Figure: 6.c (EOC) Width: 16.2 picas

Depth: 14 picas Publisher: AWL

Art Studio: ElectraGraphics, Inc.

Yield to Maturity

Term to Maturity

17. If a yield curve looks like the one shown in the figure below, what is the market predicting about the move- ment of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?

Mishkin Economics of Money. . . Second proof: 1/13/00

Figure: 6.d (EOC) Width: 16.2 picas

Depth: 14 picas Publisher: AWL

Art Studio: ElectraGraphics, Inc.

Yield to Maturity

Term to Maturity

18. If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?

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138 p a r t 2 Financial Markets

21. Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

19. If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

20. If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

All applied problems are available in MyEconLab at http://www.myeconlab.com.

22. In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek debt.

23. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years:

a. 5%, 7%, 7%, 7%, 7%

b. 5%, 4%, 4%, 4%, 4%

How would your yield curves change if people pre- ferred shorter-term bonds to longer-term bonds?

24. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and

plot the resulting yield curves for the following paths of one-year interest rates over the next five years:

a. 5%, 6%, 7%, 6%, 5%

b. 5%, 4%, 3%, 4%, 5%

How would your yield curves change if people pre- ferred shorter-term bonds over longer-term bonds?

25. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.

aPPLIeD PROBLeMs

Year

One-Year Bond Rate

Multiyear Bond Rate

1 2% 2%

2 3% 3%

3 4% 5%

4 6% 6%

5 7% 8%

Data anaLYsIs PROBLeMs

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on Moody’s Aaa corporate bond yield (AAA) and Moody’s Baa corporate bond yield (BAA). Download the data into a spreadsheet.

a. Calculate the spread (difference) between the Baa and Aaa corporate bond yields for the most recent month of data available. What does this difference represent?

b. Calculate the spread again, for the same month but one year prior, and compare the result to your answer to part (a). What do your answers

say about how the risk premium has changed over the past year?

c. Identify the month of highest and lowest spreads since the beginning of the year 2000. How do these spreads compare to the most current spread data available? Interpret the results.

2. Go to the St. Louis Federal Reserve FRED database, and find daily yield data on the following U.S. treasuries securities: one-month (DGS1MO), three- month (DGS3MO), six-month (DGS6MO), one-year (DGS1), two-year (DGS2), three-year (DGS3), five- year (DGS5), seven-year (DGS7), 10-year (DGS10), 20-year (DGS20), and 30-year (DGS30). Download the last full year of data available into a spreadsheet.

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C h a p t e r 6 The Risk and Term Structure of Interest Rates 139

b. Determine the date of the most recent Federal Open Market Committee policy statement. Construct yield curves for both the day before the policy statement was released and the day on which the policy statement was released. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?

a. Construct a yield curve by creating a line graph for the most recent day of data available, and for the same day (or as close to the same day as possible) one year prior, across all the maturities. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

WeB exeRcIses

1. The amount of additional interest investors receive due to various risk premiums changes over time. Sometimes risk premiums are much larger than at other times. For example, the default risk premium was very small in the late 1990s when the economy was so healthy that business failures were rare. This risk premium increases during recessions.

Go to http://www.federalreserve.gov/releases/h15 (historical data), and find the following three interest rate listings for AAA- and Baa-rated bonds: the most current listing; the listing for June 1, 2013; and the

listing for June 1, 2008. Prepare a graph that shows the interest rate information for these bonds over these three time periods (see Figure 1 for an example). Are the risk premiums stable, or do they change over time?

2. Figure 7 shows a number of yield curves at various points in time. Go to http://www.bloomberg.com/ markets/rates/index.html and find the Treasury yield curve. Does the current yield curve fall above or below the most recent one listed in Figure 7? Is the current yield curve flatter or steeper than the most recent one reported in Figure 7?

WeB RefeRences

http://www.federalreserve.gov/Releases/h15/update/

The Federal Reserve reports the yields on different-quality bonds. Look at the bottom of the listing of interest rates for AAA- and BBB-rated bonds.

http://stockcharts.com/charts/YieldCurve.html

This site lets you look at the dynamic yield curve at any point in time since 1995.

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Learning Objectives • Calculate the price of

common stock. • Recognize the impact

of new information on stock prices.

• Compare and contrast adaptive expectations and rational expectations.

• Explain why arbitrage opportunities imply that the efficient market hypothesis holds.

• Identify and explain the implications of the efficient market hypothesis for financial markets.

• Summarize the reasons why behavioral finance suggests that the efficient market hypothesis may not hold.

7 Preview

Rarely does a day go by that the stock market isn’t a major news item. We have witnessed huge swings in the stock market in recent years. The 1990s were an extraordinary decade for stocks: The Dow Jones and S&P 500 indexes increased by more than 400%, while the tech-laden NASDAQ index rose by more than 1,000%. By early 2000, all three indexes had reached record highs. Unfortunately, the good times did not last. Starting in early 2000, the stock market began to decline and many investors lost their shirts. The NASDAQ crashed, falling by more than 50%, while the Dow Jones and S&P 500 indexes fell by 30% through January 2003. After subsequently rising by over 30%, the stock market crashed again during the global financial crisis, falling by over 50% from its peak in the fall of 2007. Starting in 2009, the stock market recovered quickly, more than doubling and reaching new highs by 2014.

Because so many people invest in the stock market and the prices of stocks affect the ability of people to retire comfortably, the market for stocks is undoubtedly the financial market that receives the most attention and scrutiny. In this chapter, we look first at how this important market works.

We begin by discussing the fundamental theories that underlie the valuation of stocks. These theories are critical to understanding the forces that cause the value of stocks to rise and fall minute by minute and day by day. Once we have learned the methods for stock valuation, we need to explore how expectations about the market affect its behavior. We do so by examining the theory of rational expectations. When this theory is applied to financial markets, the outcome is the efficient market hypothesis, which has some general implications for how markets in other securities besides stocks operate.

ComPuting the PRiCe of Common StoCk Common stock is the principal medium through which corporations raise equity capital. Stockholders—those who hold stock in a corporation—own an interest in the corpo- ration equal to the percentage of outstanding shares they own. This ownership interest gives them a bundle of rights. The most important are the right to vote and to be a residual claimant of all funds flowing into the firm (known as cash flows), meaning that the stockholder receives whatever remains after all other claims against the firm’s

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140

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 141

assets have been satisfied. Stockholders may receive dividends from the net earnings of the corporation. Dividends are payments made periodically, usually every quarter, to stockholders. The board of directors of the firm sets the level of the dividend, usually based on the recommendation of management. In addition, the stockholder has the right to sell the stock.

One basic principle of finance is that the value of any investment is calculated by computing the present value of all cash flows the investment will generate over its life. For example, a commercial building will sell for a price that reflects the net cash flows (rents minus expenses) it is projected to have over its useful life. Similarly, we value common stock as the value in today’s dollars of all future cash flows. The cash flows that a stockholder might earn from stock are dividends, the sales price, or both.

To develop the theory of stock valuation, we begin with the simplest possible sce- nario: You buy the stock, hold it for one period to get a dividend, then sell the stock. We call this the one-period valuation model.

the one-Period Valuation model Suppose that you have some extra money to invest for one year. After a year, you will need to sell your investment to pay tuition. After watching CNBC or Nightly Business Report on TV, you decide that you want to buy Intel Corp. stock. You call your broker and find that Intel is currently selling for $50 per share and pays $0.16 per year in dividends. The analyst on CNBC predicts that the stock will be selling for $60 in one year. Should you buy this stock?

To answer this question, you need to determine whether the current price accu- rately reflects the analyst’s forecast. To value the stock today, you need to find the pres- ent discounted value of the expected cash flows (future payments) using the formula in Equation 1 of Chapter 4. In this equation, the discount factor used to discount the cash flows is the required return on investments in equity rather than the interest rate. The cash flows consist of one dividend payment plus a final sales price. When these cash flows are discounted back to the present, the following equation computes the current price of the stock:

P0 = D1

(1 + ke) +

P1 (1 + ke)

(1)

where P0 = the current price of the stock. The zero subscript refers to time period zero, or the present.

D1 = the dividend paid at the end of year 1 ke = the required return on investments in equity P1 = the price at the end of the first period; the predicted sales

price of the stock

To see how Equation 1 works, let’s compute the price of the Intel stock if, after careful consideration, you decide that you would be satisfied to earn a 12% return on the investment. If you have decided that ke = 0.12, are told that Intel pays $0.16 per year in dividends 1D1 = 0.162, and forecast the share price of $60 for next year 1P1 = $602, you get the following result from Equation 1:

P0 = 0.16

1 + 0.12 +

$60

1 + 0.12 = $0.14 + $53.57 = $53.71

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142 p a r t 2 Financial Markets

On the basis of your analysis, you find that the present value of all cash flows from the stock is $53.71. Because the stock is currently priced at $50 per share, you would choose to buy it. However, you should be aware that the stock may be selling for less than $53.71, because other investors have placed a greater risk on the cash flows or estimated the cash flows to be less than you did.

the generalized Dividend Valuation model Using the present value concept, we can extend the one-period dividend valuation model to any number of periods: The value of a stock today is the present value of all future cash flows. The only cash flows that an investor will receive are dividends and a final sales price when the stock is ultimately sold in period n. The generalized multipe- riod formula for stock valuation can be written as

P0 = D1

11 + ke21 +

D2 11 + ke22

+ g + Dn

11 + ke2n + Pn

11 + ke2n (2)

where Pn = the price of the stock in period n Di = the dividend paid at the end of year i

If you tried to use Equation 2 to find the value of a share of stock, you would soon realize that you must first estimate the value the stock will have at some point in the future before you can estimate its value today. In other words, you must find Pn before you can find P0. However, if Pn is far in the future, it will not affect P0. For example, the present value of a share of stock that sells for $50 seventy-five years from now, using a 12% discount rate, is just one cent 3$50/(1.1275) = $0.014. This reasoning implies that the current value of a share of stock can be calculated as simply the present value of the future dividend stream. The generalized dividend model is given in Equation 3. Note that it is the same formula as Equation 2, but without the final sales price:

P0 = a ∞

t = 1

Dt 11 + ke2t

(3)

Consider the implications of Equation 3 for a moment. The generalized dividend model states that the price of a stock is determined only by the present value of the dividends and that nothing else matters. Many stocks do not pay dividends, so how is it that these stocks have value? Buyers of the stock expect that the firm will pay dividends someday. Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle.

The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult, to say the least. Therefore, simplified models have been developed to make the calculations easier. One such model is the Gordon growth model, which assumes constant dividend growth.

the gordon growth model Many firms strive to increase their dividends at a constant rate each year. Equation 4 is derived from Equation 3 to reflect this constant growth in dividends:

P0 = D0 * (1 + g)1

(1 + ke)1 +

D0 * (1 + g)2

(1 + ke)2 + c +

D0 * (1 + g) ∞

(1 + ke) ∞ (4)

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 143

where D0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on an investment in equity

Equation 4 can be simplified to obtain Equation 5:1

P0 = D0 * 11 + g2

1ke - g2 =

D1 1ke - g2

(5)

This model is useful for finding the value of a stock, given a few assumptions:

1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long as the dividends are expected to grow at a constant rate for an extended period of time, the model should yield reasonable results. This is because errors about distant cash flows become small when discounted to the present.

2. The growth rate is assumed to be less than the required return on equity, ke. Myron Gordon, in his development of the model, demonstrated that this is a reasonable assumption. In theory, if the growth rate were faster than the rate demanded by holders of the firm’s equity, then in the long run the firm would grow impossibly large.

how the maRket SetS StoCk PRiCeS Suppose you go to an auto auction. The cars are available for inspection before the auction begins, and you find a little Mazda Miata that you like. You test-drive it in the parking lot and notice that it makes a few strange noises, but you decide that you still like the car. You decide that $5,000 is a fair price that will allow you to pay some repair bills should the noises turn out to be serious. You see that the auction is ready to begin, so you go in and wait for the Miata to be auctioned.

Suppose another buyer also spots the Miata. He test-drives the car and recognizes that the noises are simply the result of worn brake pads that he can fix himself at a nominal cost. He decides that the car is worth $7,000. He also goes in and waits for the Miata to come up for auction.

1To generate Equation 5 from Equation 4, first multiply both sides of Equation 4 by 11 + ke2>11 + g2, and then subtract Equation 4 from the result. This yields

P0 * 11 + ke2 11 + g2 - P0 = D0 -

D0 * 11 + g2 ∞ 11 + ke2 ∞

Assuming that ke is greater than g, the term on the far right will approach zero and so can be dropped. Thus, after factoring P0 out of the left-hand side,

P0 * c 1 + ke 1 + g

- 1 d = D0

Next, simplify by combining terms:

P0 * 11 + ke2 - 11 + g2

1 + g = D0

P0 = D0 * (1 + g)

ke - g =

D1 ke - g

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144 p a r t 2 Financial Markets

Who will buy the car, and for how much? Suppose only the two of you are inter- ested in the Miata. You begin the bidding at $4,000. Your competitor ups your bid to $4,500. You bid your top price of $5,000. He counters with $5,100. The price is now higher than you are willing to pay, so you stop bidding. The car is sold to the more informed buyer for $5,100.

This simple example raises a number of important points. First, the price is set by the buyer who is willing to pay the highest price. This price is not necessarily the highest price the asset could fetch, but it is incrementally greater than what any other buyer is willing to pay.

Second, the market price will be set by the buyer who can take best advantage of the asset. The buyer who purchased the car knew that he could fix the noise easily and cheaply. As a consequence, he was willing to pay more for the car than you were. The same concept holds for other assets. For example, a piece of property or a building will sell to the buyer who can put the asset to the most productive use.

Finally, the example shows the role played by information in asset pricing. Superior information about an asset can increase its value by reducing its risk. When you con- sider buying a stock, the future cash flows are subject to many unknowns. The buyer who has the best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain.

Now let’s apply these ideas to stock valuation. Suppose you are considering the purchase of stock expected to pay a $2 dividend next year. Market analysts expect the firm to grow at 3% indefinitely. You are uncertain about both the constancy of the divi- dend stream and the accuracy of the estimated growth rate. To compensate yourself for this uncertainty (risk), you require a return of 15%.

Now suppose Jennifer, another investor, has spoken with industry insiders and feels more confident about the projected cash flows. Jennifer requires only a 12% return because her perceived risk is lower than yours. Bud, on the other hand, is dating the CEO of the company. He knows with more certainty what the future of the firm actually looks like, and thus requires only a 10% return.

What value will each investor give to the stock? Applying the Gordon growth model yields the following stock prices:

You are willing to pay $16.67 for the stock. Jennifer will pay up to $22.22, and Bud will pay $28.57. The investor with the lowest perceived risk is willing to pay the most for the stock. If there were no other traders but these three, the market price would be between $22.22 and $28.57. If you already held the stock, you would sell it to Bud.

We thus see that the players in the market, bidding against one another, establish the market price. When new information is released about a firm, expectations change, and with them, prices change. New information can cause changes in expectations about the level of future dividends or the risk of those dividends. Because market participants are constantly receiving new information and revising their expectations, it is reasonable that stock prices are constantly changing as well.

Investor Discount Rate Stock Price

You 15% $16.67

Jennifer 12% $22.22

Bud 10% $28.57

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 145

A p p li c At i o n Monetary Policy and Stock Prices Stock market analysts tend to hang on every word uttered by the chair of the Federal Reserve because they know that an important determinant of stock prices is monetary policy. But how does monetary policy affect stock prices?

The Gordon growth model in Equation 5 explains this relationship. Monetary policy can affect stock prices in two ways. First, when the Fed lowers interest rates, the return on bonds (an alternative asset to stocks) declines, and investors are likely to accept a lower required rate of return on an investment in equity (ke). The resulting decline in ke lowers the denominator in the Gordon growth model (Equation 5), leads to a higher value of P0, and raises stock prices. Furthermore, a lowering of interest rates is likely to stimulate the economy, so the growth rate in dividends, g, is likely to be somewhat higher. This rise in g also causes the denominator in Equation 5 to decrease, which also leads to a higher P0 and a rise in stock prices.

As we will see in Chapter 25, the impact of monetary policy on stock prices is one of the key ways in which monetary policy affects the economy.

A p p li c At i o n The Global Financial Crisis and the Stock Market The global financial crisis that started in August 2007 led to one of the worst stock market declines in the past 50 years. Our analysis of stock price valuation, again using the Gordon growth model, can help us understand how this event affected stock prices.

The global financial crisis had a major negative impact on the economy, leading to a downward revision of the growth prospects for U.S. companies, thus lowering the dividend growth rate (g) in the Gordon model. In terms of Equation 5, the resulting increase in the denominator would lead to a decline in P0 and hence a decline in stock prices.

Increased uncertainty about the U.S. economy and the widening credit spreads caused by the subprime crisis also raised the required return on investment in equity. In terms of Equation 5, a higher ke leads to an increase in the denominator, a decline in P0, and a general fall in stock prices.

In the early stages of the global financial crisis, the declines in growth prospects and credit spreads were moderate, and so, as the Gordon model predicts, the stock market decline was also moderate. However, when the crisis entered a particularly virulent stage in October 2008, credit spreads shot through the roof, the economy tanked, and as the Gordon model predicts, the stock market crashed. From its peak in October 2007 (high of 14,066 for the DJIA) to its lowest point in March 2009 (DJIA low of 6,547), the market lost 53% of its value. ◆

the theoRy of Rational exPeCtationS The analysis of stock price evaluation we outlined in the previous section depends on people’s expectations—especially expectations of cash flows. Indeed, it is difficult to think of any sector of the economy in which expectations are not crucial; this is why it

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146 p a r t 2 Financial Markets

is important to examine how expectations are formed. We do so by outlining the theory of rational expectations, currently the most widely used theory to describe the formation of business and consumer expectations.

In the 1950s and 1960s, economists regularly viewed expectations as formed from past experience only. Expectations of inflation, for example, were typically viewed as being an average of past inflation rates. This view of expectation formation, called adaptive expectations, suggests that changes in expectations will occur slowly over time, as data for a variable evolve.2 So, if inflation had formerly been steady at a 5% rate, expectations of future inflation would be 5%, too. If inflation rose to a steady rate of 10%, expectations of future inflation would rise toward 10%, but slowly: In the first year, expected inflation might rise only to 6%; in the second year, to 7%; and so on.

The adaptive expectations hypothesis has been faulted on the grounds that people use more information than just past data on a single variable to form their expectations of that variable. Their expectations of inflation will almost surely be affected by their predictions of future monetary policy, as well as by current and past monetary policy. In addition, people often change their expectations quickly in the light of new informa- tion. To address these objections to the validity of adaptive expectations, John Muth developed an alternative theory of expectations, called rational expectations, which can be stated as follows: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.3

What exactly does this mean? To explain it more clearly, let’s use the theory of rational expectations to examine how expectations are formed in a situation that most of us will encounter at some point in our lifetime: our drive to work. Suppose that if Joe Commuter travels when it is not rush hour, his trip takes an average of 30 minutes. Sometimes his trip takes 35 minutes; other times, 25 minutes; but the average, non- rush-hour driving time is 30 minutes. If, however, Joe leaves for work during the rush hour, it takes him, on average, an additional 10 minutes to get to work. Given that he leaves for work during the rush hour, the best guess of his driving time—the optimal forecast—is 40 minutes.

If the only information available to Joe before he leaves for work related to his driving time is that he is leaving during the rush hour, what does rational expectations theory allow you to predict about Joe’s expectations of his driving time? Since the best guess of his driving time, using all available information, is 40 minutes, Joe’s expecta- tion should be the same. Clearly, an expectation of 35 minutes would not be rational, because it is not equal to the optimal forecast, or the best guess of the driving time.

Suppose that the next day, given the same conditions and expectations, it takes Joe 45 minutes to drive to work because he hits an abnormally large number of red lights. The day after that, Joe hits all the lights right and it takes him only 35 minutes to drive to work. Do these variations mean that Joe’s 40-minute expectation is irrational? No; an expectation of 40 minutes’ driving time is still a rational expectation. In both cases, the

2More specifically, adaptive expectations—say, of inflation—are written as a weighted average of past inflation rates:

πet = 11 - l2a ∞

j = 0 ljπt - j

where πet = adaptive expectation of inflation at time t πt - j = inflation at time t - j l = a constant between the values of 0 and 1 3John Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica 29 (1961): 315–335.

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 147

forecast is off by five minutes, so the expectation has not been perfectly accurate each time. However, the forecast does not have to be perfectly accurate to be rational—it need only be the best possible forecast given the available information; that is, it has to be correct on average, and the 40-minute expectation meets this requirement. As there is bound to be some randomness in Joe’s driving time regardless of driving conditions, an optimal forecast will never be completely accurate.

The example makes the following important point about rational expectations: Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

What if an item of information relevant to predicting driving time is unavailable or ignored? Suppose that on Joe’s usual route to work, an accident occurs and causes a two-hour traffic jam. If Joe has no way of ascertaining this information, his rush-hour expectation of 40 minutes’ driving time is still rational, because the accident informa- tion is not available to him for incorporation into his optimal forecast. However, if there was a radio or TV traffic report about the accident that Joe did not bother to listen to, or heard but ignored, his 40-minute expectation is no longer rational. In light of the availability of this information, Joe’s optimal forecast should have been two hours and 40 minutes.

Accordingly, an expectation may fail to be rational for two reasons:

1. People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible.

2. People might be unaware of some available relevant information, so their best guess of the future will not be accurate.

Nonetheless, it is important to recognize that if an additional factor is important but information about it is not available, an expectation that does not take that factor into account can still be rational.

formal Statement of the theory We can state the theory of rational expectations somewhat more formally. If X stands for the variable that is being forecast (in our example, Joe Commuter’s driving time), Xe for the expectation of this variable ( Joe’s expectation of his driving time), and Xof for the optimal forecast of X using all available information (the best guess possible of Joe’s driving time), the theory of rational expectations then simply states

Xe = Xof (6)

That is, the expectation of X equals the optimal forecast using all available information.

Rationale Behind the theory Why do people try to make their expectations match their best possible guess of future results, using all available information? The simplest explanation is that it is costly for people not to do so. Joe Commuter has a strong incentive to make his expectation of the time it takes him to drive to work as accurate as possible. If he underpredicts his driving time, he will often be late to work and risk being fired. If he overpredicts, he will, on average, get to work too early and will have given up sleep or leisure time unnecessar- ily. Accurate expectations are desirable, and therefore people have a strong incentive to try to make expectations equal to optimal forecasts by using all available information.

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148 p a r t 2 Financial Markets

The same principle applies to businesses. Suppose an appliance manufacturer— say, General Electric—knows that interest-rate movements are important to the sales of appliances. If GE makes poor forecasts of interest rates, it will earn less profit, because it will produce either too many or too few appliances. The incentives are strong for GE to acquire all available information to help it forecast interest rates and make the best possible guess of future interest-rate movements.

implications of the theory Rational expectations theory leads to two commonsense implications regarding the formation of expectations. These implications are important in the analysis of both the stock market and the aggregate economy:

1. If there is a change in the way a variable moves, the way in which expecta- tions of this variable are formed will change as well. This tenet of rational expectations theory can be most easily understood through a concrete example. Suppose interest rates move in such a way that they tend to return to a “normal” level over time. If today’s interest rate is high relative to the normal level, an optimal forecast of the interest rate in the future is that it will decline to the normal level. Rational expectations theory would imply that when today’s interest rate is high, the expectation is that it will fall in the future.

Suppose now that the way in which the interest rate moves changes so that when the interest rate is high, it stays high. In this case, when today’s interest rate is high, the optimal forecast of the future interest rate, and hence the rational expectation, is that it will stay high. Expectations of the future interest rate will no longer indicate that the interest rate will fall. The change in the way the interest-rate variable moves has therefore led to a change in the way that expectations of future interest rates are formed. The rational expectations analysis here is generalizable to expectations of any variable. Hence, when a change occurs in the way any variable moves, the way in which expecta- tions of this variable are formed will change, too.

2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time. The forecast error of an expectation is X – Xe, the difference between the realization of a variable X and the expectation of the variable. That is, if Joe Commuter’s driving time on a particular day is 45 minutes and his expectation of the driving time is 40 minutes, the forecast error is five minutes.

Suppose that in violation of the rational expectations tenet, Joe’s forecast error is not, on average, equal to zero; instead, it equals five minutes. The forecast error is now predictable ahead of time because Joe will soon notice that he is, on average, five min- utes late for work and can improve his forecast by increasing it by five minutes. Rational expectations theory implies that this is exactly what Joe will do because he will want his forecast to be the best guess possible. When Joe has revised his forecast upward by five minutes, on average, the forecast error will equal zero, so it cannot be predicted ahead of time. Rational expectations theory implies that forecast errors of expectations cannot be predicted.

The incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets, people with better forecasts of the future get rich. The application of the theory of rational expectations to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful.

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 149

the effiCient maRket hyPotheSiS: Rational exPeCtationS in finanCial maRketS

While monetary economists were developing the theory of rational expectations, financial economists were developing a parallel theory of expectations formation for financial markets. It led them to the same conclusion as that of the rational expecta- tions theorists: Expectations in financial markets are equal to optimal forecasts using all available information.4 Although financial economists, such as Eugene Fama, winner of the Nobel Prize in economics, gave their theory another name, calling it the efficient market hypothesis, in fact their theory is just an application of rational expectations to the pricing of stocks and other securities.

The efficient market hypothesis is based on the assumption that prices of securities in financial markets fully reflect all available information. You may recall from Chapter 4 that the rate of return from holding a security equals the sum of the capital gain on the security (the change in the price), plus any cash payments, divided by the initial purchase price of the security:

R = Pt + 1 - Pt + C

Pt (7)

where R = rate of return on the security held from time t to time t + 1 (say, the end of 2015 to the end of 2016)

Pt + 1 = price of the security at time t + 1, the end of the holding period Pt = price of the security at time t, the beginning of the holding period C = cash payment (coupon or dividend payments) made in the

period t to t + 1

Let’s look at the expectation of this return at time t, the beginning of the holding period. Because the current price Pt and the cash payment C are known at the outset, the only variable in the definition of the return that is uncertain is the price next period, Pt + 1.

5 Denoting expectation of the security’s price at the end of the holding period as Pet + 1, the expected return R

e is

Re = Pet + 1 - Pt + C

Pt

The efficient market hypothesis views expectations of future prices as equal to optimal forecasts using all currently available information. In other words, the market’s expectations of future securities prices are rational, so that

Pet + 1 = Poft + 1 which in turn implies that the expected return on the security will equal the optimal forecast of the return:

Re = Rof (8)

4The development of the efficient market hypothesis was not wholly independent of the development of rational expectations theory in that financial economists were aware of Muth's work. 5There are cases in which C might not be known at the beginning of the period, but that does not make a substan- tial difference to the analysis. We would in that case assume that not only price expectations but also the expecta- tions of C are optimal forecasts using all available information.

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150 p a r t 2 Financial Markets

Unfortunately, we cannot observe either Re or Pet + 1, so the rational expectations equations by themselves do not tell us much about how the financial market behaves. However, if we can devise some way to measure the value of Re, these equations will have important implications for how prices of securities change in financial markets.

The supply and demand analysis of the bond market that we developed in Chapter 5 showed us that the expected return on a security (the interest rate, in the case of the one-year discount bond we examined) will have a tendency to move toward the equilibrium return that equates the quantity demanded to the quantity supplied. Supply and demand analysis enables us to determine the expected return on a security with the following equilibrium condition:

The expected return on a security Re equals the equilibrium return R*, which equates the quantity of the security demanded to the quantity supplied; that is,

Re = R* (9)

The academic field of finance explores the factors (risk and liquidity, for example) that influence the equilibrium returns on securities. For our purposes, it is sufficient to know that we can determine the equilibrium return and thus determine the expected return with the equilibrium condition.

We can derive an equation to describe pricing behavior in an efficient market by using the equilibrium condition to replace Re with R* in the rational expectations equation (Equation 8). In this way, we obtain

Rof = R* (10)

This equation tells us that current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. Financial economists state it more simply: In an efficient market, a security’s price fully reflects all available information.

Rationale Behind the hypothesis To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities, that is, returns on a security that are larger than what is justified by the characteristics of that security. Arbitrage is of two types: pure arbitrage, in which the elimination of unexploited profit opportunities involves no risk, and the type of arbitrage we discuss here, in which the arbitrageur takes on some risk when eliminating the unexploited profit opportunities. To see how arbitrage leads to the efficient market hypothesis given a security’s risk characteristics, let’s look at an example. Suppose the normal return on ExxonMobil common stock is 10% at an annual rate, and its current price Pt is lower than the optimal forecast of tomorrow’s price P

of t + 1, so that the optimal

forecast of the return at an annual rate is 50%, which is greater than the equilibrium return of 10%. We are now able to predict that, on average, ExxonMobil’s return will be abnormally high, so there is an unexploited profit opportunity. Knowing that, on average, you can earn an abnormally high rate of return on ExxonMobil stock (because Rof 7 R*), you will buy more, which will in turn drive up the stock’s current price Pt relative to its expected future price Poft + 1, thereby lowering R

of. When the current price has risen sufficiently so that Rof equals R* and the efficient market condition (Equation 10) is satisfied, the buying of ExxonMobil stock will stop, and the unexploited profit opportunity will disappear.

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 151

Similarly, a security for which the optimal forecast of the return is -5% and the equilibrium return is 10% 1Rof 6 R*2 would be a poor investment because, on aver- age, the security earns less than the equilibrium return. In such a case, you would sell the security and drive down its current price relative to the expected future price until Rof rose to the level of R* and the efficient market condition was again satisfied. Our discussion can be summarized as follows:

Rof 7 R* S Ptc S RofT

Rof 6 R* S PtT S Rofc until

Rof = R*

Another way to state the efficient market condition is this: In an efficient market, all unexploited profit opportunities will be eliminated.

An extremely important factor in this reasoning is that not everyone in a finan- cial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds. Financial markets are structured so that many participants can play. As long as a few people (often referred to as the “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear, because in doing so they make a profit. The efficient market hypothesis makes sense because it does not require that everyone in a market be cognizant of what is happening to every security.

Random-walk Behavior of Stock Prices The term random walk describes the movements of a variable whose future values cannot be predicted (are random) because, given today’s value, the value of the variable is just as likely to fall as it is to rise. An important implication of the efficient market hypothesis is that stock prices should approximately follow a random walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable. The random-walk implication of the efficient market hypothesis is the one most commonly mentioned in the press because it is the most readily comprehensible to the public. In fact, when people mention the “random-walk theory of stock prices,” they are in reality referring to the efficient market hypothesis.

The case for random-walk stock prices can be demonstrated. Suppose people could predict that the price of Happy Feet Corporation (HFC) stock would rise 1% in the coming week. The predicted rate of capital gains and rate of return on HFC stock would then exceed 50% at an annual rate. Since this is very likely to be far higher than the equilibrium rate of return on HFC stock (Rof 7 R* ), the efficient market hypothesis indicates that people would immediately buy this stock and bid up its current price. The action would stop only when the predictable change in the price dropped to near zero, so that Rof = R*.

Similarly, if people could predict that the price of HFC stock would fall by 1%, the predicted rate of return would be negative (Rof 7 R* ), and people would imme- diately sell the stock. The current price would fall until the predictable change in the price rose back to near zero, where the efficient market condition again would hold. The efficient market hypothesis suggests that the predictable change in stock prices will be near zero, leading to the conclusion that stock prices will generally follow a

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152 p a r t 2 Financial Markets

random walk.6 As the Global Box “Should Foreign Exchange Rates Follow a Random Walk?” indicates, the efficient market hypothesis suggests that foreign exchange rates should also follow a random walk.

A p p li c At i o n Practical Guide to Investing in the Stock Market The efficient market hypothesis has numerous applications to the real world.7 It is especially valuable because it can be applied directly to an issue that concerns many of us: how to get rich (or at least not get poor) by investing in the stock market. A practical guide to investing in the stock market, which we develop here, provides a better understanding of the use and implications of the efficient market hypothesis.

how Valuable are Reports Published by investment advisers? Suppose you have just read in the “Heard on the Street” column of the Wall Street Journal that investment advisers are predicting a boom in oil stocks because an oil shortage is developing. Should you proceed to withdraw all of your hard-earned savings from the bank and invest them in oil stocks?

6Note that the random-walk behavior of stock prices is only an approximation derived from the efficient market hypothesis. Random-walk behavior would hold exactly only for a stock for which an unchanged price leads to its having the equilibrium return. Then, when the predictable change in the stock price is exactly zero, Rof = R*. 7The empirical evidence on the efficient market hypothesis is discussed in an appendix to this chapter, which can be found on the Companion Website at http://www.pearsonhighered.com/mishkin.

Global Should Foreign Exchange Rates Follow a Random Walk?

Although the efficient market hypothesis is usually applied to the stock market, it can also be used to show that foreign exchange rates, like stock prices, should generally follow a random walk. To see why this is the case, consider what would happen if investors could predict that a currency would rise in value by 1% in the coming week. By buying this currency, they could earn a greater than 50% return at an annual rate, which is likely to be far above the equilibrium return for holding a currency. As a result, investors would immediately buy the currency and bid up its current price, thereby reducing the expected return. The process would only stop when

the predictable change in the exchange rate dropped to near zero so that the optimal forecast of the return no longer differed from the equilibrium return. Likewise, if investors could predict that the currency would fall in value by 1% in the coming week, they would sell it until the predictable change in the exchange rate was again near zero. The efficient mar- ket hypothesis therefore implies that future changes in exchange rates should, for all practical purposes, be unpredictable; in other words, exchange rates should follow random walks. Indeed, the random- walk behavior of exchange rates is exactly what is found in the data.

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 153

The efficient market hypothesis tells us that when purchasing a security, we can- not expect to earn an abnormally high return, or a return greater than the equilibrium return.

Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices. So acting on this information will not yield abnormally high returns, on average. The empirical evidence for the most part confirms that recommendations from investment advisers cannot help us outperform the general market. Indeed, as the FYI box suggests, human investment advisers in San Francisco do not, on average, even outperform an orangutan!

Probably no other conclusion is met with more skepticism by students than this one when they first hear it. We all know, or have heard of, someone who has been successful in the stock market for a period of many years. We wonder, “How could someone be so consistently successful if he or she did not really know how to predict when returns would be abnormally high?” The following story, reported in the press, illustrates why such anecdotal evidence is not reliable.

A get-rich-quick artist invented a clever scam. Every week, he wrote two letters. In letter A, he would pick team A to win a particular football game; in letter B, he would pick the opponent, team B. He would then separate a mailing list into two groups, and he would send letter A to the people in one group and letter B to the people in the other. The following week he would do the same thing, but this time he would send these letters only to the group who had received the first letters containing the correct prediction. After doing this for ten games, he had a small cluster of people who had received letters predicting the correct winning team for every game. He then mailed a final letter to this group, declaring that since he was obviously an expert predictor of the outcome of football games (he had picked the winning teams ten weeks in a row), and since his predictions were profitable for the recipients who bet on the games, he would continue to send his predictions only if he were paid a substantial amount of money. When one of his clients figured out what he was up to, the con man was prosecuted and thrown in jail!

What is the lesson of the story? Even if no forecaster is an accurate predictor of the market, there will always be a group of consistent winners. A person who has done well regularly in the past cannot guarantee that he or she will do well in the future. Note that there will also be a group of persistent losers, but you rarely hear about them because no one brags about a poor forecasting record.

Should you Be Skeptical of hot tips? Suppose your broker phones you with a hot tip to buy stock in the Happy Feet Cor- poration (HFC) because it has just developed a product that is completely effective in curing athlete’s foot. The stock price is sure to go up. Should you follow this advice and buy HFC stock?

The efficient market hypothesis indicates that you should be skeptical of such news. If the stock market is efficient, it has already priced HFC stock so that its expected return will equal the equilibrium return. The hot tip is not particularly valu- able and will not enable you to earn an abnormally high return.

You might wonder, though, if the hot tip is based on new information and would give you an edge on the rest of the market. If other market participants have gotten this information before you, the answer again is no. As soon as the information hits the street, the unexploited profit opportunity it creates will be quickly eliminated. The stock’s

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price will already reflect the information, and you should expect to realize only the equilibrium return. But if you are one of the first to gain the new information, it can do you some good. Only then can you be one of the lucky ones who, on average, will earn an abnormally high return by helping eliminate the profit opportunity by buying HFC stock.

Do Stock Prices Always Rise When There Is Good News? If you follow the stock market, you might have noticed a puzzling phenomenon: When good news about a corporation, such as a particularly favorable earnings report, is announced, the price of the corporation’s stock frequently does not rise. The efficient market hypothesis explains this phenomenon.

Because changes in stock prices are unpredictable, when information is announced that has already been expected by the market, stock prices will remain unchanged. The announcement does not contain any new information that would lead to a change in stock prices. If this were not the case, and the announcement led to a change in stock prices, it would mean that the change was predictable. Because such a scenario is ruled out in an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. If the news is expected, no stock price response will occur. This is exactly what the evidence shows: Stock prices do reflect publicly available information.

Sometimes an individual stock price declines when good news is announced. Although this seems somewhat peculiar, it is completely consistent with the workings of an efficient market. Suppose that although the announced news is good, it is not as good as expected. HFC’s earnings may have risen by 15%, but if the market expected earnings to rise by 20%, the new information is actually unfavorable, and the stock price declines.

Efficient Market Prescription for the Investor What does the efficient market hypothesis recommend for investing in the stock mar- ket? It tells us that hot tips and investment advisers’ published recommendations—all of which make use of publicly available information—cannot help an investor outper- form the market. Indeed, it indicates that anyone without better information than other market participants cannot expect to beat the market. So what is an investor to do?

FYI Should You Hire an Ape as Your Investment Adviser?

The San Francisco Chronicle came up with an amusing way of evaluating how successful investment advisers are at picking stocks. They asked eight analysts to pick five stocks at the beginning of the year and then compared the performance of their stock picks to those chosen by Jolyn, an orangutan living at Marine

World/Africa USA in Vallejo, California. Jolyn beat the investment advisers as often as they beat her. Given this result, you might be just as well off hir- ing an orangutan as your investment adviser as you would be hiring a human being!

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 155

The efficient market hypothesis leads to the conclusion that such an investor (and almost all of us fit into this category) should not try to outguess the market by con- stantly buying and selling securities. This process does nothing but boost the income of brokers, who earn commissions on each trade.8 Instead, the investor should pursue a “buy and hold” strategy—purchase stocks and hold them for long periods of time. This will lead to the same returns, on average, but the investor’s net profits will be higher because fewer brokerage commissions will have to be paid.

A sensible strategy for a small investor, whose costs of managing a portfolio may be high relative to its size, is to buy into a mutual fund rather than to buy individual stocks. Because the efficient market hypothesis indicates that no mutual fund can con- sistently outperform the market, an investor should not buy into a fund that has high management fees or pays sales commissions to brokers, but rather should purchase a no-load (commission-free) mutual fund that has low management fees.

The evidence indicates that it will not be easy to beat the prescription suggested here, although some anomalies (discussed in an appendix found on this book’s website) to the efficient market hypothesis suggest that an extremely clever investor (that rules out most of us) may be able to outperform a buy-and-hold strategy. ◆

why the effiCient maRket hyPotheSiS DoeS not imPly that finanCial maRketS aRe effiCient

Many financial economists take the efficient market hypothesis one step further in their analysis of financial markets. Not only do they believe that expectations in financial markets are rational—that is, equal to optimal forecasts using all available informa- tion—but they also add the condition that prices in financial markets reflect the true fundamental (intrinsic) value of the securities. In other words, all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities), and so financial markets are efficient.

This stronger view of market efficiency has several important implications in the academic field of finance. First, it implies that in an efficient capital market, one invest- ment is as good as any other because the securities’ prices are correct. Second, it implies that a security’s price reflects all available information about the intrinsic value of the security. Third, it implies that security prices can be used by managers of both financial and nonfinancial firms to assess their costs of capital (costs of financing their investments) accurately and hence that security prices can be used to help these managers make correct decisions about whether a specific investment is worth making. This stronger version of market efficiency is a basic tenet of much analysis in the finance field.

The efficient market hypothesis may be misnamed, however. It does not imply the stronger view of market efficiency, but rather just that prices in markets like the stock market are unpredictable. Indeed, as the following application suggests, the existence of market crashes and bubbles, in which the prices of assets rise well above their fundamental values, casts serious doubt on the stronger view that financial markets are efficient. However, market crashes and bubbles do not necessarily provide strong evidence against the basic tenets of the efficient market hypothesis.

8The investor may also have to pay Uncle Sam capital gains taxes on any profits that are realized when a security is sold—an additional reason why continual buying and selling does not make sense.

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A p p li c At i o n What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis and the Efficiency of Financial Markets? On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average declined by more than 20%, the largest one-day decline in U.S. history. The collapse of the high-tech companies’ share prices from their peaks in March 2000 caused the heavily-tech-laden NASDAQ index to fall from about 5,000 in March 2000 to about 1,500 in 2001 and 2002, a decline of well over 60%. These stock market crashes caused many economists to question the validity of the efficient market hypothesis. These economists do not believe that a rational marketplace could have produced such a massive swing in share prices. To what degree should these stock market crashes make us doubt the validity of the efficient market hypothesis?

Nothing in efficient markets theory rules out large changes in stock prices. A large change in stock prices can result from new information that produces a dramatic decline in optimal forecasts of the future valuation of firms. However, economists are hard pressed to find fundamental changes in the economy that would have caused the Black Monday and tech crashes. One lesson from these crashes is that factors other than market fundamentals probably have an effect on asset prices. Indeed, as we will explore in Chapters 8 and 12, there are good reasons to believe that impediments to the proper functioning of financial markets do exist. Hence these crashes have con- vinced many economists that the stronger version of market efficiency, which states that asset prices reflect the true fundamental (intrinsic) value of securities, is incorrect. These economists attribute a large role in determination of stock and other asset prices to market psychology and to the institutional structure of the marketplace. However, nothing in this view contradicts the basic reasoning behind rational expectations or the efficient market hypothesis—that market participants eliminate unexploited profit opportunities. Even though stock market prices may not always solely reflect market fundamentals, as long as market crashes are unpredictable, the basic premises of effi- cient markets theory hold.

However, other economists believe that market crashes and bubbles suggest that unex- ploited profit opportunities may exist and that the efficient market hypothesis might be fundamentally flawed. The controversy over the efficient market hypothesis continues. ◆

BehaVioRal finanCe Doubts about the efficiency of financial markets, triggered by the stock market crash of 1987, led economists such as Nobel Prize winner Robert Shiller to develop a new field of study called behavioral finance. It applies concepts from other social sciences, such as anthropology, sociology, and particularly psychology, to explain the behavior of securities prices.9

9Surveys of this field can be found in Hersh Shefrin, Beyond Greed and Fear: Understanding of Behavioral Finance and the Psychology of Investing (Boston: Harvard Business School Press, 2000); Andrei Shleifer, Inefficient Markets (Oxford, UK: Oxford University Press, 2000); and Robert J. Shiller, “From Efficient Market Theory to Behavioral Finance,” Cowles Foundation Discussion Paper No. 1385 (October 2002).

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 157

As we have seen, the efficient market hypothesis assumes that unexploited profit opportunities are eliminated by “smart money” market participants. But can smart money dominate ordinary investors so that financial markets are efficient? Specifically, the efficient market hypothesis suggests that smart money participants will sell when a stock price goes up irrationally, with the result that the stock price falls back down to a level that is justified by fundamentals. For this to occur, smart money investors must be able to engage in short sales; that is, they must borrow stock from brokers and then sell it in the market, with the aim of earning a profit by buying the stock back again (“covering the short”) after it has fallen in price. Work by psychologists, however, sug- gests that people are subject to loss aversion: They are more unhappy when they suffer losses than they are happy when they achieve gains. Short sales can result in losses far in excess of an investor’s initial investment if the stock price climbs sharply higher than the price at which the short sale is made (and losses might be unlimited if the stock price climbs to astronomical heights).

Loss aversion can thus explain an important phenomenon: Very little short selling actually takes place. Short selling may also be constrained by rules restricting it, because it seems unsavory for someone to make money from another person’s misfortune. The existence of so little short selling can explain why stock prices are sometimes overval- ued. That is, the lack of enough short selling means that smart money does not drive stock prices back down to their fundamental value.

Psychologists have also found that people tend to be overconfident in their own judgments. As a result, investors tend to believe that they are smarter than other inves- tors. Because investors are willing to assume that the market typically doesn’t get it right, they trade on their beliefs rather than on pure facts. This theory may explain why securities markets have such a large trading volume—something that the efficient market hypothesis does not predict.

Overconfidence and social contagion (fads) provide an explanation for stock mar- ket bubbles. When stock prices go up, investors attribute their profits to their intel- ligence and talk up the stock market. This word-of-mouth enthusiasm and glowing media reports then can produce an environment in which even more investors think stock prices will rise in the future. The result is a positive feedback loop in which prices continue to rise, producing a speculative bubble, which finally crashes when prices get too far out of line with fundamentals.10

The field of behavioral finance is a young one, but it holds out hope that we might be able to explain some features of securities markets’ behavior that are not well explained by the efficient market hypothesis.

10See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2001).

SummaRy

1. Stocks are valued as the present value of future divi- dends. Unfortunately, we do not know very precisely what these dividends will be. This uncertainty intro- duces a great deal of error into the valuation process. The Gordon growth model is a simplified method of computing stock value that depends on the assumption that the dividends are growing at a constant rate

forever. Given our uncertainty regarding future divi- dends, this assumption is often the best we can do.

2. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader who values the security the most (either because of less uncertainty about cash flows or because of greater estimated cash flows) will be willing to pay the most.

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158 p a r t 2 Financial Markets

As new information is released, investors will revise their estimates of the true value of the security and will either buy or sell it, depending on how the market price compares with their estimated valuation. Because small changes in estimated growth rates or required returns result in large changes in price, it is not sur- prising that the markets are often volatile.

3. The efficient market hypothesis states that current security prices will fully reflect all available informa- tion, because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a finan- cial market to be efficient does not require that all mar- ket participants be well informed. The efficient markets hypothesis implies that stock prices generally follow a random walk.

4. The efficient market hypothesis indicates that hot tips and investment advisers’ published recommendations cannot help an investor outperform the market. The best prescription for investors is to pursue a buy-and- hold strategy—purchase stocks and hold them for long

periods of time. Empirical evidence generally supports these implications of the efficient market hypothesis in the stock market.

5. The existence of market crashes and bubbles has con- vinced many economists that the stronger version of market efficiency, which states that asset prices reflect the true fundamental (intrinsic) value of securities, is not correct. There is, however, less evidence that these crashes prove that the efficient market hypothesis is wrong. Even if the stock market were driven by factors other than fundamentals, these crashes do not clearly demonstrate that many basic tenets of the efficient market hypothesis are no longer valid, as long as the crashes could not have been predicted.

6. The new field of behavioral finance applies concepts from other social sciences, such as anthropology, soci- ology, and psychology, to our understanding of the behavior of securities prices. Loss aversion, overcon- fidence, and social contagion can explain why trading volume is so high, why stock prices become overval- ued, and why speculative bubbles occur.

key teRmS

adaptive expectations, p. 146 arbitrage, p. 150 behavioral finance, p. 156 bubbles, p. 155 cash flows, p. 140 dividends, p. 141 efficient market hypothesis, p. 148

generalized dividend model, p. 142 Gordon growth model, p. 142 market fundamentals, p. 155 optimal forecast, p. 146 random walk, p. 151 rational expectations, p. 146 residual claimant, p. 140

short sales, p. 157 stockholders, p. 140 theory of efficient capital markets,

p. 148 unexploited profit opportunity,

p. 150

QueStionS

All questions are available in MyEconLab at http://www.myeconlab.com.

1. What basic principle of finance can be applied to the valuation of any investment asset?

2. What are the two main sources of cash flows for a stockholder? How reliably can these cash flows be esti- mated? Compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. Which security would you predict to be more volatile?

3. Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How

can monetary policy be used to prick a market bubble? Explain using the Gordon growth model.

4. If monetary policy becomes more transparent about the future course of interest rates, how will stock prices be affected, if at all?

5. “Forecasters’ predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be rational.” Is this statement true, false, or uncertain? Explain your answer.

6. “Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. When it is not snowing, his expectations

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Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 159

of the driving time are perfectly accurate. Considering that it snows only once every ten years where Joe lives, Joe’s expectations are almost always perfectly accurate.” Are Joe’s expectations rational? Why or why not?

7. If a forecaster spends hours every day studying data to forecast interest rates, but his expectations are not as accurate as predicting that tomorrow’s interest rate will be identical to today’s interest rate, are his expectations rational?

8. “If stock prices did not follow a random walk, there would be unexploited profit opportunities in the mar- ket.” Is this statement true, false, or uncertain? Explain your answer.

9. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has sharply increased in the past week, you should go out and buy stocks? Why or why not?

10. If the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis predict will happen to the price of the stock when the $4 loss is announced?

11. If you read in the Wall Street Journal that the “smart money” on Wall Street expects stock prices to fall, should you follow that lead and sell all your stocks?

12. If your broker has been right in her five previous buy and sell recommendations, should you continue listen- ing to her advice?

13. Can a person with rational expectations expect the price of a share of Google to rise by 10% in the next month?

14. “If most participants in the stock market do not follow what is happening to the monetary aggregates, prices

of common stocks will not fully reflect information about them.” Is this statement true, false, or uncertain? Explain your answer.

15. “An efficient market is one in which no one ever prof- its from having better information than the rest of the market participants.” Is this statement true, false, or uncertain? Explain your answer.

16. If higher money growth is associated with higher future inflation, and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think will happen to long-term bond prices?

17. “Foreign exchange rates, like stock prices, should fol- low a random walk.” Is this statement true, false, or uncertain? Explain your answer.

18. Can we expect the value of the dollar to rise by 2% next week if our expectations are rational?

19. “Human fear is the source of stock market crashes, so these crashes indicate that expectations in the stock market cannot be rational.” Is this statement true, false, or uncertain? Explain your answer.

20. In the late 1990s, as information technology advanced rapidly and the Internet was widely developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets began to unwind and then crashed, with many commentators identifying the previous few years as a “stock market bubble.” How might it be pos- sible for this episode to be a bubble but still adhere to the efficient market hypothesis?

21. Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?

All applied problems are available in MyEconLab at http://www.myeconlab.com.

22. Compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able to sell in one year for $20, assuming you require a 15% return.

23. After careful analysis, you have determined that a firm’s dividends should grow at 7%, on average, in the foreseeable future. The firm’s last dividend was $3. Compute the current price of this stock, assuming the required return is 18%.

24. The current price of a stock is $65.88. If dividends are expected to be $1 per share for the next five years, and the required return is 10%, then what should the price of the stock be in 5 years when you plan to sell it? If the dividend and required return remain the same, and the stock price is expected to increase by $1 five years from now, does the current stock price also increase by $1? Why or why not?

25. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding. Assuming the split conveys no

aPPlieD PRoBlemS

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160 p a r t 2 Financial Markets

new information about the company, what are the value of the company, the number of shares outstand- ing, and the price per share after the split? If the

actual market price immediately following the split is $17.00 per share, what does this tell us about market efficiency?

Data analySiS PRoBlemS

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the Dow Jones Industrial Average

(DJIA). Assume the DJIA is a stock that pays no divi- dends. Apply the one-period valuation model, using the data from one year prior up to the most current date available, to determine the required return on equity investment. In other words, assume the most recent stock price of DJIA is known one year prior. What rate of return would be required in order to “buy” a share of DJIA? Suppose that a $100 dividend is paid out instead. How does this change the required rate of return?

2. Go to the St. Louis Federal Reserve FRED database, and find data on net corporate dividend payments

(B056RC1A027NBEA). Adjust the units setting to “Percent Change from Year Ago,” and download the data into a spreadsheet.

a. Calculate the average annual growth rate of divi- dends from 1960 to the most recent year of data available.

b. Find data on the Dow Jones Industrial Average (DJIA) for the most recent day of data available. Suppose that a $100 dividend is paid out at the end of next year. Use the Gordon growth model and your answer to part (a) to calculate the rate of return that would be required for equity investment over the next year, assuming you could buy a share of DJIA.

weB exeRCiSeS

1. Visit http://www.forecasts.org/data/index.htm. Click on Stock Index at the very top of the page. Now choose U.S. Stock Indices—monthly. Review the indexes for the DJIA, the S&P 500, and the NASDAQ composite. Which index appears most volatile? In which index would you rather have invested in 1985 if the invest- ment had been allowed to compound until now?

2. The Internet is a great source of information on stock prices and stock price movements. Yahoo Finance is a great source for stock market data. Go to http://finance .yahoo.com and click on the DOW ticker in the Market

Summary section to view current data on the Dow Jones Industrial Average. Click on the chart to manipu- late the different variables. Change the time range and observe the stock trend over various intervals. Have stock prices been going up or down over the past day, week, three months, and year?

3. Eugene Fama and Robert Shiller recently won the Nobel Prize in economics. Go to http://nobelprize.org/ nobel_prizes/economics/ and locate the press release on Eugene Fama and Robert Shiller. What was the Nobel Prize to them awarded for? When was it awarded?

weB RefeRenCeS

http://stocks.tradingcharts.com

Access detailed stock quotes, charts, and historical stock data.

http://www.investorhome.com/emh.htm

Learn more about the efficient market hypothesis.

weB aPPenDix

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read the Web appendix to Chapter 7.

Appendix: Evidence on the Efficient Market Hypothesis

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Financial Institutions Crisis and Response: The $700 Billion Bailout Package After a heated national debate, the U.S. House of Representatives passed the Emergency Economic Stabilization Act on October 3, 2008. This stunning $700 billion bailout package sought to promote economic recovery from the global financial crisis by authorizing the Treasury to purchase troubled mortgage assets from struggling financial institutions or to inject capital into banking institutions. To calm fears further, the Act raised the federal deposit insurance limit from $100,000 to $250,000.

The initial bill was voted down on September 29, when constituents flooded their representatives with complaints about bailing out the greedy Wall Street executives behind the crisis. The national debate pitted Wall Street against Main Street: Many people who sided with struggling homeowners saw the proposed federal bailout of financial institutions as government hypocrisy. How could injecting capital into the financial system help those fearful of losing their jobs or, worse yet, those who found themselves suddenly without work?

The central role of financial institutions in the workings of the economy—the focus of Part 3—was being overlooked. Banks and other financial institutions make financial markets work by moving funds from people who save to people who have productive investment opportunities. That bank branch on Main Street was not going to be able to lend freely to a small business owner or recent college graduate looking to fund a new car purchase until capital once again flowed.

The global financial crisis highlights how financial systems change over time, be it from financial innovations or through hard lessons learned from such crises. Chapter 8 analyzes financial structure in the United States and in the rest of the world. In Chapter 9, we look at the business and process of banking. In Chapter 10, we extend the economic analysis developed in Chapter 8 to understand the motivations for bank regulation, and we examine the pitfalls of the regulatory process. Chapter 11 examines the development of the American banking system and the growing internationalization of banking. In Chapter 12, we develop a framework for understanding the dynamics of financial crises, and focus in particular on the red-hot global crisis of 2007–2009. Chapter 13 examines how nonbank financial institutions have evolved over time. Chapter 14 discusses financial derivatives and how they can be used to reduce risk, but can cause serious damage to the economy if used improperly. In Chapter 15, we look at why conflicts of interest in the financial services industry occur and what we should do about them.

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Ahealthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities. But how does the financial system make sure that your hard-earned savings get channeled to Paula the Productive Investor rather than to Benny the Bum?

This chapter answers that question by providing an economic analysis of how our financial structure is designed to promote economic efficiency. The analysis focuses on a few simple but powerful economic concepts that enable us to explain features of our financial system, such as why financial contracts are written as they are and why financial intermediaries are more important than securities markets for getting funds to borrow- ers. The analysis also demonstrates the important link between the financial system and the performance of the aggregate economy, which is the subject of Part 6 of this book.

BAsic FActs ABout FinAnciAl structure throughout the World The financial system is complex in structure and function throughout the world. It includes many different types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on—all of which are regulated by government. The financial system channels trillions of dollars per year from savers to people with productive investment opportunities. If we take a close look at financial structure all over the world, we find eight basic facts, some of which are quite surprising, that we must explain if we are to understand how the financial system works.

The bar chart in Figure 1 shows how American businesses financed their activities using external funds (those obtained from outside the business itself) in the period 1970–2000 and compares U.S. data with data for Germany, Japan, and Canada. The conclusions drawn from this period still hold true today. The Bank Loans category is made up primarily of loans from depository institutions; Nonbank Loans are primarily loans by other financial interme- diaries; the Bonds category includes marketable debt securities, such as corporate bonds and commercial paper; and Stock consists of new issues of equity (stock market shares).

Now let’s explore the eight facts.

1. Stocks are not the most important source of external financing for businesses. Because so much attention in the media is focused on the stock market, many people

An Economic Analysis of Financial Structure

learning objectives • Identify eight basic facts about the global financial system.

• Summarize how transaction costs affect financial intermediaries.

• Describe why asymmetric information leads to adverse selection and moral hazard.

• Recognize adverse selection and summarize the ways in which it can be reduced.

• Recognize the principal–agent problem arising from moral hazard in equity contracts and summarize the methods for reducing it.

• Summarize the methods used to reduce moral hazard in debt contracts.

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C h a p t e r 8 An Economic Analysis of Financial Structure 163

have the impression that stocks are the most important source of financing for American corporations. However, as we can see from the bar chart in Figure 1, the stock market accounted for only a small fraction of the external financing of American businesses in the 1970–2000 period: 11%.1 Similarly low figures apply for the other countries presented in Figure 1. Why is the stock market less important than other sources of financing in the United States and other countries?

United States

Germany

Japan

Canada

%

0

10

20

30

40

50

60

70

80

90

100

StockBondsNonbank LoansBank Loans

18%

38%

10% 8% 18%

32%

7% 9% 15% 11% 8% 5%

12%

76% 78%

56%

FIgure 1 sources of external Funds for nonfinancial Businesses: A comparison of the united states with germany, Japan, and canada

The Bank Loans category is made up primarily of loans from depository institutions; the Nonbank Loans are primarily loans by other financial intermediaries; the Bonds category includes marketable debt securities, such as corporate bonds and commercial paper; and Stock consists of new issues of new equity (stock market shares).

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are for 1970–2000 and are gross flows as percentages of the total, not including trade and other credit data, which are not available.

MyEconLab Mini-lecture

1The 11% figure for the percentage of external financing provided by stocks is based on the flows of external funds to corporations. However, this flow figure is somewhat misleading because when a share of stock is issued, it raises funds permanently, whereas when a bond is issued, it raises funds only temporarily until it is paid back at maturity. To see this, suppose a firm raises $1,000 by selling a share of stock and another $1,000 by selling a $1,000 one-year bond. In the case of the stock issue, the firm can hold on to the $1,000 it raised by selling the stock. However, in order to hold on to the $1,000 it raised through debt, the firm has to issue a new $1,000 bond every year. If we look at the flow of funds to corporations over a 30-year period, as shown in Figure 1, the firm will have raised $1,000 through a stock issue only once in the 30-year period, while it will have raised $1,000 through debt 30 times, once in each of the 30 years. Thus it looks as though debt is 30 times more important than stocks in raising funds, even though our example indicates that the two methods are actually equally important for the firm.

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2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Figure 1 shows that bonds are a far more impor- tant source of financing in the United States than stocks are (32% versus 11%). However, stocks and bonds combined (43%), which make up the total share of marketable secu- rities, still supply less than one-half of the external funds needed by U.S. corporations to finance their activities. The fact that issuing marketable securities is not the most important source of financing is true elsewhere in the world as well. Indeed, as we see in Figure 1, other countries have a much smaller share of external financing supplied by marketable securities than does the United States. Why don’t businesses use marketable securities more extensively to finance their activities?

3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct finance involves the sale to house- holds of marketable securities, such as stocks and bonds. The 43% share of stocks and bonds used as a source of external financing for American businesses actually greatly overstates the importance of direct finance in our financial system. Since 1970, less than 5% of newly-issued corporate bonds and commercial paper, and less than one-third of stocks, have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries such as insurance companies, pension funds, and mutual funds. These figures indicate that direct finance is used in less than 10% of the external funding of American business. Because in most countries marketable securities are an even less important source of finance than in the United States, direct finance is also far less important than indirect finance in the rest of the world. Why are financial intermediaries and indirect finance so important in financial markets? In recent years, however, indirect finance has been declining in importance. Why is this happening?

4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. As we can see in Figure 1, the primary source of external funds for businesses throughout the world is loans made by banks and other nonbank financial intermediaries, such as insurance companies, pension funds, and finance companies (56% in the United States, but more than 70% in Germany, Japan, and Canada). In other industrialized countries, bank loans are the largest category of sources of external finance (more than 70% in Germany and Japan, and more than 50% in Canada). Thus the data suggest that banks in these countries have the most important role in financing business activities. In developing countries, banks play an even more important role in the financial system than they do in industrialized countries. What makes banks so important to the workings of the financial system? Although banks remain important, their contributions to external funds for businesses have been declining in recent years. What is driving this decline?

5. The financial system is among the most heavily regulated sectors of the economy. The financial system is heavily regulated in the United States and in all other developed countries. Governments regulate financial markets primarily to promote the provision of information and to ensure the soundness (stability) of the financial system. Why are financial markets so extensively regulated throughout the world?

6. Only large, well-established corporations have easy access to securities markets to finance their activities. Individuals and smaller businesses that are not well established are less likely to raise funds by issuing marketable securities. Instead, they most often obtain their financing from banks. Why do only large, well-known corpora- tions find it easier to raise funds in securities markets?

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C h a p t e r 8 An Economic Analysis of Financial Structure 165

7. Collateral is a prevalent feature of debt contracts for both households and businesses. Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well. The majority of household debt in the United States consists of collateralized loans: Your automobile is collateral for your auto loan, and your house is collateral for your mortgage. Commercial and farm mortgages, for which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial businesses; corporate bonds and other bank loans also often involve pledges of collat- eral. Why is collateral such an important feature of debt contracts?

8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. Many students think of a debt contract as a simple IOU that can be written on a single piece of paper. The real- ity of debt contracts is far different, however. In all countries, bond or loan contracts typically are long legal documents with provisions (called restrictive covenants) that restrict and specify certain activities that the borrower can engage in. Restrictive covenants are not just a feature of debt contracts for businesses; for example, personal automobile loan and home mortgage contracts include covenants that require the bor- rower to maintain sufficient insurance on the automobile or house purchased with the loan. Why are debt contracts so complex and restrictive?

As you may recall from Chapter 2, an important feature of financial markets is their substantial transaction and information costs. An economic analysis of how these costs affect financial markets will help us understand the eight facts, which will in turn give us a much deeper understanding of how our financial system works. In the next section, we examine the impact of transaction costs on the structure of our financial system. Then we turn to the effects of information costs on financial structure.

trAnsAction costs Transaction costs are a major problem in financial markets. An example will make this clear.

how transaction costs influence Financial structure Say you have $5,000 that you would like to invest, and you are thinking about invest- ing in the stock market. Because you have only $5,000, you can buy only a small number of shares. Even if you use online trading, your purchase is so small that the brokerage commission for buying the stock you pick will be a large percentage of the purchase price of the shares. If, instead, you decide to buy a bond, the problem becomes even worse; the smallest denomination offered on some bonds that you might want to buy is as large as $10,000, and you do not have that much money to invest. You are disappointed and realize that you will not be able to use financial markets to earn a return on your hard-earned savings. You can take some consolation, however, in the fact that you are not alone in being stymied by high transaction costs. This is a fact of life for many of us: Only about one-half of American households own any securities.

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You also face another problem related to transaction costs. Because you have only a small amount of funds available, you can make only a restricted number of investments, because a large number of small transactions would result in very high transaction costs. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk.

how Financial intermediaries reduce transaction costs This example of the problems posed by transaction costs, along with the example outlined in Chapter 2, in which legal costs kept you from making a loan to Carl the Carpenter, illustrate that small savers like you are frozen out of financial markets and are unable to benefit from them. Fortunately, financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets.

economies of scale One solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of econo- mies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for each individual investor. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. For example, the cost of arranging a purchase of 10,000 shares of stock is not much greater than the cost of arranging a purchase of 50 shares of stock.

The presence of economies of scale in financial markets helps explain the develop- ment of financial intermediaries and why financial intermediaries have become such an important part of our financial structure. The clearest example of a financial inter- mediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings are then passed on to individual investors after the mutual fund has taken its cut in the form of management fees for administering their accounts. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securi- ties. The increased diversification for individual investors reduces their risk, making them better off.

Economies of scale are also important in lowering the costs of resources that finan- cial institutions need to accomplish their tasks, such as computer technology. Once a large mutual fund has invested a lot of money in setting up a telecommunications system, for example, the system can be used for a huge number of transactions at a low cost per transaction.

expertise Financial intermediaries are also better able to develop expertise that can be used to lower transaction costs. Their expertise in computer technology, for example, enables them to offer their customers convenient services such as check-writing privi- leges on their accounts and toll-free numbers that customers can call for information on how well their investments are doing.

Low transaction costs enable financial intermediaries to provide their customers with liquidity services, which are services that make it easier for customers to conduct transactions. Money market mutual funds, for example, not only pay shareholders rela- tively high interest rates but also allow them to write checks for convenient bill paying.

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C h a p t e r 8 An Economic Analysis of Financial Structure 167

Asymmetric inFormAtion: Adverse selection And morAl hAzArd

The presence of transaction costs in financial markets partly explains why financial intermediaries and indirect finance play such an important role in financial markets (fact 3). To understand financial structure more fully, however, we turn to the role of information in financial markets.

Asymmetric information—a situation that arises when one party’s insufficient knowl- edge about the other party involved in a transaction makes it impossible for the first party to make accurate decisions when conducting the transaction—is an important aspect of financial markets. For example, managers of a corporation know whether they are honest and usually have better information about how well their business is doing than stockholders do. The presence of asymmetric information leads to adverse selec- tion and moral hazard problems, which were introduced in Chapter 2.

Adverse selection is an asymmetric information problem that occurs before a transac- tion occurs: Potential bad credit risks are the ones who most actively seek out loans. Thus the parties who are most likely to produce an undesirable outcome are also the ones most likely to want to engage in the transaction. For example, big risk takers or outright crooks are often the most eager to take out a loan because they know they are unlikely to pay it back. Because adverse selection increases the chances that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though good credit risks can be found in the marketplace.

Moral hazard arises after the transaction occurs: The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view, because such activites make it less likely that the loan will be paid back. For example, once borrowers have obtained a loan, they may take on big risks (which have possible high returns but also run a greater risk of default) because they are playing with some- one else’s money. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan.

The analysis of how asymmetric information problems affect economic behavior is called agency theory. We will apply this theory here to explain why financial structure takes the form it does, thereby explaining the facts outlined at the beginning of the chapter.

the lemons ProBlem: hoW Adverse selection inFluences FinAnciAl structure

A particular aspect of the way the adverse selection problem interferes with the efficient functioning of a market was outlined in a famous article by Nobel Prize winner George Akerlof. It is called the “lemons problem” because it resembles the problem created by “lemons,” that is, bad cars, in the used-car market.2 Potential buyers of used cars are

2George Akerlof, “The Market for ‘Lemons’: Quality, Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84 (1970): 488–500. Two important papers that have applied the lemons problem analysis to financial markets are Stewart Myers and N. S. Majluf, “Corporate Financing and Investment Decisions: When Firms Have Information That Investors Do Not Have,” Journal of Financial Economics 13 (1984): 187–221; and Bruce Green- wald, Joseph E. Stiglitz, and Andrew Weiss, “Information Imperfections in the Capital Market and Macroeconomic Fluctuations,” American Economic Review 74 (1984): 194–199.

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frequently unable to assess the quality of a car; that is, they can’t tell whether a particu- lar used car is one that will run well or a lemon that will continually give them grief. The price that a buyer pays must therefore reflect the average quality of the cars in the market, somewhere between the low value of a lemon and the high value of a good car.

The owner of a used car, by contrast, is more likely to know whether the car is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to pay, which, being somewhere between the value of a lemon and that of a good car, is greater than the lemon’s value. However, if the car is a peach, that is, a good car, the owner knows that the car is undervalued at the price the buyer is will- ing to pay, and so the owner may not want to sell it. As a result of this adverse selection problem, fewer good used cars will come to the market. Because the average quality of a used car available in the market will be low, and because very few people want to buy a lemon, there will be few sales. The used-car market will function poorly, if at all.

lemons in the stock and Bond markets A similar lemons problem arises in securities markets—that is, the debt (bond) and equity (stock) markets. Suppose that our friend Irving the Investor, a potential buyer of securities such as common stock, can’t distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk. In this situation, Irving will be willing to pay only a price that reflects the average quality of firms issuing securities—a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners or managers of a good firm have better information than Irving and know that they have a good firm, then they know that their securities are undervalued and will not want to sell them to Irving at the price he is willing to pay. The only firms willing to sell Irving securities will be bad firms (because his price is higher than the securities are worth). Our friend Irving is not stupid; he does not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. In an outcome similar to that in the used-car market, this securities market will not work very well because few firms will sell securities in it to raise capital.

The analysis is similar if Irving considers purchasing a corporate debt instrument in the bond market rather than an equity share. Irving will buy a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms trying to sell the debt. The knowledgeable owners of a good firm realize that they will be paying a higher interest rate than they should, so they are unlikely to want to borrow in this market. Only the bad firms will be willing to borrow, and because investors like Irving are not eager to buy bonds issued by bad firms, they will probably not buy any bonds at all. Few bonds are likely to sell in this market, so it will not be a good source of financing.

The analysis we have just conducted explains fact 2—why marketable securities are not the primary source of financing for businesses in any country in the world. It also partly explains fact 1—why stocks are not the most important source of financing for American businesses. The presence of the lemons problem keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers.

tools to help solve Adverse selection Problems In the absence of asymmetric information, the lemons problem goes away. If buyers know as much about the quality of used cars as sellers, so that all involved can tell a good car from a bad one, buyers will be willing to pay full value for good used cars.

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Because the owners of good used cars can now get a fair price, they will be willing to sell them in the market. The market will have many transactions and will perform its intended job of channeling good cars to people who want them.

Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their secu- rities in the market. The securities market will then be able to move funds to the good firms that have the most productive investment opportunities.

Private Production and sale of information The solution to the adverse selection problem in financial markets is to reduce asymmetric information by furnish- ing the people supplying funds with more details about the individuals or firms seeking to finance their investment activities. One way for saver-lenders to get this information is through private companies that collect and produce information distinguishing good firms from bad firms, and then sell it to the saver-lenders. In the United States, companies such as Standard and Poor’s, Moody’s, and Value Line gather information on firms’ balance sheet positions and investment activities, publish these data, and sell them to subscribers (individuals, libraries, and financial intermediaries involved in purchasing securities).

The system of private production and sale of information does not completely solve the adverse selection problem in securities markets, however, because of the free-rider problem. The free-rider problem occurs when people who do not pay for informa- tion take advantage of the information that other people have paid for. The free-rider problem suggests that the private sale of information is only a partial solution to the lemons problem. To see why, suppose you have just purchased information that tells you which firms are good and which are bad. You believe that this purchase is worth- while because you can make up the cost of acquiring this information, and then some, by purchasing the securities of good firms that are undervalued. However, when our savvy (free-riding) investor Irving sees you buying certain securities, he buys right along with you, even though he has not paid for any information. If many other investors act as Irving does, the increased demand for the undervalued good securities causes their low price to be bid up immediately to reflect the securities’ true value. Because of all these free riders, you can no longer buy the securities for less than their true value. Now, because you will not gain any profit from purchasing the information, you realize that you never should have paid for the information in the first place. If other inves- tors come to the same realization, private firms and individuals may not be able to sell enough of this information to make it worth their while to gather and produce it. The weakened ability of private firms to profit from selling information will mean that less information is produced in the marketplace, so adverse selection (the lemons problem) will still interfere with the efficient functioning of securities markets.

government regulation to increase information The free-rider problem pre- vents the private market from producing enough information to eliminate all the asym- metric information that leads to adverse selection. Could financial markets benefit from government intervention? The government could, for instance, produce information to help investors distinguish good from bad firms and provide it to the public free of charge. This solution, however, would involve the government releasing negative in- formation about firms, a practice that might be politically difficult. A second possibility (and one followed by the United States and most governments throughout the world) is for the government to regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are. In the United States, the Securities and Exchange Commission

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(SEC) is the government agency that requires firms selling their securities to undergo independent audits, in which accounting firms certify that the firm is adhering to stan- dard accounting principles and disclosing accurate information about sales, assets, and earnings. Similar regulations are found in other countries. However, disclosure require- ments do not always work well, as the collapse of Enron and accounting scandals at other corporations, such as WorldCom and Parmalat (an Italian company), suggest (see the FYI box, “The Enron Implosion”).

The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors of the economy (fact 5). Government regulation aimed at increasing the information available to investors is necessary to reduce the adverse selection problem, which interferes with the efficient functioning of securities (stock and bond) markets.

Although government regulation lessens the adverse selection problem, it does not eliminate it entirely. Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors: A lot more is involved in knowing the quality of a firm than statistics alone can provide. Further- more, bad firms have an incentive to make themselves look like good firms because this enables them to fetch a higher price for their securities. Bad firms will slant the informa- tion they are required to transmit to the public, thus making it harder for investors to sort out the good firms from the bad.

Financial intermediation So far we have seen that private production of informa- tion and government regulation to encourage provision of information lessen, but do not eliminate, the adverse selection problem in financial markets. How, then, can the

FYI The Enron Implosion

Until 2001, Enron Corporation, a firm that special- ized in trading in the energy market, appeared to be spectacularly successful. It controlled a quarter of the energy-trading market and was valued as high as $77 billion in August 2000 (just a little over a year before its collapse), making it the seventh-largest corporation in the United States at that time. However, toward the end of 2001, Enron came crashing down. In October 2001, Enron announced a third-quarter loss of $618 million and disclosed accounting “mistakes.” The SEC then engaged in a formal investigation of Enron’s financial dealings with partnerships led by its former finance chief. It became clear that Enron was engaged in a complex set of transactions by which it was keeping substantial amounts of debt and finan- cial contracts off its balance sheet. These transactions enabled Enron to hide its financial difficulties. Despite securing as much as $1.5 billion of new financing

from J. P. Morgan Chase and Citigroup, the company was forced to declare bankruptcy in December 2001, up to that point the largest bankruptcy declaration in U.S. history.

The Enron collapse illustrates that government regulation can lessen asymmetric information prob- lems but cannot eliminate them. Managers have tremendous incentives to hide their companies’ prob- lems, making it hard for investors to know the true value of firms.

The Enron bankruptcy not only increased con- cerns in financial markets about the quality of accounting information supplied by corporations, but also led to hardship for many of the firm’s for- mer employees, who found that their pensions had become worthless. Outrage against the duplicity of executives at Enron was high, and several of them were convicted and sent to jail.

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financial structure help promote the flow of funds to people with productive investment opportunities when asymmetric information exists? A clue is provided by the structure of the used-car market.

An important feature of the used-car market is that most used cars are not sold directly by one individual to another. An individual who considers buying a used car might pay for privately produced information by subscribing to a magazine like Consumer Reports to find out if a particular make of car has a good repair record. Nevertheless, reading Consumer Reports does not solve the adverse selection problem, because even if a particular make of car has a good reputation, the specific car someone is trying to sell could be a lemon. The prospective buyer might also bring the used car to a mechanic for a once-over. But what if the prospective buyer doesn’t know a mechanic who can be trusted or the mechanic charges a high fee to evaluate the car?

Because these roadblocks make it hard for individuals to acquire enough informa- tion about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce infor- mation in the market by becoming experts in determining whether a car is a peach or a lemon. Once a dealer knows that a car is good, the dealer can sell it with some form of a guarantee: either an explicit guarantee such as a warranty or an implicit guaran- tee in which the dealer stands by its reputation for honesty. People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to sell the used car at a higher price than the dealer paid for it. Thus the dealer profits from the production of information about automobile quality. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free-riding on the information they produced.

Just as used-car dealers help solve adverse selection problems in the automobile market, financial intermediaries play a similar role in financial markets. A financial intermediary, such as a bank, becomes an expert in producing information about firms so that it can sort out good credit risks from bad ones. It then can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity.

An important element of the bank’s ability to profit from the information it pro- duces is that it avoids the free-rider problem by primarily making private loans, rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and bid down the loan’s interest rate to the point that the bank receives no compensation for the informa- tion it has produced. The bank’s role as an intermediary that holds mostly nontraded loans is the key to its success in reducing asymmetric information in financial markets.

Our analysis of adverse selection indicates that financial intermediaries in general— and banks in particular, because they hold a large fraction of nontraded loans—should play a greater role in moving funds to corporations than securities markets do. Our analysis thus explains facts 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses.

Our analysis also explains the greater importance of banks, as opposed to securities markets, in the financial systems of developing countries. As we have seen, better infor- mation about the quality of firms lessens asymmetric information problems, making it easier for firms to issue securities. Information about private firms is harder to collect in

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developing countries than in industrialized countries; therefore, the smaller role played by securities markets leads to a greater role for financial intermediaries such as banks. As a corollary to our analysis, as information about firms becomes easier to acquire, the role of banks should decline. A major development in the past 30 years in the United States has been huge improvements in information technology. Thus our analysis sug- gests that the lending role of financial institutions such as banks in the United States should have declined, and this is exactly what has occurred (see Chapter 11).

Our analysis of adverse selection also explains fact 6, which questions why large firms are more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route. The better known a corpora- tion is, the more information about its activities is available in the marketplace. Thus it is easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one. Because investors have fewer worries about adverse selection when dealing with well-known corporations, they are more willing to invest directly in their securities. Thus, in accordance with adverse selection, a pecking order for firms that can issue securities should exist. Hence we have an explanation for fact 6: The larger and more established a corporation is, the more likely it will be to issue securities to raise funds.

collateral and net Worth Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults on the loan. Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it re- duces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you fail to make your mortgage payments, the lender can take the title to your house, auction it off, and use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely that the loan will be made, perhaps even at a better loan rate. The presence of adverse selection in credit markets thus explains why collateral is an important feature of debt contracts (fact 7).

Net worth (also called equity capital), the difference between a firm’s assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to that of collateral. If a firm has a high net worth, then even if it engages in invest- ments that lead to negative profits and so defaults on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans. This concept lies behind the often-heard lament, “Only the people who don’t need money can borrow it!”

summary So far we have used the concept of adverse selection to explain seven of the eight facts about financial structure introduced earlier: The first four facts emphasize the importance of financial intermediaries and the relative unimportance of securities markets with regard to the financing of corporations; the fifth, that financial markets are among the most heavily regulated sectors of the economy; the sixth, that only large, well-established corporations have access to securities markets; and the seventh, that collateral is an important feature of debt contracts. In the next section, we will see that

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the other asymmetric information concept, moral hazard, provides additional reasons for the importance of financial intermediaries and the relative unimportance of securi- ties markets as related to the financing of corporations, the prevalence of government regulation, and the importance of collateral in debt contracts. In addition, the concept of moral hazard can be used to explain our final fact (fact 8): why debt contracts are complicated legal documents that place substantial restrictions on the behavior of the borrower.

hoW morAl hAzArd AFFects the choice BetWeen deBt And equity contrActs

Moral hazard is the asymmetric information problem that occurs after a financial trans- action takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts.

moral hazard in equity contracts: the Principal–Agent Problem Equity contracts, such as common stock, are claims to a share in the profits and assets of a business. Equity contracts are subject to a particular type of moral hazard called the principal–agent problem. When managers own only a small fraction of the firm they work for, the stockholders who own most of the firm’s equity (called the principals) are not the same people as the managers of the firm. Thus the managers are the agents of the owners. This separation of ownership and control involves moral hazard, in that the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do.

To understand the principal–agent problem more fully, suppose that your friend Steve asks you to become a silent partner in his ice-cream store. The store set-up requires an initial investment of $10,000, and Steve has only $1,000. So you purchase an equity stake (stock shares) for $9,000, which entitles you to 90% of the ownership of the firm, while Steve owns only 10%. If Steve works hard to make tasty ice cream, keeps the store clean, smiles at all the customers, and hustles to wait on tables quickly, after all expenses (including Steve’s salary) have been paid, the store will make $50,000 in profits per year, of which Steve will receive 10% ($5,000) and you will receive 90% ($45,000).

But if Steve doesn’t provide quick and friendly service to his customers, uses the $50,000 in income to buy artwork for his office, and even sneaks off to the beach while he should be at the store, the store will not earn any profit. Steve can earn the additional $5,000 (his 10% share of the profits) over his salary only if he works hard and forgoes unproductive investments (such as art for his office). Steve might decide that the extra $5,000 just isn’t enough to make him expend the effort to be a good manager. If Steve feels this way, he does not have enough incentive to be a good manager and will end up with a beautiful office, a good tan, and a store that doesn’t show any profits. Because the store won’t show any profits, Steve’s decision not to act in your interest will cost you $45,000 (your 90% of the profits had he chosen to be a good manager instead).

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The moral hazard arising from the principal–agent problem might be even worse if Steve is not totally honest. Because his ice-cream store is a cash business, Steve has the incentive to pocket $50,000 in cash and tell you that the profits were zero. He now gets a return of $50,000, and you get nothing.

Further proof that the principal–agent problem created by equity contracts can be severe is provided by past scandals involving corporations such as Enron and Tyco International, in which managers were found to have diverted corporate funds for their own personal use. In addition to pursuing personal benefits, managers might also pursue corporate strategies (such as the acquisition of other firms) that enhance their personal power but do not increase the corporation’s profitability.

The principal–agent problem would not arise if the owners of a firm had complete information about what the managers were up to and could prevent wasteful expen- ditures or fraud. The principal–agent problem, which is an example of moral hazard, arises only because a manager, such as Steve, has more information about his activities than the stockholder does—that is, information is asymmetric. The principal–agent problem also would not occur if Steve alone owned the store, and ownership and control were not separate. If this were the case, Steve’s hard work and avoidance of unproductive investments would yield him a profit (and extra income) of $50,000, an amount that would make it worth his while to be a good manager.

Tools to Help Solve the Principal–Agent Problem

Production of Information: Monitoring You have seen that the principal–agent problem arises because managers have more information about their activities and actual profits than stockholders do. One way for stockholders to reduce this moral hazard problem is for them to engage in a particular type of information production: monitor- ing the firm’s activities by auditing the firm frequently and checking on what the man- agement is doing. The problem is that the monitoring process can be expensive in terms of time and money, as reflected in the name economists give it: costly state verification. Costly state verification makes the equity contract less desirable and explains in part why equity is not a more important element in our financial structure.

As with adverse selection, the free-rider problem decreases the amount of private information production that would reduce the moral hazard (principal–agent) problem. In this example, the free-rider problem decreases monitoring. If you know that other stockholders are paying to monitor the activities of the company you hold shares in, you can take a free ride on their activities. Then you can use the money you save by not engaging in monitoring to vacation on a Caribbean island. If you can do this, though, so can other stockholders. Perhaps all the stockholders will go to the islands, and no one will spend any resources on monitoring the firm. The moral hazard problem for shares of common stock will then be severe, making it hard for firms to issue them to raise capital (providing an additional explanation for fact 1).

Government Regulation to Increase Information As with adverse selection, the government has an incentive to try to reduce the moral hazard problem created by asymmetric information, which provides another reason why the financial system is so heavily regulated (fact 5). Governments everywhere have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also pass laws to impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits. However, these measures can be only partly effective. Catching this kind

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of fraud is not easy; fraudulent managers have the incentive to make it very hard for government agencies to find or prove fraud.

Financial intermediation Financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard, and this is another reason why indirect finance is so important (fact 3). One financial intermediary that helps reduce the moral hazard arising from the principal–agent problem is the venture capital firm. Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses. In exchange for supplying the venture capital, the firm receives an equity share in the new business. Because verification of earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist on having several of their own people participate as members of the managing body— the board of directors—of the new business so that they can keep a close watch on the new firm’s activities. When a venture capital firm supplies start-up funds, the equity in the new firm is private—that is, not marketable to anyone except the venture capital firm.3 Thus other investors are unable to take a free ride on the venture capital firm’s verification activities. As a result of this arrangement, the venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incen- tives to reduce the moral hazard problem. Venture capital firms have been important in the development of the high-tech sector in the United States, which has resulted in job creation, economic growth, and increased international competitiveness.

debt contracts Moral hazard arises with an equity contract, which is a claim on profits in all situations, whether the firm is making or losing money. If a contract could be structured so that moral hazard would exist only in certain situations, the need to monitor managers would be reduced, and the contract would be more attractive than the equity contract. The debt contract has exactly these attributes because it is a contractual agree- ment by the borrower to pay the lender fixed dollar amounts at periodic intervals. When a firm has high profits, the lender receives the contractual payments and does not need to know the exact profits of the firm. If the managers are hiding profits or pursuing activities that are personally beneficial but don’t increase the firm’s profitability, the lender doesn’t care, as long as these activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm cannot meet its debt payments, thereby putting itself in a state of default, does the lender need to verify the state of the firm’s profits. Only in this situation do lenders involved in debt contracts need to act more like equity holders; to get their fair share, they now must know how much income the firm has.

The less frequent need to monitor the firm, and thus the lower cost of state verifica- tion, helps explain why debt contracts are used more frequently than equity contracts to raise capital. The concept of moral hazard therefore helps explain fact 1, which states that stocks are not the most important source of financing for businesses.4

3Private equity firms, which also engage in private equity investment, solve the free-rider problem in a way that is similar to the method used by venture capital firms. Venture capital firms invest in new businesses and then, when the new company matures, sell shares to the public. In contrast to venture capital firms, which take new companies public, private equity firms take older, public companies and make them private—that is, they purchase all the publicly-traded shares and retire them. They then exercise control over the company using methods similar to those used by venture capital firms. 4Another factor that encourages the use of debt contracts rather than equity contracts in the United States is our tax code. Debt interest payments are a deductible expense for American firms, whereas dividend payments to equity shareholders are not.

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hoW morAl hAzArd inFluences FinAnciAl structure in deBt mArkets

Even with the advantages just described, debt contracts are still subject to moral hazard. Because a debt contract requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take on invest- ment projects that are riskier than the lenders would like.

For example, suppose you are concerned about the problem of verifying the profits of Steve’s ice-cream store, and so you decide not to become an equity part- ner. Instead, you lend Steve the $9,000 he needs to set up his business, and you and he sign a debt contract that pays you an interest rate of 10%. As far as you are concerned, this is a surefire investment, because the demand for ice cream is strong and steady in your neighborhood. However, once you give Steve the funds, he might use them for purposes other than what he proposed to you. Instead of opening up the ice-cream store, Steve might use your $9,000 loan to invest in chemical research equipment because he thinks he has a 1-in-10 chance of invent- ing a diet ice cream that tastes every bit as good as the premium brands but has no fat or calories.

Obviously, this is a very risky investment, but if Steve is successful, he will become a multimillionaire. He has a strong incentive to undertake the riskier investment with your money because the gains to him would be so large if he succeeded. You would clearly be very unhappy if Steve used your loan for the riskier investment, because if he were unsuccessful, which is highly likely, you would lose most, if not all, of the money you gave him. And if he were successful, you wouldn’t share in his success— you would still get only a 10% return on the loan because the principal and interest payments are fixed. Because of the potential moral hazard (that Steve might use your money to finance a very risky venture), you would probably not make the loan to Steve, even though an ice-cream store in the neighborhood is a good investment that would provide benefits to everyone.

tools to help solve moral hazard in debt contracts

net Worth and collateral When borrowers have more at stake because their net worth (the difference between their assets and their liabilities) is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard—the temptation to act in a manner that lenders find objectionable—is greatly reduced because the bor- rowers themselves have a lot to lose. In other words, if borrowers have more “skin in the game” because they have higher net worth or pledge collateral, they are likely to take less risk at the lender’s expense. Let’s return to Steve and his ice-cream business. Sup- pose that the cost of setting up either the ice-cream store or the research equipment is $100,000 instead of $10,000. Now Steve needs to invest $91,000 (instead of $1,000) of his own money in the business, in addition to the $9,000 supplied by your loan. If Steve is unsuccessful in inventing the no-calorie, nonfat ice cream, he has a lot to lose—the $91,000 of net worth (the $100,000 in assets minus the $9,000 loan from you). He will think twice about undertaking the riskier investment and is more likely to invest in the ice-cream store, which is more of a sure thing. Thus, when Steve has more of his own money (net worth) invested in the business, and hence more skin in the game, you are more likely to make him the loan. Similarly, if you have pledged your house as collateral,

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you are less likely to go to Las Vegas and gamble away your earnings that month, because you might not be able to make your mortgage payments and therefore might lose your house.

One way of describing the solution that high net worth and collateral provide to the moral hazard problem is to say that it makes the debt contract incentive-compatible; that is, it aligns the incentives of the borrower with those of the lender. The greater the borrower’s net worth and collateral pledged, then the greater the borrower’s incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is for the firm or household to borrow. Conversely, when the borrower’s net worth and collateral are lower, the moral hazard problem is greater, making it harder to borrow.

monitoring and enforcement of restrictive covenants As the example of Steve and his ice-cream store shows, if you could make sure that Steve doesn’t invest in anything riskier than the ice-cream store, it would be worth your while to make him the loan. You can ensure that Steve uses your money for the purpose you expect by writing provisions (restrictive covenants) into the debt contract that restrict his firm’s activities. By monitoring Steve’s activities to check whether he is complying with the restrictive covenants and by enforcing the covenants if he is not, you can make sure that he will not take on risks at your expense. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. There are four types of restrictive covenants that achieve this objective:

1. Covenants to discourage undesirable behavior. Covenants can be designed to lower moral hazard by keeping the borrower from engaging in the undesirable behav- ior of undertaking risky investment projects. Some covenants mandate that a loan be used only to finance specific activities, such as the purchase of particular equipment or inventories. Others restrict the borrowing firm from engaging in certain risky business activities, such as purchasing other businesses.

2. Covenants to encourage desirable behavior. Restrictive covenants can encour- age the borrower to engage in desirable activities that make it more likely that the loan will be paid off. One such restrictive covenant requires the breadwinner in a household to carry life insurance that will pay off the mortgage upon that person’s death. For businesses, restrictive covenants of this type focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive covenants typically specify that the borrowing firm must maintain minimum holdings of certain assets relative to the firm’s size.

3. Covenants to keep collateral valuable. Because collateral is an important pro- tection for the lender, restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the bor- rower. This is the type of covenant ordinary people encounter most often. Automobile loan contracts, for example, require the car owner to maintain a minimum amount of collision and theft insurance and prevent the sale of the car unless the loan is paid off. Similarly, the recipient of a home mortgage must have adequate insurance on the home and must pay off the mortgage when the property is sold.

4. Covenants to provide information. Restrictive covenants also require a borrow- ing firm to provide information about its activities periodically, in the form of quarterly

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accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. This type of covenant may also stipulate that the lender has the right to audit and inspect the firm’s books at any time.

We now see why debt contracts are often complicated legal documents with numer- ous restrictions on the borrower’s behavior (fact 8): Debt contracts require complicated restrictive covenants to lower moral hazard.

Financial intermediation Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it completely. It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find loopholes in restrictive covenants that make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A restrictive covenant is meaningless if the borrower can violate it knowing that the lender won’t check up or is unwilling to pay for legal recourse. Because moni- toring and enforcement of restrictive covenants are costly, the free-rider problem arises in the debt securities (bond) market just as it does in the stock market. If you know that other bondholders are monitoring and enforcing the restrictive covenants, you can free-ride on their monitoring and enforcement. But other bondholders can do the same thing, so the likely outcome is that not enough resources will be devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues to be a severe problem for marketable debt.

As we have seen before, financial intermediaries—particularly banks—can avoid the free-rider problem by primarily making private loans. Private loans are not traded, so no one else can free-ride on the intermediary’s monitoring and enforcement of the restrictive covenants. The intermediary making private loans thus receives the full benefits of monitoring and enforcement, and will work to shrink the moral hazard problem inherent in debt contracts. The concept of moral hazard has provided us with additional reasons why financial intermediaries play a more important role in chan- neling funds from savers to borrowers than marketable securities do, as described in facts 3 and 4.

summary Asymmetric information in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of those markets. Tools to help solve these problems involve the private production and sale of information, government regulation to increase information in financial markets, the importance of collateral and net worth to debt contracts, and the use of monitoring and restric- tive covenants. Our analysis suggests that the existence of the free-rider problem for traded securities such as stocks and bonds indicates that financial intermediaries— particularly banks—should play a greater role than securities markets in financing the activities of businesses. Economic analysis of the consequences of adverse selec- tion and moral hazard has helped explain the basic features of our financial system, including the eight facts about our financial structure outlined at the beginning of this chapter.

As a study aid, Table 1 summarizes the asymmetric information problems and tools that help solve them. In addition, it notes how these tools and asymmetric information problems explain the eight facts of financial structure described at the beginning of the chapter.

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a P P lI c at I o n Financial Development and Economic Growth Recent research has found that an important reason why many developing countries and ex-communist countries like Russia (which are referred to as transition countries) experience very low rates of economic growth is that their financial systems are underdeveloped (a situation referred to as financial repression).5 The economic analy- sis of financial structure helps explain how an underdeveloped financial system leads to a low state of economic development and economic growth.

The financial systems of developing and transition countries face several difficulties that keep them from operating efficiently. As we have seen, two important tools used

Asymmetric information Problems and tools to solve them

Asymmetric Information Problem

Tools to Solve It

Explains Fact Number

Adverse selection Private production and sale of information 1, 2

  Government regulation to increase information 5

  Financial intermediation 3, 4, 6

  Collateral and net worth 7

Moral hazard in equity contracts Production of information: monitoring 1

(principal–agent problem) Government regulation to increase information 5

  Financial intermediation 3

  Debt contracts 1

Moral hazard in debt contracts Collateral and net worth 6, 7

  Monitoring and enforcement of restrictive covenants 8

  Financial intermediation 3, 4

Note: List of facts: 1. Stocks are not the most important source of external financing. 2. Marketable securities are not the primary source of financing. 3. Indirect finance is more important than direct finance. 4. Banks are the most important source of external funds. 5. The financial system is heavily regulated. 6. Only large, well-established firms have access to securities markets. 7. Collateral is prevalent in debt contracts. 8. Debt contracts have numerous restrictive covenants.

Summary table 1

5See World Bank, Finance for Growth: Policy Choices in a Volatile World (World Bank and Oxford University Press, 2001), and Frederic S. Mishkin, The Next Great Globalization: How Disadvantaged Nations Can Harness Their Finan- cial Systems to Get Rich (Princeton University Press, 2006) for a survey of the literature linking economic growth with financial development and a list of additional references.

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to help solve adverse selection and moral hazard problems in credit markets are col- lateral and restrictive covenants. In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, and the absence of corruption) functions poorly, making it hard for these two tools to function effectively.

As discussed in the FYI box, “The Tyranny of Collateral,” the weak systems of property rights common in developing and transition countries impede the use of col- lateral, making adverse selection problems worse because the lender will need even more information about the quality of the borrower in order to screen out a good loan from a bad one. As a result, it is harder for lenders to channel funds to the borrowers with the most productive investment opportunities, ultimately leading to less produc- tive investment and hence a slower-growing economy.

FYI The Tyranny of Collateral

To use property, such as land or capital, as collateral, a person must legally own it. Unfortunately, as Her- nando De Soto documents in his book The Mystery of Capital, it is extremely expensive and time-consuming for the poor in developing countries to make their ownership of property legal. Obtaining legal title to a dwelling on urban land in the Philippines, for exam- ple, involved 168 bureaucratic steps and 53 public and private agencies, and the process took anywhere from thirteen to twenty-five years. Obtaining legal title to desert land in Egypt took 77 steps, 31 public and private agencies, and anywhere from five to fourteen years. To legally buy government land in Haiti, an ordinary citizen had to go through 176 steps over nineteen years. These legal barriers do not mean that the poor do not invest: they still build houses and buy equipment, even if they don’t have legal title to these assets. By De Soto’s calculations, the “total value of the real estate held but not legally owned by the poor of the Third World and former communist nations is at least $9.3 trillion.”*

Without legal title, however, none of this property can be used as collateral to borrow funds, a requirement for most lenders. Even when people have legal title to their property, the legal system in most developing countries is so inefficient that collateral does not mean much. Typically, creditors must first sue the defaulting debtor for payment, which takes several years, and then, upon obtaining a favorable judgment, the creditor has to sue again to obtain title to the collateral. This process

often takes in excess of five years. By the time the lender acquires the collateral, it is likely to have been neglected or stolen and thus has little value. In addition, govern- ments often block lenders from foreclosing on borrow- ers in politically powerful sectors of a society, such as agriculture.

When the financial system is unable to use col- lateral effectively, the adverse selection problem worsens because the lender needs even more infor- mation about the quality of the borrower in order to distinguish a good loan from a bad one. Little lending will take place, especially in transactions that involve collateral, such as mortgages. In Peru, for example, the value of mortgage loans relative to the size of the economy is less than 1/20 that in the United States.

The poor in developing countries have an even harder time obtaining loans because it is too costly for them to get title to their property, and therefore they have no collateral to offer, resulting in what Raghuram Rajan, the governor of India’s central bank, and Luigi Zingales of the University of Chicago refer to as the “tyranny of collateral.”** Even when poor people have a good idea for a business and are willing to work hard, they cannot get the funds to finance the busi- ness, making it difficult for them to escape poverty.

*Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000), 35. **Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportu- nity (New York: Crown Business, 2003).

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Similarly, a poorly developed or corrupt legal system makes it extremely difficult for lenders to enforce restrictive covenants. Thus their ability to reduce moral hazard on the part of borrowers is severely limited, and so they are less willing to lend. Again, the outcome is less productive investment and a lower growth rate for the economy. The importance of an effective legal system in promoting economic growth suggests that lawyers play a more positive role in the economy than we give them credit for.

Governments in developing and transition countries often use their financial systems to direct credit to themselves or to favored sectors of the economy by setting interest rates at artificially low levels for certain types of loans, by creating development finance institutions to make specific types of loans, or by directing existing institutions to lend to certain entities. As we have seen, private institutions have an incentive to solve adverse selection and moral hazard problems and to lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so because they are not driven by the profit motive and thus their directed credit programs may not channel funds to sectors that will produce high growth for the economy. The likely outcome is, again, less efficient investment and slower economic growth.

In addition, banks in many developing and transition countries are owned by their governments. Again, because of the absence of the profit motive, these state-owned banks have little incentive to allocate their capital to the most productive uses. Not surprisingly, the primary loan customer of these state-owned banks is often the govern- ment itself, which does not always use the funds wisely.

We have seen that government regulation can increase the amount of information available in financial markets and thus help them work more efficiently. Many develop- ing and transition countries have an underdeveloped regulatory apparatus that retards the provision of adequate information to the marketplace. For example, these countries often have weak accounting standards, making it very hard to ascertain the quality of a borrow- er’s balance sheet. As a result, asymmetric information problems are more severe, and the financial system is severely hampered in channeling funds to the most productive uses.

The institutional environment of a poor legal system, weak accounting standards, inadequate government regulation, and government intervention through directed credit programs and state ownership of banks all help explain why many countries stay poor while others grow rich.

a P P lI c at I o n Is China a Counterexample to the Importance of Financial Development? Although China appears to be on its way to becoming an economic powerhouse, its financial development remains in the early stages. The country’s legal system is weak, so that financial contracts are difficult to enforce, and accounting standards are lax, making high-quality information about creditors hard to obtain. Regulation of the banking system is still in its formative stages, and the banking sector is dominated by large, state-owned banks. Yet the Chinese economy has enjoyed one of the highest growth rates in the world over the past twenty years. How has China been able to grow so rapidly, given its low level of financial development?

As noted above, China is in an early state of financial development, with a per capita income that is still less than $10,000, one-fifth the per capita income in the United States. With an extremely high savings rate, averaging around 40% over the

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past two decades, the country has been able to rapidly build up its capital stock and shift a massive pool of underutilized labor from the subsistence-agriculture sector into higher-productivity activities that use capital. Even though available savings have not always been allocated to their most productive uses, the huge increase in capital, com- bined with the gains in productivity achieved by moving labor out of low-productivity, subsistence agriculture, have been enough to produce high growth.

As China gets richer, however, this strategy is unlikely to continue to work. The Soviet Union provides a graphic example. In the 1950s and 1960s, the Soviet Union shared many characteristics with modern-day China: high growth fueled by a high sav- ings rate, a massive buildup of capital, and shifts of a large pool of underutilized labor from subsistence agriculture to manufacturing. During this high-growth phase, how- ever, the Soviet Union was unable to develop the institutions needed to allocate capital efficiently. As a result, once the pool of subsistence laborers was used up, the Soviet Union’s growth slowed dramatically and it was unable to keep up with the Western economies. Today, no one considers the Soviet Union an economic success story, and its inability to develop the institutions necessary to sustain financial development and growth is an important reason for the demise of this superpower.

To move into the next stage of development, China will need to allocate its capital more efficiently, which requires that it improve its financial system. The Chinese lead- ership is well aware of this challenge; the government has announced that state-owned banks are being put on the path to privatization. In addition, the government is engaged in legal reform aimed at making financial contracts more enforceable. New bankruptcy law is being developed so that lenders will have the ability to take over the assets of firms that default on their loan contracts. Whether the Chinese government will suc- ceed in developing a first-rate financial system, thereby enabling China to join the ranks of developed countries, is a big question mark. ◆

summAry

1. There are eight basic facts that summarize the U.S. financial structure. The first four emphasize the importance of financial intermediaries and the rela- tive unimportance of securities markets with regard to the financing of corporations; the fifth recognizes that financial markets are among the most heavily regulated sectors of the economy; the sixth states that only large, well-established corporations have access to securi- ties markets; the seventh indicates that collateral is an important feature of debt contracts; and the eighth presents debt contracts as complicated legal documents that place substantial restrictions on the behavior of the borrower.

2. Transaction costs freeze many small savers and borrow- ers out of direct involvement with financial markets. Financial intermediaries can take advantage of econo- mies of scale and are better able to develop expertise, leading to lower transaction costs and thus enabling

their savers and borrowers to benefit from the existence of financial markets.

3. Asymmetric information results in two problems: adverse selection, which occurs before the transaction takes place, and moral hazard, which occurs after the transaction has taken place. Adverse selection refers to the fact that bad credit risks are the ones most likely to seek loans, and moral hazard refers to the risk of the borrower engaging in activities that are undesirable from the lender’s point of view.

4. Adverse selection interferes with the efficient functioning of financial markets. Tools that help reduce the adverse selection problem include private production and sale of information, government regulation to increase infor- mation, financial intermediation, and collateral and net worth. The free-rider problem occurs when people who do not pay for information take advantage of informa- tion that other people have paid for. This problem

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C h a p t e r 8 An Economic Analysis of Financial Structure 183

prevalent in financial markets than equity contracts. Tools that help reduce the principal–agent problem include monitoring, government regulation to increase information, and financial intermediation.

6. Tools that are used to reduce the moral hazard prob- lem in debt contracts include net worth, monitoring and enforcement of restrictive covenants, and financial intermediaries.

explains why financial intermediaries, particularly banks, play a more important role in financing the activities of businesses than do securities markets.

5. Moral hazard in equity contracts, known as the prin- cipal–agent problem, occurs because managers (the agents) have less incentive to maximize profits than stockholders (the principals). The principal–agent problem explains why debt contracts are so much more

key terms

agency theory, p. 167 collateral, p. 165 costly state verification, p. 174 free-rider problem, p. 169

incentive-compatible, p. 177 net worth (equity capital), p. 172 principal–agent problem, p. 173 restrictive covenants, p. 165

secured debt, p. 165 state-owned banks, p. 181 unsecured debt, p. 165 venture capital firm, p. 175

questions

All questions are available in MyEconLab at http://www.myeconlab.com.

1. For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding: United States; Germany; Japan; Canada. Comment on the similarities and differ- ences among the countries’ funding sources.

2. How can economies of scale help explain the existence of financial intermediaries?

3. Describe two ways in which financial intermediaries help lower transaction costs in an economy.

4. Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

5. Suppose you go to your local bank, intending to buy a certificate of deposit with your savings. Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next individual who enters the bank and applies for a car loan.

6. Wealthy people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection?

7. Do you think the lemons problem would be more severe for stocks traded on the New York Stock Exchange or for those traded over-the-counter? Explain.

8. Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why?

9. What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?

10. What steps can the government take to reduce asym- metric information problems and help the financial system function more smoothly and efficiently?

11. How can asymmetric information problems lead to a bank panic?

12. In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous value. A few years later, Argentina announced it would pay back 25% of the face value of its debt. Comment on the effects of infor- mation asymmetries on government bond markets. Do you think investors are currently willing to buy bonds issued by the government of Argentina?

13. How does the free-rider problem aggravate adverse selec- tion and moral hazard problems in financial markets?

14. Would moral hazard and adverse selection still arise in financial markets if information were not asymmetric? Explain.

15. How do standardized accounting principles help finan- cial markets work more efficiently?

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184 P a r t 3 Financial Institutions

20. Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in the United States. Explain why this might create more problems than solutions in the financial system of a developing country.

21. Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Explain why banks might require that much collateral in such a financial system. Com- ment on the consequences of such a system for eco- nomic growth.

16. Which firms are most likely to use bank financing rather than issue bonds or stocks to finance their activities? Why?

17. How can the existence of asymmetric information pro- vide a rationale for government regulation of financial markets?

18. “The more collateral there is backing a loan, the less the lender has to worry about adverse selection.” Is this statement true, false, or uncertain? Explain your answer.

19. Explain how the separation of ownership and control in American corporations might lead to poor management.

All applied problems are available in MyEconLab at http://www.myeconlab.com.

For Problems 22–25, use the fact that the expected value of an event is a probability weighted average, the sum of each possible outcome multiplied by the probability of the event occurring.

22. You are in the market for a used car and decide to visit a used car dealership. You know that the Blue Book value of the car you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you do, how much are you willing to pay? Why? Assume that you care only about the expected value of the car you will buy and that the car values are symmetrically distributed.

23. Refer to Problem 22. Now you believe the dealer knows more about the car than you do. How much are you will- ing to pay? Why? How can this asymmetric information problem be resolved in a competitive market?

24. You wish to hire Ron to manage your Dallas opera- tions. The profits from the operations depend partially on how hard Ron works, as follows.

If Ron is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity. However, Ron views working hard as a “personal cost” valued at $1,000. What fixed percentage of the profits should you offer Ron? Assume Ron cares only about his expected payment less any “personal cost.”

25. You own a house worth $400,000 that is located on a river. If the river floods moderately, the house will be completely destroyed. Moderate flooding happens about once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, and such heavy flooding happens only about once every 200 years. What would be the annual pre- mium for a flood insurance policy that offers full insur- ance? For a policy that pays only 75% of the home value, what are your expected costs with and without a seawall? Do the different policies provide an incentive to be safer (i.e., to build the seawall)?

Applied problems

Profit Probabilities

  Profit = $10,000

Profit = $50,000

Lazy 60% 40%

Hard worker 20% 80%

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C h a p t e r 8 An Economic Analysis of Financial Structure 185

Data analysis Problems

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the percent of value of loans secured

by collateral for all commercial and industrial loans (ESANQ) and the net percentage of domestic banks tightening standards for commercial and industrial loans to large and middle-market firms (DRTSCILM). Download the data into a spreadsheet.

a. Calculate the average, over the most recent four quarters and the four quarters prior to that, for the bank standards indicator and the “percent of loans secured by collateral” indicator. Do these averages behave as you would expect?

b. Use the Data Analysis tool in Excel to calculate the correlation coefficient for the two data series from 1997:Q3 to the most recent quarter of data available. What can you conclude about the relationship between collateral and bank C&I lending standards? Is this result consistent with efforts to reduce asymmetric information?

2. Go to the St. Louis Federal Reserve FRED database, and find data on net worth of households (TNWBSHNO) and the net percentage of domestic banks tightening standards for prime mortgage loans (DRTSPM). Adjust the units setting for the net worth indicator to “Percent Change from Year Ago,” and download the data into a spreadsheet.

a. Calculate the average, over the most recent four quarters and the four quarters prior to that, for the bank standards indicator and the “percent change in net worth” indicator. Do these averages behave as you would expect?

b. Use the Data Analysis tool in Excel to calculate the correlation coefficient for the two data series from 2007:Q3 to the most recent quarter of data available. What can you conclude about the relationship between the net worth of households and bank mortgage lending standards? Is this result consistent with efforts to reduce asymmetric information?

Web exercises

1. In this chapter, we discuss the lemons problem and its effect on the efficient functioning of a market. This theory was initially developed by George Akerlof. Go to http://www.nobel.se/economics/laureates/2001/public .html. This site reports that Akerlof, Spence, and

Stiglitz were awarded the Nobel Prize in economics in 2001 for their work. Read this report down through the section on George Akerlof. Summarize his research ideas in one page.

Web references

http://nobelprize.org/nobel_prize/economics/laureates/2001/ public.html

A complete discussion of the lemons problem on a site dedicated to Nobel Prize winners.

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Preview

Because banking plays such a major role in channeling funds to borrowers with productive investment opportunities, this financial activity is important in ensur-ing that the financial system and the economy run smoothly and efficiently. In the United States, banks (depository institutions) supply on the order of $10 trillion in credit annually. They provide loans to businesses, help us finance our college educa- tions and our purchases of new cars and homes, and provide us with services such as checking and savings accounts, debit cards, and ATMs.

In this chapter, we examine how banking is conducted to earn the highest profits possible: how and why banks make loans, how they acquire funds and manage their assets and liabilities (debts), and how they earn income. Although we focus on commer- cial banks, because commercial banks are the most important financial intermediary, many of the same principles are applicable to other types of financial intermediaries.

The Bank Balance SheeT To understand how banking works, we start by looking at the bank balance sheet, a list of the bank’s assets and liabilities. As the name implies, this list balances; that is, it has the characteristic that

total assets = total liabilities + capital

A bank’s balance sheet is also a list of its sources of bank funds (liabilities and capital) and uses to which the funds are put (assets). Banks obtain funds by borrowing and by issuing other liabilities, such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by earning interest on their asset hold- ings of securities and loans that is higher than the interest and other expenses on their liabilities. The balance sheet used by all commercial banks as of June 2014 is shown in Table 1.

liabilities A bank acquires funds by issuing (selling) liabilities, which are the sources of funds the bank uses. The funds obtained from issuing liabilities are used to purchase income- earning assets.

learning Objectives • Summarize the features of a bank balance sheet.

• Apply changes to a bank’s assets and liabili- ties on a T-account.

• Identify the ways in which banks can manage their assets and liabilities to maximize profit.

• List the ways in which banks deal with credit risk.

• Apply gap analysis and duration analysis, and identify interest-rate risk.

• Summarize the types of off-balance-sheet activities.

9 Banking and the Management of Financial Institutions

186

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C h a p t e r 9 Banking and the Management of Financial Institutions 187

Checkable Deposits Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties. Checkable deposits include all accounts on which checks can be drawn. Table 1 shows that the category of checkable deposits accounts for 11% of bank liabilities. Checkable deposits were once the most important source of bank funds (more than 60% of bank liabilities in 1960), but with the advent of new, more attractive financial instruments, such as money market deposit accounts, the share of checkable deposits in total bank liabilities has shrunk over time.

Checkable deposits are payable on demand; that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately. Similarly, if a person who receives a check written on an account from a bank presents that check at the bank, the bank must pay the funds out immediately (or credit them to that person’s account).

A checkable deposit is an asset for the depositor because it is part of his or her wealth. Because the depositor can withdraw funds and the bank is obligated to pay, checkable deposits are a liability for the bank. They are usually the lowest-cost source of bank funds, because depositors are willing to forgo some interest in exchange for access to a liquid asset that they can use to make purchases immediately. The bank’s costs of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts—processing, preparing, and sending out monthly statements; providing efficient tellers (human or otherwise); maintaining an impressive building and conveniently located branches; and advertising and marketing aimed at enticing customers to deposit their funds in the bank. In recent

*In order of decreasing liquidity.

Source: http://www.federalreserve.gov/releases/h8/current/.

Assets (Uses of Funds)* Liabilities (Sources of Funds)

Reserves and cash items 19% Checkable deposits 11%

Securities   Nontransaction deposits  

U.S. government and agency 13 Small-denomination time deposits (6$100,000) + savings deposits

47

table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014)

State and local government and other securities

6   Large-denomination time deposits 11

Loans Borrowings 20

Commercial and industrial 12 Bank capital 11

Real estate 25    

Consumer 8    

Interbank 1    

Other 7    

Other assets (for example, physical capital)

9

Total 100 Total 100

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188 P a r t 3 Financial Institutions

years, interest paid on deposits (checkable and nontransaction) has accounted for around 10% of total bank operating expenses, whereas the costs involved in servicing accounts (employee salaries, building rent, and so on) have been approximately 85% of operating expenses.

Nontransaction Deposits Nontransaction deposits are the primary source of bank funds (58% of bank liabilities in Table 1). Owners cannot write checks on nontransac- tion deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits. There are two basic types of nontransaction deposits: savings accounts and time deposits (also called certificates of deposit, or CDs).

Savings accounts were once the most common type of nontransaction deposit. Funds can be added to or withdrawn from savings accounts at any time. For these accounts, transactions and interest payments are recorded in a monthly statement or in a passbook held by the owner of the account.

Time deposits have a fixed maturity length, ranging from several months to over five years, and assess substantial penalties (the forfeiture of several months’ interest) for early withdrawal of funds. Small-denomination time deposits (deposits of less than $100,000) are less liquid for the depositor than passbook savings, earn higher interest rates, and are a more costly source of funds for the banks.

Large-denomination time deposits (CDs) are available in denominations of $100,000 or more and are typically bought by corporations or other banks. Large- denomination CDs are negotiable; like bonds, they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds, and other financial institutions as alternative assets to Treasury bills and other short-term bonds. Since 1961, when they first appeared, negotiable CDs have become an important source of bank funds (11% in Table 1).

Borrowings Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are called discount loans (also known as advances). Banks also borrow reserves overnight in the federal (fed) funds market from other U.S. banks and financial institu- tions. Banks borrow funds overnight in order to have enough deposits at the Federal Reserve to meet the amount required by the Fed. (The federal funds designation is some- what confusing, because these loans are not made by the federal government or by the Federal Reserve, but rather by banks to other banks.) Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks). Borrowings have become a more important source of bank funds over time: In 1960, they made up only 2% of bank liabilities; currently, they ac- count for 20% of bank liabilities.

Bank Capital The final category on the right-hand side of the balance sheet is bank capital, or the bank’s net worth, which equals the difference between total assets and liabilities (11% of total bank assets in Table 1). Bank capital is raised by selling new equity (stock) or from retained earnings. A bank’s capital is its cushion against a drop in the value of its assets, which could force the bank into insolvency, which occurs when a bank has liabilities in excess of assets, meaning that the bank can be forced into liquidation.

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C h a p t e r 9 Banking and the Management of Financial Institutions 189

Assets A bank uses the funds that it has acquired by issuing liabilities to purchase income- earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits.

Reserves All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves consist of these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults overnight). Although reserves earn a low interest rate, banks hold them for two reasons. First, some reserves, called required reserves, are held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction (10 cents, for example) must be kept as reserves. This fraction (10% in our example) is called the required reserve ratio. Banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account.

Cash Items in Process of Collection Suppose that a check written on an account at another bank is deposited in your bank, and the funds for this check have not yet been received (collected) from the other bank. The check is classified as a “cash item in process of collection,” and it is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days.

Deposits at Other Banks Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is one aspect of a system called correspondent banking.

Collectively, cash items in process of collection and deposits at other banks are referred to as cash items. As can be seen in Table 1, in June 2014, reserves and cash items made up 19% of total assets.

Securities A bank’s holdings of securities are an important income-earning asset: Securities (made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock) account for 19% of bank assets in Table 1, and they provide commercial banks with about 10% of their revenue. These securities can be classified into three categories: U.S. government and agency securities, state and local government securities, and other securities. The U.S. government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Because of their high liquidity, short-term U.S. government securities are called secondary reserves.

Banks hold state and local government securities because state and local govern- ments are more likely to do business with banks that hold their securities. State and local government and other securities are both less marketable (less liquid) and riskier than U.S. government securities, primarily because of default risk: Some possibility exists that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature.

Loans Banks make their profits primarily by issuing loans. In Table 1, some 53% of bank assets are in the form of loans, and in recent years loans have generally produced more than half of bank revenues. A loan is a liability for the individual or corporation

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190 p a r t 3 Financial Institutions

receiving it, but an asset for a bank, because it provides income to the bank. Loans are typically less liquid than other assets because they cannot be turned into cash until the loan matures. If a bank makes a one-year loan, for example, it cannot get its funds back until the loan comes due in one year. Loans also have a higher probability of default than other assets. Because of their lack of liquidity and their higher default risk, the bank earns its highest return on loans.

As indicated in Table 1, the largest categories of loans for commercial banks are com- mercial and industrial loans made to businesses and real estate loans. Commercial banks also make consumer loans and lend to each other. The bulk of these interbank loans are overnight loans lent in the federal funds market. The major difference in the balance sheets of the various categories of depository institutions is primarily in the type of loan in which they specialize. Savings and loans and mutual savings banks, for example, special- ize in residential mortgages, while credit unions tend to make consumer loans.

Other assets The physical capital (bank buildings, computers, and other equipment) owned by banks is included in the other assets category.

BaSIc BankIng Before proceeding to a more detailed study of how a bank manages its assets and liabili- ties to make the highest profit, you should understand the basic operation of a bank.

In general terms, banks make profits by selling liabilities with one set of characteris- tics (a particular combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a different set of characteristics. This process is often referred to as asset transformation. For example, a savings deposit held by one person can provide the funds that enable the bank to make a mortgage loan to another person. The bank has, in effect, transformed the savings deposit (an asset held by the depositor) into a mortgage loan (an asset held by the bank). Another way of describing this process of asset transformation is to say that the bank “borrows short and lends long” because it makes long-term loans and funds them by issuing short-term deposits.

The process of transforming assets and providing a set of services (check clearing, record keeping, credit analysis, and so forth) is like any other production process in a firm. If the bank produces desirable services at low cost and earns substantial income on its assets, it earns profits; if not, the bank suffers losses.

To make our analysis of the operation of a bank more concrete, we use a tool called a T-account. A T-account is a simplified balance sheet, with lines in the form of a T, that lists only the changes that occur in balance sheet items starting from some initial balance sheet position. Let’s say that Jane Brown has heard that the First National Bank provides excellent service, so she opens a checking account with a $100 bill. She now has a $100 checkable deposit at the bank, which shows up as a $100 liability on the bank’s balance sheet. The bank now puts her $100 bill into its vault so that the bank’s assets rise by the $100 increase in vault cash. The T-account for the bank looks like this:

First National Bank

Assets Liabilities

Vault cash +$100 Checkable deposits +$100

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C h a p t e r 9 Banking and the Management of Financial Institutions 191

Because vault cash is also part of the bank’s reserves, we can rewrite the T-account as follows:

Note that Jane Brown’s opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits.

If Jane had opened her account with a $100 check written on an account at another bank, say, the Second National Bank, we would get the same result. The initial effect on the T-account of the First National Bank would be as follows:

The process initiated by Jane Brown can be summarized as follows: When a check written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount. Therefore, when a bank receives additional deposits, it gains an equal amount of reserves; when it loses depos- its, it loses an equal amount of reserves.

Now that you understand how banks gain and lose reserves, we can examine how a bank rearranges its balance sheet to make a profit when it experiences a change in its

Checkable deposits increase by $100 as before, but now the First National Bank is owed $100 by the Second National Bank. This asset for the First National Bank is entered in the T-account as $100 of cash items in process of collection because the First National Bank will now try to collect the funds that it is owed. It could go directly to the Second National Bank and ask for payment of the funds, but if the two banks are in separate states, that would be a time-consuming and costly process. Instead, the First National Bank deposits the check in its account at the Fed, and the Fed collects the funds from the Second National Bank. The net result is that the Fed transfers $100 of reserves from the Second National Bank to the First National Bank, and the final balance sheet positions of the two banks are as follows:

Assets Liabilities

Reserves +$100 Checkable deposits +$100

Assets Liabilities

Cash items in process of collection

+$100 Checkable deposits +$100

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable deposits

+$100 Reserves -$100 Checkable deposits

-$100

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192 p a r t 3 Financial Institutions

deposits. Let’s return to the situation in which the First National Bank has just received the extra $100 of checkable deposits. As you know, the bank is obliged to keep a cer- tain fraction of its checkable deposits as required reserves. If the fraction (the required reserve ratio) is 10%, the First National Bank’s required reserves have increased by $10, and we can rewrite its T-account as follows:

The bank is now making a profit because it holds short-term liabilities, such as check- able deposits, and uses the proceeds to fund longer-term assets, such as loans with higher interest rates. As mentioned earlier, this process of asset transformation is frequently described by saying that banks are in the business of “borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a 5% interest rate and it costs another $3 per year to service the account, the cost per year of these deposits is $8. The bank’s profit on the new deposits is then $1 per year, plus any interest that it earns on required reserves.

Let’s see how well the bank is doing as a result of the additional checkable deposits. Servicing the extra $100 of checkable deposits is costly, because the bank must keep records, pay tellers, pay for check clearing, and so forth. Because reserves earn little interest, the bank is taking a loss! The situation is even worse if the bank makes inter- est payments on the deposits, as with NOW accounts. To make a profit, the bank must put to productive use all or part of the $90 of excess reserves it has available. One way to do this is to invest in securities. The other is to make loans; as we have seen, loans account for approximately 50% of the total value of bank assets (uses of funds). Because lenders are subject to the asymmetric information problems of adverse selection and moral hazard (discussed in Chapter 8), banks take steps to reduce the incidence and severity of these problems. Bank loan officers evaluate potential borrowers using what are called the “five C’s”—character, capacity (ability to repay), collateral, conditions (in the local and national economies), and capital (net worth)—before they agree to lend. (A more detailed discussion of the methods banks use to reduce the risk involved in lending is given later in this chapter.)

Let’s assume that the First National Bank chooses not to hold any excess reserves but to make loans instead. The T-account then looks like this:

First National Bank

Assets Liabilities

Required reserves +$10 Checkable deposits +$100 Excess reserves +$90    

Assets Liabilities

Required reserves +$10 Checkable deposits +$100 Loans +$90    

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C h a p t e r 9 Banking and the Management of Financial Institutions 193

geneRal PRIncIPleS Of Bank ManageMenT Now that you have some idea of how a bank operates, let’s look at how a bank man- ages its assets and liabilities to earn the highest possible profit. The bank manager has four primary concerns. The first is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows—that is, when deposits are lost because depositors make withdrawals and demand payment. To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of assets that are liquid enough to meet the bank’s obligations to depositors. Second, the bank man- ager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). The manager’s third concern is acquiring funds at low cost (liability management). Finally, the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management).

To understand bank (and other financial institution) management fully, we must go beyond the general principles of bank asset and liability management described next and look in more detail at how a financial institution manages its assets. The two sections follow- ing this one provide an in-depth discussion of how a financial institution manages credit risk, the risk arising because borrowers may default, and how it manages interest-rate risk, the riskiness of earnings and returns on bank assets caused by interest-rate changes.

liquidity Management and the Role of Reserves Let’s see how a typical bank, the First National Bank, can deal with deposit outflows that occur when its depositors withdraw cash from checking or savings accounts or write checks that are deposited in other banks. In the example that follows, we assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% (the bank is required to keep 10% of deposits as reserves). Suppose that the First National Bank’s initial balance sheet is as follows:

The bank’s required reserves are 10% of $100 million, or $10 million. Given that it holds $20 million of reserves, the First National Bank has excess reserves of $10 million.

If a deposit outflow of $10 million occurs, the bank’s balance sheet becomes

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank capital $ 10 million

Securities $10 million    

Assets Liabilities

Reserves $10 million Deposits $90 million

Loans $80 million Bank capital $10 million

Securities $10 million    

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The bank loses $10 million of deposits and $10 million of reserves, but because its required reserves are now 10% of only $90 million (that is, $9 million), its reserves still exceed this amount by $1 million. In short, if a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.

The situation is quite different when a bank holds insufficient excess reserves. Let’s assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $10 million, so that it holds no excess reserves. Its ini- tial balance sheet would then be

After $10 million has been withdrawn from deposits and hence reserves, the bank has a problem: It has a reserve requirement of 10% of $90 million, or $9 million, but it has no reserves! To eliminate this shortfall, the bank has four basic options. One option is to acquire the reserves needed to meet a deposit outflow by borrowing them from other banks in the federal funds market, or by borrowing from corporations.1 If the First National Bank acquires the $9 million shortfall in reserves by borrowing it from other banks or corporations, its balance sheet becomes

When it suffers the $10 million deposit outflow, its balance sheet becomes

Assets Liabilities

Reserves $10 million Deposits $100 million

Loans $90 million Bank capital $ 10 million

Securities $10 million    

Assets Liabilities

Reserves $ 0 Deposits $90 million

Loans $90 million Bank capital $10 million

Securities $10 million    

1One way in which the First National Bank can borrow from other banks and corporations is by selling negotiable certificates of deposit. This method for obtaining funds is discussed in the section on liability management.

Assets Liabilities

Reserves $ 9 million Deposits $90 million

Loans Securities

$90 million $10 million

Borrowings from other banks or corporations

$ 9 million

Bank capital $10 million

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The cost of this activity is the interest rate on these borrowings, such as the federal funds rate.

A second alternative is for the bank to sell some of its securities to help cover the deposit outflow. For example, it might sell $9 million of its securities and deposit the proceeds with the Fed, resulting in the following balance sheet:

The cost associated with discount loans is the interest rate that must be paid to the Fed (called the discount rate).

As a last option, a bank can acquire the $9 million of reserves to meet the deposit outflow by reducing its loans by this amount and depositing the $9 million it then receives with the Fed, thereby increasing its reserves by $9 million. This transaction changes the balance sheet as follows:

The bank incurs some brokerage and other transaction costs when it sells these securi- ties. The U.S. government securities that are classified as secondary reserves are very liquid, so the transaction costs of selling them are quite modest. However, the other securities the bank holds are less liquid, and the transaction costs can be appreciably higher.

The bank has a third option for meeting a deposit outflow: It can acquire reserves by borrowing from the Fed. In our example, the First National Bank could leave its security and loan holdings the same, and borrow $9 million in discount loans from the Fed. Its balance sheet would then be

Assets Liabilities

Reserves $ 9 million Deposits $90 million

Loans $90 million Bank capital $10 million

Securities $ 1 million    

Assets Liabilities

Reserves $ 9 million Deposits $90 million

Loans $90 million Borrowings from the Fed

$ 9 million

Securities $10 million Bank capital $10 million

Assets Liabilities

Reserves $ 9 million Deposits $90 million

Loans $81 million Bank capital $10 million

Securities $10 million    

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The First National Bank is once again in good shape because its $9 million of reserves satisfies the reserve requirement.

However, this process of reducing its loans is the bank’s costliest way of acquiring reserves when a deposit outflow exists. If the First National Bank has numerous short- term loans renewed at fairly short intervals, it can reduce its total amount of loans out- standing fairly quickly by calling in loans—that is, by not renewing some loans when they come due. Unfortunately for the bank, this is likely to antagonize the customers whose loans are not being renewed because they have not done anything to deserve such treatment. Indeed, they are likely to take their business elsewhere in the future, a very costly consequence for the bank.

A second method of reducing its loans is for the bank to sell them off to other banks. Again, this is very costly because other banks do not know how risky these loans are and so may not be willing to buy the loans at their full value. (This is an example of the lemons adverse selection problem described in Chapter 8.)

The foregoing discussion explains why banks hold excess reserves even though loans or securities earn a higher return. When a deposit outflow occurs, excess reserves enable the bank to escape the costs of (1) borrowing from other banks or corporations, (2) selling securities, (3) borrowing from the Fed, or (4) calling in or selling off loans. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves a bank will want to hold.

Just as you and I would be willing to pay an insurance company to insure us against a casualty loss such as the theft of a car, a bank is willing to pay the cost of holding excess reserves (the opportunity cost—that is, the earnings forgone by not holding income-earning assets such as loans or securities) to insure against losses due to deposit outflows. Because excess reserves, like insurance, have a cost, banks also take other steps to protect themselves; for example, they might shift their holdings of assets to more liquid securities (secondary reserves).

Asset Management Now that you understand a bank’s need for liquidity, we can examine the basic strategy a bank pursues in managing its assets. To maximize its profits, a bank must simultane- ously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Banks try to accomplish these three goals in four basic ways.

First, banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. They seek out loan business by advertising their borrowing rates and by approaching corporations directly to solicit loans. It is up to the bank’s loan officer to decide if potential borrowers are good credit risks who will make interest and principal payments on time (i.e., banks engage in screening to reduce the adverse selection problem). Typically, banks are conservative in their loan policies; the default rate is usually less than 1%. It is important, however, that banks not be so conserva- tive that they miss out on attractive lending opportunities that earn high interest rates.

Second, banks try to purchase securities with high returns and low risk. Third, in managing their assets, banks must attempt to lower risk by diversifying.

They accomplish this by purchasing many different types of assets (short- and long- term, U.S. Treasury, and municipal bonds) and approving many types of loans to a variety of customers. Banks that have not sufficiently sought the benefits of diversifica- tion often come to regret it later. For example, banks that had overspecialized in making

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loans to energy companies, real estate developers, or farmers suffered huge losses in the 1980s with the slump in energy, property, and farm prices. Indeed, many of these banks went broke because they had “put too many eggs in one basket.”

Finally, the bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets. The bank must decide, for example, how much it should hold in excess reserves to avoid the costs associated with a deposit outflow. In addition, it will want to hold U.S. government securities as secondary reserves so that even if a deposit outflow forces some costs on the bank, these will not be terribly high. Again, it is not wise for a bank to be too conservative. If it avoids all costs associated with deposit outflows by holding only excess reserves, the bank suffers losses, because reserves earn low interest, while the bank’s liabilities are costly to maintain. The bank must balance its desire for liquidity against the benefits of the increased earnings that can be obtained from less liquid assets, such as loans.

liability Management Before the 1960s, liability management was a staid affair: For the most part, banks took their liabilities as fixed and spent their time trying to achieve an optimal mix of assets. There were two main reasons for the emphasis on asset management. First, more than 60% of bank funds were obtained through checkable (demand) deposits that by law could not pay any interest. Thus banks could not actively compete with one another for these deposits by paying interest on them, and so their amount was effectively a given for an individual bank. Second, because the markets for making overnight loans between banks were not well developed, banks rarely borrowed from other banks to meet their reserve needs.

Starting in the 1960s, however, large banks (called money center banks) in key financial centers, such as New York, Chicago, and San Francisco, began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity. This move led to an expansion of overnight loan markets, such as the federal funds market, and the development of new financial instruments, such as negotiable CDs (first developed in 1961), which enabled money center banks to acquire funds quickly.2

This new flexibility in liability management meant that banks could take a different approach to bank management. They no longer needed to depend on checkable depos- its as the primary source of bank funds and as a result no longer treated their sources of funds (liabilities) as given. Instead, they aggressively set target goals for their asset growth and tried to acquire funds (by issuing liabilities) as they were needed.

For example, today, when a money center bank finds an attractive loan opportu- nity, it can acquire funds by selling a negotiable CD. Or, if it has a reserve shortfall, it can borrow funds from another bank in the federal funds market without incurring high transaction costs. The federal funds market can also be used to finance loans. Because of the increased importance of liability management, most banks now manage both sides of the balance sheet together in an asset–liability management (ALM) committee.

The greater emphasis on liability management explains some of the important changes over the past three decades in the composition of banks’ balance sheets. While

2Because small banks are not as well known as money center banks and so might be a higher credit risk, they find it harder to raise funds in the negotiable CD market. Hence they do not engage nearly as actively in liability management.

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negotiable CDs and bank borrowings have greatly increased in importance as a source of bank funds in recent years (rising from 2% of bank liabilities in 1960 to 31% by mid- 2014), checkable deposits have decreased in importance (from 61% of bank liabilities in 1960 to 11% by mid-2014). Newfound flexibility in liability management and the search for higher profits have also stimulated banks to increase the proportion of their assets held in loans, which earn higher income (from 46% of bank assets in 1960 to 53% by mid-2014) than other assets.

Capital Adequacy Management Banks have to make decisions about the amount of capital they need to hold for three reasons. First, bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors, and so goes out of business. Second, the amount of capital held affects returns for the owners (equity holders) of the bank. Third, a minimum amount of bank capital (bank capital require- ments) is required by regulatory authorities.

How Bank Capital Helps Prevent Bank Failure Let’s consider two banks with identical balance sheets, except that High Capital Bank has a ratio of capital to assets of 10%, while Low Capital Bank has a ratio of 4%.

Suppose both banks get caught up in the euphoria of the housing market, only to find later that $5 million of their housing loans have become worthless. When these bad loans are written off (valued at zero), the total value of assets declines by $5 million. As a consequence, bank capital, which equals total assets minus liabilities, also declines by $5 million. The balance sheets of the two banks now look like this:

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million

Loans $90 million Bank capital

$10 million Loans $90 million Bank capital

$ 4 million

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million

Loans $85 million Bank capital

$ 5 million Loans $85 million Bank capital

-$ 1 million

High Capital Bank takes the $5 million loss in stride because its initial cushion of $10 million in capital means that it still has a positive net worth (bank capital) of $5 million after the loss. Low Capital Bank, however, is in big trouble. The value of its assets has

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fallen below that of its liabilities, and its net worth is now –$1 million. Because the bank has a negative net worth, it is insolvent: It does not have sufficient assets to pay off all holders of its liabilities. When a bank becomes insolvent, government regulators close the bank, its assets are sold off, and its managers are fired. Because the owners of Low Capital Bank will find their investment wiped out, they clearly would have preferred the bank to have had a large enough cushion of bank capital to absorb the losses, as was the case for High Capital Bank. We therefore see an important rationale for a bank to maintain a sufficient level of capital: A bank maintains bank capital to lessen the chance that it will become insolvent.

how the amount of Bank capital affects Returns to equity holders Because owners of a bank must know whether their bank is being managed well, they need good measures of bank profitability. A basic measure of bank profitability is the return on assets (ROA), the net profit after taxes per dollar of assets:

ROA = net profit after taxes

assets

The return on assets provides information on how efficiently a bank is being run because it indicates how much profit is generated, on average, by each dollar of assets.

However, what the bank’s owners (equity holders) care about most is how much the bank is earning on their equity investment. This information is provided by the other basic measure of bank profitability, the return on equity (ROE), which is defined as the net profit after taxes per dollar of equity (bank) capital:

ROE = net profit after taxes

equity capital

There is a direct relationship between the return on assets (which measures how efficiently the bank is run) and the return on equity (which measures how well the owners are doing on their investment). This relationship is determined by the equity multiplier (EM), or the amount of assets per dollar of equity capital:

EM = assets

equity capital

To see this, we note that

net profit after taxes

equity capital =

net profit after taxes

assets *

assets

equity capital

which, using our definitions, yields

ROE = ROA * EM (1)

The formula in Equation 1 tells us what happens to the return on equity when a bank holds a smaller amount of capital (equity) for a given amount of assets. As we have seen, High Capital Bank initially has $100 million of assets and $10 million of equity, which gives it an equity multiplier of 10 (= $100 million>$10 million). Low Capital Bank, by contrast, has only $4 million of equity, so its equity multiplier is higher, equal- ing 25 (= $100 million>$4 million). Suppose these banks have been equally well run, so that they both have the same return on assets, 1%. The return on equity for High

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Capital Bank equals 1% * 10 = 10%, whereas the return on equity for Low Capital Bank equals 1% * 25 = 25%. The equity holders in Low Capital Bank are clearly a lot happier than the equity holders in High Capital Bank because they are earning more than twice as high a return. We now see why the owners of a bank may not want it to hold too much capital. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Trade-off Between Safety and Returns to equity holders We now see that bank capital has both benefits and costs. Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. In determining the optimal amount of bank capital, managers must compare the benefit of maintaining higher capital (increased safety) with the cost of higher capital (the lower return on equity for bank owners).

In more uncertain times, when the possibility of large losses on loans increases, bank managers might want to hold more capital in order to protect the equity holders. Conversely, if the managers have confidence that loan losses won’t occur, they might want to reduce the amount of bank capital, have a high equity multiplier, and thereby increase the return on equity.

Bank capital Requirements Banks also hold capital because they are required to do so by regulatory authorities. Because of the high costs of holding capital (for the reasons just described), bank managers often want to hold less bank capital relative to assets than is required by the regulatory authorities. In this case, the amount of bank capital is determined by the bank capital requirements. We discuss the details of bank capital requirements and their important role in bank regulation in Chapter 10.

A p p li c At i o n Strategies for Managing Bank Capital Suppose that, as the manager of the First National Bank, you have to make decisions about the appropriate amount of bank capital to hold in your bank. Looking at the balance sheet of the bank, which, like that of High Capital Bank, has a ratio of bank capital to assets of 10% ($10 million of capital and $100 million of assets), you are concerned that the large amount of bank capital is causing the return on equity to be too low. You conclude that the bank has a capital surplus and should increase the equity multiplier to raise the return on equity. What should you do next?

To lower the amount of capital relative to assets and raise the equity multiplier, you can do any of three things: (1) You can reduce the amount of bank capital by buy- ing back some of the bank’s stock; (2) you can reduce the bank’s capital by paying out higher dividends to its stockholders, thereby reducing the bank’s retained earnings; or (3) you can keep bank capital constant but increase the bank’s assets by acquiring new funds—say, by issuing CDs—and then seeking out loan business or purchasing more securities with these new funds. Because you think it will enhance your position with the stockholders, you decide to pursue the second alternative and raise the dividend on the First National Bank stock.

Now suppose that the First National Bank is in a situation similar to that of Low Capital Bank and has a ratio of bank capital to assets of 4%. You now worry that the bank is short on capital relative to assets because it does not have a sufficient cushion

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to prevent bank failure. To raise the amount of capital relative to assets, you now have the following three choices: (1) You can raise capital for the bank by having it issue equity (common stock); (2) you can raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account; or (3) you can keep capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce the bank’s liabilities. Suppose that raising bank capital is not easy to do at the current time because bank stock is selling at low prices or because shareholders will protest if their dividends are cut. Then you might have to choose the third alternative and shrink the size of the bank.

Our discussion of the strategies for managing bank capital at the First National Bank leads to the following conclusion, which deserves particular emphasis: A shortfall of bank capital is likely to lead a bank to reduce its assets and therefore is likely to cause a contraction in lending. In past years, many banks experienced capital shortfalls and had to restrict asset and lending growth. The important consequences of this deci- sion for the credit markets are illustrated by the application that follows.

A p p li c At i o n How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis The dramatic slowdown in the growth of credit in the wake of the financial crisis that began in 2007 triggered a “credit crunch” during which credit was hard to get. As a result, the performance of the economy in 2008 and 2009 was very poor. What caused the credit crunch?

Our analysis of how a bank manages its capital indicates that the 2008–2009 credit crunch was caused, at least in part, by the capital crunch, in which shortfalls of bank capital led to slower credit growth.

A major boom and bust in the housing market led to huge losses for banks from their holdings of securities backed by residential mortgages. These losses reduced bank capital, which led to capital shortfalls: Banks had to either raise new capital or restrict asset growth by cutting back on lending. Banks did raise some capital, but with the growing weakness of the economy, raising new capital was extremely difficult, so banks also chose to tighten their lending standards and reduce lending. Both of these reactions to capital shortfalls helped produce a weak economy in 2008 and 2009. ◆

ManagIng cReDIT RISk As noted in our earlier discussion of the general principles of asset management, banks and other financial institutions must make successful loans that are paid back in full (and so subject the institution to little credit risk) if they are to earn high profits. The economic concepts of adverse selection and moral hazard (discussed in Chapters 2 and 8) provide a framework for understanding the principles that financial institutions must follow if they are to reduce credit risk and make successful loans.3

3Other financial intermediaries, such as insurance companies, pension funds, and finance companies, also make private loans, and the credit risk management principles we outline here apply to them as well.

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Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; in other words, those who are most likely to produce an adverse outcome are also the most likely to be selected. Borrowers with very risky investment projects have much to gain if their projects are successful, so they are the most eager to obtain loans. Clearly, however, they are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans.

Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lender’s point of view. In such situa- tions, it is more likely that the lender will be subjected to the hazard of default. Once borrowers have obtained a loan, they are more likely to invest in high-risk investment projects—projects that pay high returns to the borrower if successful. The high risk associated with these investments, however, makes it less likely that these borrowers will be able to pay back their loans.

To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely. Financial institutions attempt to solve these problems by using a number of principles for managing credit risk: screening and monitoring, establishment of long-term customer relationships, loan commitments, collateral and compensating balance requirements, and credit rationing.

Screening and Monitoring Asymmetric information is present in loan markets because lenders have less informa- tion about the investment opportunities and activities of borrowers than borrowers do. This situation leads banks and other financial institutions to perform two information- producing activities:screening and monitoring. Indeed, Walter Wriston, a former head of Citicorp, one of the largest bank corporations in the United States, was often quoted as stating that the business of banking is the production of information.

Screening Adverse selection in loan markets requires that lenders screen out the bad credit risks from the good ones, so that loans are profitable to them. To accomplish ef- fective screening, lenders must collect reliable information from prospective borrowers. Effective screening and information collection together form an important principle of credit risk management.

When you apply for a consumer loan (such as a car loan or a mortgage to purchase a house), the first thing you are asked to do is fill out forms that elicit a great deal of information about your personal finances. You are asked about your salary, your bank accounts and other assets (such as cars, insurance policies, and furnishings), and your outstanding loans; your record of loan, credit card, and charge account repayments; and the number of years you’ve worked and the names of your employers. You also are asked personal questions such as your age, marital status, and number of children. The lender uses this information to evaluate how good a credit risk you are by calcu- lating your credit score, a statistical measure derived from your answers that is used to predict whether you are likely to have trouble making your loan payments. Decid- ing how good a risk you are cannot be entirely scientific, so the lender must also use judgment. The loan officer, whose job it is to decide whether you should be given the loan, might call your employer or talk to some of the personal references you have supplied. The officer might even make a judgment based on your demeanor or your appearance. (This is why most people dress neatly and conservatively when they go to a bank to apply for a loan.)

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The process of screening and collecting information is similar when a financial institution makes a business loan. It collects information about the company’s profits and losses (income) along with information about its assets and liabilities. The lender also has to evaluate the likely future success of the business. So, in addition to obtain- ing information such as sales figures, a loan officer might ask questions about the company’s future plans, the purpose of the loan, and competition within the industry. The officer may even visit the company to obtain a firsthand look at its operations. The bottom line is that, whether they are considering making personal loans or business loans, bankers and other financial institutions need to be nosy.

Specialization in lending One puzzling feature of bank lending is that a bank often specializes in lending to local firms or to firms in particular industries, such as energy. In one sense, this behavior seems surprising because it means that the bank is not diversifying its portfolio of loans and thus is exposing itself to more risk. But from another perspective, such specialization makes perfect sense. The adverse selection problem requires that the bank screen out bad credit risks. It is easier for the bank to collect information about local firms and determine their creditworthiness than to col- lect comparable information on firms that are farther away. Similarly, by concentrating its lending on firms in specific industries, the bank becomes more knowledgeable about these industries and is therefore better able to predict which firms will be able to make timely payments on their debt.

Monitoring and enforcement of Restrictive covenants Once a loan has been made, the borrower has an incentive to engage in risky activities that make it less likely that the loan will be paid off. To reduce this moral hazard, financial institutions must write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. By monitoring borrowers’ activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers are not taking on risks at their expense. The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and information-collecting activities.

long-Term customer Relationships An additional way for banks and other financial institutions to obtain information about their borrowers is through long-term customer relationships, another important prin- ciple of credit risk management.

If a prospective borrower has had a checking account, a savings account, or a loan with a bank over a long period of time, a loan officer can look at past activity on the accounts and learn quite a bit about the borrower. The balances in the checking and savings accounts tell the banker how liquid the potential borrower is and at what time of year the borrower has a strong need for cash. A review of the checks the borrower has written reveals the borrower’s suppliers. If the borrower has borrowed previously from the bank, the bank has a record of the loan payments. Thus long-term customer relationships reduce the costs of information collection and make it easier to screen out bad credit risks.

The need for monitoring by lenders adds to the importance of long-term customer relationships. If the borrower has borrowed from the bank before, the bank has already established procedures for monitoring that customer. Therefore, the costs of monitor- ing long-term customers are lower than the costs of monitoring new customers.

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Long-term relationships benefit customers as well as banks. A firm that has had a previous relationship with a bank will find it easier to obtain a loan from the bank at a low interest rate because the bank has an easier time determining if the prospec- tive borrower is a good credit risk and therefore incurs fewer costs in monitoring the borrower.

A long-term customer relationship has another advantage for the bank. No bank can think of every contingency when it writes a restrictive covenant into a loan con- tract; there will always be risky borrower activities that are not ruled out. However, what if a borrower wants to preserve a long-term relationship with a bank because it will be easier to get future loans from the bank, at low interest rates? The borrower then has the incentive to avoid risky activities that would upset the bank, even if restrictions on these risky activities are not specified in the loan contract. Indeed, if a bank doesn’t like what a borrower is doing even when the borrower isn’t violating any restrictive covenants, it has some power to discourage the borrower from such activity: The bank can threaten not to give the borrower new loans in the future. Long-term customer relationships therefore enable banks to deal with even unantici- pated moral hazard contingencies.

loan commitments Banks also create long-term relationships and gather information by issuing loan commitments to commercial customers. A loan commitment is a bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. The majority of commercial and industrial loans are made under the loan commitment arrangement. The advantage for the firm is that it has a source of credit when it needs it. The advantage for the bank is that the loan commitment promotes a long-term relationship, which in turn facili- tates information collection. In addition, provisions in the loan commitment agreement require that the firm continually supply the bank with information about the firm’s income, asset and liability position, business activities, and so on. A loan commitment arrangement is a powerful method for reducing the bank’s costs of screening and infor- mation collection.

collateral and compensating Balances Collateral requirements for loans are important credit risk management tools. Collateral, which is property promised to the lender as compensation if the borrower defaults, lessens the consequences of adverse selection because it reduces the lender’s losses in the case of a loan default. It also reduces moral hazard because the borrower has more to lose from a default. If a borrower defaults on a loan, the lender can sell the collat- eral and use the proceeds to make up for its losses on the loan. One particular form of collateral required when a bank makes commercial loans is called compensating balances: A firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank. For example, a business getting a $10 million loan may be required to keep compensating balances of at least $1 million in its checking account at the bank. This $1 million in compensating balances can then be taken by the bank to make up some of the losses on the loan if the borrower defaults.

In addition to serving as collateral, compensating balances increase the likelihood that a loan will be paid off. They do this by helping the bank monitor the borrower and consequently reduce moral hazard. Specifically, by requiring the borrower to use a

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C h a p t e r 9 Banking and the Management of Financial Institutions 205

checking account at the bank, the bank can observe the firm’s check payment practices, which may yield a great deal of information about the borrower’s financial condition. For example, a sustained drop in the borrower’s checking account balance may signal that the borrower is having financial trouble, or account activity may suggest that the borrower is engaging in risky activities; perhaps a change in suppliers means the bor- rower is pursuing a new line of business. Any significant change in the borrower’s pay- ment procedures is a signal to the bank that it should make inquiries. Compensating balances therefore make it easier for banks to monitor borrowers more effectively and are an important credit risk management tool.

credit Rationing Another way in which financial institutions deal with adverse selection and moral haz- ard is through credit rationing: refusing to make loans even though borrowers are willing to pay the stated interest rate, or even a higher rate. Credit rationing takes two forms. The first occurs when a lender refuses to make a loan of any amount to a bor- rower, even if the borrower is willing to pay a higher interest rate. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like.

Initially, you might be puzzled by the first type of credit rationing. After all, even if the potential borrower is a credit risk, why doesn’t the lender just extend the loan, but at a higher interest rate? The answer is that adverse selection prevents this from being a wise course of action. Individuals and firms with the riskiest investment projects are exactly those that are willing to pay the highest interest rates. If a bor- rower took on a high-risk investment and succeeded, the borrower would become extremely rich. But a lender wouldn’t want to make such a loan precisely because the credit risk is high; the likely outcome is that the borrower will not succeed and the lender will not be paid back. Charging a higher interest rate just makes adverse selection worse for the lender; that is, it increases the likelihood that the lender is lending to a bad credit risk. The lender would therefore rather not make any loans at a higher interest rate; instead, it would engage in the first type of credit rationing and would turn down loans.

Financial institutions engage in the second type of credit rationing to guard against moral hazard: They grant loans to borrowers, but loans that are not as large as the bor- rowers want. Such credit rationing is necessary because the larger the loan, the greater the benefits from moral hazard. If a bank gives you a $1,000 loan, for example, you are likely to take actions that enable you to pay it back because you don’t want to hurt your credit rating for the future. However, if the bank lends you $10 million, you are more likely to fly down to Rio to celebrate. The larger your loan, the greater your incentives to engage in activities that make it less likely that you will repay the loan. Because more borrowers repay their loans if the loan amounts are small, financial institutions ration credit by providing borrowers with smaller loans than they seek.

ManagIng InTeReST-RaTe RISk With the increased volatility of interest rates that occurred in the 1980s, banks and other financial institutions became more concerned about their exposure to inter- est-rate risk, the riskiness of earnings and returns that is associated with changes

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in interest rates. To see what interest-rate risk is all about, let’s again take a look at the First National Bank, which has the following balance sheet:

First National Bank

Assets Liabilities

Rate-sensitive assets Variable-rate and short-term loans Short-term securities

$20 million Rate-sensitive liabilities Variable-rate CDs

Money market deposit accounts

$50 million

Fixed-rate assets $80 million Fixed-rate liabilities $50 million

Reserves   Checkable deposits  

Long-term loans   Savings deposits  

Long-term securities   Long-term CDs  

    Equity capital  

A total of $20 million of First National Bank’s assets are rate-sensitive, with inter- est rates that change frequently (at least once a year), and $80 million of its assets are fixed-rate, with interest rates that remain unchanged for a long period (over a year). On the liabilities side, the First National Bank has $50 million of rate-sensitive liabilities and $50 million of fixed-rate liabilities. Suppose that interest rates rise by 5 percentage points on average, from 10% to 15%. The income on the assets increases by $1 mil- lion (= 5% * $20 million of rate-sensitive assets), while the payments on the liabilities increase by $2.5 million (= 5% * $50 million of rate-sensitive liabilities). The First National Bank’s profits now decline by $1.5 million (= $1 million - $2.5 million). Conversely, if interest rates fall by 5 percentage points, similar reasoning tells us that the First National Bank’s profits increase by $1.5 million. This example illustrates the following point: If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits, and a decline in interest rates will raise bank profits.

gap and Duration analysis The sensitivity of bank profits to changes in interest rates can be measured more directly using gap analysis, in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets. In our example, this calculation (called the “gap”) is -$30 million (= $20 million - $50 million). By multiplying the gap times the change in the interest rate, we can immediately obtain the effect on bank profits. For example, when interest rates rise by 5 percentage points, the change in profits is 5% * -$30 mil- lion, which equals -$1.5 million, as we saw.

The analysis we just conducted is known as basic gap analysis, and it can be refined in two ways. Clearly, not all assets and liabilities in the fixed-rate category have the same maturity. One refinement, the maturity bucket approach, is to measure the gap for several maturity subintervals, called maturity buckets, so that effects of interest-rate changes over a multiyear period can be calculated. The second refinement, called

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C h a p t e r 9 Banking and the Management of Financial Institutions 207

standardized gap analysis, accounts for the differing degrees of rate sensitivity among rate-sensitive assets and liabilities.

An alternative method for measuring interest-rate risk, called duration analysis, examines the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates. Duration analysis is based on what is known as Macaulay’s concept of duration, which measures the average lifetime of a security’s stream of pay- ments.4 Duration is a useful concept because it provides a good approximation of the sensitivity of a security’s market value to a change in its interest rate:

percent change in market value of security ≈

-percentage@point change in interest rate * duration in years

where ≈ denotes “approximately equals.” Duration analysis involves using the average (weighted) duration of a financial

institution’s assets and of its liabilities to see how its net worth responds to a change in interest rates. Going back to our example of the First National Bank, suppose the aver- age duration of the bank’s assets is three years (that is, the average lifetime of the stream of payments is three years), whereas the average duration of its liabilities is two years. In addition, the First National Bank has $100 million of assets and, say, $90 million of liabilities, so its bank capital is 10% of assets. With a 5-percentage-point increase in interest rates, the market value of the bank’s assets falls by 15% (= -5% * 3 years), a decline of $15 million on the $100 million of assets. However, the market value of the liabilities falls by 10% (= -5% * 2 years), a decline of $9 million on the $90 million of liabilities. The net result is that the net worth (the market value of the assets minus the liabilities) has declined by $6 million, or 6% of the total original asset value. Similarly, a 5-percentage-point decline in interest rates increases the net worth of the First National Bank by 6% of the total asset value.

As our example makes clear, both duration analysis and gap analysis indicate that the First National Bank will suffer if interest rates rise but will gain if they fall. Duration analysis and gap analysis are thus useful tools for a manager of a financial institution who is concerned about its degree of exposure to interest-rate risk.

A p p l i c At i o n Strategies for Managing Interest-Rate Risk Suppose that as manager of the First National Bank, you have done a duration and gap analysis for the bank. Now you need to decide which alternative strategies you should pursue to manage the interest-rate risk.

4Algebraically, Macaulay’s duration, D, is defined as

D = a N

τ = 1 τ

CPτ 11 + iτ2n a

N

τ = 1

CPτ 11 + iτ2

where τ = time until cash payment is made CPt = cash payment (interest plus principal) at time t i = interest rate N = time to maturity of the security For a more detailed discussion of duration gap analysis using the concept of Macaulay’s duration, see the appendix to this chapter on the Companion Website at http://www.pearsonhighered.com/mishkin.

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If you firmly believe that interest rates will fall in the future, you may be willing to forego action because you know that the bank has more rate-sensitive liabilities than rate-sensitive assets and so will benefit from the expected interest-rate decline. How- ever, you also realize that the First National Bank is subject to substantial interest-rate risk because there is always a possibility that interest rates will rise rather than fall. What should you do to eliminate this interest-rate risk? One thing you could do is to shorten the duration of the bank’s assets to increase their rate sensitivity. Alternatively, you could lengthen the duration of the liabilities. By this adjustment of the bank’s assets or liabilities, the bank’s income will be less affected by interest-rate swings.

One problem with eliminating the First National Bank’s interest-rate risk by altering the balance sheet is that doing so might be very costly in the short run. The bank may be locked into assets and liabilities of particular durations because of where its expertise lies. Fortu- nately, recently developed financial instruments known as financial derivatives—financial forwards and futures, options, and swaps—can help the bank reduce its interest-rate risk exposure but do not require that the bank rearrange its balance sheet. ◆

Off-Balance-SheeT acTIvITIeS Although asset and liability management has traditionally been the primary concern of banks, in the more competitive environment of recent years banks have been aggres- sively seeking out profits by engaging in off-balance-sheet activities.5 Off-balance-sheet activities involve trading financial instruments and generating income from fees and loan sales, activities that affect bank profits but do not appear on bank balance sheets. Indeed, off-balance-sheet activities have been growing in importance for banks: The income from these activities as a percentage of assets has nearly doubled since 1980.

loan Sales One type of off-balance-sheet activity that has grown in importance in recent years involves income generated by loan sales. A loan sale, also called a secondary loan participation, involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan so that it is no longer an asset on the bank’s balance sheet. Banks earn profits by selling loans for amounts that are slightly greater than the amounts of the original loans. Because the high interest rate on these loans makes them attractive, institutions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage point.

generation of fee Income Another type of off-balance-sheet activity involves the generation of income from fees that banks receive for providing specialized services to their customers, such as making foreign exchange trades on a customer’s behalf, servicing a mortgage-backed security by

5Managers of financial institutions also need to know how well their banks are doing at any point in time. A second appendix to this chapter discusses how bank performance is measured; it can be found on the Companion Website at http://www.pearsonhighered.com/mishkin.

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collecting interest and principal payments and then paying them out, guaranteeing debt securities such as banker’s acceptances (by which the bank promises to make interest and principal payments if the party issuing the security cannot), and providing backup lines of credit. There are several types of backup lines of credit. We have already men- tioned the most important, the loan commitment, under which, for a fee, the bank agrees to provide a loan at the customer’s request, up to a given dollar amount, over a specified period of time. Credit lines with “overdraft privileges” are also now avail- able to bank depositors—these bank customers can write checks in excess of their deposit balances and, in effect, write themselves a loan. Other lines of credit for which banks get fees include standby letters of credit to back up issues of commercial paper and other securities, and credit lines (called note issuance facilities, NIFs, and revolv- ing underwriting facilities, RUFs) for underwriting Euronotes, which are medium-term Eurobonds.

Off-balance-sheet activities involving guarantees of securities and backup credit lines increase the risk a bank faces. Even though a guaranteed security does not appear on a bank’s balance sheet, it still exposes the bank to default risk: If the issuer of the security defaults, the bank is left holding the bag and must pay off the security’s owner. Backup credit lines also expose the bank to risk because the bank may be forced to provide loans when it does not have sufficient liquidity or when the borrower is a very poor credit risk.

Trading activities and Risk Management Techniques We have already mentioned that banks’ attempts to manage interest-rate risk have led them to trading in financial futures, options for debt instruments, and interest-rate swaps. Banks engaged in international banking also conduct transactions in the for- eign exchange market. All transactions in these markets are off-balance-sheet activities because they do not have a direct effect on the bank’s balance sheet. Although bank trading in these markets is often directed toward reducing risk or facilitating other bank business, banks also try to outguess the markets and engage in speculation. This specu- lation can be a very risky business and has led to bank insolvencies, the most dramatic being the failure of Barings, a British bank, in 1995.

Trading activities, although often highly profitable, are also highly risky because they make it easy for financial institutions and their employees to make huge bets quickly. The principal–agent problem, discussed in Chapter 8, is an especially severe problem for management of trading activities. Because a trader (the agent) has the opportunity to place large bets, whether she trades in bond markets, foreign exchange markets, or financial derivatives, she has an incentive to take on excessive risks: If her trading strategy leads to large profits, she is likely to receive a high salary and bonuses, but if she takes large losses, the financial institution (the principal) will have to cover them. As the Barings Bank failure of 1995 so forcefully demonstrated, a trader subject to the principal–agent problem can take an institution that is quite healthy and drive it into insolvency very rapidly (see the Global box).

To reduce the principal–agent problem, managers of financial institutions must set up internal controls to prevent debacles like the one at Barings. Such controls include the complete separation of the people in charge of trading activities from those in charge of the bookkeeping for trades. In addition, managers must set limits on the total amount of traders’ transactions and on the institution’s risk exposure. Managers must also scrutinize risk assessment procedures using the latest computer technology. One such method involves the value-at-risk approach. In this approach, the institution

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Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase: Rogue Traders and the Principal–Agent Problem

The demise of Barings, a venerable British bank more than a century old, is a sad morality tale of how the principal–agent problem operating through a rogue trader can take a financial institution that has a healthy balance sheet one month and turn it into an insolvent tragedy the next.

In July 1992, Nick Leeson, Barings’s new head clerk at its Singapore branch, began to speculate on the Nikkei, the Japanese version of the Dow Jones stock index. By late 1992, Leeson had suffered losses of $3 million, which he hid from his superiors by stash- ing the losses in a secret account. He even fooled his superiors into thinking he was generating large prof- its, thanks to a failure of internal controls at his firm, which allowed him to execute trades on the Singapore exchange and oversee the bookkeeping of those trades. (As anyone who runs a cash business, such as a bar, knows, there is always a lower likelihood of fraud if more than one person handles the cash. Similarly, in trading operations, you never mix management of the back room with management of the front room; this principle was grossly violated by Barings management.)

Things didn’t get better for Leeson, who by late 1994 had suffered losses exceeding $250 million. In January and February of 1995, Leeson bet the bank. On January 17, 1995, the day of the earthquake in Kobe, Japan, he lost $75 million, and by the end of the week he had lost more than $150 million. When the stock market declined on February 23, leaving him with a further loss of $250 million, he called it quits and fled Singapore. Three days later, he turned himself in at the Frankfurt airport. By the end of his wild ride, Leeson’s losses, $1.3 billion in all, ate up Barings’s capital and caused the bank to fail. Leeson was subsequently con- victed and sent to jail in Singapore for his activities. He was released in 1999 and apologized for his actions.

Our asymmetric information analysis of the principal–agent problem explains Leeson’s behavior and highlights the danger of a management lapse like Barings’s. Letting Leeson control both his own trades and the back room increased asymmetric informa- tion, because it reduced the principal’s (Barings’s) knowledge about Leeson’s trading activities. This lapse

increased the moral hazard incentive for him to take risks at the bank’s expense, as he was now less likely to be caught. Furthermore, once he had experienced large losses, he had even greater incentives to take on even higher risk because, if his bets worked out, he could reverse his losses and keep in good standing with the company; whereas if his bets soured, he had little to lose because he was out of a job anyway. Indeed, the bigger his losses, the more he had to gain by bigger bets, which explains the escalation of the amount of his trades as his losses mounted. If Barings’s managers had understood the principal–agent problem, they would have been more vigilant at finding out what Leeson was up to, and the bank might still be here today.

Unfortunately, Nick Leeson is no longer a rarity in the rogue traders’ billionaires club, made up of those who have lost more than $1 billion. Over eleven years, Toshihide Iguchi, an officer in the New York branch of Daiwa Bank, also had control of both the bond trading operation and the back room book- keeping activities, and he racked up $1.1 billion in losses over the period. In July 1995, Iguchi disclosed his losses to his superiors, but the management of the bank did not disclose them to its regulators. The result was that Daiwa was slapped with a $340 mil- lion fine and the bank was thrown out of the country by U.S. bank regulators.

Yasuo Hamanaka is another member of the bil- lionaires club. In July 1996, he topped Leeson’s and Iguchi’s record, losing $2.6 billion for his employer, the Sumitomo Corporation, one of Japan’s top trading companies. In January 2008, Jerome Kerviel’s loss for his bank, Société Générale, set the all-time record for a rogue trader: His unauthorized trades cost the French bank $7.2 billion. In 2012, even the highly successful JP Morgan Chase bank experienced a trading loss of over $2 billion, caused by rogue trader Bruno Iksill, who was colorfully nicknamed “the London Whale.”

The moral of these stories is that management of firms engaged in trading activities must reduce the principal–agent problem by closely monitoring their traders’ activities, or the rogues’ gallery will continue to grow.

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C h a p t e r 9 Banking and the Management of Financial Institutions 211

develops a statistical model with which it can calculate the maximum loss that its portfolio is likely to sustain over a given time interval, dubbed the value at risk, or VaR. For example, a bank might estimate that the maximum loss it would be likely to sustain over one day with a probability of 1 in 100 is $1 million; the $1 million figure is the bank’s calculated value at risk. Another approach is called “stress testing.” In this approach, a manager uses a computer model to project what would happen if a doomsday scenario occurred; that is, she looks at the losses the institution would sustain in the event of an unusual combination of bad events. With the value-at-risk approach and stress testing, a financial institution can assess its risk exposure and take steps to reduce it.

U.S. bank regulators have become concerned about the increased risk that banks are facing from their off-balance-sheet activities and, as we will see in Chapter 10, are encouraging banks to pay increased attention to risk management. In addition, the Bank for International Settlements is developing additional bank capital requirements based on value-at-risk calculations for a bank’s trading activities.

SuMMaRy

1. The balance sheet of a commercial bank can be thought of as a list of the sources and uses of bank funds. A bank’s liabilities are its sources of funds, which include checkable deposits, time deposits, discount loans from the Fed, borrowings from other banks and corporations, and bank capital. A bank’s assets are its uses of funds, which include reserves, cash items in process of collection, deposits at other banks, securities, loans, and other assets (mostly physical capital).

2. Banks make profits through the process of asset trans- formation: They borrow short (accept short-term deposits) and lend long (make long-term loans). When a bank takes in additional deposits, it gains an equal amount of reserves; when it pays out deposits, it loses an equal amount of reserves.

3. Although more-liquid assets tend to earn lower returns, banks still desire to hold them. Specifically, banks hold excess and secondary reserves because they provide insurance against the costs of a deposit outflow. Banks manage their assets to maximize profits by seeking the highest returns possible on loans and securities while at the same time trying to lower risk and make adequate provisions for liquidity. Although liability management was once a staid affair, large (money center) banks now actively seek out sources of funds by issuing liabilities such as negotiable CDs or by actively borrowing from other banks and corporations. Banks manage the amount of capital they hold with

the goals of preventing bank failure and meeting bank capital requirements set by the regulatory authorities. However, banks do not want to hold too much capi- tal because by so doing they will lower the returns to equity holders.

4. The concepts of adverse selection and moral hazard explain many credit risk management principles involving loan activities: screening and monitoring, establishment of long-term customer relationships and loan commitments, collateral and compensating bal- ances, and credit rationing.

5. With the increased volatility of interest rates that occurred in the 1980s, financial institutions became more concerned about their exposure to interest-rate risk. Gap and duration analyses tell a financial institu- tion if it has more rate-sensitive liabilities than assets (in which case a rise in interest rates will reduce profits, and a fall in interest rates will raise profits). Financial institutions manage their interest-rate risk by modifying their balance sheets, but can also use strate- gies involving financial derivatives.

6. Off-balance-sheet activities consist of trading financial instruments and generating income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets. Because these off-balance-sheet activities expose banks to increased risk, bank manage- ment must pay particular attention to risk assessment procedures and internal controls to restrict employees from taking on too much risk.

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key TeRMS

asset management, p. 193 asset transformation, p. 190 balance sheet, p. 186 capital adequacy management, p. 193 compensating balances, p. 204 credit rationing, p. 205 credit risk, p. 193 deposit outflows, p. 193 discount loans, p. 188 discount rate, p. 195

duration analysis, p. 207 equity multiplier (EM), p. 199 excess reserves, p. 189 gap analysis, p. 206 interest-rate risk, p. 193 liability management, p. 193 liquidity management, p. 193 loan commitment, p. 204 loan sale, p. 208 money center banks, p. 197

off-balance-sheet activities, p. 208 required reserve ratio, p. 189 required reserves, p. 189 reserve requirements, p. 189 reserves, p. 189 return on assets (ROA), p. 199 return on equity (ROE), p. 199 secondary reserves, p. 189 T-account, p. 190 vault cash, p. 189

QueSTIOnS

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the Fed?

2. Rank the following bank assets from most to least liquid:

a. Commercial loans

b. Securities

c. Reserves

d. Physical capital

3. The bank you own has the following balance sheet:

5. Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?

6. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explain- ing that you don’t have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs?

7. If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE?

8. If a bank is falling short of meeting its capital require- ments by $1 million, what three things can it do to rectify the situation?

9. Why do equity holders care more about ROE than about ROA?

10. If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?

11. What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

12. Why is being nosy a desirable trait for a banker?

13. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

14. If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why or why not?

15. “Because diversification is a desirable strategy for avoid- ing risk, it never makes sense for a bank to specialize in

Assets Liabilities

Reserves $ 75 million Deposits $500 million

Loans $525 million Bank capital $100 million

If the bank suffers a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, what actions should you take?

4. If a deposit outflow of $50 million occurs, which balance sheet would a bank rather have initially, the balance sheet in Question 3 or the following balance sheet? Why?

Assets Liabilities

Reserves $100 million Deposits $500 million

Loans $500 million Bank capital $100 million

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C h a p t e r 9 Banking and the Management of Financial Institutions 213

17. “Bank managers should always seek the highest return possible on their assets.” Is this statement true, false, or uncertain? Explain your answer.

18. Why has noninterest income been growing as a source of bank operating income?

making specific types of loans.” Is this statement true, false, or uncertain? Explain your answer.

16. If you are a banker and expect interest rates to rise in the future, would you prefer to make short-term loans or long-term loans?

aPPlIeD PROBleMS

All applied problems are available in MyEconLab at http://www.myeconlab.com.

19. Using the T-accounts of the First National Bank and the Second National Bank given in this chapter, describe what happens when Jane Brown writes a $50 check on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second National Bank.

20. What happens to reserves at the First National Bank if one person withdraws $1,000 of cash and another per- son deposits $500 of cash? Use T-accounts to explain your answer.

Questions 21 and 22 relate to the first month’s operations of NewBank.

21. NewBank started its first day of operations with $6 million in capital. A total of $100 million in checkable deposits is received. The bank makes a $25 million commercial loan and lends another $25 million in mortgage loans. If required reserves are 8%, what does the bank balance sheet look like?

22. NewBank decides to invest $45 million in 30-day T-bills. The T-bills are currently trading at $4,986.70 (including commissions) for a $5,000 face value instru- ment. How many T-bills does NewBank purchase? What does the balance sheet look like?

23. X-Bank reported an ROE of 15% and an ROA of 1%. How well capitalized is this bank?

24. Suppose you are the manager of a bank whose $100 bil- lion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank’s interest-rate risk?

25. Suppose you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of rate-sensitive assets, $25 million of fixed-rate liabilities, and $20 million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by 5 percentage points. What actions could you take to reduce the bank’s interest-rate risk?

DaTa analySIS PROBleMS

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data for all commercial banks on total

liabilities (TLBACBM027SBOG), total deposits (DPSACBM027SBOG), and residual of assets less liabilities (RALACBM027SBOG).

a. What is the balance sheet interpretation of the residual of assets less liabilities?

b. For the most recent month of data available, use the three indicators listed above to calculate the total amount of borrowings by banks.

2. Go to the St. Louis Federal Reserve FRED database, and find data for all commercial banks on total

assets (TLAACBM027SBOG), U.S. government and agency securities held (USGSEC), other securities held (OTHSEC), commercial and industrial loans (BUSLOANS), real estate loans (REALLN), consumer loans (CONSUMER), interbank loans (IBLACBM027S- BOG), other loans (OLLACBM027SBOG), and other assets (OATACBM027SBOG). Use the most recent month of data available across all indicators.

a. What is the total amount of loans held by banks? What is this number as a percentage of total bank assets?

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214 p a r t 3 Financial Institutions

WeB exeRcISeS

1. Table 1 reports the balance sheet of all commercial banks based on aggregate data found in the Federal Reserve Bulletin. Compare this table to the most recent balance sheet reported by Bank of America. Go to http://www.bankofamerica.com/investor.index .cfm?section=700 and click on Annual Reports to view the balance sheet. Does Bank of America have more or less of its portfolio in loans than the average bank? Which type of loan is most common?

2. It is relatively easy to find up-to-date information on banks because of their extensive reporting require- ments. Go to http://www2.fdic.gov/qbp/, where you

will find summary data on financial institutions. This site is sponsored by the Federal Deposit Insurance Corporation. Go to the most recent Quarterly Banking Profile. Scroll to the bottom and open Table 1-A.

a. Have banks’ returns on assets been increasing or decreasing over the past few years?

b. Has the core capital been increasing, and how does it compare to the capital ratio reported in Table 1 of the text?

c. How many institutions are currently reporting to the FDIC?

WeB RefeRenceS

http://www.bankofamerica.com/investor/index .cfm?section=700

Click on Annual Reports to view the balance sheet.

http://www.federalreserve.gov/boarddocs/SupManual/ default.htm#trading

The Federal Reserve Bank Trading and Capital Market Activities Manual offers an in-depth discussion of a wide range of risk management issues encountered in trading operations.

WeB aPPenDIx

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read the Web appendices to Chapter 9.

Appendix 1: Duration Gap Analysis

Appendix 2: Measuring Bank Performance

b. What is the total amount of securities held by banks? What is this number as a percentage of total bank assets?

c. What is the total amount of reserves and cash items? What is this number as a percentage of total bank assets?

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Learning Objectives • Identify the reasons for and forms of a government safety net in financial markets.

• List and summarize the types of financial regu- lation and how each reduces asymmetric information problems.

10 Preview

As we have seen in previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heav-ily regulated of financial institutions. In this chapter, we develop an economic analysis of why regulation of the financial system takes the form it does.

Unfortunately, the regulatory process may not always work very well, as evidenced by the recent global financial crisis. Here we also use our economic analysis of financial regulation to explain the worldwide crises in banking and to consider how the regula- tory system can be reformed to prevent future such disasters.

Asymmetric infOrmAtiOn As A rAtiOnALe fOr finAnciAL reguLAtiOn

In earlier chapters, we saw how asymmetric information—the fact that different parties in a financial contract do not have the same information—leads to adverse selection and moral hazard problems, which have an important impact on our financial system. The concepts of asymmetric information, adverse selection, and moral hazard are especially useful in understanding why governments pursue financial regulation.

government safety net As we saw in Chapter 8, financial intermediaries, like banks, are particularly well suited to solving adverse selection and moral hazard problems because they make private loans that help avoid the free-rider problem. However, this solution to the free-rider problem creates another asymmetric information problem, because depositors lack information about the quality of these private loans. This asymmetric information problem leads to other problems that interfere with the proper functioning of the financial system.

Bank Panics and the need for Deposit insurance Before the FDIC (Federal Deposit Insurance Corporation) started operations in 1934, a bank failure (in which a bank is unable to meet its obligations to pay its depositors and other creditors, and so must go out of business) meant that depositors would have to wait until the bank was liquidated (until its assets had been turned into cash) to get their deposit funds; at that time, they would be paid only a fraction of the value of their deposits. Because they

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216 P a r t 3 Financial Institutions

couldn’t know if bank managers were taking on too much risk or were outright crooks, depositors would be reluctant to put money in banks, thus making banking institutions less viable. Second, depositors’ lack of information about the quality of bank assets can lead to a bank panic, in which many banks fail simultaneously. Because the simultane- ous failure of many banks leads to a sharp decline in bank lending, bank panics have serious, harmful consequences for the economy.

To understand why bank panics occur, consider the following situation. Deposit insurance does not exist, and an adverse shock hits the economy. As a result of the shock, 5% of banks have such large losses on loans that they become insolvent (have a negative net worth and so are bankrupt). Because of asymmetric information, deposi- tors are unable to tell whether their bank is a “good” bank or one of the 5% that are insolvent. Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits, and therefore are inclined to withdraw them. Indeed, because banks operate on a “sequential service constraint” (a first-come, first- served basis), depositors have a very strong incentive to be the first to show up at the bank, because if they are last in line, the bank may have paid out all its funds and they will get nothing. The incentive to “run” to the bank to be first is why withdrawals when there is fear about the health of a bank is described as a “bank run.” Uncertainty about the health of the banking system in general can lead to runs on both good and bad banks, and the failure of one bank can hasten the failure of others (referred to as the contagion effect). If nothing is done to restore the public’s confidence, a bank panic can ensue.

Indeed, bank panics were a fact of American life in the nineteenth and early twen- tieth centuries, with major panics occurring every 20 years or so, in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. Bank failures were a serious problem even during the boom years of the 1920s, when the number of bank failures averaged around 600 per year.

A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome depositors’ reluctance to put funds into the banking system. One form of safety net is deposit insurance, such as that provided by the Federal Deposit Insurance Corporation (FDIC) of the United States. The FDIC guarantees that current depositors will be paid off in full on the first $250,000 they have deposited in a bank if the bank fails. (In 1934, deposits were insured up to $2,500.) With fully insured deposits, depositors don’t need to run to the bank to make withdrawals—even if they are worried about the bank’s health— because their deposits will be worth 100 cents on the dollar no matter what. From 1930 to 1933, the years immediately preceding the creation of the FDIC, the number of bank failures averaged more than 2,000 per year. After the establishment of the FDIC in 1934, bank failures averaged fewer than 15 per year until 1981.

The FDIC uses two primary methods to handle a failed bank. In the first, called the payoff method, the FDIC allows the bank to fail and pays off depositors up to the $250,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets. Typically, when the payoff method is used, account holders with deposits in excess of the $250,000 limit get back more than 90 cents on the dollar, although the process can take several years to complete.

In the second method, called the purchase and assumption method, the FDIC reor- ganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank’s liabilities so that no depositor or other creditor loses a

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 217

penny. The FDIC often sweetens the pot for the merger partner by providing it with subsidized loans or by buying some of the failed bank’s weaker loans. The net effect of the purchase and assumption method is that the FDIC has guaranteed all liabilities and deposits, not just deposits under the $250,000 limit. The purchase and assumption method is typically more costly for the FDIC than the payoff method, but nevertheless was the FDIC’s more common procedure for dealing with a failed bank before new banking legislation was introduced in 1991.

In recent years, government deposit insurance has been growing in popularity and has spread to many countries throughout the world. Whether this trend is desirable is discussed in the Global box, “The Spread of Government Deposit Insurance Through- out the World: Is This a Good Thing?”

Other forms of the government safety net Deposit insurance is not the only form of government safety net. In other countries, governments have often stood ready to provide support to domestic banks facing runs even in the absence of explicit deposit insurance. Furthermore, banks are not the only financial intermediaries that can pose a systemic threat to the financial system. When financial institutions are very large or highly interconnected with other financial institutions or markets, their failure has the potential to bring down the entire financial system. This is exactly what happened with Bear Stearns and Lehman Brothers, two investment banks, and AIG, an insurance com- pany, during the global financial crisis in 2008.

Global The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

For the first 30 years after federal deposit insurance was established in the United States, only six coun- tries emulated the United States and adopted deposit insurance. However, this began to change in the late 1960s, with the trend accelerating in the 1990s, when the number of countries adopting deposit insurance topped 70. Government deposit insur- ance has taken off throughout the world because of growing concern about the health of banking systems, particularly after the increasing number of banking crises in recent years (documented at the end of this chapter). Has this spread of deposit insurance been a good thing? Has it helped improve the performance of the financial system and prevent banking crises?

The answer seems to be “no” under many cir- cumstances. Research at the World Bank has found that, on average, the adoption of explicit government deposit insurance is associated with less banking

sector stability and a higher incidence of banking crises.* Furthermore, on average, deposit insurance seems to retard financial development. However, these negative effects of deposit insurance occur only in countries with weak institutional environments: an absence of rule of law, ineffective regulation and supervision of the financial sector, and high corrup- tion. This situation is exactly what might be expected because, as we will see later in this chapter, a strong institutional environment is needed to limit the moral hazard incentives for banks to engage in the exces- sively risky behavior encouraged by deposit insur- ance. The problem is that development of a strong institutional environment may be very difficult to achieve in many emerging market countries. We are left with the following conclusion: Adoption of deposit insurance may be exactly the wrong medicine for promoting stability and efficiency of banking sys- tems in emerging market countries.

*See World Bank, Finance for Growth: Policy Choices in a Volatile World (Oxford: World Bank and Oxford University Press, 2001).

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One way in which governments provide support is through lending from the cen- tral bank to troubled institutions, as the Federal Reserve did during the global financial crisis (more on this in Chapter 18). This form of support is often referred to as the “lender of last resort” role of the central bank. In other cases, funds are provided directly to troubled institutions, as was done by the U.S. Treasury and by other governments in 2008 during a particularly virulent phase of the global financial crisis (see Chapter 12). Governments can also take over (nationalize) troubled institutions and guarantee that all creditors’ loans will be paid in full.

Drawbacks of the government safety net Although a government safety net can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it is a mixed blessing.

moral Hazard and the government safety net The most serious drawback of the government safety net stems from moral hazard, the incentives of one party in a transaction to engage in activities detrimental to the other party. Moral hazard is an important concern in insurance arrangements in general because the existence of insur- ance provides increased incentives for taking risks that might result in an insurance payoff. For example, some drivers with automobile collision insurance that has a low deductible might be more likely to drive recklessly, because if they get into an accident, the insurance company pays most of the costs for damage and repairs.

Moral hazard is a prominent concern associated with government safety nets. With a safety net, depositors and creditors know they will not suffer losses if a financial insti- tution fails, so they do not impose the discipline of the marketplace on these institu- tions by withdrawing funds when they suspect that the financial institution is taking on too much risk. Consequently, financial institutions with a government safety net have an incentive to take on greater risks than they otherwise would, because taxpayers will foot the bill if the bank subsequently goes belly up. Financial institutions can place the following bet: “Heads, I win; tails, the taxpayer loses.”

Adverse selection and the government safety net A further problem with a government safety net like deposit insurance is adverse selection, the fact that the people who are most likely to produce the adverse outcome the bank is insured against (bank fail- ure) are the same people who most want to take advantage of the insurance. For example, bad drivers are more likely than good drivers to take out automobile collision insurance with a low deductible. Because depositors and creditors protected by a government safety net have little reason to impose discipline on financial institutions, risk-loving entrepre- neurs might find the financial industry a particularly attractive one—they know they will be able to engage in highly risky activities. Even worse, because protected depositors and creditors have so little reason to monitor the financial institution’s activities, without gov- ernment intervention outright crooks might also find finance an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement.

“too Big to fail” The moral hazard created by a government safety net and the desire to prevent financial institution failures have presented financial regulators with a particular quandary, the too-big-to-fail problem, in which regulators are reluctant to close down large financial institutions and impose losses on their depositors and credi- tors because doing so might precipitate a financial crisis. The too-big-to-fail problem first arose when Continental Illinois, one of the ten largest banks in the United States, became insolvent in May 1984. Not only did the FDIC guarantee depositors up to the

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$100,000 insurance limit (the maximum at that time), but it also guaranteed accounts exceeding $100,000 and even prevented losses for Continental Illinois bondholders. Shortly thereafter, the Comptroller of the Currency (the regulator of national banks) testified to Congress that eleven of the largest banks would receive treatment similar to that received by Continental Illinois. Although the comptroller did not use the term “too big to fail” (it was actually used by Congressman Stewart McKinney in those Congressional hearings), this term is now applied to a policy in which the government provides guarantees of repayment of large, uninsured creditors of the largest banks, so that no depositor or creditor suffers a loss, even when these depositors and creditors are not automatically entitled to this guarantee. The FDIC does this by using the purchase and assumption method, giving the insolvent bank a large infusion of capital and then finding a willing merger partner to take over the bank and its deposits. The too-big-to-fail policy was extended to big banks that were not even among the eleven largest. (Note that “too big to fail” is a somewhat misleading term, because when a financial institution is closed or merged into another financial institution, the managers are usually fired and the stockholders in the financial institution lose their investment.)

One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. If the FDIC were willing to close a bank using the payoff method, paying depositors only up to the current $250,000 limit, large depositors with more than $250,000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bank’s activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less risky activities. However, once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk: No matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big financial institutions might take on even greater risks, thereby making bank failures more likely.

Similarly, the too-big-to-fail policy increases the moral hazard incentives for non- bank financial institutions that are extended a government safety net. Knowing that the financial institution will be bailed out, creditors have little incentive to monitor the institution and pull their money out when the institution is taking on excessive risk. As a result, large or interconnected financial institutions are more likely to engage in highly risky activities, making a financial crisis more likely.

Indeed, financial institutions that were considered too big to fail—including Bear Stearns, Lehman Brothers, and AIG—did take on excessive risk in the period leading to the global financial crisis, and their subsequent collapse helped trigger the worst financial crisis (discussed in Chapter 12) since the Great Depression.

financial consolidation and the government safety net With financial in- novation and the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex financial organizations. Financial consolidation poses two challenges to financial regulation because of the existence of the government safety net. First, the increased size of financial institutions resulting from financial consolidation increases the too-big-to-fail problem, because there are now more large institutions whose failure would expose the financial system to systemic (system-wide) risk. Thus more financial institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk increases the fragility of the financial system. Second, financial consolidation of banks with other financial services

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firms means that the government safety net may be extended to new activities, such as securities underwriting, insurance, or real estate activities, as occurred during the global financial crisis. This situation increases incentives for greater risk-taking in these activi- ties, which can also weaken the fabric of the financial system. Limiting the moral hazard incentives for the larger, more complex financial organizations that have arisen as a result of recent changes in legislation is one of the key issues facing banking regulators in the aftermath of the global financial crisis.

tyPes Of finAnciAL reguLAtiOn There are eight basic types of financial regulation aimed at lessening asymmetric infor- mation problems and excessive risk taking in the financial system: (1) restrictions on asset holdings, (2) capital requirements, (3) prompt corrective action, (4) chartering and examination, (5) assessment of risk management, (6) disclosure requirements, (7) consumer protection, and (8) restrictions on competition.

restrictions on Asset Holdings As we have seen, the moral hazard associated with a government safety net encourages too much risk taking on the part of financial institutions. Bank regulations that restrict asset holdings are directed at minimizing this moral hazard, which can cost taxpayers dearly.

Even in the absence of a government safety net, financial institutions still have the incentive to take on too much risk. Risky assets may provide the financial institution with higher earnings when they pay off, but if they do not pay off and the institution fails, depositors and creditors are left holding the bag. If depositors and creditors were able to monitor the bank easily by acquiring information on its risk-taking activities, they would be able to withdraw their funds immediately if the institution was taking on too much risk. To prevent such a loss of funds, the institution would be more likely to reduce its risk-taking activities. Unfortunately, acquiring information on an institution’s activities to learn how much risk it is taking on can be a difficult task. Hence most depositors and many creditors are incapable of imposing the discipline that might prevent financial institutions from engaging in risky activities. A strong rationale for government regulation aimed at reducing risk taking on the part of financial institutions therefore existed even before the establishment of government safety nets like federal deposit insurance.

Because banks are the financial institutions most prone to panics, they are subjected to strict regulations that restrict their holdings of risky assets, such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the dollar amounts of loans in particular categories or to individual borrowers. With the extension of the gov- ernment safety net during the global financial crisis, and the calls for regulatory reform in its aftermath, it is likely that nonbank financial institutions may face greater restrictions on their holdings of risky assets in the future. The danger exists, however, that these restric- tions may become so onerous that the efficiency of the financial system will be impaired.

capital requirements Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions. When a financial institution is forced to hold a large amount of equity capital, the institution has more to lose if it fails and is thus more likely to pursue less risky activities. In addition, as was illustrated in Chapter 9, capital functions as a cushion when bad shocks occur, making it less likely that a financial institution will fail, thereby directly adding to the safety and soundness of financial institutions.

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 221

Capital requirements for banks take two forms. The first type is based on the leverage ratio, the amount of capital divided by the bank’s total assets. To be classified as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

In the wake of the Continental Illinois and savings and loans bailouts of the 1980s, regulators in the United States and the rest of the world have become increasingly wor- ried about banks’ holdings of risky assets and about the increase in banks’ off-balance- sheet activities. Off-balance-sheet activities, which do not appear on bank balance sheets but nevertheless expose banks to risk, involve trading financial instruments and generating income from fees. To help combat the problems of risky assets and off-balance- sheet activities, banking officials from industrialized nations agreed to set up the Basel Committee on Banking Supervision (so named because it meets under the auspices of the Bank for International Settlements in Basel, Switzerland), which implemented the Basel Accord, which deals with a second type of capital requirements, risk-based capital requirements. The Basel Accord, which requires that banks hold as capital at least 8% of their risk-weighted assets, has been adopted by more than 100 countries, including the United States. Assets are allocated into four categories, each with a different weight to reflect the degree of credit risk. The first category carries a zero weight and includes items that have little default risk, such as reserves and government securities issued by the Organization for Economic Cooperation and Development (OECD—industrialized) countries. The second category has a 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off-balance-sheet activities are treated in a similar manner. They are assigned a credit-equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies, and there are minimum capital requirements for risks in banks’ trading accounts.

Over time, the limitations of the Basel Accord have become apparent, because the regulatory measure of bank risk, as stipulated by the risk weights, can differ substantially from the actual risk the bank faces. This discrepancy has resulted in regulatory arbitrage, a practice in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off their books low-risk assets, such as a loan to a company with a very high credit rating. The Basel Accord thus might lead to increased risk taking, the opposite of its intent. To address these limitations, the Basel Committee on Bank Super- vision came up with a new capital accord, often referred to as Basel 2. However, in the aftermath of the global financial crisis, the committee developed an even newer accord, which the media has dubbed “Basel 3.” These accords are described in the Global box, “Where Is the Basel Accord Heading After the Global Financial Crisis?”

Prompt corrective Action If the amount of a financial institution’s capital falls to low levels, two serious problems result. First, the bank is more likely to fail because it has a smaller capital cushion if it suffers loan losses or other asset write-downs. Second, with less capital, a financial institution has less “skin in the game” and is therefore more likely to take on exces- sive risks. In other words, the moral hazard problem becomes more severe, making it more likely that the institution will fail and the taxpayer will be left holding the bag. To prevent this, the Federal Deposit Insurance Corporation Improvement Act of 1991

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Global Where Is the Basel Accord Heading After the Global Financial Crisis?

Starting in June 1999, the Basel Committee on Banking Supervision released several proposals to reform the original 1988 Basel Accord. These efforts have culminated in what bank supervisors refer to as Basel 2, which is based on three pillars.

1. Pillar 1 links capital requirements for large, inter- nationally active banks more closely to actual risk of three types: market risk, credit risk, and opera- tional risk. It does so by specifying many more categories of assets, with different risk weights, in its standardized approach. Alternatively, it allows sophisticated banks to pursue an internal ratings- based approach that permits these banks to use their own models of credit risk.

2. Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have ade- quate procedures in place for determining how much capital they need.

3. Pillar 3 focuses on improving market discipline through increased disclosure of details about a bank’s credit exposures, its amount of reserves and capital, the officials who control the bank, and the effectiveness of its internal rating system.

Although Basel 2 made great strides toward limiting excessive risk taking by internationally active banking institutions, it greatly increased the complexity of the accord. The document describing the original Basel Accord was 26 pages long, whereas the final draft of Basel 2 exceeded 500 pages. The original timetable called for the completion of the final round of consul- tation by the end of 2001, with the new rules taking effect by 2004. However, criticism from banks, trade associations, and national regulators led to several postponements. The final draft of Basel 2 was not published until June 2004, and European banks began to implement the new accord at the start of 2008. U.S. banks submitted plans for compliance with Basel 2 in 2008, but full implementation did not occur until 2009. Only the dozen or so largest U.S. banks are sub- ject to Basel 2; all others are allowed to use a simplified version of the standards it imposes.

The global financial crisis, however, revealed many limitations of the new accord. First, Basel 2 did not require banks to have sufficient capital to weather the financial disruption that occurred during this period. Second, risk weights in the standardized approach are heavily reliant on credit ratings, which proved to be extremely unreliable in the run-up to the financial crisis. Third, Basel 2 is very procyclical— that is, it demands that banks hold less capital when times are good but more when times are bad, thereby exacerbating credit cycles. Because the probability of default and expected losses on different classes of assets rises during bad times, Basel 2 may require more capital at exactly the time when capital is most short. This has been a particularly serious concern in the aftermath of the global financial crisis. As a result of this crisis, banks’ capital balances eroded, lead- ing to a cutback on lending that was a big drag on the economy. Basel 2 made this cutback in lending even worse, doing yet more harm to the economy. Fourth, Basel 2 did not focus sufficiently on the dan- gers of a possible drying up of liquidity, a problem that brought down financial institutions during the financial crisis.

As a result of these limitations, in 2010 the Basel Committee developed a new accord, Basel 3. It beefs up capital standards not only by raising them sub- stantially but also by improving the quality of the capital, makes capital standards less procyclical by raising capital requirements in good times and low- ering them in bad, makes new rules on the use of credit ratings, and requires financial institutions to have more stable funding so that they are better able to withstand liquidity shocks. Measures to achieve these objectives are highly controversial because of concerns that tightening up capital standards might cause banks to restrict their lending, which would make it harder for economies throughout the world to recover from the recent deep recession. Basel 3 is being implemented slowly over time, with the target for full implementation extending out to the end of 2019. Whether Basel 3 will be fully in place by that date, and whether it will be successful in restraining risk taking, is highly uncertain.

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 223

adopted prompt corrective action provisions that require the FDIC to intervene earlier and more vigorously when a bank gets into trouble.

Banks are now classified into five groups based on bank capital. Group 1, classi- fied as “well capitalized,” comprises banks that significantly exceed minimum capital requirements and are allowed privileges such as the ability to do some securities under- writing. Banks in group 2, classified as “adequately capitalized,” meet minimum capital requirements and are not subject to corrective actions but are not allowed the privileges of the well-capitalized banks. Banks in group 3, “undercapitalized,” fail to meet capital requirements. Banks in groups 4 and 5 are “significantly undercapitalized” and “criti- cally undercapitalized,” respectively, and are not allowed to pay interest on their depos- its at rates that are higher than average. In addition, for group 4 and 5 banks, the FDIC is required to take prompt corrective actions, such as requiring these banks to submit capital restoration plans, restrict their asset growth, and seek regulatory approval to open new branches or develop new lines of business. Banks that are so undercapitalized as to have equity capital that amounts to less than 2% of assets fall into group 5, and the FDIC must take steps to close them down.

financial supervision: chartering and examination Overseeing who operates financial institutions and how they are operated, referred to as financial supervision or prudential supervision, is an important method for reducing adverse selection and moral hazard in the financial industry. Because financial institutions can be used by crooks or overambitious entrepreneurs to engage in highly speculative activities, such undesirable people are often eager to run a financial institu- tion. Chartering financial institutions is one method of preventing this adverse selection problem; through chartering, proposals for new institutions are screened to prevent undesirable people from controlling them.

A commercial bank obtains a charter either from the Comptroller of the Currency (in the case of a national bank) or from a state banking authority (in the case of a state bank). To obtain a charter, the people planning to organize the bank must submit an application that shows how they plan to operate the bank. In evaluating the application, the regulatory authority looks at whether the bank is likely to be sound by examining the quality of the bank’s intended management, the likely earnings of the bank, and the amount of the bank’s initial capital. Before 1980, the chartering agency typically explored the issue of whether the community needed a new bank. Often a new bank charter would not be granted if existing banks in a community would be hurt by its presence. Today this anticompetitive stance (justified by the desire to prevent failures of existing banks) is no longer as strong in the chartering agencies.

Once a bank has been chartered, it is required to file periodic (usually quarterly) call reports that reveal the bank’s assets and liabilities, income and dividends, ownership, for- eign exchange operations, and other details. The bank is also subject to examination by the bank regulatory agencies to ascertain its financial condition at least once a year. To avoid duplication of effort, the three federal agencies work together and usually accept each other’s examinations. This means that, typically, national banks are examined by the Office of the Comptroller of the Currency, state banks that are members of the Federal Reserve System are examined by the Fed, and insured nonmember state banks are examined by the FDIC.

Regular on-site examinations, which allow regulators to monitor whether the institu- tion is complying with capital requirements and restrictions on asset holdings, function to limit moral hazard. Bank examiners give banks a CAMELS rating. The acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity,

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and sensitivity to market risk. With this information about a bank’s activities, regulators can enforce regulations by taking formal actions such as issuing cease and desist orders to alter the bank’s behavior, or even closing a bank if its CAMELS rating is sufficiently low. Actions taken to reduce moral hazard by restricting banks from taking on too much risk also help reduce the adverse selection problem further, because with less opportunity for risk taking, risk-loving entrepreneurs are less likely to be attracted to the banking industry.

Note that the methods used by regulators to cope with adverse selection and moral hazard have their counterparts in private financial markets (see Chapters 8 and 9). Char- tering is similar to the screening of potential borrowers; regulations that restrict risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risky investment activities; capital requirements act like restrictive covenants that require minimum amounts of net worth for borrowing firms; and regular examinations are similar to the monitoring of borrowers by lending institutions.

Bank examinations are conducted by bank examiners, who sometimes make unan- nounced visits to the bank (so that nothing can be “swept under the rug” in anticipation of their examination). The examiners study a bank’s books to see whether it is comply- ing with the rules and regulations that apply to its holdings of assets. If a bank is hold- ing securities or loans that are too risky, the bank examiner can force the bank to get rid of them. If a bank examiner decides that a loan is unlikely to be repaid, the examiner can force the bank to declare the loan worthless (to write off the loan, which reduces the bank’s capital). If, after examining the bank, the examiner feels that it does not have sufficient capital or has engaged in dishonest practices, the bank can be declared a “problem bank” and will be subject to more frequent examinations.

Assessment of risk management Traditionally, on-site examinations have focused primarily on assessment of the qual- ity of a financial institution’s balance sheet at a point in time and whether it complies with capital requirements and restrictions on asset holdings. Although the traditional focus is still important in reducing excessive risk taking by financial institutions, it is no longer thought to be adequate in today’s world, in which financial innovation has produced new markets and instruments that make it easy for financial institutions and their employees to make huge bets easily and quickly. In this new financial environ- ment, a financial institution that is healthy at a particular point in time can be driven into insolvency extremely rapidly by trading losses, as forcefully demonstrated by the failure of Barings in 1995 (discussed in Chapter 9). Thus an examination that focuses only on a financial institution’s position at a point in time may not be effective in indi- cating whether it will, in fact, be taking on excessive risk in the near future.

This change in the financial environment resulted in a major shift in thinking about the prudential supervisory process throughout the world. Bank examiners, for example, now place far greater emphasis on evaluating the soundness of a bank’s management processes with regard to controlling risk. This shift in thinking was reflected in a new focus on risk management by the Federal Reserve System, starting with 1993 guidelines for examiners regarding trading and derivatives activities. The focus was expanded and formalized in the Trading Activities Manual issued early in 1994, which provided bank examiners with tools to evaluate risk management systems. In late 1995, the Federal Reserve and the Comptroller of the Currency announced that they would be assessing risk management processes at the banks they supervised. Now, bank examiners give a separate risk management rating, from 1 to 5, that feeds into the overall management rating as part of the CAMELS system. Four elements of sound risk management are assessed to arrive at the risk management rating: (1) the quality of oversight provided

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 225

by the board of directors and senior management; (2) the adequacy of policies and lim- its for all activities that present significant risks; (3) the quality of the risk measurement and monitoring systems; and (4) the adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees.

This shift toward focusing on management processes is also reflected in recent guidelines adopted by the U.S. bank regulatory authorities to deal with interest-rate risk. These guidelines require the bank’s board of directors to establish interest-rate risk limits, appoint officials of the bank to manage this risk, and monitor the bank’s risk exposure. The guidelines also require that senior management of a bank develop formal risk management policies and procedures to ensure that the board of directors’ risk lim- its are not violated and to implement internal controls to monitor interest-rate risk and compliance with the board’s directives. Particularly important is the implementation of stress tests, which calculate potential losses and the need for more capital under fictional dire scenarios, and value-at-risk (VaR) calculations, which measure the size of the loss on a trading portfolio—say, over a two-week period—that might happen 1% of the time. In addition to these guidelines, bank examiners will continue to consider interest-rate risk in deciding the bank’s capital requirements.

Disclosure requirements The free-rider problem described in Chapter 8 indicates that individual depositors and creditors do not have enough incentive to produce private information about the qual- ity of a financial institution’s assets. To ensure that better information is available in the marketplace, regulators can require that financial institutions adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of an institution’s portfolio and the amount of its exposure to risk. More public information about the risks incurred by financial institutions and the qual- ity of their portfolios can better enable stockholders, creditors, and depositors to evalu- ate and monitor financial institutions and so act as a deterrent to excessive risk taking.

Disclosure requirements are a key element of financial regulation. Basel 2 puts a particular emphasis on disclosure requirements, with one of its three pillars focusing on increasing market discipline by mandating increased disclosure by banking institutions of their credit exposure, amount of reserves, and capital. The Securities Act of 1933 and the Securities and Exchange Commission (SEC), which was established in 1934, also impose disclosure requirements on any corporation, including financial institu- tions, that issues publicly-traded securities. In addition, the SEC has required financial institutions to provide additional disclosure regarding their off-balance-sheet positions and more information about how they value their portfolios.

Regulation to increase disclosure is needed to limit incentives to take on excessive risk and to upgrade the quality of information in the marketplace so that investors can make informed decisions, thereby improving the ability of financial markets to allocate capital to its most productive uses. The efficiency of markets is assisted by the SEC’s disclosure requirements mentioned above, as well as its regulation of brokerage firms, mutual funds, exchanges, and credit-rating agencies to ensure that they produce reli- able information and protect investors. The Sarbanes-Oxley Act of 2002 took disclosure of information even further by increasing the incentives to produce accurate audits of corporate income statements and balance sheets, establishing the Public Company Accounting Oversight Board (PCAOB) to oversee the audit industry, and putting in place regulations to limit conflicts of interest in the financial services industry.

Particularly controversial in the wake of the global financial crisis is the move to so-called mark-to-market accounting, also called fair-value accounting, in which

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226 P a r t 3 Financial Institutions

assets are valued in the balance sheet at what they could sell for in the market (see the FYI box, “Mark-to-Market Accounting and the Global Financial Crisis”).

Consumer Protection The existence of asymmetric information suggests that consumers may not have enough information to protect themselves fully in financial dealings. Consumer protection regulation has taken several forms. The Consumer Protection Act of 1969 (more commonly referred to as the Truth in Lending Act) requires all lenders, not just banks, to provide information to consumers about the cost of borrowing, including the disclo- sure of a standardized interest rate (called the annual percentage rate, or APR) and the total finance charges on the loan. The Fair Credit Billing Act of 1974 requires creditors, especially credit card issuers, to provide information on the method of assessing finance charges, and requires that billing complaints be handled quickly.

Congress also passed legislation to reduce discrimination in credit markets. The Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination

FYI Mark-to-Market Accounting and the Global Financial Crisis

The controversy over mark-to-market accounting has made accounting a hot topic. Mark-to-market accounting was made standard practice in the U.S. account- ing industry in 1993. The rationale behind mark-to- market accounting is that market prices provide the best basis for estimating the true value of assets, and hence capital, in a firm. Before mark-to-market accounting, firms relied on traditional historical-cost (book value) accounting, in which the value of an asset is set at its initial purchase price. The problem with historical-cost accounting is that fluctuations in the values of assets and liabilities caused by changes in interest rates or default risk are not reflected in the calculation of the firm’s equity capital. Yet changes in the market values of assets and liabilities—and hence changes in the market value of equity capital—are what indicate whether a firm is in good shape or, alternatively, is getting into trouble and may therefore be more susceptible to moral hazard.

Mark-to-market accounting, however, is subject to a major flaw: At times, markets stop working, as occurred during the global financial crisis. The price of an asset sold at a time of financial distress does not reflect its fundamental value. That is, the fire-sale liqui- dation value of an asset can at times be well below the present value of its expected future cash flows. Many people, particularly bankers, have criticized mark-to- market accounting, claiming that it was an important factor driving the recent global financial crisis. They

claim that the seizing up of financial markets led to market prices that were well below their fundamental values. Mark-to-market accounting requires that financial firms’ assets be marked down in value. This markdown creates a shortfall in capital that leads to a cutback in lending, which causes a further deteriora- tion in asset prices, which in turn causes a further cut- back in lending. The resulting adverse feedback loop can then make the financial crisis even worse. Although the criticisms of mark-to-market accounting have some validity, some of the criticism by bankers is self-serving. The criticism was made only when asset values were falling and mark-to-market accounting was painting a bleaker picture of banks’ balance sheets, as opposed to when asset prices were booming and mark-to-market accounting made banks’ balance sheets look very good.

The criticisms of mark-to-market accounting led to a Congressional focus on mark-to-market accounting that resulted in a provision in the Emergency Economic Stabilization Act of 2008, that required the SEC, in consultation with the Federal Reserve and the U.S. Treasury, to submit a study of mark-to-market account- ing applicable to financial institutions. The resulting report concluded that the rules requiring mark-to- market accounting were not a major cause of the global financial crisis and should be retained. However, the report did suggest some improvements. Who knew that accounting could get even politicians worked up!

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 227

by lenders based on race, gender, marital status, age, or national origin. The act is administered by the Federal Reserve under Regulation B. The Community Reinvest- ment Act (CRA) of 1977 was enacted to prevent “redlining,” a lender’s refusal to lend in a particular area (marked off by a hypothetical red line on a map). The Community Reinvestment Act requires that banks show that they lend in all areas in which they take deposits, and if banks are found to be in noncompliance with the act, regulators can reject their applications for mergers, branching, or other new activities.

The global financial crisis has illustrated the need for greater consumer protection, because so many borrowers took out loans with terms they did not understand and that were well beyond their means to repay. (Most infamous were so-called NINJA loans, which were issued to borrowers with No Income, No Job, and No Assets.) The result was millions of foreclosures, with many households losing their homes. As we will see in Chapter 12, Congress responded by creating a new consumer protection agency to prevent this type of lending from happening again.

restrictions on competition Increased competition can also increase moral hazard incentives for financial institu- tions to take on more risk. Declining profitability resulting from increased competition could tip the incentives of financial institutions toward assuming greater risk in an effort to maintain former profit levels. Thus governments in many countries have insti- tuted regulations to protect financial institutions from competition. These regulations took two forms in the United States in the past. First were restrictions on branching, described in Chapter 11, which reduced competition between banks. These restrictions were eliminated, however, in 1994. The second form involved preventing nonbank institutions from competing with banks by preventing them from engaging in banking business, as embodied in the Glass-Steagall Act, which was repealed in 1999.

Although restrictions on competition propped up the health of banks, they had some serious disadvantages: They led to higher charges to consumers and decreased the efficiency of banking institutions, which now did not have to compete as vigorously. Thus, although the existence of asymmetric information provided a rationale for anticompetitive regula- tions, it did not mean they would be beneficial. Indeed, in recent years, the impulse of governments in industrialized countries to restrict competition has been waning.

summary Asymmetric information analysis explains the types of financial regulations that are needed to reduce moral hazard and adverse selection problems in the financial system. However, understanding the theory behind regulation does not mean that regulation and supervi- sion of the financial system are easy in practice. Getting regulators and supervisors to do their job properly is difficult for several reasons. First, as we will see in our discussion of financial innovation in Chapter 11, financial institutions, in their search for profits, have strong incentives to avoid existing regulations by loophole mining. Thus regulation applies to a moving target. Regulators are continually playing cat-and-mouse with financial institutions—financial institutions think up clever ways to avoid regulations, which then leads regulators to modify their regulation activities. Regulators continually face new challenges in a dynamically changing financial system, and unless they can respond rapidly, they may not be able to keep financial institutions from taking on excessive risk. This problem can be exacerbated if regulators and supervisors do not have the resources or expertise necessary to keep up with clever people seeking to cir- cumvent the existing regulations.

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228 P a r t 3 Financial Institutions

Financial regulation and supervision are difficult for two other reasons. In the regula- tion and supervision game, the devil is in the details. Subtle differences in the details may have unintended consequences; unless regulators get the regulation and supervision just right, they may be unable to prevent excessive risk taking. In addition, regulated firms may lobby politicians to lean on regulators and supervisors to go easy on them.

For all of these reasons, there is no guarantee that regulators and supervisors will be successful in promoting a healthy financial system. These same problems bedevil financial regulators in other countries as well, as the Global box, “International Finan- cial Regulation,” indicates. Indeed, financial regulation and supervision have not always worked well, leading to banking crises in the United States and throughout the world.1

1The United States suffered a major banking crisis in the 1980s, a crisis that hit the savings and loan industry particularly hard. The story of this banking crisis is a fascinating one, involving juicy scandals and even Senator John McCain, who was a presidential candidate in 2008. This crisis is discussed in the first Web appendix to this chapter, “The 1980s Banking and Saving and Loan Crisis,” which can be found on the book’s Companion Website at http://www.pearsonhighered.com/mishkin. A second Web appendix to this chapter, “Banking Crises Throughout the World,” discusses banking crises in other countries. The second Web appendix can also be found on the Companion Website.

Global International Financial Regulation Because asymmetric information problems in the bank- ing industry are a fact of life throughout the world, financial regulation in other countries is similar to that in the United States. Financial institutions are chartered and supervised by government regulators, just as they are in the United States. Disclosure requirements for financial institutions and corporations issuing securities are similar in other developed countries. Deposit insur- ance is also a feature of the regulatory systems of most other countries, although its coverage is often smaller than that in the United States, and it is intentionally not advertised. We have also seen that capital requirements are in the process of being standardized across countries in compliance with agreements like the Basel Accord.

Particular problems in financial regulation occur when financial institutions operate in many coun- tries and thus can shift their business readily from one country to another. Financial regulators closely examine the domestic operations of financial insti- tutions in their own country, but they often do not have the knowledge or ability to keep a close watch on operations in other countries, operations run either by domestic institutions’ foreign affiliates or by foreign institutions with domestic branches. In addi- tion, when a financial institution operates in many countries, it is not always clear which national regula- tory authority should have primary responsibility for

keeping the institution from engaging in overly risky activities.

The difficulties inherent in international financial regulation were highlighted by the collapse of the Bank of Credit and Commerce International (BCCI). BCCI, although it operated in more than 70 countries, including the United States and the United Kingdom, was supervised by Luxembourg, a tiny country unlikely to be up to the task. When massive fraud was discovered, the Bank of England closed BCCI down, but not before depositors and stockholders were exposed to huge losses. Cooperation among regulators in different countries and standardization of regulatory requirements provide potential solutions to the problems of international financial regulation. The world has moved in this direction through agree- ments like the Basel Accord and oversight procedures announced by the Basel Committee in July 1992, which require a bank’s worldwide operations to be under the scrutiny of a single home-country regulator with enhanced powers to acquire information on the bank’s activities. The Basel Committee also ruled that regulators in other countries can restrict the opera- tions of a foreign bank if they believe it lacks effective oversight. Whether agreements of this type will solve the problem of international financial regulation in the future is an open question.

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 229

Because so many laws regulating the financial system have been passed in the United States, it is hard to keep track of them all. As a study aid, Table 1 lists the major financial legislation passed since the beginning of the twentieth century and outlines the key provisions of each act.

Federal Reserve Act (1913)

Created the Federal Reserve System

McFadden Act of 1927

Effectively prohibited banks from branching across state lines

Put national and state banks on equal footing regarding branching

Banking Acts of 1933 (Glass-Steagall) and 1935

Created the FDIC

Separated commercial banking from the securities industry

Prohibited interest on checkable deposits and restricted such deposits to commercial banks

Put interest-rate ceilings on other deposits

Securities Act of 1933 and Securities Exchange Act of 1934

Required that investors receive financial information on securities offered for public sale

Prohibited misrepresentations and fraud in the sale of securities

Created the Securities and Exchange Commission (SEC)

Investment Company Act of 1940 and Investment Advisers Act of 1940

Regulated investment companies, including mutual funds

Regulated investment advisers

Bank Holding Company Act and Douglas Amendment (1956)

Clarified the status of bank holding companies (BHCs)

Gave the Federal Reserve regulatory responsibility for BHCs

Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980

Gave thrift institutions wider latitude in activities

Approved NOW and sweep accounts nationwide

Phased out interest-rate ceilings on deposits

Imposed uniform reserve requirements on depository institutions

Eliminated usury ceilings on loans

Increased deposit insurance to $100,000 per account

Depository Institutions Act of 1982 (Garn–St. Germain)

Gave the FDIC and the Federal Savings and Loan Insurance Corporation (FSLIC) emergency powers to merge banks and thrifts across state lines

Allowed depository institutions to offer money market deposit accounts (MMDAs)

Granted thrifts wider latitude in commercial and consumer lending

table 1 major financial Legislation in the united states

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230 P a r t 3 Financial Institutions

Competitive Equality in Banking Act (CEBA) of 1987

Provided $10.8 billion to shore up the FSLIC

Made provisions for regulatory forbearance in depressed areas

Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989

Provided funds to resolve savings and loan (S&L) failures

Eliminated FSLIC and the Federal Home Loan Bank Board

Created the Office of Thrift Supervision to regulate thrifts

Created the Resolution Trust Corporation to resolve insolvent thrifts

Raised deposit insurance premiums

Reimposed restrictions on S&L activities

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991

Recapitalized the FDIC

Limited brokered deposits and the too-big-to-fail policy

Set provisions for prompt corrective action

Instructed the FDIC to establish risk-based premiums

Increased examinations, capital requirements, and reporting requirements

Included the Foreign Bank Supervision Enhancement Act (FBSEA), which strengthened the Fed’s au- thority to supervise foreign banks

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

Overturned prohibition of interstate banking

Allowed branching across state lines

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

Repealed Glass-Steagall and removed the separation of banking and securities industries

Sarbanes-Oxley Act of 2002

Created Public Company Accounting Oversight Board (PCAOB)

Prohibited certain conflicts of interest

Required certification by CEO and CFO of financial statements and independence of audit committee

Federal Deposit Insurance Reform Act of 2005

Merged the Bank Insurance Fund and the Savings Association Insurance Fund

Increased deposit insurance on individual retirement accounts to $250,000 per account

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Created Consumer Financial Protection Bureau to regulate mortgages and other financial products

Required routine derivatives to be cleared through central clearinghouses and exchanges

Authorized government takeovers of financial holding companies

Created Financial Stability Oversight Council to regulate systemically important financial institutions

Banned banks from proprietary trading and from owning large percentages of hedge funds

table 1 (continued)

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 231

summAry

1. The concepts of asymmetric information, adverse selection, and moral hazard help explain why governments pursue financial regulation.

2. There are eight basic types of financial regulation aimed at lessening asymmetric information problems and excessive risk taking in the financial system: (1)

restrictions on asset holdings; (2) capital requirements; (3) prompt corrective action; (4) chartering and examination; (5) assessment of risk management: (6) disclosure requirements; (7) consumer protection; and (8) restrictions on competition.

Key terms

bank failure, p. 215 bank panic, p. 216 Basel Accord, p. 221 Basel Committee on Banking

Supervision, p. 221

fair-value accounting, p. 225 financial supervision (prudential

supervision), p. 223 leverage ratio, p. 221 mark-to-market accounting, p. 225

off-balance-sheet activities, p. 221 regulatory arbitrage, p. 221 stress tests, p. 225 too-big-to-fail problem, p. 218 value-at-risk (VaR), p. 225

QuestiOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Why are deposit insurance and other types of government safety nets important to the health of the economy?

2. If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result?

3. Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer.

4. How could higher deposit insurance premiums for banks with riskier assets benefit the economy?

5. What are the costs and benefits of a too-big-to-fail policy?

6. What types of bank regulations are designed to reduce moral hazard problems? Will they completely eliminate moral hazard problems?

7. Why does imposing bank capital requirements on banks help limit risk taking?

8. At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of the largest U.S. banks to accept capital injections in exchange for nonvoting ownership stock, even though some of the banks did not need the capital and did not want to

participate. What could be the Treasury’s rationale for doing this?

9. What special problem do off-balance-sheet activities present to bank regulators, and what have they done about it?

10. What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3 Accord attempt to address these limitations?

11. How does bank chartering reduce adverse selection problems? Does it always work?

12. Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management?

13. How do disclosure requirements help limit excessive risk taking by banks?

14. Suppose Universal Bank holds $100 million in assets, which are composed of the following:

Required reserves: $10 million

Excess reserves: $ 5 million

Mortgage loans: $20 million

Corporate bonds: $15 million

Stocks: $25 million

Commodities: $25 million

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232 P a r t 3 Financial Institutions

a mark-to-market accounting system or the historical- cost system?

d. What do your answers to parts (b) and (c) tell you about the tradeoffs between the two accounting systems?

15. Why might more competition in financial markets be a bad idea? Would restrictions on competition be a better idea? Why or why not?

a. Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and commodities as assets? Why or why not?

b. If the housing market suddenly crashed, would Universal Bank be better off using a mark-to-market accounting system or the historical-cost system?

c. If the price of commodities suddenly increased sharply, would Universal Bank be better off using

All applied problems are available in MyEconLab at http://www.myeconlab.com.

16. Consider a failing bank. How much is a deposit of $350,000 worth if the FDIC uses the payoff method? The purchase and assumption method? Which method is more costly to taxpayers?

17. Consider a bank with the following balance sheet:

mortgages with the following terms: 200 standard, 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for $250,000.

Assume that required reserves are 8%.

a. What does the bank balance sheet look like?

b. How well capitalized is the bank?

c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day.

19. Early the next day, the bank invests $50 million of its excess reserves in commercial loans. Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%, implying a present value of Oldhat’s current mortgage holdings of $124,798 per mortgage. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat’s balance sheet look like? How do these events affect its capital position?

20. To avoid insolvency, regulators decide to provide the bank with $25 million in bank capital. However, the bad news about the mortgages is featured in the local newspaper, causing a bank run. As a result, $30 mil- lion in deposits is withdrawn. Show the effects of the capital injection and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank? If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further runs on the bank, how much of an additional capital injection is required to reach a 10% capital ratio?

APPLieD PrOBLems

The bank makes a loan commitment for $10 million to a commercial customer. Calculate the bank’s capital ratio before and after the agreement. Calculate the bank’s risk-weighted assets before and after the agreement.

Problems 18–20 relate to a sequence of transactions at Oldhat Financial.

18. Oldhat Financial starts its first day of operations with $9 million in capital. A total of $130 million in checkable deposits is received. The bank makes a $25 million commercial loan and another $50 million in

Assets Liabilities

Required reserves

$ 8 million Checkable deposits

$100 million

Excess reserves

$ 3 million Bank capital

$ 6 million

T-bills $45 million    

Commercial loans

$50 million    

DAtA AnALysis PrOBLems

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the number of commercial banks

in the U.S. in each of the following categories: average assets less than $100 million (US100NUM), average assets between $100 million and $300 million (US13NUM), average assets between $300 million

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C h a P t e r 1 0 Economic Analysis of Financial Regulation 233

2. Go to the St. Louis Federal Reserve FRED database, and find data on the residual of assets less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks (TLAACBM027SBOG). Download the data from January 1990 through the most recent month available into a spreadsheet. For each monthly observation, calculate the bank lever- age ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in commercial banks over time?

and $1 billion (US31NUM), average assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15 billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories, as a percentage of the total number of banks, for the most recent quarter of data available and for 1990:Q1. What has happened to the propor- tion of very large banks? What has happened to the proportion of very small banks? What does this say about the “too-big-to-fail” problem and moral hazard?

WeB exercises

1. The Office of the Comptroller of the Currency is responsible for many of the regulations affecting bank operations. Go to http://www.occ.treas.gov/. Click on “OCC Regulations” under “Law and Regulations.” Now

click on “12 CFR Parts 1 to 199.” What does Part 1 cover? How many parts are there in 12 CFR? Open Part 18. What topic does it cover? Summarize its purpose.

WeB references

http://www.ny.frb.org/banking/supervisionregulate.html

View bank regulation information.

http://www.federalreserve.gov/Regulations/default.htm

Access regulatory publications of the Federal Reserve Board.

http://www.fdic.gov/regulations/laws/important/index.html

Describes the most important laws that have affected the banking industry in the United States.

http://www.fdic.gov/bank/historical/bank/index.html

Search for data on bank failures in any year.

WeB APPenDices

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read the Web appendices to Chapter 10.

Appendix 1: The 1980s Banking and Savings and Loan Crisis

Appendix 2: Banking Crises Throughout the World

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Learning Objectives • Recognize the key features of the bank- ing system and the historical context of the implementation of these features.

• Explain how financial innovation led to the growth of the shadow banking system.

• Identify the key structural changes in the commercial banking industry.

• Summarize the factors that led to consolida- tion in the commercial banking industry.

• Assess the reasons for separating banking from other financial services through legislation.

• Summarize the distinctions between thrift institutions and commercial banks.

• Identify the reasons for U.S. banks to operate in foreign countries and for foreign banks to operate in the United States.

11 Preview

The operations of individual banks (how they acquire, use, and manage funds to make a profit) are roughly similar throughout the world. In all countries, banks are financial intermediaries in the business of earning profits. When you con- sider the structure and operation of the banking industry as a whole, however, the United States is in a class by itself. In most countries, four or five large banks typically dominate the banking industry, but in the United States there are on the order of 5,700 commercial banks, 800 savings and loan associations, 350 mutual savings banks, and 7,000 credit unions.

Is more necessarily better? Does this diversity mean that the American banking system is more competitive and therefore more economically efficient and sound than banking systems in other countries? What in the American economic and political system explains this large number of banking institutions? In this chapter, we try to answer these questions by examining the historical trends in the banking industry and its overall structure.

We start by examining the historical development of the banking system and how financial innovation has increased the competitive environment for the banking indus- try and is causing fundamental changes in it. We go on to look at the commercial bank- ing industry in detail and then discuss the thrift industry, which includes savings and loan associations, mutual savings banks, and credit unions. We spend more time on commercial banks because they are by far the largest depository institutions, accounting for more than two-thirds of the deposits in the banking system. In addition to looking at our domestic banking system, we examine the forces behind the growth of interna- tional banking to see how it has affected us in the United States.

HisTOricaL DeveLOPmenT Of THe Banking sysTem The modern commercial banking industry in the United States began when the Bank of North America was chartered in Philadelphia in 1782. With the success of this bank, other banks opened for business, and the American banking industry was off and run- ning. (As a study aid, Figure 1 provides a time line of the most important dates in the history of American banking before World War II.)

A major controversy involving the industry in its early years was whether the federal government or the states should charter banks. The Federalists, particularly

Banking Industry: Structure and Competition

234

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Alexander Hamilton, advocated greater centralized control of banking and federal chartering of banks. Their efforts led to the creation in 1791 of the Bank of the United States, which had elements of both a private bank and a central bank, a government institution that has responsibility for the amount of money and credit supplied in the economy as a whole. Agricultural and other interests, however, were quite suspicious of centralized power and hence advocated chartering by the states. Furthermore, their distrust of moneyed interests in the big cities led them to exert political pressure in an effort to eliminate the Bank of the United States, and in 1811 their efforts met with suc- cess when its charter was not renewed. Because of abuses by state banks and the clear need for a central bank to help the federal government raise funds during the War of 1812, Congress was stimulated to create the Second Bank of the United States in 1816. Tensions between advocates and opponents of centralized banking power were a recur- rent theme during the operation of this second attempt at central banking in the United States, and with the election of Andrew Jackson, a strong advocate of states’ rights, the fate of the Second Bank was sealed. After the election in 1832, Jackson vetoed the rechartering of the Second Bank of the United States as a national bank, and its charter lapsed in 1836.

Bank of North America is chartered.

Bank of the United States is chartered.

Bank of the United States’ charter is allowed to lapse.

Second Bank of the United States is chartered.

Andrew Jackson vetoes rechartering of Second Bank of the United States; charter lapses in 1836.

National Bank Act of 1863 establishes national banks and Office of the Comptroller of the Currency.

Federal Reserve Act of 1913 creates Federal Reserve System.

Banking Act of 1933 (Glass-Steagall) creates

Federal Deposit Insurance Corporation (FDIC) and separates banking and securities industries.

19331913186318321816181117911782

Figure 1 Time Line of the early History of commercial Banking in the United states The most important dates in the history of American banking before World War II.

MyEconLab Mini-lecture

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236 p a r t 3 Financial Institutions

Until 1863, all commercial banks in the United States were chartered by the bank- ing commission of the state in which each operated. No national currency existed, and banks obtained funds primarily by issuing banknotes (currency circulated by the banks that could be redeemed for gold). Because banking regulations were extremely lax in many states, banks regularly failed due to fraud or lack of sufficient bank capital; their banknotes became worthless.

To eliminate the abuses of the state-chartered banks (called state banks), the National Bank Act of 1863 (and subsequent amendments to it) created a new banking system of federally chartered banks (called national banks), supervised by the Office of the Comptroller of the Currency, a department of the U.S. Treasury. This legislation was originally intended to dry up sources of funds to state banks by imposing a prohibitive tax on their banknotes while leaving the banknotes of the federally chartered banks untaxed. The state banks cleverly escaped extinction by acquiring funds through deposits. As a result, today the United States has a dual banking system in which banks chartered by the federal government and banks chartered by the states operate side by side.

Central banking did not reappear in this country until the Federal Reserve System (the Fed) was created in 1913 to promote an even safer banking system. All national banks were required to become members of the Federal Reserve System and became subject to a new set of regulations issued by the Fed. State banks could choose (but were not required) to become members of the system, and most did not because of the high costs of membership stemming from the Fed’s regulations.

During the Great Depression years 1930–1933, some 9,000 bank failures wiped out the savings of many depositors at commercial banks. To prevent future depositor losses from such failures, banking legislation in 1933 established the Federal Deposit Insurance Corporation (FDIC), which provided federal insurance on bank deposits. Member banks of the Federal Reserve System were required to purchase FDIC insur- ance for their depositors, and non–Federal Reserve commercial banks could choose to buy this insurance (almost all of them did). The purchase of FDIC insurance made banks subject to another set of regulations imposed by the FDIC.

Because the investment banking activities of the commercial banks were blamed for many bank failures, provisions in the banking legislation in 1933 (also known as the Glass-Steagall Act) prohibited commercial banks from underwriting or dealing in corporate securities (though allowing them to sell new issues of government securities) and limited banks to the purchase of debt securities approved by the bank regulatory agencies. Likewise, this legislation prohibited investment banks from engaging in com- mercial banking activities. In effect, the Glass-Steagall Act separated the activities of commercial banks from those of the securities industry.

Under the conditions of the Glass-Steagall Act, which was repealed in 1999, com- mercial banks had to sell off their investment banking operations. The First National Bank of Boston, for example, spun off its investment banking operations into the First Boston Corporation, now part of one of the most important investment banking firms in America, Credit Suisse First Boston. Investment banking firms typically discontinued their deposit business, although J.P. Morgan discontinued its investment banking business and reorganized as a commercial bank; however, some senior officers of J.P. Morgan went on to organize Morgan Stanley, another one of the largest investment banking firms today.

multiple regulatory agencies Commercial bank regulation in the United States has developed into a crazy quilt of multiple regulatory agencies with overlapping jurisdictions. The Office of the Comptroller

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of the Currency has the primary supervisory responsibility for national banks that own more than half of the assets in the commercial banking system. The Federal Reserve and the state banking authorities have joint primary responsibility for state banks that are members of the Federal Reserve System. The Fed also has regulatory responsibil- ity over companies that own one or more banks (called bank holding companies) and secondary responsibility for the national banks. The FDIC and the state banking authorities jointly supervise state banks that have FDIC insurance but are not members of the Federal Reserve System. The state banking authorities have sole jurisdiction over state banks without FDIC insurance. (Such banks hold less than 0.2% of the deposits in the commercial banking system.)

If you find the U.S. bank regulatory system confusing, imagine how confusing it is for the banks, which have to deal with multiple regulatory agencies. Several proposals have been raised by the U.S. Treasury to rectify this situation by centralizing the regu- lation of all depository institutions under one independent agency. However, none of these proposals has been successful in Congress, and whether there will be regulatory consolidation in the future is highly uncertain.

financiaL innOvaTiOn anD THe grOwTH Of THe “sHaDOw Banking sysTem”

Although banking institutions are still the most important financial institutions in the U.S. economy, in recent years the traditional banking business of making loans that are funded by deposits has been in decline. Some of this business has been replaced by the shadow banking system, in which bank lending has been replaced by lending via the securities markets, with the involvement of a number of different financial institutions.

To understand how the banking industry has evolved over time, we must first under- stand the process of financial innovation, which has transformed the entire financial sys- tem. Like other industries, the financial industry is in business to earn profits by selling its products. If a soap company perceives that a need exists in the marketplace for a laundry detergent with fabric softener, it develops a product to fit that need. Similarly, to maximize their profits, financial institutions develop new products to satisfy their own needs as well as those of their customers; in other words, innovation—which can be extremely beneficial to the economy—is driven by the desire to get (or stay) rich. This view of the innovation process leads to the following simple analysis: A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable.

Starting in the 1960s, individuals and financial institutions operating in financial markets were confronted with drastic changes in the economic environment: Inflation and interest rates climbed sharply and became harder to predict, a situation that changed demand conditions in financial markets. The rapid advances in computer technology changed supply conditions. In addition, financial regulations became more burdensome. Financial institutions found that many of the old ways of doing business were no lon- ger profitable; the financial services and products they had been offering to the public were not selling. Many financial intermediaries found that they were no longer able to acquire funds with their traditional financial instruments, and without these funds they would soon be out of business. To survive in the new economic environment, financial institutions had to research and develop new products and services that would meet customer needs and prove profitable, a process referred to as financial engineering. In their case, necessity was the mother of innovation.

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Our discussion of the factors that drive financial innovation suggests that there are three basic types of financial innovation: responses to changes in demand conditions, responses to changes in supply conditions, and avoidance of existing regulations. These three motivations often interact to produce particular financial innovations. Now that we have a framework for understanding why financial institutions produce innovations, let’s look at examples of how financial institutions, in their search for profits, have pro- duced financial innovations of the three basic types.

responses to changes in Demand conditions: interest-rate volatility The most significant change in the economic environment that altered the demand for financial products in recent years has been the dramatic increase in the volatility of interest rates. In the 1950s, the interest rate on three-month Treasury bills fluctuated between 1.0% and 3.5%; in the 1970s, it fluctuated between 4.0% and 11.5%; in the 1980s, it ranged from 5% to more than 15%. Large fluctuations in interest rates lead to substantial capital gains or losses and greater uncertainty about returns on investments. Recall that the risk that is related to the uncertainty about interest-rate movements and returns is called interest-rate risk, and high volatility of interest rates, such as we saw in the 1970s and 1980s, leads to a higher level of interest-rate risk.

We would expect the increase in interest-rate risk to increase the demand for finan- cial products and services that could reduce that risk. This change in the economic envi- ronment would thus stimulate a search by financial institutions for profitable innovations that meet this new demand and would spur the creation of new financial instruments that help lower interest-rate risk. Two financial innovations that were developed in the 1970s confirm this prediction: adjustable-rate mortgages and financial derivatives.

adjustable-rate mortgages Like other investors, financial institutions find that lending is more attractive if interest-rate risk is lower. They would not want to make a mortgage loan at a 10% interest rate and two months later find that they could obtain 12% in interest on the same mortgage. To reduce interest-rate risk, in 1975 savings and loans in California began to issue adjustable-rate mortgages, that is, mortgage loans on which the interest rate changes when a market interest rate (usually the Treasury bill rate) changes. Initially, an adjustable-rate mortgage might have a 5% interest rate. In six months, this interest rate might increase or decrease by the amount of the increase or decrease in, say, the six-month Treasury bill rate, and the mortgage payment would then change. Because adjustable-rate mortgages allow mortgage-issuing institutions to earn higher interest rates on existing mortgages when market rates rise, profits remain high during these periods.

This attractive feature of adjustable-rate mortgages has encouraged mortgage-issuing institutions to issue adjustable-rate mortgages with lower initial interest rates than those on conventional fixed-rate mortgages, making them popular with many households. However, because the mortgage payment on a variable-rate mortgage can increase, many households continue to prefer fixed-rate mortgages. Hence both types of mortgages are widespread.

financial Derivatives Given the greater demand for the reduction of interest-rate risk, commodity exchanges such as the Chicago Board of Trade recognized that if they could develop a product that would help investors and financial institutions protect

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themselves from, or hedge, interest-rate risk, then they could make profits by selling this new instrument. Futures contracts, in which the seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed-on price, had been around for a long time. Officials at the Chicago Board of Trade realized that if they created futures contracts in financial instruments, which are called financial derivatives because their payoffs are linked to (i.e., derived from) previously issued securities, they could be used to hedge risk. Thus, in 1975, financial derivatives were born.

responses to changes in supply conditions: information Technology The most important source of the changes in supply conditions that stimulated financial innovation has been the improvement in computer and telecommunications technol- ogy. This technology, called information technology, has had two effects. First, it has lowered the cost of processing financial transactions, making it profitable for financial institutions to create new financial products and services for the public. Second, it has made it easier for investors to acquire information, thereby making it easier for firms to issue securities. The rapid developments in information technology have resulted in many new financial products and services, which we examine here.

Bank credit and Debit cards Credit cards have been around since well before World War II. Many individual stores (Sears, Macy’s) institutionalized charge accounts by providing customers with credit cards that allowed them to make purchases at these stores without cash. Nationwide credit cards were not established until after World War II, when Diners Club developed a card to be used in restaurants all over the country (and abroad). Similar credit card programs were started by American Express and Carte Blanche, but because of the high cost of operating these programs, cards were issued only to select persons and businesses that could afford expensive purchases.

A firm issuing credit cards earns income from loans it makes to credit card hold- ers and from payments made by stores on credit card purchases (a percentage of the purchase price, say, 5%). A credit card program’s costs arise from loan defaults, stolen cards, and the expense involved in processing credit card transactions.

Seeing the success of Diners Club, American Express, and Carte Blanche, bank- ers wanted to share in the profitable credit card business. Several commercial banks attempted to expand the credit card business to a wider market in the 1950s, but the cost per transaction of running these programs was so high that their early attempts failed.

In the late 1960s, improved computer technology, which lowered the transaction costs for providing credit card services, made it more likely that bank credit card programs would be profitable. The banks tried to enter this business again, and this time their efforts led to the creation of two successful bank credit card programs: BankAmericard (originally started by Bank of America but now an independent organization called Visa) and MasterCharge (now MasterCard, run by the Interbank Card Association). These programs have become phenomenally successful; around 500 million of their cards are in use in the United States and over a billion more in the rest of the world. Indeed, bank credit cards have been so profitable that nonfinancial institutions such as Sears (which launched the Discover card), General Motors, and AT&T have also entered the credit card business. Consumers have benefited because credit cards are more widely accepted than checks as a method of paying for purchases (particularly abroad), and they allow consumers to take out loans more easily.

The success of bank credit cards led these institutions to come up with another financial innovation, debit cards. Debit cards often look just like credit cards and can be

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240 P a r t 3 Financial Institutions

used to make purchases in an identical fashion. However, in contrast to credit cards, which extend the purchaser a loan that does not have to be paid off immediately, a debit card purchase is immediately deducted from the card holder’s bank account. Debit cards depend even more on low costs of processing transactions, because their profits are generated entirely from the fees paid by merchants on debit card purchases at their stores. Debit cards have grown extremely popular in recent years.

Electronic Banking The wonders of modern computer technology have also enabled banks to lower the cost of bank transactions by having the customer interact with an elec- tronic banking (e-banking) facility rather than with a human being. One important form of an e-banking facility is the automated teller machine (ATM), an electronic machine that allows customers to get cash, make deposits, transfer funds from one account to another, and check balances. ATM machines do not have to be paid overtime and never sleep, and thus are available for use 24 hours a day. Not only does this result in cheaper transactions for the bank, but it also provides more convenience for the customer. Because of their low cost, ATMs can be put at locations other than a bank or its branches, further increasing customer convenience. The low cost of ATMs has encouraged banks to install them everywhere, and ATMs now number more than 400,000 in the United States alone. Furthermore, it is now just as easy to get foreign currency from an ATM when you are traveling in Europe as it is to get cash from your local bank.

With the drop in the cost of telecommunications, banks have developed another financial innovation, home banking. It is now cost-effective for banks to set up an electronic banking facility in which the bank’s customer is linked up with the bank’s computer and allowed to carry out transactions by using a smart phone, tablet, or per- sonal computer. Now a bank’s customers can conduct many of their bank transactions without ever leaving the comfort of home. The advantage for the customer is the con- venience of home banking, while banks find that the cost of transactions is substantially less than the cost associated with brick-and-mortar banking. The success of ATMs and home banking has led to another innovation, the automated banking machine (ABM), which combines in one location an ATM, an Internet connection to the bank’s website, and a telephone link to customer service.

With the decline in the price of personal computers and their increasing pres- ence in the home, we have seen a further innovation in the home banking area, the creation of a new type of banking institution, the virtual bank, a bank that has no physical location but rather exists only in cyberspace. In 1995, Security First Network Bank, based in Atlanta but now owned by Royal Bank of Canada, became the first virtual bank, offering an array of banking services on the Internet—accepting check- ing account and savings deposits, selling certificates of deposits, issuing ATM cards, providing bill-paying facilities, and so on. The virtual bank thus takes home bank- ing one step further, enabling the customer to have a full set of banking services at home, 24 hours a day. In 1996, Bank of America and Wells Fargo entered the virtual banking market, to be followed by many others, with Bank of America now being the largest Internet bank in the United States. Will virtual banking be the predominant form of banking in the future? (See the FYI box, “Will ‘Clicks’ Dominate ‘Bricks’ in the Banking Industry?”)

Junk Bonds Before the advent of computers and advanced telecommunications, it was difficult to acquire information about the financial situations of firms that might want to sell securities. Because of the difficulty in screening out bad from good credit risks, the only firms that were able to sell bonds were very well-established corporations

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that had high credit ratings.1 Before the 1980s, then, only corporations that could issue bonds with ratings of Baa or above could raise funds by selling newly issued bonds. Some firms that had fallen on bad times, known as fallen angels, had previously issued long-term corporate bonds with ratings that had now fallen below Baa, bonds that were pejoratively dubbed “junk bonds.”

With the improvement in information technology in the 1970s, it became easier for investors to acquire financial information about corporations, making it easier to screen out bad from good credit risks. With easier screening, investors were more will- ing to buy long-term debt securities from less-well-known corporations with lower credit ratings. With this change in supply conditions, we would expect that some smart individual would pioneer the concept of selling new public issues of junk bonds, not for fallen angels but for companies that had not yet achieved investment-grade status. This is exactly what Michael Milken of Drexel Burnham Lambert, an investment bank- ing firm, started to do in 1977. Junk bonds became an important factor in the corporate bond market, with the amount outstanding exceeding $200 billion by the late 1980s. Although there was a sharp slowdown in activity in the junk bond market after Milken was indicted for securities law violations in 1989, the junk bond market heated up again in the 1990s and 2000s.

FYI Will “Clicks” Dominate “Bricks” in the Banking Industry?

With the advent of virtual banks (“clicks”) and the convenience they provide, a key question is whether they will become the primary form in which banks do their business, eliminating the need for physical bank branches (“bricks”) as the main delivery mecha- nism for banking services. Indeed, will stand-alone Internet banks be the wave of the future?

The answer seems to be no. Internet-only banks such as Wingspan (owned by Bank One), First-e (Dublin- based), and Egg (a British Internet-only bank owned by Prudential) have had disappointing revenue growth and profits. The result is that pure online banking has not been the success that proponents had hoped for. Why has Internet banking been a disappointment?

Internet banking has several strikes against it. First, bank depositors want to know that their savings are secure, and so are reluctant to put their money into new institutions without a long track record. Second, customers worry about the security of their online trans- actions and whether their transactions will truly be kept

private. Traditional banks are viewed as being more secure and trustworthy in terms of protecting private information. Third, many customers prefer that certain services be provided by physical branches. For example, banking customers seem to prefer purchasing long-term savings products face-to-face. Fourth, Internet banking has run into technical problems—server crashes, slow connections over phone lines, mistakes in conducting transactions—that will probably diminish over time as technology improves.

The wave of the future thus does not appear to be pure Internet banks. Instead, it looks as though “clicks and bricks” will be the predominant form of banking, in which online banking is used to comple- ment the services provided by traditional banks. Nonetheless, the delivery of banking services is undergoing massive changes, with more and more banking services delivered over the Internet and the number of physical bank branches likely to decline in the future.

1The discussion of adverse selection problems in Chapter 8 provides a more detailed analysis of why only well- established firms with high credit ratings were able to sell securities.

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commercial Paper market Commercial paper is a short-term debt security issued by large banks and corporations. The commercial paper market has undergone tremendous growth since 1970, when $33 billion was outstanding, to around $1 trillion outstanding at the end of 2013. Indeed, commercial paper has been one of the fastest-growing money market instruments.

Improvements in information technology also help explain the rapid rise of the commercial paper market. We have seen that improvements in information technol- ogy made it easier for investors to screen out bad from good credit risks, thus making it easier for corporations to issue debt securities. Not only did this make it simpler for corporations to issue long-term debt securities, as in the junk bond market, but it also meant they could raise funds by issuing short-term debt securities, such as commercial paper, with greater ease. Many corporations that used to do their short-term borrow- ing from banks now frequently raise short-term funds in the commercial paper market instead.

The development of money market mutual funds has been another factor in the rapid growth of the commercial paper market. Because money market mutual funds need to hold liquid, high-quality, short-term assets such as commercial paper, the growth of assets in these funds to around $2.7 trillion has created a ready market in commercial paper. The growth of pension and other large funds that invest in com- mercial paper has also stimulated the growth of this market.

securitization and the shadow Banking system One of the most important financial innovations of the past two decades, arising from improvements in information technology, is securitization. Securitization is the process of bundling small and otherwise illiquid financial assets (such as residential mortgages, auto loans, and credit card receivables), which have typically been the bread and butter of banking institutions, into marketable capital market securities. Securiti- zation is the fundamental building block of the shadow banking system.

How the shadow Banking system works In traditional banking, one entity engages in the process of asset transformation—that is, it issues liabilities with one set of desirable characteristics (say, deposits with high liquidity and low risk) to fund the purchase of assets with a different set of characteristics (say, loans with low liquidity and high returns). Securitization, on the other hand, is a process of asset transformation that involves a number of different financial institutions working together. These insti- tutions comprise the shadow banking system. In other words, asset transformation ac- complished through securitization and the shadow banking system is not done “under one roof,” as is traditional banking.

For example, a mortgage broker (more generally referred to as a loan originator) will arrange for a residential mortgage loan to be made by a financial institution that will then service the loan (that is, collect the interest and principal payments). This servicer then sells the mortgage to another financial institution, which bundles the mortgage with a large number of other residential mortgages. The bundler takes the interest and principal payments on the portfolio of mortgages and “passes them through” (pays them out) to third parties. The bundler goes to a distributor (typically an investment bank), which designs a security that divides the portfolio of loans into standardized amounts. The distributor then sells the claims to these interest and principal payments as securities, mostly to other financial intermediaries that are also part of the shadow

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banking system—for example, a money market mutual fund or a pension fund. Sche- matically, the securitization process is described by the following sequence:

Loan origination 1 servicing 1 bundling 1 distribution

Because the securitization process involves the origination of loans and then finally the distribution of securities, securitization is also characterized as an originate-to-distribute business model.

At each step of the securitization process, the loan originator, servicer, bundler and distributor earn a fee. Each of these four institutions has specialized in a particular element of the financial intermediation process. The shadow banking system, which comprises all of the financial institutions involved in the securitization process, can thus be very profitable if transaction costs and the costs of collecting information are low. Advances in information technology have therefore been critical to the growth of securitization and the shadow banking system. Lower costs of acquiring information make it far easier to sell capital market securities, while lower transaction costs make it cheaper for financial institutions to collect interest and principal payments on bundled loans and then pay them out to the securities holders.

subprime mortgage market A particularly important financial innovation that developed in the 2000s as a result of securitization and the shadow banking system was the subprime mortgage, a new class of residential mortgages offered to borrowers with less-than-stellar credit records. Before 2000, only the most credit-worthy (prime) bor- rowers could obtain residential mortgages. Advances in computer technology and new statistical techniques, known as data mining, led to enhanced, quantitative evaluation of the credit risk for residential mortgages. Households with credit records could now be assigned a numerical credit score, known as a FICO score (named after the Fair Isaac Corporation that developed it), that predicted how likely the household would be to default on its loan payments. Because it now became easier to assess the risk associated with a pool of subprime mortgages, it became possible to bundle them into a mortgage- backed-security, providing a new source of funding for these mortgages. The result was an explosion of subprime mortgage lending which, as we will see in Chapter 12, was a key factor that led to the global financial crisis of 2007–2009.

avoidance of existing regulations The process of financial innovation, as we have discussed it so far, is much like inno- vation in other areas of the economy: It occurs in response to changes in demand and supply conditions. However, because the financial industry is more heavily regulated than other industries, government regulation is a much greater spur to innovation in this industry. Government regulation leads to financial innovation by creating incentives for firms to skirt regulations that restrict their ability to earn profits. Edward Kane, an economist at Boston College, describes this process of avoiding regulations as “loophole mining.” The economic analysis of innovation suggests that when the economic environ- ment changes such that regulatory constraints are so burdensome that large profits can be made by avoiding them, loophole mining and innovation are more likely to occur.

Because banking is one of the most heavily regulated industries in America, loop- hole mining is especially likely to occur. The rise in inflation and interest rates from the late 1960s to 1980 made the regulatory constraints imposed on this industry even more burdensome, leading to financial innovation.

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Two sets of regulations have seriously restricted the ability of banks to make prof- its: reserve requirements that force banks to keep a certain fraction of their deposits as reserves (vault cash and deposits in the Federal Reserve System) and restrictions on the interest rates that can be paid on deposits. For the following reasons, these regulations have been major forces behind financial innovation.

1. Reserve requirements. The key to understanding why reserve requirements led to financial innovation is to recognize that they act, in effect, as a tax on deposits. Because up until 2008 the Fed did not pay interest on reserves, the opportunity cost of holding them was the interest that a bank could otherwise earn by lending the reserves out. For each dollar of deposits, reserve requirements therefore imposed a cost on the bank equal to the interest rate, i, that could be earned if the reserves could be lent out times the fraction of deposits required as reserves, r. The cost of i * r imposed on the bank was just like a tax on bank deposits of i * r per dollar of deposits. This “tax” on deposits rises as interest rates rise.

It is a great tradition to avoid taxes if possible, and banks also play this game. Just as taxpayers look for loopholes to lower their tax bills, banks seek to increase their profits by mining loopholes and by producing financial innovations that enable them to escape the tax on deposits imposed by reserve requirements.

2. Restrictions on interest paid on deposits. Until 1980, legislation prohibited banks in most states from paying interest on checking account deposits, and through Regulation Q, the Fed set maximum limits on the interest rate that could be paid on time deposits. To this day, banks are not allowed to pay interest on corporate checking accounts. The desire of banks to avoid these deposit rate ceilings also led to financial innovations.

If market interest rates rose above the maximum rates that banks paid on time deposits under Regulation Q, depositors withdrew funds from banks to put them into higher-yielding securities. This loss of deposits from the banking system restricted the amount of funds that banks could lend (called disintermediation) and thus limited bank profits. Banks had an incentive to get around deposit rate ceilings, because by so doing, they could acquire more funds to make loans and earn higher profits.

We can now look at how the desire to avoid restrictions on interest payments and the tax effect of reserve requirements led to two important financial innovations.

money market mutual funds Money market mutual funds issue shares that are redeemable at a fixed price (usually $1) by writing checks. For example, if you buy 5,000 shares for $5,000, the money market fund uses these funds to invest in short-term money market securities (Treasury bills, negotiable certificates of deposit, commercial paper) that provide you with interest payments. In addition, you are able to write checks up to the $5,000 held as shares in the money market fund. Although money market fund shares effectively function as checking account deposits that earn interest, they are not legally deposits and so are not subject to reserve requirements or prohibitions on interest payments. For this reason, they can pay higher interest rates than deposits at banks.

The first money market mutual fund was created by two Wall Street mavericks, Bruce Bent and Henry Brown, in 1970. However, the low market interest rates from 1970 to 1977 (which were just slightly above Regulation Q ceilings of 5.25–5.5%) kept money market mutual funds from being particularly advantageous relative to bank deposits. In early 1978, the situation changed rapidly as inflation rose and market interest rates began to climb over 10%, well above the 5.5% maximum interest rates

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payable on savings accounts and time deposits under Regulation Q. In 1977, money market mutual funds had assets of less than $4 billion; in 1978, their assets climbed to close to $10 billion; in 1979, to more than $40 billion; and in 1982, to $230 billion. Currently, their assets are around $2.7 trillion. To say the least, money market mutual funds have been a successful financial innovation, which is exactly what we would have predicted given the financial climate of the late 1970s and early 1980s, in which interest rates soared beyond Regulation Q ceilings.

In a supreme irony, risky investments by a money market mutual fund founded by Bruce Brent almost brought down the money market mutual fund industry during the global financial crisis in 2008 (see the FYI box, “Bruce Bent and the Money Market Mutual Fund Panic of 2008”).

sweep accounts Another innovation that enables banks to avoid the “tax” from reserve requirements is the sweep account. In this arrangement, any balances above a certain amount in a corporation’s checking account at the end of a business day are “swept out” of the account and invested in overnight securities that pay interest. Because the “swept out” funds are no longer classified as checkable deposits, they are not subject to reserve requirements and thus are not “taxed.” They also have the advantage that they allow banks, in effect, to pay interest on these checking accounts, which otherwise is not allowed under existing regulations. Because sweep accounts have become so popular, they

FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008

Bruce Bent, one of the originators of money market mutual funds, almost brought down the industry dur- ing the global financial crisis in the fall of 2008. Mr. Bent told his shareholders in a letter written in July 2008 that the fund was managed on a basis of “unwav- ering discipline focused on protecting your principal.” He also wrote to the Securities and Exchange Commis- sion in September 2007, stating “When I first created the money market fund back in 1970, it was designed with the tenets of safety and liquidity.” He added that these principles had “fallen by the wayside as portfolio managers chased the highest yield and compromised the integrity of the money fund.” Alas, Bent did not follow his own advice, and his fund, the Reserve Primary Fund, bought risky assets that made its yield higher than the industry average.

When Lehman Brothers went into bankruptcy on September 15, 2008, the Reserve Primary Fund, with assets over $60 billion, was caught holding the bag on $785 million of Lehman’s debt, which then had to be marked down to zero. The resulting losses meant that on September 16, Bent’s fund could no

longer afford to redeem its shares at the par value of $1, a situation known as “breaking the buck.” Bent’s shareholders began to pull their money out of the fund, causing it to lose 90% of its assets.

The fear that this could happen to other money mar- ket mutual funds led to a classic panic in which share- holders began to withdraw their funds at an alarming rate. The whole money market mutual fund industry looked as though it would come crashing down. To prevent this, the Federal Reserve and the U.S. Treasury rode to the rescue on September 19. The Fed set up a facility, discussed in Chapter 18, to make loans to be used to purchase commercial paper from money mar- ket mutual funds so that they could meet the demands for redemptions from their investors. The Treasury then put in a temporary guarantee for all money market mutual fund redemptions, and the panic subsided.

Not surprisingly, given the extension of a govern- ment safety net to the money market mutual fund industry, there are calls to regulate this industry more heavily. The money market mutual fund industry will never be the same.

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have lowered the amount of required reserves to the degree that most banking institutions do not find reserve requirements binding: In other words, they voluntarily hold more reserves than they are required to.

The financial innovations of sweep accounts and money market mutual funds are particularly interesting because they were stimulated not only by the desire to avoid a costly regulation, but also by a change in supply conditions—in this case, informa- tion technology. Without low-cost computers to process inexpensively the additional transactions required by these innovations, they would not have been profitable and therefore would not have been developed. Technological factors often combine with other incentives, such as the desire to get around a regulation, to produce innovation.

financial innovation and the Decline of Traditional Banking The traditional financial intermediation role of banking has been to make long-term loans and to fund them by issuing short-term deposits, a process of asset transforma- tion commonly referred to as “borrowing short and lending long.” Here we examine how financial innovations have created a more competitive environment for the bank- ing industry, causing the industry to change dramatically, with its traditional banking business going into decline.

In the United States, the importance of commercial banks as a source of funds for nonfinancial borrowers has shrunk dramatically. As we can see in Figure 2, in 1974,

% of Total Credit

Advanced

Thrifts

Commercial Banks

0

10

20

30

40

20001995 2005 2010 20151990198519801975197019651960

Figure 2 Bank share of Total nonfinancial Borrowing, 1960–2014 In 1974, commercial banks provided close to 40% of these funds; by 2014, their market share was down

to 27%. The decline in market share for thrift institutions has been even more precipitous, from more than 20% in the late 1970s to 2.5% today.

Source: Federal Reserve Bank of St. Louis, FRED data base: http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/ index.asp.

MyEconLab Mini-lecture

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C h a p t e r 1 1 Banking Industry: Structure and Competition 247

commercial banks provided close to 40% of these funds; by 2014, their market share was down to 27%. The decline in market share for thrift institutions has been even more precipitous, from more than 20% in the late 1970s to 2.5% today. To understand why the traditional banking business has declined in size, we need to look at how the financial innovations described earlier have caused banks to suffer declines in their cost advantages in acquiring funds—that is, on the liabilities side of their balance sheet— while at the same time losing income advantages on the assets side of their balance sheet. The simultaneous decline of cost and income advantages has resulted in reduced profitability of traditional banking and an effort by banks to leave this business and engage in new and more profitable activities.

Decline in Cost Advantages in Acquiring Funds (Liabilities) Until 1980, banks were subject to deposit rate ceilings that restricted them from paying any interest on checkable deposits and (under Regulation Q) limited them to paying a maximum interest rate of a little more than 5% on time deposits. Until the 1960s, these restric- tions worked to the banks’ advantage because their major source of funds (in excess of 60%) was checkable deposits, and the zero interest cost on these deposits meant that the banks had a very low cost of funds. Unfortunately, this cost advantage for banks did not last. The rise in inflation beginning in the late 1960s led to higher interest rates, which made investors more sensitive to yield differentials on different assets. The result was the disintermediation process, in which people began to take their money out of banks, with their low interest rates on both checkable and time deposits, and began to seek out higher-yielding investments. At the same time, as we have seen, attempts to get around deposit rate ceilings and reserve requirements led to the financial innovation of money market mutual funds, which put the banks at an even further disadvantage because depositors could now obtain checking account–like services while earning high interest on their money market mutual fund accounts. One manifestation of these changes in the financial system was that the low-cost source of funds, checkable deposits, declined dramatically in importance for banks, falling from more than 60% of bank liabilities to 11% today.

The growing difficulty for banks in raising funds led them to support legislation in the 1980s that eliminated Regulation Q ceilings on time and savings deposit interest rates and allowed checkable deposit accounts that paid interest. Although these changes in regulation helped make banks more competitive in their quest for funds, it also meant that their cost of acquiring funds had risen substantially, thereby reducing their earlier cost advantage over other financial institutions.

Decline in Income Advantages on Uses of Funds (Assets) The loss of cost advantages on the liabilities side of the balance sheet for American banks is one reason they have become less competitive, but they have also been hit by a decline in income advantages on the assets side from the financial innovations we discussed earlier—junk bonds, securitization, and the rise of the commercial paper market. The resulting loss of income advantages for banks relative to these innovations has resulted in a loss of market share and has led to the growth of the shadow banking system, which has made use of these innovations to enable borrowers to bypass the traditional banking system.

We have seen that improvements in information technology have made it easier for firms to issue securities directly to the public. This change means that instead of going to banks to finance short-term credit needs, many of the banks’ best business custom- ers now find it cheaper to go instead to the commercial paper market for funds. In addition, the commercial paper market has allowed finance companies, which depend

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primarily on commercial paper to acquire funds, to expand their operations at the expense of banks. Finance companies, which lend to many of the same businesses that borrow from banks, have maintained their market share relative to banks: Before 1980, finance company loans to business equaled about 30% of commercial and industrial bank loans; currently, they account for 32%.

The emergence of the junk bond market has also eaten into banks’ loan business. Improvements in information technology have made it easier for corporations to sell their bonds to the public directly, thereby bypassing banks. Although Fortune 500 com- panies started taking this route in the 1970s, now lower-quality corporate borrowers are using banks less often because they have access to the junk bond market.

We have also seen that improvements in computer technology have led to the growth of the shadow banking system and securitization, whereby illiquid financial assets such as bank loans and mortgages are transformed into marketable securities. Computers enable other financial institutions to originate loans because these institutions can now accurately evaluate credit risk with statistical methods. Computers also have lowered transaction costs, making it possible to bundle these loans and sell them as securities. When default risk can be easily evaluated using computers, banks no longer have an advantage in making loans. Without their former advantages, banks have lost loan business to other financial institutions even though the banks themselves are involved in the process of securitization. Securitization has been a particular problem for mortgage-issuing institu- tions such as S&Ls, because most residential mortgages are now securitized.

Banks’ responses In any industry, a decline in profitability usually results in an exit from the industry (often due to widespread bankruptcies) and a shrinkage of mar- ket share. This occurred in the U.S. banking industry during the 1980s via consolida- tions and bank failures (discussed in Chapter 10).

In an attempt to survive and maintain adequate profit levels, many U.S. banks faced two alternatives. First, they could attempt to maintain their traditional lending activity by expanding into new and riskier areas of lending. For example, U.S. banks increased their risk taking by placing a greater percentage of their total funds in commercial real estate loans, traditionally a riskier type of loan. In addition, they increased lending for corporate takeovers and leveraged buyouts, which are highly leveraged transactions. The decline in the profitability of banks’ traditional business may thus have helped lead to the global financial crisis of 2007 to 2009.

The second way in which banks have sought to maintain their former profit levels is by pursuing new off-balance-sheet activities that are more profitable and in effect embrace the shadow banking system. U.S. commercial banks did this during the early 1980s, more than doubling the share of their income coming from off-balance-sheet, non–interest-income activities. Nontraditional bank activities can be riskier and, there- fore, result in excessive risk taking by banks. Indeed, they led to a substantial weaken- ing of bank balance sheets during the global financial crisis.

The decline of banks’ traditional business has driven the banking industry to seek out new lines of business. This search for business opportunities may be beneficial because it may ultimately keep banks vibrant and healthy. Indeed, bank profitability was high up until 2007, and nontraditional, off-balance-sheet activities played an important role in the high bank profits. However, the new directions in banking led to increased risk taking, and thus the decline in traditional banking has required regula- tors to be more vigilant. Nontraditional bank activities pose new challenges for bank regulators, who, as we saw in Chapter 10, must now be far more concerned about banks’ off-balance-sheet activities.

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C h a p t e r 1 1 Banking Industry: Structure and Competition 249

Decline of Traditional Banking in Other industrialized countries Forces similar to those in the United States have led to the decline of traditional banking in other industrialized countries. The loss of banks’ monopoly power over depositors has occurred outside the United States as well. Financial innovation and deregulation are occurring worldwide and have created attractive alternatives for both depositors and borrowers. In Japan, for example, deregulation opened a wide array of new financial instruments to the public, causing a disintermediation process similar to that in the United States. In European countries, innovations have steadily eroded the barriers that have traditionally protected banks from competition.

In other countries, banks also faced increased competition from the expansion of securities markets and the growth of the shadow banking system. Both financial deregulation and advances in information technology in other countries have improved the availability of information in securities markets, making it easier and less costly for firms to finance their activities by issuing securities rather than going to banks. Further, even in countries where securities markets have not grown, banks have still lost loan business because their best corporate customers have had increasing access to foreign and offshore capital markets, such as the Eurobond market. In smaller economies, like that of Australia, which still do not have as well-developed corporate bond or commer- cial paper markets, banks have lost loan business to international securities markets. In addition, the same forces that drove the securitization process in the United States have been at work in other countries and have undercut the profitability of traditional bank- ing in these countries as well. The United States has not been unique in seeing its banks face a more difficult competitive environment. Thus, although the decline of traditional banking occurred earlier in the United States than in other countries, the same forces have caused a decline in traditional banking abroad.

sTrUcTUre Of THe U.s. cOmmerciaL Banking inDUsTry

There are approximately 5,700 commercial banks in the United States, far more than in any other country in the world. As Table 1 indicates, we have an extraordinary number of small banks. Thirty percent of the banks have less than $100 million

Source: https://www2.fdic.gov/qbp/2014jun/cb4.html.

Assets

Number of Banks

Share of Banks (%)

Share of Assets Held (%)

Less than $100 million 1,744 30.3 0.7

$100 million–$1 billion 3,469 60.3 7.4

$1 billion–$10 billion 451 7.8 8.5

More than $10 billion 93 1.6 83.4

Total 5,757 100.00 100.00

table 1 size Distribution of insured commercial Banks, June 30, 2014

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250 P a r t 3 Financial Institutions

in assets. Far more typical is the size distribution in Canada or the United Kingdom, where five or fewer banks dominate the industry. In contrast, the ten largest com- mercial banks in the United States (listed in Table 2) together hold just 57% of the assets in their industry.

Most industries in the United States have far fewer firms than the commercial bank- ing industry; typically, large firms tend to dominate these industries to a greater extent than in the commercial banking industry. (Consider the computer software industry, which is dominated by Microsoft, or the automobile industry, which is dominated by General Motors, Ford, Daimler-Chrysler, Toyota, and Honda.) Does the large number of banks in the commercial banking industry and the absence of a few dominant firms suggest that commercial banking is more competitive than other industries?

Restrictions on Branching The presence of so many commercial banks in the United States actually reflects past regulations that restricted the ability of these financial institutions to open branches (additional offices for the conduct of banking operations). Each state had its own regu- lations on the type and number of branches that a bank could open. Regulations on both coasts, for example, tended to allow banks to open branches throughout a state; in the middle part of the country, regulations on branching were more restrictive, in some cases allowing no branches at all. The McFadden Act of 1927, which was designed to put national banks and state banks on equal footing (and the Douglas Amendment of 1956, which closed a loophole in the McFadden Act), effectively prohibited banks from branching across state lines and forced all national banks to conform to the branching regulations of the state in which their headquarters were located.

Bank

Assets ($ millions)

Share of All Commercial Bank Assets (%)

1. J.P. Morgan Chase 1,945,467 14.23

2. Bank of America Corp. 1,433,716 10.49

3. Wells Fargo 1,373,600 10.05

4. Citibank 1,346,747 9.85

5. U.S. Bank 360,478 2.64

6. PNC 310,000 2.27

7. Bank of NY Mellon 296,626 2.17

8. State Street 239,051 1.75

9. Capital One 238,483 1.74

10. TD Bank 217,626 1.59

Total 7,761,794 56.78

table 2 Ten Largest U.S. Banks, June 30, 2014

Source: http://www.federalreserve.gov/Releases/Lbr/

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C h a p t e r 1 1 Banking Industry: Structure and Competition 251

The McFadden Act and state branching regulations constituted strong anticompeti- tive forces in the commercial banking industry, allowing many small banks to stay in existence because larger banks were prevented from opening branches nearby. If com- petition is beneficial to society, why did regulations restricting branching arise in America? The simplest explanation is that the American public has historically been hostile to large banks. States with the most restrictive branching regulations were typically ones in which populist antibank sentiment was strongest in the nineteenth century. (These states usually had large farming populations whose relations with banks periodically became tempestuous when banks would foreclose on farmers who couldn’t pay their debts.) The legacy of nineteenth-century politics was a banking system with restrictive branching regulations and hence an inordinate number of small banks. However, as we will see later in this chapter, branching restrictions have been eliminated, and we have moved toward nationwide banking.

response to Branching restrictions An important feature of the U.S. banking industry is that competition can be repressed by regulation but not completely quashed. As we saw earlier in this chapter, the exis- tence of restrictive regulation stimulates financial innovations that get around these regulations, in the banks’ search for profits. Regulations restricting branching have stimulated similar economic forces and have promoted the development of two finan- cial innovations: bank holding companies and automated teller machines.

Bank Holding companies A holding company is a corporation that owns several different companies. This form of corporate ownership has important advantages for banks. It has allowed them to circumvent restrictive branching regulations, because the holding company can own a controlling interest in several banks even if branching is not permitted. Furthermore, a bank holding company can engage in other activities related to banking, such as the provision of investment advice, data processing and transmission services, leasing, credit card services, and servicing of loans in other states.

The growth of bank holding companies has been dramatic over the past three decades. Today bank holding companies own almost all large banks, and more than 90% of all commercial bank deposits are held in banks owned by holding companies.

automated Teller machines Another financial innovation that resulted from the desire to avoid restrictions on branching is the automated teller machine (ATM). Banks quickly realized that if they did not own or rent an ATM, but instead let it be owned by someone else and paid a fee for each transaction, the ATM would probably not be considered a branch of the bank and thus would not be subject to branching regula- tions. This is exactly what the regulatory agencies and courts in most states concluded. Because they enable banks to widen their markets, a number of these shared facilities (such as Cirrus and NYCE) have been established nationwide. Furthermore, even when an ATM is owned by a bank, states typically have special provisions that allow wider establishment of ATMs than is permissible for traditional “brick and mortar” branches.

As we saw earlier in this chapter, avoiding regulation was not the only reason for the development of the ATM. The advent of cheaper computer and telecommunications tech- nology enabled banks to provide ATMs at low cost, making them a profitable innovation. This example further illustrates that technological factors often combine with incentives, such as the desire to avoid restrictive regulations, to produce financial innovation.

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Bank cOnsOLiDaTiOn anD naTiOnwiDe Banking As we can see in Figure 3, after a remarkable period of stability from 1934 to the mid- 1980s, the number of commercial banks in the United States began to fall dramatically. Why did this sudden decline take place?

The banking industry hit some hard times in the 1980s and early 1990s, with bank failures running at a rate of over 100 per year from 1985 to 1992 (more on this later in the chapter; also see Chapter 10). But bank failures are only part of the story. In the years 1985–1992, the number of banks declined by 3,000—more than double the number of failures. And in the period 1992–2007, when the banking industry returned to health, the number of commercial banks decreased by a little over 3,800, less than 5% of which were bank failures, and most of these were of small banks. Thus we see that bank failures played an important, though not predominant, role in reducing the number of banks in the 1985–1992 period, and an almost negligible role through 2007. The global financial crisis, however, led to additional declines in the number of banks because of bank failures.

So what explains the rest of the story? The answer is bank consolidation. Banks have been merging to create larger entities or have been buying up other banks. This gives rise to a new question: Why has bank consolidation been taking place in recent years?

1935 1945 1955 1965 1975 1985 1995 2000 2005 2010 2015 0

2,000

6,000

8,000

10,000

12,000

14,000

16,000

Number of Banks

4,000

Figure 3 number of insured commercial Banks in the United states, 1934–2013 (Third Quarter) After a period of stability from 1934 to the mid-1980s, the number of commercial banks began to fall

dramatically. Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

MyEconLab Mini-lecture

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C h a p t e r 1 1 Banking Industry: Structure and Competition 253

As we have seen, loophole mining by banks reduced the effectiveness of branching restrictions, with the result that many states recognized it would be in their best interest if they allowed ownership of banks across state lines. The result was the formation of reciprocal regional compacts in which banks in one state were allowed to own banks in other states in the region. In 1975, Maine enacted the first interstate banking legisla- tion that allowed out-of-state bank holding companies to purchase banks in that state. In 1982, Massachusetts enacted a regional compact with other New England states to allow interstate banking, and many other regional compacts were adopted thereafter until, by the early 1990s, almost all states allowed some form of interstate banking.

With the barriers to interstate banking breaking down in the early 1980s, banks recognized that they could gain the benefits of diversification because they would now be able to make loans in many states rather than just one. This gave them an advan- tage: If one state’s economy was weak, another state in which they operated might have a strong economy, thus decreasing the likelihood that loans in different states would default at the same time. In addition, allowing banks to own banks in other states meant that they could increase their size through out-of-state acquisition of banks or by merging with banks in other states. Mergers and acquisitions explain the first phase of banking consolidation, which has played such an important role in the decline in the number of banks since 1985. Another result of the loosening of restrictions on interstate branching is the development of a new class of banks, called superregional banks, which are bank holding companies that have begun to rival the money center banks in size but whose headquarters are not in one of the money center cities (New York, Chicago, and San Francisco). Examples of these superregional banks are Bank of America of Charlotte, North Carolina, and Banc One of Columbus, Ohio.

Not surprisingly, the advent of the Web and improved computer technology is another factor driving bank consolidation. Economies of scale have increased because large, upfront investments are required to set up information technology platforms for financial institu- tions. To take advantage of these economies of scale, banks have needed to get bigger, and this development has led to additional consolidation. Information technology has also been increasing economies of scope, the ability to use one resource to provide many different products and services. For example, details about the quality and creditworthiness of firms not only inform decisions about whether to make loans to them but also can be useful in determining at what price their shares should trade. Similarly, once you have marketed one financial product to an investor, you probably know how to market another. Business people describe economies of scope by saying there are “synergies” between different lines of business, and information technology is making these synergies more likely. The result is that consolidation is taking place not only to make financial institutions bigger, but also to increase the combination of products and services they can provide. This consolidation has had two consequences. First, different types of financial intermediaries are encroaching on each other’s territory, making them more alike. Second, consolidation has led to the devel- opment of large, complex banking organizations. This development has been facilitated by the repeal of the Glass-Steagall restrictions on combinations of banking and other financial service industries, as discussed in the next section.

The riegle-neal interstate Banking and Branching efficiency act of 1994 Banking consolidation was given further stimulus by the passage in 1994 of the Riegle- Neal Interstate Banking and Branching Efficiency Act. This legislation expanded the regional compacts to the entire nation and overturned the McFadden Act and Douglas

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Amendment’s prohibition of interstate banking. Not only did this act allow bank hold- ing companies to acquire banks in any other state, notwithstanding any state laws to the contrary, but bank holding companies could also merge the banks they owned into one bank with branches in different states. States were, however, given the option of opting out of interstate branching, but only Texas did so, although it later reversed its position and now allows it.

The Riegle-Neal Act finally established the basis for a true nationwide banking sys- tem. Although interstate banking was accomplished previously by out-of-state purchase of banks by bank holding companies, until 1994 it was virtually nonexistent because very few states had enacted interstate branching legislation. Allowing banks to conduct interstate banking through branching is especially important because many bankers feel that economies of scale cannot be fully exploited through the bank holding company structure, but only through branching networks in which all of the bank’s operations are fully coordinated.

Nationwide banks have now emerged. Starting with the merger in 1998 of Bank of America and NationsBank, which created the first bank with branches on both coasts, consolidation in the banking industry has created some banking organizations with operations in all 50 states.

what will the structure of the U.s. Banking industry Look Like in the future? Now that true nationwide banking in the United States is a reality, the benefits of bank consolidation for the banking industry have increased substantially, driving the next phase of mergers and acquisitions and accelerating the decline in the number of com- mercial banks. With great changes occurring in the structure of this industry, the ques- tion naturally arises: What will the industry look like in ten years?

One view is that the industry will become more like that in many other coun- tries (see the Global box, “Comparison of Banking Structure in the United States and Abroad”), and we will end up with only a couple of hundred banks. A more extreme view is that the industry will look like that of Canada or the United Kingdom, with a few large banks dominating the industry. Most experts come up with a different answer: The structure of the U.S. banking industry will still be unique, but not to the degree it once was. The consolidation surge is likely to settle down as the U.S. banking industry approaches several thousand, rather than several hundred, banks.

Banking consolidation will result not only in a smaller number of banks but also, as the mergers between Chase Manhattan Bank and Chemical Bank and between Bank of America and NationsBank suggest, in a shift in assets from smaller banks to larger banks. Within ten years, the share of bank assets in banks with less than $100 million in assets is expected to halve, while the amount at the megabanks, those with more than $100 billion in assets, is expected to more than double. Indeed, the United States now has several trillion-dollar banks (e.g., Citibank, J.P. Morgan Chase, and Bank of America).

are Bank consolidation and nationwide Banking good Things? Advocates of nationwide banking believe that it will produce more efficient banks and a healthier banking system that is less prone to bank failures. However, critics of bank consolidation fear that it will eliminate small banks, referred to as community banks,

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C h a p t e r 1 1 Banking Industry: Structure and Competition 255

and that this will result in less lending to small businesses. In addition, they worry that a few banks will come to dominate the industry, making the banking business less competitive.

Most economists are skeptical of these criticisms of bank consolidation. As we have seen, research indicates that even after bank consolidation is completed, the United States will still have plenty of banks. The banking industry will thus remain highly competitive, probably even more so than it is now, considering that banks that had been protected from competition from out-of-state banks now have to compete with them vigorously to stay in business.

It also does not look as though community banks will disappear. When New York state liberalized its branching laws in 1962, there were fears that community banks upstate would be driven from the market by the big New York City banks. Not only did this not happen, but some of the big boys found that the small banks were able to run rings around them in the local markets. Similarly, California, which has allowed unrestricted statewide branching for a long time, continues to have a thriving popula- tion of community banks.

Economists see some important benefits from bank consolidation and nationwide banking. The elimination of geographic restrictions on banking increases competition and drives inefficient banks out of business, increasing the efficiency of the banking sector. The move to larger banking organizations also means that there is some increase in efficiency because these organziations can take advantage of economies of scale and scope. The increased diversification of banks’ loan portfolios may lower the probability of a banking crisis in the future. In the 1980s and early 1990s, bank failures were often concentrated in states with weak economies. For example, after the decline in oil prices in 1986, all of the major commercial banks in Texas, which had been very profitable, found themselves in trouble. At that time, banks in New England were doing fine. However, when the 1990–1991 recession hit New England hard, some New England banks started failing. With nationwide banking, a bank could make loans in both New England and Texas and would thus be less likely to fail because when loans went sour in one location, they probably still would be doing well in the other. Thus nationwide banking is seen as a major step toward creating a banking system that is less vulnerable to banking crises.

global Comparison of Banking Structure in the United States and Abroad

The structure of the commercial banking industry in the United States is radically different from that in other industrialized nations. The United States came late to developing a true national banking system in which banks have branches throughout the country. One result is that many more banks are found in the United States than in other industrialized countries. In contrast to the United States, which has on the order of 5,700

commercial banks, every other industrialized country has far fewer than 1,000. Japan, for example, has fewer than 100 commercial banks—a mere fraction of the number in the United States, even though its economy and population are half the size of those of the United States. Another result of past restrictions on branching in the United States is that our banks tend to be much smaller than those in other countries.

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Two concerns remain about the effects of bank consolidation—that it may lead to a reduction in lending to small businesses and that banks rushing to expand into new geographic markets may take increased risks leading to bank failures. The jury is still out on these concerns, but most economists see the benefits of bank consolidation and nationwide banking as outweighing the costs.

seParaTiOn Of Banking anD OTHer financiaL service inDUsTries

Until recently, an important feature of the structure of the banking industry in the United States was the separation of the banking and other financial services industries— such as securities, insurance, and real estate—mandated by the Glass-Steagall Act of 1933. As pointed out earlier in the chapter, Glass-Steagall allowed commercial banks to sell new offerings of government securities but prohibited them from underwriting corporate securities or from engaging in brokerage activities. It also prevented banks from engaging in insurance and real estate activities. In turn, it prevented investment banks and insurance companies from engaging in commercial banking activities and thus protected banks from competition.

erosion of glass-steagall Despite the Glass-Steagall prohibitions, the pursuit of profits and financial innovation stimulated both banks and other financial institutions to bypass the intent of the Glass- Steagall Act and encroach on each other’s traditional territory. With the development of money market mutual funds and cash management accounts, brokerage firms began to engage in the traditional banking business of issuing deposit instruments. After the Federal Reserve used a loophole in Section 20 of the Glass-Steagall Act in 1987 to allow bank holding companies to underwrite previously prohibited classes of securities, banks began to enter this business. The loophole allowed affiliates of approved com- mercial banks to engage in underwriting activities as long as the revenue didn’t exceed a specified amount, which started at 10% but was raised to 25% of the affiliates’ total revenue. After the U.S. Supreme Court validated the Fed’s action in July 1988, the Federal Reserve allowed J.P. Morgan, a commercial bank holding company, to underwrite corporate debt securities (in January 1989) and to underwrite stocks (in September 1990), with the privilege later extended to other bank holding companies. The regula- tory agencies also allowed banks to engage in some real estate and insurance activities.

The gramm-Leach-Bliley financial services modernization act of 1999: repeal of glass-steagall Because restrictions on commercial banks’ securities and insurance activities put American banks at a competitive disadvantage relative to foreign banks, bills to overturn Glass- Steagall appeared in almost every session of Congress in the 1990s. With the merger in 1998 of Citicorp, the second-largest bank in the United States, and Travelers Group, an insurance company that also owned the third-largest securities firm in the country (Salomon Smith Barney), the pressure to abolish Glass-Steagall became overwhelming. Legislation to eliminate Glass-Steagall finally came to fruition in 1999. This legislation, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999,

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allows securities firms and insurance companies to purchase banks, and allows banks to underwrite insurance and securities and engage in real estate activities. Under this legislation, states retain regulatory authority over insurance activities, while the Securities and Exchange Commission continues to have oversight of securities activities. The Office of the Comptroller of the Currency has the authority to regulate bank subsidiaries engaged in securities underwriting, but the Federal Reserve continues to have the authority to oversee the bank holding companies under which all real estate and insur- ance activities and large securities operations will be housed.

implications for financial consolidation As we have seen, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 stimulated consolidation of the banking industry. The financial consolidation process was further hastened by the Gramm-Leach-Bliley Act of 1999, because the way is now open to consolidation not only in terms of the number of banking institutions but also across financial service activities. Given that information technology is increas- ing economies of scope, mergers of banks with other financial service firms like that of Citicorp and Travelers have become increasingly common, and more mega-mergers are likely to be on the way. Banking institutions are becoming not only larger but also increasingly complex organizations, engaging in the full gamut of financial service activities. The trend toward larger and more complex banking organizations has been accelerated by the global financial crisis of 2007–2009 (see the FYI box, “The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks”).

FYI The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks

Although the move toward bringing financial service activities into larger, more complex banking organiza- tions was inevitable after the demise of Glass-Steagall, no one expected it to occur as rapidly as it did in 2008. Over a six-month period from March to September 2008, all five of the largest, free-standing investment banks ceased to exist in their old form. When Bear Stearns, the fifth-largest investment bank, revealed its large losses from investments in subprime mortgage- backed securities, it had to be bailed out by the Fed in March 2008; the price it paid was a forced sale to J.P. Morgan for less than one-tenth of its worth only a year or so before. The Bear Stearns bailout made it clear that the government safety net had been extended to investment banks. The tradeoff is that investment banks will be subject to more regulation, along the lines of that of commercial banks, in the future.

Next to go was Lehman Brothers, the fourth- largest investment bank, which declared bankruptcy on September 15. Only one day before, Merrill Lynch, the third-largest investment bank, which also suffered large losses on its holdings of subprime securities, announced its sale to Bank of America for less than half of its year-earlier price. Within a week, Goldman Sachs and Morgan Stanley, the first- and second-largest investment banks, both of which had smaller exposure to subprime securities, nevertheless saw the writing on the wall. They realized that they would soon become regulated on a similar basis and decided to become bank holding companies so that they could access insured deposits, a more stable funding base.

It was the end of an era. Large, free-standing investment banking firms are now a thing of the past.

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separation of Banking and Other financial services industries Throughout the world In the aftermath of the Great Depression, not many other countries followed the lead of the United States in separating the banking and other financial services industries. In fact, in the past this separation was the most prominent difference between banking regulation in the United States and that in other countries. Around the world, there are three basic frameworks for the banking and securities industries.

The first framework is universal banking, which exists in Germany, the Netherlands, and Switzerland. It provides no separation at all between the banking and securities industries. In a universal banking system, commercial banks provide a full range of banking, securities, real estate, and insurance services, all within a single legal entity. Banks are allowed to own sizable equity shares in commercial firms, and often they do.

The British-style universal banking system, the second framework, is found in the United Kingdom and countries with close ties to it, such as Canada and Australia, and now the United States. The British-style universal bank engages in securities underwrit- ing, but it differs from the German-style universal bank in three ways: Separate legal subsidiaries are more common, bank equity holdings of commercial firms are less com- mon, and combinations of banking and insurance firms are less common.

The third framework, found in Japan, features some legal separation of the bank- ing and other financial services industries. A major difference between the U.S. and Japanese banking systems is that Japanese banks are allowed to hold substantial equity stakes in commercial firms, whereas American banks are not. In addition, most American banks use a bank holding company structure, but bank holding companies are illegal in Japan. Although the banking and securities industries are legally separated in Japan under Section 65 of the Japanese Securities Act, commercial banks are increasingly being allowed to engage in securities activities and, like U.S. banks, are becoming more like British-style universal banks.

THrifT inDUsTry: regULaTiOn anD sTrUcTUre Not surprisingly, the regulation and structure of the thrift industry (savings and loan associations, mutual savings banks, and credit unions) closely parallel the regulation and structure of the commercial banking industry.

savings and Loan associations Just as there is a dual banking system for commercial banks, savings and loan associa- tions (S&Ls) can be chartered either by the federal government or by the states. Most S&Ls, whether state or federally chartered, are members of the Federal Home Loan Bank System (FHLBS). Established in 1932, the FHLBS was styled after the Federal Reserve System. It has twelve district Federal Home Loan banks, which are supervised by the Office of Thrift Supervision.

Federal deposit insurance up to $250,000 per account for S&Ls is provided by the FDIC. The Office of Thrift Supervision regulates federally insured S&Ls by setting mini- mum capital requirements, requiring periodic reports, and examining the S&Ls. It is also the chartering agency for federally chartered S&Ls, and for these S&Ls it approves mergers and sets the rules for branching.

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The branching regulations for S&Ls were historically more liberal than those for commercial banks: In the past, almost all states permitted branching of S&Ls, and since 1980, federally chartered S&Ls were allowed to branch statewide in all states. Since 1981, mergers of financially troubled S&Ls were allowed across state lines, and nationwide branching of S&Ls is now a reality.

The FHLBS, like the Fed, makes loans to the members of the system (obtaining funds for this purpose by issuing bonds). However, in contrast to the Fed’s discount loans, which are expected to be repaid quickly, loans from the FHLBS often need not be repaid for long periods of time. In addition, the rates charged to S&Ls for these loans are often below the rates that the S&Ls must pay when they borrow in the open market. In this way, the FHLBS loan program provides a subsidy to the savings and loan industry (and implicitly to the housing industry, since most S&L loans are for residential mortgages).

The savings and loans industry experienced serious difficulties in the 1980s. Because savings and loans now engage in many of the same activities as commercial banks, many experts view the existence of a separate charter and regulatory apparatus for S&Ls as an anachronism that no longer makes sense.

mutual savings Banks Of the 350 or so mutual savings banks, which are similar to S&Ls but are jointly owned by the depositors, approximately half are chartered by states. Although the mutual sav- ings banks are primarily regulated by the states in which they are located, the majority have their deposits insured by the FDIC up to the limit of $250,000 per account; these banks are also subject to many of the FDIC’s regulations for state-chartered banks. As a rule, the mutual savings banks whose deposits are not insured by the FDIC have their deposits insured by state insurance funds.

The branching regulations for mutual savings banks are determined by the states in which they operate. Because these regulations are not particularly restrictive, few mutual savings banks have assets of less than $25 million.

credit Unions Credit unions are small cooperative lending institutions organized around a particu- lar group of individuals with a common bond (e.g., union members or employees of a particular firm). They are the only depository institutions that are tax-exempt and can be chartered either by the states or by the federal government; more than half are federally chartered. The National Credit Union Administration (NCUA) issues federal charters and regulates federally chartered credit unions by setting minimum capital requirements, requiring periodic reports, and examining the credit unions. Federal deposit insurance (up to the $250,000-per-account limit) is provided to both federally chartered and state-chartered credit unions by a subsidiary of the NCUA, the National Credit Union Share Insurance Fund (NCUSIF). Because the majority of credit union lending is for consumer loans with fairly short terms to maturity, these institutions did not suffer the financial difficulties of the S&Ls and mutual savings banks in the 1980s.

Because their members share a common bond, credit unions are typically quite small; most hold less than $10 million of assets. In addition, their ties to a particular industry or company make them more likely to fail when large numbers of workers in that industry or company are laid off and have trouble making loan payments. Recent regulatory changes allow individual credit unions to cater to a more diverse group of

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people by interpreting the common bond requirement less strictly, and this has encour- aged an expansion in the size of credit unions that may help reduce credit union failures in the future.

Often a credit union’s shareholders are dispersed over many states, and sometimes even worldwide, so branching across state lines and into other countries is permitted for federally chartered credit unions. The Navy Federal Credit Union, for example, whose shareholders are members of the U.S. Navy and Marine Corps, has branches throughout the world.

inTernaTiOnaL Banking In 1960, only eight U.S. banks operated branches in foreign countries, and their total assets were less than $4 billion. Currently, around 100 American banks have branches abroad, with assets totaling more than $2.5 trillion. The spectacular growth in interna- tional banking can be explained by three factors.

First is the rapid growth in international trade and multinational corporations that has occurred since 1960. When American firms operate abroad, they need banking ser- vices in foreign countries to help finance international trade. For example, they might need a loan in a foreign currency to operate a factory abroad. And when they sell goods abroad, they need to have a bank exchange the foreign currency they have received for their goods into dollars. Although these firms could use foreign banks to provide them with these international banking services, many of them prefer to do business with the U.S. banks with which they have established long-term relationships and which understand American business customs and practices. As international trade has grown, international banking has grown with it.

Second, American banks have been able to earn substantial profits by being very active in global investment banking, in which they underwrite foreign securities. They also sell insurance abroad, and they derive substantial profits from these investment banking and insurance activities.

Third, American banks have wanted to tap into the large pool of dollar-denominated deposits in foreign countries known as Eurodollars. To understand the structure of U.S. banking overseas, let’s first look at the Eurodollar market, an important source of growth for international banking.

eurodollar market Eurodollars are created when deposits in accounts in the United States are transferred to a bank outside the country and are kept in the form of dollars. (For a discussion of the birth of the Eurodollar, see the Global box, “Ironic Birth of the Eurodollar Market.”) For example, if Rolls-Royce PLC deposits a $1 million check, written on an account at an American bank, in its bank in London—specifying that the deposit is payable in dollars—$1 million in Eurodollars is created.2 More than 90% of Eurodollar deposits are time deposits, more than half of them certificates of deposit with maturities of 30 days or more. The Eurodollar market is massive, over $5 trillion, making it one of the most important financial markets in the world economy.

2Note that the London bank keeps the $1 million on deposit at the American bank, so the creation of Eurodollars has not caused a reduction in the amount of bank deposits in the United States.

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Why would companies such as Rolls-Royce want to hold dollar deposits outside the United States? First, the dollar is the most widely used currency in international trade, so Rolls-Royce might want to hold deposits in dollars to conduct its international transactions. Second, Eurodollars are “offshore” deposits—they are held in countries that will not subject them to regulations such as reserve requirements or restrictions (called capital controls) on taking the deposits outside the country.3

The main center of the Eurodollar market is London, a major international financial center for hundreds of years. Eurodollars are also held outside Europe in locations that provide offshore status to these deposits—for example, Singapore, the Bahamas, and the Cayman Islands.

The minimum transaction in the Eurodollar market is typically $1 million, and approximately 75% of Eurodollar deposits are held by banks. Plainly, you and I are unlikely to come into direct contact with Eurodollars. The Eurodollar market is, however, an important source of funds to U.S. banks. Rather than using an intermedi- ary and borrowing all the deposits from foreign banks, American banks decided that they could earn higher profits by opening their own branches abroad to attract these deposits. Consequently, the Eurodollar market has been an important stimulus to U.S. banking overseas.

structure of U.s. Banking Overseas U.S. banks have most of their foreign branches in Latin America, the Far East, the Caribbean, and London. The largest volume of assets is held by branches in London, because it is a major international financial center and the central location for the Eurodollar market. Latin America and the Far East have many branches because of the importance of U.S. trade with these regions. Parts of the Caribbean (especially the Bahamas and the Cayman Islands) have become important as tax havens, with minimal taxation and few restrictive regulations. In actuality, the bank branches in the Bahamas and the Cayman Islands are “shell operations” because they function primarily as bookkeeping centers and do not provide normal banking services.

3Although most offshore deposits are denominated in dollars, some are denominated in other currencies. Collectively, these offshore deposits are referred to as Eurocurrencies. A Japanese yen-denominated deposit held in London, for example, is called a Euroyen.

global Ironic Birth of the Eurodollar Market One of capitalism’s great ironies is that the Eurodollar market, one of the most important financial markets used by capitalists, was fathered by the Soviet Union. In the early 1950s, during the height of the Cold War, the Soviets had accumulated a substantial amount of dollar balances held by banks in the United States. Because the Russians feared that the U.S. government might freeze these assets in the United States, they wanted to move the deposits to Europe, where they

would be safe from expropriation. (This fear was not unjustified—consider the U.S. freeze on Iranian assets in 1979 and on Iraqi assets in 1990.) However, they also wanted to keep the deposits in dollars so that they could be used in their international transac- tions. The solution to the problem was to transfer the deposits to European banks but to keep the deposits denominated in dollars. When the Soviets did this, the Eurodollar was born.

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An alternative corporate structure for U.S. banks that operate overseas is the Edge Act corporation, a special subsidiary engaged primarily in international banking. U.S. banks (through their holding companies) can also own a controlling interest in foreign banks and in foreign companies that provide financial services, such as finance compa- nies. The international activities of U.S. banking organizations are governed primarily by the Federal Reserve’s Regulation K.

In late 1981, the Federal Reserve approved the creation of international banking facilities (IBFs) within the United States that can accept time deposits from foreigners but are not subject to either reserve requirements or restrictions on interest payments. IBFs are also allowed to make loans to foreigners, but they are not allowed to make loans to domestic residents. States have encouraged the establishment of IBFs by exempting them from state and local taxes. In essence, IBFs are treated like foreign branches of U.S. banks and are not subject to domestic regulations and taxes. The purpose of establishing IBFs is to encourage American and foreign banks to do more banking business in the United States rather than abroad. From this point of view, IBFs are a success: Their assets climbed to nearly $200 billion in the first two years, and are in excess of $1 trillion currently.

foreign Banks in the United states The growth in international trade has not only encouraged U.S. banks to open offices overseas, but has also encouraged foreign banks to establish offices in the United States. Foreign banks have been extremely successful in the United States. Currently, they hold more than 6.5% of total U.S. bank assets and do a large portion of all U.S. bank lending, with around a 28% market share for lending to U.S. corporations.

Foreign banks engage in banking activities in the United States by operating an agency office of the foreign bank, a subsidiary U.S. bank, or a branch of the foreign bank. An agency office can lend and transfer funds in the United States, but it cannot accept deposits from domestic residents. Agency offices have the advantage of not being subject to regulations that apply to full-service banking offices (such as requirements for FDIC insurance). A subsidiary U.S. bank is just like any other U.S. bank (it may even have an American-sounding name) and is subject to the same regulations, but it is owned by the foreign bank. A branch of a foreign bank bears the foreign bank’s name and is usually a full-service office. Foreign banks may also form Edge Act corporations and IBFs.

Before 1978, foreign banks were not subject to many of the regulations that applied to domestic banks: They could open branches across state lines and were not expected to meet reserve requirements, for example. The passage of the International Banking Act of 1978, however, put foreign and domestic banks on more equal footing. The act stipulated that foreign banks could open new full-service branches only in the state they designated as their home state or in states that allowed the entry of out-of-state banks. Limited-service branches and agency offices in any other state were permitted, however, and foreign banks were allowed to retain any full-service branches opened before the act was ratified.

The internationalization of banking, both by U.S. banks going abroad and by for- eign banks entering the United States, has meant that financial markets throughout the world have become more integrated. As a result, there is a growing trend toward inter- national coordination of bank regulation, one example of which is the Basel Accords, discussed in Chapter 10, which were established to standardize minimum bank capital requirements in industrialized countries . Financial market integration has also encouraged

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bank consolidation abroad, culminating in the creation of the first trillion-dollar bank with the merger of the Industrial Bank of Japan, Dai-Ichi Kangyo Bank, and Fuji Bank, in 2002. Another development has been the importance of foreign banks in interna- tional banking. As is shown in Table 3, in 2014, nine out of ten of the largest banking groups in the world were foreign. The implications of this financial market integration for the operation of our economy are examined further in Chapter 21, where we discuss the international financial system in more detail.

Bank Assets (U.S. $ millions)

1. Industrial and Commercial Bank of China, China 3,181,884

2. HSBC Holdings, UK 2,758,447

3. China Construction Bank Corp, China 2,602,536

4. BNP Paribas SA, France 2,589,191

5. The Bank of Tokyo-Mitsubishi UFJ Ltd, Japan 2,508,839

6. JP Morgan-Chase NA, US 2,476,986

7. Agricultural Bank of China, China 2,470,432

8. Bank of China, China 2,435,485

9. Credit Agricole SA, France 2,346,562

10. Barclays PLC, UK 2,266,815

table 3 Ten Largest Banks in the world, 2014

Source: http://www.relbanks.com/worlds-top-banks/market-cap.

sUmmary

1. The history of banking in the United States has left us with a dual banking system, with commercial banks chartered by the states and the federal government. Multiple agencies regulate commercial banks: the Office of the Comptroller, the Federal Reserve, the FDIC, and the state banking authorities.

2. A change in the economic environment will stimulate financial institutions to search for financial innovations. Changes in demand conditions, especially an increase in interest-rate risk; changes in supply conditions, especially improvements in information technology; and the desire to avoid costly regulations have been major driving forces behind financial innovation. Financial innovation has caused banks to suffer declines in cost advantages in acquiring funds and in income advantages on their assets. The resulting squeeze has hurt profitability

in banks’ traditional lines of business and has led to a decline in traditional banking.

3. Restrictive state branching regulations and the McFadden Act, which prohibited branching across state lines, led to a large number of small commercial banks. The large number of commercial banks in the United States reflects the past lack of competition, not the presence of vigorous competition. Bank holding companies and ATMs were important responses to branching restrictions that weakened the restrictions’ anticompetitive effect.

4. Since the mid-1980s, bank consolidation has been occurring at a rapid pace. The first phase of bank consolidation was the result of bank failures and the reduced effectiveness of branching restrictions. The second phase was stimulated by enhanced information

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Supervision, and deposit insurance is administered by the FDIC. Mutual savings banks are regulated by the states, and federal deposit insurance is provided by the FDIC. Credit unions are regulated by the National Credit Union Administration, and deposit insurance is provided by the National Credit Union Share Insurance Fund.

7. With the rapid growth of world trade since 1960, international banking has grown dramatically. United States banks engage in international banking activities by opening branches abroad, owning controlling interests in foreign banks, forming Edge Act corporations, and operating international banking facilities (IBFs) located in the United States. Foreign banks operate in the United States by owning a subsidiary American bank or by operating branches or agency offices in the United States.

technology and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which establishes the basis for a nationwide banking system. Once banking consolidation has settled down, we are likely to be left with a banking system with several thousand banks. Most economists believe that the benefits of bank consolidation and nationwide banking will outweigh the costs.

5. The Glass-Steagall Act separated commercial banking from the securities industry. Legislation in 1999, however, repealed the Glass-Steagall Act, removing the separation of these industries.

6. The regulation and structure of the thrift industry (savings and loan associations, mutual savings banks, and credit unions) parallel closely the regulation and structure of the commercial banking industry. Savings and loans are primarily regulated by the Office of Thrift

key Terms

automated banking machine (ABM), p. 240

automated teller machine (ATM), p. 240 bank holding companies, p. 237 branches, p. 250 central bank, p. 235 community banks, p. 254 deposit rate ceilings, p. 244 disintermediation, p. 244

dual banking system, p. 236 economies of scope, p. 253 Edge Act corporation, p. 262 financial derivatives, p. 239 financial engineering, p. 237 futures contracts, p. 239 hedge, p. 239 international banking facilities

(IBFs), p. 262

national banks, p. 236 originate-to-distribute, p. 243 securitization, p. 242 shadow banking system, p. 237 state banks, p. 236 subprime mortgage, p. 243 superregional banks, p. 253 sweep account, p. 245 virtual bank, p. 240

QUesTiOns

All questions are available in MyEconLab at http://www.myeconlab.com.

1. Why was the United States one of the last major industrialized countries to have a central bank?

2. Why does the United States operate under a dual banking system?

3. What were the motivations for the original Glass- Steagall Act of 1933?

4. Which regulatory agency has the primary responsibility for supervising the following categories of commercial banks?

a. National banks

b. Bank holding companies

c. Non–Federal Reserve member state banks

d. Federal Reserve member state banks

e. Federally chartered savings and loan associations

f. Federally chartered credit unions

5. How does the emergence of interest-rate risk help explain financial innovation?

6. Why did new technology make it harder to enforce limitations on bank branching?

7. “The invention of the computer is the major factor behind the decline of the banking industry.” Is this statement true, false, or uncertain? Explain your answer.

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C h a p t e r 1 1 Banking Industry: Structure and Competition 265

restrictions on setting up branches in other states. Why, then, are credit unions typically smaller than the other depository institutions?

17. Why has the number of bank holding companies dramatically increased?

18. What are the advantages and disadvantages of interstate banking?

19. How did competitive forces lead to the repeal of the Glass-Steagall Act’s separation of the banking and securities industries?

20. What has been the likely effect of the Gramm-Leach- Bliley Act on financial consolidation?

21. What factors explain the rapid growth of international banking?

22. What incentives have regulatory agencies created to encourage international banking? Why have they done this?

23. How could the approval of international banking facili- ties (IBFs) by the Fed in 1981 have reduced employ- ment in the banking industry in Europe?

24. If the bank at which you keep your checking account is owned by foreigners, should you worry that your deposits are less safe than if the bank were owned by Americans?

25. Why is there only one U.S. bank among the ten largest banks in the world?

8. “If inflation had not risen in the 1960s and 1970s, the banking industry might be healthier today.” Is this statement true, false, or uncertain? Explain your answer.

9. How do sweep accounts and money market mutual funds allow banks to avoid reserve requirements?

10. If reserve requirements were eliminated in the future, as some economists advocate, what effects would this have on the size of money market mutual funds?

11. Why is loophole mining so prevalent in the banking industry in the United States?

12. Why have banks been losing cost advantages in acquiring funds in recent years?

13. Why have banks been losing income advantages on their assets in recent years?

14. “The commercial banking industry in Canada is less competitive than the commercial banking industry in the United States because in Canada only a few large banks dominate the industry, while in the United States there are around 5,700 commercial banks.” Is this statement true, false, or uncertain? Explain your answer.

15. Why is there a higher percentage of banks with less than $25 million of assets among commercial banks than among savings and loans and mutual savings banks?

16. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did not have

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the 30-year conventional mortgage rate (WRMORTG) and the 5/1-year adjustable-rate mortgage (MORTGAGE5US).

a. What are the mortgage rates reported for the most recent week of data available?

b. If the principal payment for a given month were $2000, then what would be the interest payment per month (using simple interest) for each of the mortgage types, using the most recent week of data?

c. Over a one-year period, how much would the difference in interest payments between the two mortgage types amount to?

2. Go to the St. Louis Federal Reserve FRED database, and find data on the level of money market mutual fund assets (MMMFFAQ027S). Download the data into a spreadsheet.

a. When did assets start entering money market mutual funds? What was the total worth of assets in money market mutual funds at the end of 1970?

b. For each decade period, calculate the total percentage change in assets from the begin- ning of the decade to the end of the decade: 1980:Q1–1990:Q1; 1990:Q1–2000:Q1; 2000:Q1–2010:Q1. For each decade period, divide the total percentage change by 10 to get the average yearly percent increase. Which

DaTa anaLysis PrOBLems

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266 p a r t 3 Financial Institutions

year prior. How does this growth rate compare to the highest average yearly growth rate for the decades from part (b)?

decade had the largest average yearly growth in money market mutual funds?

c. Calculate the growth rate from the most recent quarter of data available to the same quarter a

weB exercises

1. Go to http://www2.fdic.gov/hsob/index.asp. Select “Commercial Bank Reports,” and then select “Number of Institutions, Branches, and Total Offices.” If you look at the trend in the number of bank branches, does the public currently appear to have more or less access to banking facilities? How many banks were there in 1934, and how many are there now? Does the graph indicate that the trend toward consolidation is continuing?

2. Despite the regulations that protect banks from failure, some banks do fail. Go to http://www2.fdic.gov/hsob/ index.asp. Select the tab labeled “Failures and Assistance Transactions.” How many bank failures occurred in the United States during the most recent complete calendar year? What were the total assets held by the banks that failed? How many banks failed in 1937?

weB references

http://www.fdic.gov/bank/

The FDIC gathers data about individual financial institu- tions and the banking industry.

http://www2.fdic.gov/hsob/index.asp

Visit this website to gather statistics on the banking industry.

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Learning Objectives • Define the term “financial crisis.”

• Identify the key features of the three stages of a financial crisis.

• Describe the causes and consequences of the global financial crisis of 2007–2009.

• Summarize the changes to financial regula- tion that occurred in response to the global financial crisis of 2007–2009.

• Identify the gaps in current financial regulation and how those gaps may be addressed with future regulatory changes.

12 Preview

Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures. Beginning in August 2007, defaults in the subprime mortgage market (by borrowers with weak credit records) sent a shudder through the financial markets, leading to the worst financial crisis since the Great Depres- sion. In Congressional testimony, Alan Greenspan, former chairman of the Fed, described the financial crisis as a “once-in-a-century credit tsunami.” Wall Street firms and commer- cial banks suffered hundreds of billions of dollars of losses. Households and businesses found they had to pay higher rates on their borrowings—and it was much harder to get credit. All over the world, stock markets crashed, with the U.S market falling by over 50% from its peak. Many financial firms, including commercial banks, investment banks, and insurance companies, went belly up. A recession began in December of 2007, and by the fall of 2008, the economy was in a tailspin. The recession, which ended in June of 2009, was the most severe since World War II and is now known as the “Great Recession.”

Why did this financial crisis occur? Why have financial crises been so prevalent throughout U.S. history, as well as in so many other countries, and what insights do they provide on the most recent crisis? Why are financial crises almost always followed by severe contractions in economic activity, as occurred during the Great Recession? We will examine these questions in this chapter by developing a framework with which to understand the dynamics of financial crises. Building on Chapter 8, we make use of agency theory, the economic analysis of the effects of asymmetric information (adverse selection and moral hazard) on financial markets, to see why financial crises occur and why they have such dev- astating effects on the economy. We then apply our analysis to explain the course of events that led to a number of past financial crises, including the most recent global financial crisis.1

What is a FinanciaL crisis? In Chapter 8, we saw that a well-functioning financial system solves asymmetric infor- mation problems (moral hazard and adverse selection) so that capital is allocated to its most productive uses. These asymmetric information problems, which act as a barrier

Financial Crises

267

1Web Chapter 1, “Financial Crises in Emerging Economies,” available on the Companion Website, http://www .pearsonhighered.com/mishkin, extends the analysis to financial crises in emerging market economies, economies in an early stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world.

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to efficient allocation of capital, are often described by economists as financial frictions. When financial frictions increase, financial markets are less capable of channeling funds efficiently from savers to households and firms with productive investment opportuni- ties, with the result that economic activity declines. A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning. Then economic activity collapses.

Dynamics OF FinanciaL crises As earth-shaking and headline-grabbing as the most recent financial crisis was, it was only one of a number of financial crises that have hit industrialized countries like the United States over the years. These experiences have helped economists uncover insights into present-day economic turmoil.

Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 1, which traces the stages and sequence of events in financial crises in advanced economies.

stage One: initial Phase Financial crises can begin in two ways: credit boom and bust, or a general increase in uncertainty caused by failures of major financial institutions.

credit Boom and Bust The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions. In the long run, financial liberalization promotes financial development and encourages a well-run financial system that allocates capital efficiently. However, financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lend- ing spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions—and government regulators—to screen and monitor credit risks, leading to overly risky lending.

As we learned in Chapter 10, government safety nets, such as deposit insur- ance, weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Because lender-savers know that government-guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Without proper monitoring, risk-taking grows unchecked.

Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial insti- tutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their

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funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash.

When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric informa- tion problems of adverse selection and moral hazard (as shown in the arrow pointing from the first factor, “Deterioration in Financial Institutions’ Balance Sheets,” in the top row of Figure 1). As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract.

asset-Price Boom and Bust Prices of assets such as equity shares and real estate can be driven by investor psychology (dubbed “irrational exuberance” by Alan Green- span when he was chairman of the Federal Reserve) well above their fundamental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Examples of asset-price bubbles are the tech stock market bubble of the late 1990s and the recent housing price bubble that we will discuss later in this chapter. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price.

When the bubble bursts and asset prices realign with fundamental economic val- ues, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral these com- panies can pledge drops. Now these companies have less at stake because they have less “skin in the game,” and so they are more likely to make risky investments because they have less to lose, the problem of moral hazard. As a result, financial institutions tighten lending standards for borrower-spenders and lending contracts (as shown by the downward arrow pointing from the second factor, “Asset-Price Decline,” in the top row of Figure 1).

The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in the institutions’ net worth and hence a deterioration in their balance sheets (shown by the arrow from the second factor to the first factor in the top row of Figure 1), which causes them to deleverage, steepening the decline in economic activity.

increase in Uncertainty U.S. financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. Crises began after the failure of Ohio Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity (as shown by the arrow pointing from the last factor, “Increase in Uncertainty,” in the top row of Figure 1).

stage two: Banking crisis Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, which happens when their net worth becomes negative.

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Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of or with limited

Adverse Selection and Moral Hazard Problems Worsen

and Lending Contracts

Economic Activity Declines

Economic Activity Declines

Banking Crisis

STAGE ONE Initial Phase

STAGE TWO Banking Crisis

STAGE THREE Debt Deflation

Unanticipated Decline in Price Level

Adverse Selection and Moral Hazard Problems Worsen

and Lending Contracts

Economic Activity Declines

Adverse Selection and Moral Hazard Problems Worsen

and Lending Contracts

Consequences of Changes in FactorsFactors Causing Financial Crises

Asset-Price Decline

Increase in Uncertainty

Deterioration in Financial Institutions’ Balance Sheets

Figure 1 sequence of events in Financial crises in advanced economies The solid arrows trace the sequence of events during a typical financial crisis; the dotted arrows show the

additional set of events that occurs if the crisis develops into a debt deflation. The sections separated by the dashed horizontal lines show the different stages of a financial crisis.

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amounts of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which forces banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that more banks become insolvent and the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic.

With fewer banks operating, information about the creditworthiness of borrower- spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Figure 1 represents this progression in the stage two portion. Bank panics were a feature of all U.S. financial crises during the nineteenth and twentieth centuries, occurring every twenty years or so until World War II—1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. (The 1933 establishment of federal deposit insurance, which protects depositors from losses, has prevented subsequent bank pan- ics in the United States.)

Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recov- ers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery.

stage three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recovery process can be short-circuited. In stage three of Figure 1, debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness.

In economies with moderate inflation, which characterizes most advanced countries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ and households’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of their assets. The borrowers’ net worth in real terms (the difference between assets and liabilities in real terms) thus declines.

To better understand how this decline in net worth occurs, consider what hap- pens if a firm in 2016 has assets of $100 million (in 2016 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth (the difference between the values of assets and liabilities). If the price level falls by 10% in 2017, the real value of the liabilities would rise to $99 million in 2016 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2016 dollars would fall from $10 million to $1 million ($100 million minus $99 million).

The substantial decline in the real net worth of borrowers caused by a sharp drop in the price level creates an increase in adverse selection and moral hazard problems for lenders. Lending and economic activity decline for a long time. The most significant financial crisis that displayed debt deflation was the Great Depression, the worst eco- nomic contraction in U.S. history.

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A p p li c At i o n The Mother of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to analyze how a financial crisis unfolded during the Great Depression and how it led to the worst economic downturn in U.S. history.

Stock Market Crash In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as caused by excessive speculation. To curb it, they pur- sued a tightening of monetary policy to raise interest rates in an effort to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in Figure 2.

Bank Panics By the middle of 1930, stocks had recovered almost half of their losses and credit mar- ket conditions had stabilized. What might have been a normal recession turned into something far worse, however, when severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The general weakness of the economy, and of the banks in agricultural regions in particular, prompted substantial withdrawals from banks, building to a full-fledged panic in November and December of 1930, with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. After what would be the era’s final panic in March 1933, President Franklin Delano Roosevelt declared a bank holiday, a temporary closing of all banks. “The only thing we have to

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Stock market trough in December 1932 at 10% of September 1929 peak value

Figure 2 Stock Prices During the Great Depression Period Stock prices crashed in 1929, falling by 40% by the end of 1929, and then con- tinued to fall to only 10% of their peak value by 1932. Source: Dow-Jones Industrial Average (DJIA). Global Financial Data: http://www .globalfinancialdata.com/ index_tabs.php?action= detailedinfo&id=1165.

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C h a P t e r 1 2 Financial Crises 273

fear is fear itself,” Roosevelt told the nation. The damage was done, however, and more than one-third of U.S. commercial banks had failed.

Continuing Decline in Stock Prices Stock prices kept falling. By mid-1932, stocks had declined to 10% of their value at the 1929 peak (as shown in Figure 2), and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets. With a greatly reduced number of financial intermediaries still in business, adverse selection and moral hazard problems intensified even further. Financial markets struggled to channel funds to borrower- spenders with productive investment opportunities. The amount of outstanding com- mercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level.

A manifestation of the rise in financial frictions is that lenders began charging businesses much higher interest rates to protect themselves from credit losses. The resulting rise in the credit spread—the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities—is shown in Figure 3, which displays the difference between interest rates on corporate bonds with a Baa (medium-quality) credit rating and rates on similar-maturity Treasury bonds. (Note the credit spread is closely related to the risk premium discussed in Chapter 6.)

Debt Deflation The ongoing deflation that accompanied declining economic activity eventually led to a 25% decline in the price level. This deflation short-circuited the normal recovery pro- cess that occurs in most recessions. The huge decline in prices triggered a debt deflation in which net worth fell because of the increased burden of indebtedness borne by firms

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Figure 3 Credit Spreads During the Great Depression Credit spreads (the difference between rates on Baa corpo- rate bonds and U.S. Treasury bonds) rose sharply during the Great Depression.

Source: Federal Reserve Bank of St. Louis FRED database: http://research .stlouisfed.org/fred2/.

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274 P a r t 3 Financial Institutions

and households. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contrac- tion in which unemployment rose to 25% of the labor force. The financial crisis of the Great Depression was the worst ever experienced in the United States, which explains why the economic contraction was also the most severe ever experienced by the nation.

international Dimensions Although the Great Depression started in the United States, it was not just a U.S. phenomenon. Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression financial crisis were disastrous. ◆

the GLOBaL FinanciaL crisis OF 2007–2009 For many years, most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries like the United States. Unfortunately, the financial crisis that engulfed the world in 2007–2009 proved them wrong.

causes of the 2007–2009 Financial crisis We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit-rating process.

Financial innovation in the mortgage markets As we saw in Chapter 11, start- ing in the early 2000s advances in information technology made it easier to securitize subprime mortgages, leading to an explosion in subprime mortgage-backed securities. Financial innovation didn’t stop there. Financial engineering, the development of new, sophisticated financial instruments, led to structured credit products that paid out income streams from a collection of underlying assets, designed to have par- ticular risk characteristics that appealed to investors with differing preferences. The most notorious of these products were collateralized debt obligations (CDOs) (discussed in the FYI box, “Collateralized Debt Obligations).

agency Problems in the mortgage markets The mortgage brokers who orig- inated the mortgage loans often did not make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate-to- distribute business model was exposed to the principal–agent problem of the type discussed in Chapter 8, in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mort- gage broker earns his or her fee, why should the broker care if the borrower makes good on his or her payment? The more volume the broker originates, the more money he or she makes.

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Not surprisingly, adverse selection became a major problem. Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down. The principal–agent problem also created incentives for mortgage brokers to encour- age households to take on mortgages they could not afford, or to commit fraud by falsifying information on borrowers’ mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans.

The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instru- ments whose payoffs are linked to (i.e., derived from) previously issued securities, also were an important source of excessive risk taking. Large fees from writing a type of financial insurance contract called a credit default swap, a financial derivative that provides payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars’ worth of these risky contracts.

FYi Collateralized Debt Obligations (CDOs)

The creation of a collateralized debt obligation involves a corporate entity called a special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. The SPV then separates the payment streams (cash flows) from these assets into a number of buckets that are referred to as tranches. The highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk. The super senior CDO is a bond that pays out these cash flows to investors, and because it has the least risk, it also has the lowest interest rate. The next bucket of cash flows, known as the senior tranche, is paid out next; the senior CDO has a little more risk and pays a higher interest rate. The next tranche of pay- ment streams, the mezzanine tranche of the CDO, is paid out after the super senior and senior tranches and so it bears more risk and has an even higher interest rate. The lowest tranche of the CDO is the equity tranche; this is the first set of cash flows that are not paid out if the underlying assets go into

default and stop making payments. This tranche has the highest risk and is often not traded.

If all of this sounds complicated, it is. Tranches also included CDO2s and CDO3s that sliced and diced risk even further, paying out the cash flows from CDOs to CDO2s and from CDO2s to CDO3s. Although financial engineering carries the potential benefit of creating products and services that match investors’ risk appetites, it also has a dark side. Struc- tured products like CDOs, CDO2s, and CDO3s can get so complicated that it becomes hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets. Indeed, in October 2007, Ben Bernanke, then chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.” In other words, the increased complexity of structured prod- ucts can actually reduce the amount of information in financial markets, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems.

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Asymmetric Information and Credit-Rating Agencies Credit-rating agen- cies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, while at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they themselves were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized.

Effects of the 2007–2009 Financial Crisis Consumers and businesses alike suffered as a result of the 2007–2009 financial crisis. The impact of the crisis was most evident in five key areas: the U.S. residential housing market, financial institutions’ balance sheets, the shadow banking system, global finan- cial markets, and the headline-grabbing failures of major firms in the financial industry.

Residential Housing Prices: Boom and Bust The subprime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage market was encouraged by econo- mists and politicians alike because it led to a “democratization of credit” and helped raise U.S. homeownership rates to the highest levels in history. The asset-price boom in housing (see Figure 4), which took off after the 2000–2001 recession was over, also

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Figure 4 Housing Prices and the Financial Crisis of 2007–2009 Housing prices boomed from 2002 to 2006, fueling the market for subprime mortgages and forming an

asset-price bubble. Housing prices began declining in 2006, falling by more than 30% subsequently, which led to defaults by subprime mortgage holders.

Source: Case-Shiller U.S. National Composite House Price Index from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/.

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helped stimulate the growth of the subprime mortgage market. High housing prices meant that subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value. With housing prices rising, subprime borrow- ers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages had high returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fueled the boom in housing prices, result- ing in a housing price bubble.

Further stimulus for the inflated housing market came from low interest rates on residential mortgages, which were the result of several different forces. First were the huge capital inflows into the United States from countries like China and India. Second was Congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillions of dollars of mortgage-backed securities.2 Third was Federal Reserve monetary policy that made it easy to lower interest rates. The low cost of financing for housing purchases that resulted from these forces further stimulated the demand for housing, pushing up housing prices. (A highly controversial issue is whether the Federal Reserve was to blame for the housing price bubble, and this is discussed in the Inside the Fed box.)

As housing prices rose and profitability for mortgage originators and lenders grew higher, the underwriting standards for subprime mortgages fell lower and lower. High-risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% loan-to-value mortgage, so that they had to put almost no money down. When asset

inside the Fed Was the Fed to Blame for the Housing Price Bubble? Some economists—most prominently, John Taylor of Stanford University—have argued that the low interest rate policy of the Federal Reserve in the 2003–2006 period caused the housing price bubble.* Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble.

In a speech given in January 2010, then-Federal Reserve Chairman Ben Bernanke countered this argu- ment.† He concluded that monetary policy was not to blame for the housing price bubble. First, he said, it is not at all clear that the federal funds rate was too low durng the 2003–2006 period. Rather, the culprits

were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from countries such as China and India. Bernanke’s speech was very contro- versial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day.

*John Taylor, “Housing and Monetary Policy,” in Federal Reserve Bank of Kansas City, Housing, Housing Finance and Monetary Policy (Kansas City: Federal Reserve Bank of Kansas City, 2007), 463–476. †Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” speech given at the annual meeting of the American Economic Association, Atlanta Georgia, January 3, 2010; http://www.federalreserve.gov/newsevents/speech/ bernanke20100103a.htm.

2For a discussion of the government’s role in encouraging the housing boom, which led to a subsequent bust in the housing market, see Thomas Sowell, The Housing Boom and Bust, Revised Edition (New York, Basic Books, 2010).

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prices rise too far out of line with fundamentals—in the case of housing, the cost of purchasing a home relative to the cost of renting it, or the cost of houses relative to households’ median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006 (see Figure 4), the rot in the financial system began to reveal itself. The decline in housing prices led many subprime borrowers to find that their mortgages were “underwater”—that is, the value of the house was below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to foreclosures on millions of mortgages.

Deterioration of Financial institutions’ Balance sheets The decline in U.S. housing prices led to rising defaults on mortgages. As a result, the values of mortgage- backed securities and CDOs collapsed, leaving banks and other financial institutions holding those securities with a lower value of assets and thus a lower net worth. With weakened balance sheets, these banks and other financial institutions began to delever- age, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets.

run on the shadow Banking system The sharp decline in the values of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other nondepository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans.

These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, the bor- rower might have to post $105 million of mortgage-backed securities as collateral, for a haircut of 5%.

Rising defaults on mortgages caused the values of mortgage-backed securities to fall, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but eventually they rose to nearly 50%.3 The result was that financial institu- tions could borrow only half as much with the same amount of collateral. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity.

3See Gary Gorton and Andrew Metrick, “Securitized Banking and the Run on Repo,” National Bureau of Economic Research Working Paper No. 15223 (August 2009).

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The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009, as shown in Figure 5) and the more than 30% drop in residential house prices (shown in Figure 4), along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets. This worsening of financial frictions manifested itself in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending stan- dards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract.4

Global Financial markets Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor’s an- nounced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, suspend- ed redemption of shares held in some of its money market funds, which had sustained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank fail- ure in the United Kingdom in over 100 years when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, and Spain. The re- sulting crisis in markets for government-issued (sovereign) debt in Europe is described in the Global box, “The European Sovereign Debt Crisis.”

4This period was also characterized by a substantial supply shock that occurred when oil and other commodity prices rose sharply until the summer of 2008, but then fell precipitously thereafter. We discuss the aggregate demand and supply analysis of the impact of this supply shock in Chapter 23.

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Figure 5 stock Prices and the Financial crisis of 2007–2009 Stock prices fell by 50% from October 2007 to March 2009.

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data: http://www .globalfinancialdata.com/ index_tabs.php?action=de tailedinfo&id=1165.

MyEconLab Mini-lecture

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Failure of high-Profile Firms The impact of the financial crisis on firms’ balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securities, had a run on its repo funding and was forced to sell itself to J.P. Morgan for less than one-tenth of its worth just a year earlier. To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearns’s hard-to-value assets. In July, Fannie Mae and Freddie Mac, the two privately-owned, government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, were propped up by the U.S. Treasury and the Federal Reserve after suffering substantial losses from their holdings of subprime securities. In early September 2008, Fannie Mae and Freddy Mac were put into conservatorship (in effect, run by the government).

global The European Sovereign Debt Crisis The global financial crisis of 2007–2009 led not only to a worldwide recession but also to a sovereign debt crisis that still threatens to destabilize Europe today. Up until 2007, all of the countries that had adopted the euro found their interest rates converging to very low levels, but with the onset of the global finan- cial crisis, several of these countries were hit very hard by the contraction in economic activity, which reduced tax revenues at the same time that govern- ment bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits then led to fears that the govern- ments of these hard-hit countries would default on their debt. The result was a surge in interest rates that threatened to spiral out of control.*

Greece was the first domino to fall in Europe. In September 2009, with an economy weakened by reduced tax revenues and increased spending demands, the Greek government was projecting a budget deficit for the year of 6% and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone had imagined, because the previous government had provided misleading numbers about both the budget deficit, which was at least double the 6% number, and the amount of government debt, which was ten percent- age points higher than previously reported. Despite austerity measures aimed at dramatically cutting gov- ernment spending and raising taxes, interest rates on

Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister.

The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain, and Italy. The governments of these countries were forced to embrace austerity measures to shore up their public finances while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do “whatever it takes” to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in inter- est rates in these countries, the countries experienced severe recessions, with unemployment rates rising to double-digit levels and Spain’s unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the euro zone, the countries that have adopted the euro, has raised doubts about whether the euro will survive. *For a discussion of the dynamics of sovereign debt crises and case studies of the European debt crisis, see David Greenlaw, James D. Hamilton, Frederic S. Mishkin, and Peter Hooper, “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” U.S. Monetary Policy Forum (Chicago: Chicago Booth Initiative on Global Markets, 2013).

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On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 bil- lion in assets and 25,000 employees, filed for bankruptcy, making it the largest bank- ruptcy filing in U.S. history. The day before, Merrill Lynch, the third-largest investment bank, which had also suffered large losses on its holdings of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September 16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rating was downgraded. It had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities. The Federal Reserve then stepped in with an $85 billion loan to keep AIG afloat (with total government loans later increased to $173 billion).

Height of the 2007–2009 Financial Crisis The financial crisis reached its peak in September 2008 after the House of Representa- tives, fearing the wrath of constituents who were angry about the Wall Street bailout, voted down a $700 billion dollar bailout package proposed by the Bush administration. The Emergency Economic Stabilization Act was finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points), as illustrated by Figure 6.

2%

6%

4%

B aa

-U .S

. T re

as ur

y S

pr ea

d (p

er ce

nt )

0% 20042002 2003 2006 2007 2008 20092005

Credit spread peak

Figure 6 Credit Spreads and the 2007–2009 Financial Crisis Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose by more

than 4 percentage points (400 basis points) during the crisis. Debate over the bailout package and the stock market crash caused credit spreads to peak in December 2008.

Source: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/.

MyEconLab Mini-lecture

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The impaired financial markets and surging interest rates faced by borrower- spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a -1.3% annual rate in the third quarter of 2008 and then at a -5.4% and -6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and as a result is now referred to as the “Great Recession.”

Government intervention and the recovery Although the recession produced by the global financial crisis was very severe, the economic contraction was far smaller in magnitude than during the Great Depression because of massive interventions by governments to prop up financial markets and stimulate the economy.

As we will see in Chapter 18, the Federal Reserve took extraordinary actions to contain the crisis, actions involving both monetary policy to stimulate the economy and liquidity provision to support orderly functioning of financial markets. In addition, the U.S. government engaged in massive bailouts, with over $150 billion of loans to AIG and the Troubled Asset Relief Program (TARP), the most important provision of the Bush administration’s Emergency Economic Stabilization Act passed in October 2008, which authorized the Treasury to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or to inject capital into these institutions—the route actually followed. In addition, the Act raised the federal deposit insurance limit temporarily from $100,000 to $250,000 in order to limit withdrawals from banks. Shortly thereafter, the FDIC put in place a guarantee for certain debt newly issued by banks, and the Treasury guaranteed for a year money market mutual fund shares at par value. Similarly, European governments conducted massive bailouts, in excess of $10 trillion, in order to prop up their banking systems (see the Global box, “Worldwide Government Bailouts During the 2007–2009 Financial Crisis”).

Fiscal policy aimed at stimulating the economy was another key piece of the U.S. government’s response to the crisis. In February 2008, Congress passed the Bush administration’s Economic Stimulus Act of 2008, whereby the government gave out one-time tax rebates totaling $78 billion by sending $600 checks to individual taxpay- ers. Shortly after coming to office, the Obama administration proposed the American Recovery and Reinvestment Act of 2009, a much bigger, $787 billion fiscal stimulus package passed by Congress that to this day is highly controversial. This stimulus pack- age is discussed more extensively in Part 6 of the book.

With the government bailouts, the Fed’s extraordinary actions, and fiscal stimulus, a bull market in stocks got under way starting in March 2009 (see Figure 5), and credit spreads began to fall (Figure 6).5 With the recovery of financial markets, the economy also started to recover, but unfortunately the pace of recovery has been slow.

5The financial market recovery was aided by the U.S. Treasury’s requirement, announced in February 2009, that the nineteen largest banking institutions undergo what became known as the bank stress tests (the Supervisory Capital Assessment Program, or SCAP). The stress tests were a supervisory assessment, led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC, of the balance sheet positions of these banks to ensure that they had sufficient capital to withstand bad macroeconomic outcomes. The Treasury announced the results in early May, and they were well received by market participants, enabling these banks to raise substantial amounts of capital from private capital markets. The stress tests were a key factor that helped increase the amount of information in the marketplace, thereby reducing asymmetric information and adverse selection and moral hazard problems.

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Response of financial Regulation Given the cost to the economy of the 2007–2009 financial crisis, the size of the bailouts, and the nationalization of so many financial institutions, the system of financial regula- tion is currently undergoing dramatic changes.

Macroprudential Versus Microprudential supervision Before the global financial crisis, regulatory authorities engaged in microprudential supervision, which focuses on the safety and soundness of individual financial institu- tions. Microprudential supervision looks at each individual institution separately and assesses the riskiness of its activities and whether it complies with disclosure require- ments. Most importantly, microprudential supervision checks whether a particular institution satisfies capital ratios and, if it does not, either engages in prompt corrective action to force the institution to raise its capital ratios or the supervisor closes it down, along the lines we have discussed previously.

A focus on microprudential supervision is not enough to prevent financial crises. The run on the shadow banking system illustrates how the problems of one financial institution can harm other financial institutions that are otherwise healthy. When the troubled financial institution is forced to engage in fire sales and sell off assets in order to meet target capital ratios or haircut requirements, this leads to a decline in asset values. The decline in asset values then causes other institutions to engage in fire sales, leading to a rapid deleveraging process and a systemic crisis. In situations like this, even institutions that have high capital ratios and would normally be healthy may find themselves in trouble.

Global Worldwide Government Bailouts During the 2007–2009 Financial Crisis

The spreading bank failures in Europe in the fall of 2008 led to massive bailouts of financial institutions: the Netherlands, Belgium, and Luxembourg injected $16 billion to prop up Fortis, a major European bank; the Netherlands injected $13 billion into ING, a banking and insurance giant; Germany provided a $50 billion rescue package for Hypo Real Estate Holdings; and Iceland took over its three largest banks after its bank- ing system collapsed. Ireland’s government guaranteed all the deposits of its commercial banks as well as interbank lending, as did Greece. Spain implemented a bailout package similar to the United States’ to buy up to 50 billion euros ($70 billion) of assets in its banks in order to encourage them to lend. The U.K. Treasury

set up a bailout plan with a price tag similar to that of the U.S. Treasury’s plan of 400 billion pounds ($699 billion). It guaranteed 250 billion pounds of bank liabilities, added 100 billion pounds to a facility that swaps these assets for government bonds, and allowed the U.K. government to buy up to 50 billion pounds of equity stakes in British banks. Bailout plans to the tune of over $100 billion in South Korea, $200 billion in Sweden, $400 billion in France, and $500 billion in Germany, all of which guaranteed the debt of their banks as well as the injection of capital into them, then followed. Both the scale of these bail- out packages and the degree of international coordina- tion was unprecedented.

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The global financial crisis has therefore made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate. Rather than focusing on the safety and soundness of individual institutions, macroprudential supervision seeks to mitigate system-wide fire sales and deleveraging by assessing the overall capacity of the financial system to avoid them. In addition, because many institutions that were well capitalized faced liquidity shortages and found that their access to short-term funding was cut off, macropruden- tial supervision focuses not only on capital adequacy as a whole but also on whether the financial system has sufficient liquidity.

Macroprudential policies can take several forms. The run-up to the global finan- cial crisis included a so-called leverage cycle, in which a feedback loop resulted from a boom in issuing credit, which led to higher asset prices, which resulted in higher capital buffers at financial institutions, which supported further lending in the context of unchanging capital requirements, which then raised asset prices further, and so on; in the bust, the value of the capital dropped precipitously, leading to a cut in lending. To short-circuit this leverage cycle, macroprudential policies make capital requirements countercyclical; that is, they are adjusted upward during a boom and downward during a bust. In addition, during the upward swing in the leverage cycle, macroprudential policies might involve forcing financial institutions to tighten credit standards or even direct limits on the growth of credit. In the downward swing, macroprudential super- vision might be needed to force the banking system as a whole to raise an aggregate amount of new capital so that banks will not curtail lending in order to reduce the level of their assets and raise capital ratios. To ensure that financial institutions have enough liquidity, macroprudential policies could require that financial institutions have a suf- ficiently low net stable funding ratio (NSFR), which is the percentage of the institution’s short-term funding in relation to total funding. Macroprudential policies of the type discussed here are being considered as part of the Basel 3 framework, but have not yet been completely worked out.

Dodd-Frank Wall street reform and consumer Protection act of 2010 The global financial crisis raised calls for a new regulatory structure that would make a repeat of the crisis less likely. The result was the Dodd-Frank bill, which was passed in July 2010 after more than a year of discussion. It is the most comprehensive financial reform legislation since the Great Depression. The bill addresses five different categories of regulation, which are discussed next.

consumer Protection Dodd-Frank created a new Consumer Financial Protection Bureau that is funded and housed within the Federal Reserve, although it is a com- pletely independent agency. It has the authority to examine and enforce regulations on all businesses with more than $10 billion in assets that are engaged in issuing resi- dential mortgage products, as well as on issuers of other financial products marketed to low-income people. The legislation requires lenders to make sure borrowers can repay residential mortgages by requiring verification of their income, credit history, and job status. It also bans payments to brokers for pushing borrowers into higher- priced loans. It allows states to impose stricter consumer protection laws on national banks and gives state attorney generals the power to enforce certain rules issued by the new bureau. It also permanently increased the level of federal deposit insurance to $250,000.

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resolution authority Before the new legislation was passed, the FDIC had the author- ity to seize failing banks and wind them down, but it did not have such resolution authority over the largest financial institutions—those structured as holding companies. Indeed, the U.S. Treasury and the Federal Reserve argued that one reason they were unable to rescue Lehman Brothers, and instead had to let it go into bankruptcy, was that they did not have the legal means with which to take over Lehman and break it up. The Dodd-Frank bill now provides the U.S. government with this authority for financial firms that are deemed systemic—that is, firms that pose a risk to the overall health of the financial system because their failure would cause widespread economic damage. It also gives regulators the right to levy fees on financial institutions with more than $50 billion in assets to recoup any losses.

systemic risk regulation The Dodd-Frank bill created a Financial Stability Oversight Council, chaired by the Treasury secretary, that monitors markets for asset price bubbles and the buildup of systemic risk. In addition, it designates which financial firms are systemically important and so receive the official designation of systemically important financial institutions (SIFIs). These firms are subject to additional regulation by the Federal Reserve, which includes higher capital standards and stricter liquidity require- ments, along with the requirement that such firms draw up a “living will,” that is, a plan for orderly liquidation if the firm gets into financial difficulties.

Volcker rule Under the new legislation, banks are limited in the extent of their pro- prietary trading—that is, trading with their own money—and are allowed to own only a small percentage of hedge and private equity funds. These provisions are named after Paul Volcker, a former Chairman of the Board of Governors of the Federal Reserve, who argued that banks should not be allowed to take large trading risks when they receive the benefits of federal deposit insurance.

Derivatives As discussed in Chapter 11, derivatives such as credit default swaps ended up being “weapons of mass destruction” that helped lead to a financial meltdown when AIG had to be rescued after making overly extensive use of them. To prevent this from happening again, the Dodd-Frank bill requires that many standardized derivative products be traded on exchanges and cleared through clearinghouses to reduce the risk of losses if one counterparty in the derivative transaction goes bankrupt. More custom- ized derivative products are subject to higher capital requirements. Banks are banned from some of their derivative-dealing operations, such as those involving riskier swaps. In addition, the bill imposes capital and margin requirements on firms dealing in deriva- tives and forces them to disclose more information about their activities.

tOO-BiG-tO-FaiL anD FUtUre reGULatiOn The Dodd-Frank bill leaves out many of the details of future regulation, and there are doubts as to whether it has dealt sufficiently with the too-big-to-fail problem, which, as we have seen, was an important factor that contributed to the global financial crisis. Here we discuss some possible measures to reduce the too-big-to-fail problem and explore several areas in which regulation might be heading in the future.

What can Be Done about the too-Big-to-Fail Problem? Three approaches to solving the too-big-to-fail problem have been actively debated.

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Break Up Large, Systemically Important Financial Institutions One way to eliminate the too-big-to-fail problem is to make sure that no financial institution is so large that it can bring down the financial system. Then, regulators will no longer see the need to bail out these institutions if they fail, thereby subjecting them to market discipline. One way to shrink overly-large institutions is to reimpose the restrictions that were in place before Glass-Steagall was repealed, thereby forcing these large SIFIs to break up their different activities into smaller, cohesive companies. Alternatively, regulations could specify that no financial institution can have assets over a specified maximum limit, forcing SIFIs to break up into smaller pieces.

Not surprisingly, both of these approaches have been vehemently opposed by the largest financial institutions. Although breaking up SIFIs would eliminate the too-big- to-fail problem, if there are synergies available that might enable large institutions to manage risk better or to provide financial services at a lower cost, then breaking up SIFIs might decrease the efficiency of the financial system rather than increase it.

Higher Capital Requirements Because institutions that are “too big to fail” have incentives to take on excessive risk, another way to reduce their risk taking is to impose higher capital requirements on them. With higher capital, not only will these institutions have a larger buffer with which to withstand losses if they occur, but they will also have more to lose and hence have more “skin in the game,” thereby reducing moral hazard and giving them less incentive to take on excessive risk. Another way of describing this approach is to say that higher capital requirements reduce the subsidy to risk-taking for institutions that are too big to fail. In addition, because risk taking by SIFIs is far greater during booms, capital requirements could be increased when credit is expanding rapidly and reduced when credit is contracting. Such measures would cause capital requirements to become more countercyclical and could help restrain the boom-bust credit cycle.

The Swiss central bank has been a leader in this kind of approach: It has the highest capital requirements among advanced countries for its largest banks, and it raises them when credit markets become particularly frothy. Legislation has been proposed in the U.S. Congress to double capital requirements for large financial institutions, legislation that these institutions vigorously oppose.

Leave It to Dodd-Frank Another view is that Dodd-Frank has effectively eliminated the too-big-to-fail problem by making it harder for the Federal Reserve to bail out financial institutions, by imposing stricter regulations on SIFIs, and through application of the Volcker rule. Indeed, the authors of the bill have declared that Dodd-Frank will “end too-big-to- fail as we know it.” Although the provisions of Dodd-Frank do take away some of the incentives for excessive risk-taking by large, systemically important financial institutions, there are doubts that this bill completely removes the too-big-to-fail problem.

Other Issues for Future Regulation The Dodd-Frank bill leaves out many of the details of future regulation and does not address some important regulatory issues at all. Here we examine four areas in which regulation may be heading in the future.

Compensation in the Financial Services Industry The high fees and executive compensation that so outraged the public created incentives for the financial industry to create securities that turned out to be much riskier than advertised. Regulators are adopting regulations aimed at modifying compensation in the financial services

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industry to reduce risk taking. For example, regulators are issuing requirements that bonuses be paid out for a number of years after they have been earned, and only if the firm remains in good health. Such “clawbacks” will encourage employees to reduce the riskiness of their activities so that they are more likely to be paid these bonuses in the future.

Government-sponsored enterprises (Gses) A major gap in the Dodd-Frank bill is that it does not address privately-owned, government-sponsored enterprises, such as Fannie Mae and Freddie Mac. During the global financial crisis, both of these firms got into serious financial trouble and had to be taken over by the government, with mas- sive loans and government guarantees needed to prop them up. To prevent this from occurring again, the government might take any of four routes:

1. Fully privatize GSEs by taking away their government sponsorship, thereby removing the implicit backing for their debt.

2. Completely nationalize them by taking away their private status and making them government agencies.

3. Leave them as privately owned GSEs, but strengthen regulations to restrict the amount of risk they take and to impose higher capital standards.

4. Leave them as privately owned GSEs, but force them to shrink dramatically so that they no longer expose the taxpayer to huge losses or pose a systemic risk to the financial system when they fail.

credit-rating agencies Regulations to restrict conflicts of interest at credit- rating agencies and to give them greater incentives to provide reliable ratings have already been strengthened in the aftermath of the global financial crisis, but even more regulation is likely to be imposed. The inaccurate ratings provided by credit- rating agencies helped promote risk taking throughout the financial system and led to investors not having the information they needed to make informed choices about their investments. The reliance on credit ratings in the Basel 2 capital requirements may also have to be rethought, given the poor performance of credit-rating agencies in recent years.

the Danger of Overregulation As a result of the global financial crisis, the world of financial regulation will never be the same. Although it is clear that more regulation is needed to prevent such a crisis from ever occurring again, the danger is substantial that too much or poorly designed regulation could hamper the efficiency of the financial sys- tem. If new regulations choke off financial innovation that can benefit both households and businesses, future economic growth will suffer.

sUmmary

1. A financial crisis occurs when a particularly large disruption to information flows occurs in financial markets, with the result that financial frictions increase sharply, thereby rendering financial markets incapable of channeling funds to households and firms with pro- ductive investment opportunities, and causing a sharp contraction in economic activity.

2. Financial crises start in advanced countries like the United States in two ways: credit booms and busts, or a general increase in uncertainty when major financial institutions fail. The result is a substantial increase in adverse selection and moral hazard prob- lems, which leads to a contraction of lending and a decline in economic activity. The worsening business

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Key Terms

asset-price bubble, p. 269 credit boom, p. 268 credit default swaps, p. 275 credit spread, p. 273 debt deflation, p. 271 deleveraging, p. 268 financial crisis, p. 268 financial derivatives, p. 275

financial frictions, p. 268 financial innovation, p. 268 financial liberalization, p. 268 fire sales, p. 271 fundamental economic values, p. 269 haircuts, p. 278 leverage cycle, p. 284 macroprudential supervision, p. 284

microprudential supervision, p. 283 repurchase agreements

(repos), p. 278 structured credit products, p. 274 systemically important financial

institutions (SIFIs), p. 285 Troubled Asset Relief Program

(TARP), p. 282

QuesTions

All questions are available in MyEconLab at http://www.myeconlab.com.

1. How does the concept of asymmetric information help to define a financial crisis?

2. How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?

3. How does an unanticipated decline in the price level cause a drop in lending?

4. How can a decline in real estate prices cause deleveraging and a decline in lending?

5. How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

6. How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

conditions and deterioration in bank balance sheets then trigger the second stage of the crisis, the simultaneous failure of many banking institutions, a banking crisis. The resulting decrease in the number of banks causes a loss of their information capital, leading to a further decline of lending and a spiral- ing down of the economy. In some instances, the resulting economic downturn leads to a sharp slide in prices, which increases the real liabilities of firms and households and therefore lowers their net worth, leading to a debt deflation. The further decline in borrowers’ net worth worsens adverse selection and moral hazard problems, so that lending, investment spending, and aggregate economic activity remain depressed for a long time.

3. The most significant financial crisis in U.S. history, that which led to the Great Depression, involved several stages: a stock market crash, bank panics, worsening of asymmetric information problems, and finally a debt deflation.

4. The global financial crisis of 2007–2009 was triggered by mismanagement of financial innovations involving subprime residential mortgages and the bursting of a housing price bubble. The crisis spread globally, with substantial deterioration in banks’ and other financial

institutions’ balance sheets, a run on the shadow bank- ing system, and the failure of many high-profile firms.

5. Financial regulation has undergone many changes in the wake of the global financial crisis. First is the shift from microprudential supervision, which focuses on the safety and soundness of individual institutions, to macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate. Second is the Dodd-Frank Act of 2010, which is the most comprehensive financial reform leg- islation since the Great Depression. It makes provisions in five areas: (1) consumer protection, (2) resolution authority, (3) systemic risk regulation, (4) the Volcker rule, and (5) derivatives.

6. Future regulation needs to address five issues: (1) the too-big-to-fail problem, which can be at least partially addressed by either breaking up large financial institu- tions or by imposing higher capital requirements on them; (2) compensation at financial firms to reduce incentives to take on excessive risk; (3) GSEs to make it less likely that they will require government bailouts in the future; (4) credit-rating agencies to improve incen- tives for these agencies to provide accurate assessments of credit risk; and (5) the dangers of overregulation, which can decrease the efficiency of the financial system.

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Data anaLysis PrOBLems

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on house prices (SPCS20RSA), stock prices (SP500), a measure of the net wealth of households (TNWBSHNO), and personal consump- tion expenditures (PCEC). For all four measures, be sure to convert the frequency setting to “Quarterly.” Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For all four series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, and then divide by the previ- ous quarter data. Multiply by 100 to change each result to a percent, and multiply by 4 to annualize the data.

a. For the four series, calculate the average growth rates over the most recent four quarters of data available. Comment on the relationships among house prices, stock prices, net wealth of house- holds, and consumption as they relate to your results.

b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results, before and during the crisis.

c. How do the current household data compare to the data from the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

2. Go to the St. Louis Federal Reserve FRED database, and find data on corporate net worth of nonfinan- cial businesses (TNWMVBSNNCB), private domes- tic investment (GPDIC1), and a measure of financial frictions, the St. Louis Fed financial stress index (STLFSI). For all three measures, be sure to convert the frequency setting to “Quarterly.” Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For cor- porate net worth and private domestic investment, calculate the annualized growth rates from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, then divide by the

7. What is a credit spread? Why do credit spreads rise significantly during a financial crisis?

8. What causes bank panics to occur?

9. Why do bank panics worsen asymmetric information problems in credit markets?

10. How can financial innovation lead to financial crises?

11. What role does weak financial regulation and supervision play in causing financial crises?

12. Describe two similarities and two differences between the United States’ experiences during the Great Depression and the financial crisis of 2007–2009.

13. What do you think prevented the financial crisis of 2007–2009 from becoming a depression?

14. What technological innovations led to the development of the subprime mortgage market?

15. Why is the originate-to-distribute business model subject to the principal–agent problem?

16. “Financial engineering always leads to a more efficient financial system.” Is this statement true, false, or uncertain?

17. How did a decline in housing prices help trigger the subprime financial crisis that began in 2007?

18. What role did the shadow banking system play in the 2007–2009 financial crisis?

19. Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?

20. How did the global financial crisis promote a sovereign debt crisis in Europe?

21. Why is it a good idea for macroprudential policies to require countercyclical capital requirements?

22. How does the process of financial innovation impact the effectiveness of macroprudential regulation?

23. What are the three approaches to limiting the too-big- to-fail problem? Briefly describe the advantages and disadvantages of each of the approaches.

24. Why were consumer protection provisions included in the Dodd-Frank bill, a bill designed to strengthen the financial system?

25. Why is it important for the U.S. government to have resolution authority?

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previous quarter data. Multiply by 100 to change the results to percentage form, and then multiply by 4 to annualize the data.

a. Calculate the average growth rates over the most recent four quarters of data available for the corporate net worth and private domestic invest- ment variables. Calculate the difference between the value of the stress index during the most recent quarter and the value of the stress index one year earlier. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment.

b. Repeat part (a) for the four quarters of 2005 and for the period from 2008:Q3 to 2009:Q2.

Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment before and during the crisis as they relate to your results. Assum- ing the financial stress measure is indicative of heightened asymmetric information problems, comment on how the crisis-period data relate to the typical dynamics of a financial crisis.

c. How do the current investment data compare to the data for the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

WeB exercises

1. This chapter discusses how an understanding of adverse selection and moral hazard can help us better understand financial crises. The greatest financial crisis faced by the United States was the Great Depression of 1929–1933. Go to http://www.amatecon.com/ greatdepression.html. This site contains a brief discussion of the factors that led to the Great Depression. Write a one-page summary explaining how adverse selection and moral hazard contributed to the Great Depression.

2. Go to the International Monetary Fund’s Financial Crisis page at http://www.imf.org/external/np/exr/key/ finstab.htm. Report on the three countries that most recently received emergency loans from the IMF in response to a financial crisis. According to the IMF, what caused the crisis in each country?

3. One of the countries hardest hit by the global financial crisis of 2008 was Iceland. Go to http://assets.opencrs .com/rpts/RS22988_20081120.pdf and summarize the causes and events that led to the crisis in Iceland.

WeB reFerences

http://www.amatecon.com/gd/gdtimeline.html

A time line of the Great Depression.

http://assets.opencrs.com/rpts/RS22988_20081120.pdf

The Congressional Research Service (CRS) report to Congress about Iceland’s financial crisis of 2008.

http://freerepublic.com/focus/f-news/2167257/posts

Paper by Carmen Reinhart and Kenneth Rogoff comparing the 2007 subprime crisis to other international crises.

WeB chaPter

Please visit the Companion Website at http://www .pearsonhighered.com/mishkin to read Web Chapter 1.

Web Chapter 1: Financial Crises in Emerging Market Economies

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Preview

Banking is not the only type of financial intermediation you are likely to encounter. You might decide to purchase insurance, take out an installment loan from a finance company, or buy a share of stock. In carrying out each of these transactions, you will be engaging in nonbank finance and dealing with nonbank financial institutions. In our economy, nonbank finance plays an important role in channeling funds from lender-savers to borrower-spenders. Furthermore, the process of financial innovation we discussed in Chapter 11 has increased the importance of nonbank finance and has led to the growth of the shadow banking system, which played such a prominent role in the recent global financial crisis (Chapter 12). In this chapter, we will examine in more detail how institutions engaged in nonbank finance operate and how they are regulated. We will also examine recent trends in nonbank finance.

Insurance Every day we face the possibility of the occurrence of catastrophic events that might lead to large financial losses. A spouse’s earnings might disappear due to death or illness; a car accident might result in costly repair bills or payments to an injured party. Because financial losses from crises can be large relative to our financial resources, we protect our- selves against them by purchasing insurance coverage that will pay out a sum of money if a catastrophic event occurs. Life insurance companies sell policies that provide income if a person dies, is incapacitated by illness, or retires. Property and casualty companies specialize in policies that pay for losses incurred as a result of accidents, fire, or theft.

Life Insurance The first life insurance company in the United States (Presbyterian Ministers’ Fund in Philadelphia) was established in 1759 and is still in existence. There are currently around 900 life insurance companies in the United States, and they are organized in two forms: as stock companies or as mutuals. Stock companies are owned by stockholders; mutuals are technically owned by the policyholders. Although more than 90% of life insurance compa- nies are organized as stock companies, some of the largest ones are organized as mutuals.

Unlike commercial banks and other depository institutions, life insurance compa- nies have never experienced widespread failures, and so the federal government has

Learning Objectives • Summarize the different types of insurance prod- ucts and ways in which insurance companies can reduce asymmetric information problems.

• Summarize the distinctions between defined-benefit and defined-contribution pensions, and the key features of private and public pension plans.

• List and describe the different types of finance companies.

• Summarize the roles of investment banks, securities brokers and dealers, and organized exchanges in the securities market.

• Describe the role and activities of mutual funds in financial intermediation.

• Summarize the key distinctions between hedge funds and mutual funds.

• Define private equity and venture capital, and summarize their advantages as invest- ment funds.

• Describe the two types of government finan- cial intermediation.

13Nonbank Finance

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not seen the need to regulate the industry. Instead, regulation is left to the states in which a company operates. State regulation is directed at sales practices, the provision of adequate liquid assets to cover losses, and restrictions on the amount of risky assets (such as common stock) that the companies can hold. The regulatory authority is typi- cally a state insurance commissioner.

Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance companies can accurately predict their future payouts to policyholders. Consequently, they hold long-term assets that are not particularly liquid—corporate bonds and commercial mortgages, as well as some corporate stock.

Life insurance policies are offered in two principal forms: permanent life insur- ance (such as whole, universal, and variable life) and temporary life insurance (such as term). Permanent life insurance policies require the payment of a fixed premium throughout the life of the policy. In the early years of the policy, the size of this pre- mium exceeds the cost of insuring against death because the probability of death is low. Thus the policy builds up a cash value in its early years. In later years, however, the cash value declines because the amount of the fixed premium falls below the cost of insuring against death, the probability of which is now higher. The policyholder can borrow against the cash value of the permanent life policy or can claim it by canceling the policy.

Term insurance, by contrast, is characterized by a premium that is matched every year, for the period of the term (such as one year or five years), to the cost of insuring against death. As a result, a term policy requires the policyholder to pay a premium that increases over time as the probability of death increases (or else to pay a level premium, characterized by a decline over the term of the policy in the amount of death benefits). Term policies have no cash value and thus, in contrast to permanent life policies, pro- vide insurance only, with no savings aspect.

In the 1970s, weak investment returns on permanent life insurance led to slow growth of the demand for life insurance products. The result was a decrease in the size of the life insurance industry relative to the sizes of other financial intermediaries, with life insurance companies’ share of total financial intermediary assets falling from 15.3% at the end of 1970 to 11.5% at the end of 1980 (see Table 1, which shows the relative shares of financial intermediary assets for each of the financial intermediaries discussed in this chapter).

Beginning in the mid-1970s, life insurance companies decided to restructure their industry and began to manage assets for pension funds. An important factor behind this restructuring was 1974 legislation that encouraged pension funds to turn fund manage- ment over to life insurance companies. Now more than half of the assets managed by life insurance companies are for pension funds, not for life insurance. Insurance com- panies have also begun to sell investment vehicles for retirement, such as annuities, arrangements whereby the customer pays an annual premium in exchange for a future stream of annual payments beginning at a set age—say, 65—and continuing until death. As a result of this new business, the market share of life insurance companies as a percentage of total financial intermediary assets has held steady since 1980.

Property and casualty Insurance Property and casualty insurance companies in the United States, the two largest of which are State Farm and Allstate, number on the order of 2,500. Property and casu- alty insurance companies are organized as both stock and mutual companies and are regulated by the states in which they operate.

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Because of high interest rates in the 1970s and 1980s, property and casualty insur- ance companies had high investment income that enabled them to keep insurance rates low. Since then, however, interest rates have declined and investment income has fallen, while growth in the number of lawsuits involving property and casualty insur- ance, along with the explosion of the sums awarded in such cases, lowered their profits.

In order to return to profitability, property and casualty insurance companies raised their rates and have refused to provide coverage for some people. They have also campaigned actively for limits on insurance payouts, particularly on payouts for medical malpractice. In their search for profits, these types of insurance companies have branched out into uncharted territory by insuring the payment of interest on municipal and corporate bonds and on mortgage-backed securities. This led to insurance com- panies taking on excessive risk in an attempt to boost their profits. Concern about the health of the property and casualty insurance industry, particularly after the near death of AIG discussed later in this chapter, led insurance regulators to implement new rules that impose risk-based capital requirements on these insurance companies. The capital requirements are based on the riskiness of the companies’ assets and operations.

The investment policies of property and casualty insurance companies are shaped by two basic facts. First, because these companies are subject to federal income taxes, the larg- est share of their assets is held in tax-exempt municipal bonds. Second, because property losses in a population are more uncertain than the death rate, these insurers are less able to predict how much they will have to pay out to policyholders than are life insurance

1970 1980 1990 2000 2010 2013

Insurance Companies

Life insurance 15.0 11.5 12.5 12.0 12.4 11.4

Property and casualty 3.8 4.5 4.9 3.3 3.4 2.9

Pension Funds          

Private 8.4 12.5 14.9 16.6 14.6 15.1

Public (state and local government) 4.6 4.9 6.7 8.8 7.0 9.2

Finance Companies 4.9 5.1 5.6 4.4 3.8 2.8

Mutual Funds            

Stocks and bonds 3.6 1.7 5.9 17.0 19.0 21.8

Money market 0.0 1.9 4.6 6.9 6.6 5.1

Depository Institutions (Banks)

Commercial banks 38.5 36.7 30.4 24.7 24.1 24.0

S&Ls and mutual savings banks 19.4 19.6 12.5 4.7 7.0 5.9

Credit union 1.4 1.6 2.0 1.7 2.2 1.8

Total 100.0 100.0 100.0 100.0 100.0 100.0

Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov/releases/z1/Current/z1.pdf.

table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2013 (percent)

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companies. Natural and unnatural disasters—including the Los Angeles earthquake of 1994; the September 11, 2001, destruction of the World Trade Center; Hurricane Katrina, which devastated New Orleans in 2005; and Hurricane Sandy, which inflicted substantial damage on the Northeast in 2012—have exposed the property and casualty insurance industry to billions of dollars of losses. Because such disasters cannot be predicted with any degree of certainty, property and casualty insurance companies must hold more liquid assets than life insurance companies. Municipal bonds and U.S. government securities amount to over half of their assets, and most of the remainder is held in corporate bonds and corporate stock.

Property and casualty insurance companies will insure against losses from almost any type of event, including fire, theft, negligence, malpractice, earthquakes, and automobile accidents. If a potential loss is too large for any one firm to insure against, several firms may join together to write a policy and thus share the risk. Insurance companies may also reduce their risk exposure by obtaining reinsurance. Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium and is particularly important for small insurance companies. You can think of reinsurance as insurance for the insurance company. The most famous risk-sharing operation is Lloyd’s of London, an association in which different insurance companies can underwrite a fraction of an insurance policy. Lloyd’s of London has claimed that it will insure against any contingency—for a price.

The competitive Threat from the Banking Industry Banks used to be restricted in their ability to sell life insurance products. This has changed, however. More than two-thirds of the states now allow banks to sell life insur- ance in one form or another. In recent years, the bank regulatory authorities, particu- larly the Office of the Comptroller of the Currency (OCC), have encouraged banks to enter the insurance field in order to help diversify banks’ business, thereby improving their economic health and making bank failures less likely. As a result, the banks’ share of the annuities market has increased to around 25%. Most banks now sell insurance products in addition to their traditional offerings.

Insurance companies and their agents reacted to this competitive threat with both lawsuits and lobbying actions to block banks from entering the insurance business. Their efforts were set back by several Supreme Court rulings that favored the banks. Particularly important was a ruling in favor of Barnett Bank in March 1996, which held that state laws to prevent banks from selling insurance can be superseded by federal rulings from bank- ing regulators that allow banks to sell insurance. This decision gave banks a green light to further their insurance activities, and with the passage of the Gramm-Leach-Bliley Act of 1999, banking institutions began to engage even more deeply in the insurance business, thus blurring the distinction between insurance companies and banks.

credit Insurance Insurance companies have not taken the encroachment of banks on their territory lying down. They have responded by getting into the business of supplying credit insurance. They have done this in two ways.

credit Default swaps One way in which insurance companies can, in effect, provide credit insurance is by selling a traded derivative called a credit default swap (CDS). In a credit default swap, the seller is required to make a payment to the holder of the CDS if there is a credit event for that instrument, such as a bankruptcy or a downgrading of the firm’s credit rating. (Credit derivatives are discussed more extensively in the next chapter.)

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Issuing a CDS is thus tantamount to providing insurance on the debt instrument because, just like insurance, it makes a payment to the holder of the CDS when a negative credit event occurs. Major insurance companies have entered the CDS market in recent years, sometimes to their great regret (see the FYI box, “The AIG Blowup”).

Monoline Insurance An alternative way of providing credit insurance is to supply it directly, just as is done with any insurance policy. However, insurance regulations do not allow property and casualty insurance companies, life insurance companies, or insurance companies with multiple lines of business to underwrite credit insurance. Monoline insurance companies, which specialize in credit insurance alone, are there- fore the only insurance companies that are allowed to provide insurance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults. These insurance companies, such as Ambac Financial Group and MBIA, have become particu- larly important in the municipal bond market, where they insure a large percentage of these securities. When a municipal security with a lower credit rating (say, an A rating) buys an insurance policy from a monoline insurer, it takes on the credit rating (say, AAA) of the monoline insurer. This action lowers the interest cost for the municipality and so makes it worthwhile for the municipality to pay the premium for this insurance policy. Of course, for this arrangement to work, the monoline insurer must have a very high credit rating. When monoline insurers experienced credit rating downgrades dur- ing the global financial crisis, they did not suffer alone—so did the municipal bond market (see the FYI box, “The Global Financial Crisis and the Monoline Insurers”).

FYI The AIG Blowup

American International Group, better known as AIG, was a trillion-dollar insurance giant, and prior to 2008 was one of the twenty largest companies in the world. A small separate unit, AIG’s Financial Products division, went into the credit default swap business in a big way, insuring over $400 billion of securities, of which $57 billion were debt securities backed by subprime mortgages. Lehman Brothers’ troubles and eventual bankruptcy on September 15, 2008, revealed that these subprime securities were worth much less than the value stated on the books, and investors came to the realization that AIG’s losses, which had already been substantial in the first half of the year, could bankrupt the company. Lenders to AIG then pulled back with a vengeance, and AIG could not raise enough capital to stay afloat.

On September 16, the Federal Reserve and the U.S. Treasury decided to rescue AIG because its failure was deemed potentially catastrophic for the financial

system. Banks and mutual funds were large holders of AIG’s debt, and the bankruptcy of AIG would have rendered worthless all of the credit default swaps it had sold, thereby imposing huge losses on the finan- cial institutions that had bought them. The Federal Reserve set up an $85 billion credit facility (with the total loans from the Fed and the government eventually reaching $173 billion) to provide liquidity to AIG. The rescue did not come cheap, however: AIG was charged a very high interest rate on the loans from the Fed, and the government was given the rights to an 80% stake in the company if it survived. Maurice Greenberg, for- mer CEO of the company, described the government’s actions as a “nationalization” of AIG.

Insurance companies had never been viewed as pos- ing a risk to the entire financial system, so their regula- tion had been left to insurance commissions in each state. Because the problems at AIG nearly brought down the U.S. financial system, this view is no longer tenable. The insurance industry will never be the same.

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A p p li c At i o n Insurance Management Insurance, like banking, is in the financial intermediation business of transforming one type of asset into another for the public. Insurance providers use the premiums paid on policies to invest in assets such as bonds, stocks, mortgages, and other loans; the earnings from these assets are then used to pay out claims on the policies. In effect, insurers transform assets such as bonds, stocks, and loans into insurance poli- cies that provide a set of services (for example, claim adjustments, savings plans, and friendly insurance agents). If the insurer’s production process of asset transformation efficiently provides its customers with adequate insurance services at low cost, and if it can earn high returns on its investments, it will make profits; if not, it will suffer losses.

In Chapter 9, we applied the economic concepts of adverse selection and moral hazard to help us understand the principles of bank management as they relate to credit risk; many of these same principles apply to the lending activities of insurers. Here again we will apply the adverse selection and moral hazard concepts to explain many of the management practices that are specific to insurance.

In the case of an insurance policy, moral hazard arises when the existence of insurance encourages the insured party to take risks that increase the likelihood of an insurance payout. For example, a person covered by burglary insurance might not take as many precautions to prevent a burglary because he or she knows the insurance company will pay for most of the losses if a theft occurs. Adverse selection holds that the people most likely to receive large insurance payouts are the ones who will most want to purchase insurance. For example, a person suffering from a terminal disease would want to take out the biggest life and medical insurance policies possible, thereby exposing the insurance company to potentially large losses. Both adverse selection and moral hazard can result in large losses to insurance companies because they lead to higher payouts on insurance claims. Lowering adverse selection and moral hazard to reduce these payouts is therefore an extremely important goal for insurance companies, and this goal explains the insurance practices we will discuss here.

FYi The Global Financial Crisis and the Monoline Insurers

One spillover from the global financial crisis was a hit to the monoline insurers, with knock-on effects on the municipal bond market. Unfortunately for the monoline insurers, they insured not only municipal bonds but also debt securities backed by subprime mortgages. As defaults on these mort- gages grew, monoline insurers began to suffer big losses, resulting in credit downgrades from their AAA status. These downgrades weakened the value of their insurance guarantees, not only on subprime securities but on municipal securities as well. As the

global crisis got into full swing, the markets took the view that monoline insurance was not worth much, and so municipal bonds began to trade at lower prices that were based solely on the municipality’s credit rating. As a result, state and local govern- ments now found their interest costs rising. They were hit by a double whammy of higher borrow- ing costs and lower tax revenues because of their weaker economies. The result was weaker state and local finances, as well as cutbacks in spending on roads, schools, and hospitals.

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screening To reduce adverse selection, insurance providers try to screen out good insurance risks from poor ones. Effective information collection procedures are therefore an important principle of insurance management.

When you apply for auto insurance, the first thing your insurance agent does is ask you questions about your driving record (number of speeding tickets and accidents), the type of car you are insuring, and certain personal matters (age, marital status). If you are applying for life insurance, you go through a similar grilling, but you are asked even more personal questions about such things as your health, your smoking habits, and your drug and alcohol use. The life insurer even orders a medical evaluation (usu- ally done by an independent company) that involves taking blood and urine samples. Just as a bank calculates a credit score to evaluate a potential borrower, an insurer uses the information you provide to allocate you to a risk class—a statistical estimate of how likely you are to make an insurance claim. Based on this information, the insurer decides whether to insure you or turn you down because you pose too high a risk and thus are likely to be an unprofitable customer.

risk-Based Premiums Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance provider is a time-honored principle of insurance management. Adverse selection explains why this principle is so important to insurance company profitability.

To understand why an insurance provider finds it necessary to charge risk-based premiums, let’s look at an example of risk-based insurance premiums that at first glance seems unfair. Harry and Sally, both college students with no driving accidents or speeding tickets, apply for auto insurance. Normally, Harry will be charged a much higher premium than Sally. Insurance providers do this because young males have a much higher accident rate than young females. Suppose, though, that one insurer does not base its premiums on a risk classification but rather charges a premium based on the average combined risk for males and females. Then Sally will be charged too much and Harry too little. Sally can go to another insurer and get a lower rate, but Harry will sign up for the insurance. Because Harry’s premium isn’t high enough to cover the accidents he is likely to have, on average the insurer will lose money on Harry. Only with a premium based on a risk classification, so that Harry is charged more, can the insurance provider make a profit and stay in business.1

restrictive Provisions Restrictive provisions in policies are an insurance management tool for reducing moral hazard. Such provisions discourage policyholders from engaging in risky activities that make an insurance claim more likely. For example, life insurers have provisions in their policies that eliminate death benefits if the insured person commits suicide within the first two years that the policy is in effect. Restrictive provisions may also require cer- tain behaviors on the part of the insured. A company that rents motor scooters may be required to provide helmets to renters if it wishes to be covered for liabilities associated with the rental. The role of restrictive provisions is not unlike that of restrictive cov- enants on debt contracts as described in Chapter 8: Both serve to reduce moral hazard by ruling out undesirable behavior.

1Note that the example here is, in fact, the lemons problem described in Chapter 8.

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Prevention of Fraud Insurance providers also face moral hazard problems because an insured person has an incentive to lie to the insurer and seek a claim even if the claim is not valid. For example, a person who has not complied with the restrictive provisions of an insurance contract may still submit a claim. Even worse, a person may file a claim for an event that did not actually occur. Thus an important management principle for insurance provid- ers is that they must conduct investigations to prevent fraud so that only policyholders with valid claims receive compensation.

cancellation of Insurance Being prepared to cancel a policy is another insurance management tool. Insurers can discourage moral hazard by threatening to cancel a policy when the insured person engages in activities that make a claim more likely. If your auto insurance company makes it clear that its policy is to cancel the coverage of any driver who gets too many speeding tickets, you will be less likely to speed.

Deductibles A deductible is a fixed amount by which the insured’s loss payment is reduced when a claim is paid out. A $500 deductible on an auto policy, for example, means that if you suffer a loss of $1,200 because of an accident, the insurer will pay you only $700. Deductibles are an additional management tool that helps insurance providers reduce moral hazard. With a deductible, you experience a loss along with the insurer when you make a claim. Because you too (not just the insurance company) stand to lose if you have an accident, you have an incentive to drive more carefully. A deductible thus encourages the policyholder to act in a way that is profitable for the insurer; moral hazard has been reduced. And because moral hazard has been reduced, the insurance provider can lower the premium by more than enough to compensate the policyholder for the existence of the deductible. The deductible also functions to eliminate the administrative costs of handling small claims by forcing the insured to bear these losses.

coinsurance When a policyholder shares a percentage of the losses with the insurer, the arrangement is called coinsurance. For example, some medical insurance plans provide coverage for 80% of medical bills, and the insured person pays 20% after a certain deductible has been met. Coinsurance works to reduce moral hazard in exactly the same way that a deductible does. A policyholder who suffers a loss along with the insurer has less incen- tive to take actions, such as going to the doctor unnecessarily, that will generate more claims. Coinsurance is thus another useful management tool for insurance providers.

Limits on the amount of Insurance Another important principle of insurance management is that limits should be placed on the amount of insurance provided, even if a customer is willing to pay for more cov- erage. The higher the insurance coverage, the more the insured person stands to gain from engaging in risky activities that make an insurance payout more likely, and hence the greater the moral hazard. For example, if Zelda’s car is insured for more than its

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true value, she might not take proper precautions to prevent its theft, such as making sure the key is always removed or putting in an alarm system. If her car is stolen, she will come out ahead because the excessive insurance payment will enable her to buy an even better car. By contrast, if the amount of insurance coverage is lower than the value of her car, she will suffer a loss if the car is stolen and thus will take precautions to prevent this from happening. Insurance providers must always make sure that the coverage they provide is not so high that moral hazard leads to large losses.

summary Effective insurance management consists of several practices: information collection and screening of potential policyholders, risk-based premiums, restrictive provisions, prevention of fraud, insurance cancellation provisions, deductibles, coinsurance, and limits on the amount of insurance. All of these practices reduce moral hazard and adverse selection by making it harder for policyholders to benefit if they engage in activities that increase the amount and likelihood of claims. With less to gain, the poor insurance risks (those who are more likely to engage in these activities in the first place) see less benefit from the insurance and thus are less likely to seek it out. ◆

PensIOn FunDs In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: regular income payments during retirement. Employers, unions, and private individuals can set up pension plans, which acquire funds through contributions from the plans’ participants. As we can see in Table 1, both public and private pension plans have grown in importance, with their share of total financial intermediary assets rising from 17.4% at the end of 1980 to 24.3% at the end of 2013. Federal tax policy has been a major factor behind the rapid growth of pension funds because employer contributions to employee pen- sion plans are tax-deductible. Furthermore, tax policy has also encouraged employee contributions to pension funds by making these contributions tax-deductible as well and enabling self-employed individuals to set up their own tax-sheltered pension plans and individual retirement accounts (IRAs).

Because the benefits paid out of a pension fund each year are highly predictable, pension funds invest in long-term securities, with the bulk of their asset holdings in bonds, stocks, and long-term mortgages. The key management issues associated with pension funds revolve around asset management: Pension fund managers try to hold assets with high expected returns and also try to reduce risk through diversification. They also use the techniques we discussed in Chapter 9 to manage credit and interest- rate risk. The investment strategies of pension plans have changed radically over time. In the aftermath of World War II, most pension fund assets were held in government bonds, with less than 1% held in stock. However, the strong performance of stocks in the 1950s and 1960s afforded pension plans higher returns, causing them to shift their portfolios into stocks, which currently account for approximately two-thirds of their assets. As a result, pension plans now have a much stronger presence in the stock mar- ket: In the early 1950s, they held on the order of 1% of corporate stock outstanding; they currently hold on the order of 15%. Pension funds, along with mutual funds, are now the dominant players in the stock market.

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Although the purpose of all pension plans is the same, they can differ in a number of attributes. First is the method by which payments are made: If benefits are deter- mined by contributions into the plan and their earnings, the pension is a defined- contribution plan; if future income payments (benefits) are set in advance by the pension plan, the pension is a defined-benefit plan. Defined-benefit plans fall into two categories. A defined-benefit plan is fully funded if contributions into the plan and their earnings over the years are sufficient to pay out the defined benefits when they come due. If the contributions and earnings are not sufficient to pay out the defined benefits, the plan is underfunded. For example, if Jane Brown contributes $100 per year to her pension plan and the interest rate is 10%, then after ten years her contribu- tions and their earnings will be worth $1,753.2 If the defined benefit on her pension plan is $1,753 or less after ten years, then the plan is fully funded, because her contri- butions and their earnings will be sufficient to pay this amount in full. But if the defined benefit on her plan is $2,000, the plan is underfunded, because her contributions and their earnings do not cover this amount.

A second characteristic of pension plans is their vesting, the length of time that a person must be enrolled in the pension plan (i.e., must be either a member of the union or an employee of the company) before he or she is entitled to receive benefits. Typically, firms require that an employee work five years for the company before he or she becomes vested and is qualified to receive pension benefits; if the employee leaves the firm before the five years are up, because the employee either quits or is fired, all rights to benefits are lost.

Private Pension Plans Private pension plans are administered by banks, life insurance companies, and pension fund managers. In employer-sponsored pension plans, contributions are usually shared between employer and employee. Many companies’ pension plans are underfunded because the companies plan to meet their pension obligations by taking funds from current earnings when the benefits come due. As long as companies have sufficient earnings, underfunding creates no problems, but if they do not, they may not be able to meet their pension obligations. Because of problems caused by corporate underfund- ing, mismanagement, fraudulent practices, and other abuses of private pension funds (Teamsters’ pension funds are notorious in this regard), Congress enacted the Employee Retirement Income Security Act (ERISA) in 1974. This act established minimum stan- dards for the reporting and disclosure of information, set rules for vesting, put limits on the degree of underfunding allowed, placed restrictions on investment practices, and assigned responsibility for regulatory oversight to the Department of Labor.

ERISA also created the Pension Benefit Guarantee Corporation (PBGC, also called “Penny Benny”), which performs a role similar to that of the FDIC. It insures pension benefits up to a specified limit (currently $59,320 per year per person) if a company with an underfunded pension plan goes bankrupt or is unable to meet its pension obligations for other reasons. Penny Benny charges pension plans premiums to pay for this insurance, and it can also borrow up to $100 million from the U.S. Treasury. Unfortunately, the problem of pension plan underfunding has been growing worse in recent years.

2The $100 contributed in year 1 will be worth $100 * (1 + 0.10)10 = $259.37at the end of ten years; the $100 contributed in year 2 will be worth $100 * (1 + 0.10)9 = $235.79 at the end of ten years; and so on, until the $100 contributed in year 10 will be worth $100 * (1 + 0.10) = $110. Adding these together, we get the total value of these contributions and their earnings at the end of ten years: $259.37 + $235.79 + $214.36 + $194.87 + $177.16 + $161.05 + $146.41 + $133.10 + $121.00 + $110.00 = $1,753.11.

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Public Pension Plans The most important public pension plan is Social Security (Old Age and Survivors’ Insur- ance Fund), which covers virtually all individuals employed in the private sector. Funds are obtained from workers through FICA (Federal Insurance Contribution Act) deduc- tions from their paychecks and from employers through payroll taxes. Social Security benefits include retirement income, Medicare payments, and aid to the disabled.

When Social Security was established in 1935, the federal government intended to operate it like a private pension fund. However, unlike a private pension plan, benefits are typically paid out from current contributions and are not closely tied to a partici- pant’s past contributions. This “pay as you go” system led at one point to a massive underfunding, estimated at more than $1 trillion, of the Social Security system.

The problems of the Social Security system might become worse in the future because of the growth in the number of retired people relative to the number of people working. Congress has been grappling with the problems of the Social Security system for years,

FYI Should Social Security Be Privatized?

In recent years, public confidence in the Social Secu- rity system has reached new lows. Some surveys suggest that young people have more confidence in the existence of flying saucers than they do in the government’s ability to pay them their Social Security benefits when they become eligible for these benefits. Without some overhaul of the system, Social Security will not be able to meet its future obligations. This problem is not restricted to the United States, how- ever. Indeed, European countries and Japan face an even greater problem because their populations are aging more quickly than the U.S. population. How to fix Social Security has become a hotly debated politi- cal issue in recent years.

Currently, all of the assets of the U.S. Social Secu- rity system, which reside in a trust fund, are invested in U.S. Treasury securities. Because stocks and corporate bonds have higher returns than Treasury securities, many proposals to save the Social Secu- rity system suggest investing part of the trust fund in corporate securities, a move that would partially privatize the system.

Proposals for privatization take three basic forms:

1. Government investment of trust fund assets in cor- porate securities. This plan has the advantage of possibly improving the trust fund’s overall return while minimizing transaction costs because it exploits the economies of scale of the trust fund.

Critics warn that government ownership of private assets could lead to increased government inter- vention in the private sector.

2. Shift of trust fund assets to individual accounts that can be invested in private assets. This option has the advantage of possibly increasing the return on investments and does not involve the govern- ment in the ownership of private assets. However, critics warn that it might expose individuals to greater risk and to transaction costs on individual accounts that might be very high because of the small size of many of these accounts.

3. Individual accounts in addition to those in the trust fund. This option has advantages and disadvan- tages similar to those of option 2 and may provide more funds to individuals at retirement. However, some increases in taxes would be required to fund these accounts.

Whether some privatization of the Social Security system will occur is an open question. In the short term, Social Security reform is likely to involve an increase in taxes, a reduction in benefits, or both. For example, the age at which benefits begin is already scheduled to increase from 65 to 67, and might be increased further to 70. It is also likely that the cap on wages subject to the Social Security tax will be raised, thereby increasing taxes paid into the system.

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but the prospect of a huge bulge in new retirees—namely, the 77 million baby boomers born between 1946 and 1964, who began to retire in 2011—has resulted in calls for radi- cal surgery on Social Security (see the FYI box, “Should Social Security Be Privatized?”).

State and local governments and the federal government, like private employers, have also set up pension plans for their employees. These plans are almost identical in operation to private pension plans and hold similar assets. Underfunding of the plans is also prevalent, and some investors in municipal bonds worry that state and local governments will be unable to meet their debt obligations in the future.

FInance cOMPanIes Finance companies acquire funds by issuing commercial paper or stocks and bonds or by borrowing from banks, and they use the proceeds to make loans (often for small amounts) that are particularly well suited to consumer and business needs. The finan- cial intermediation process of finance companies often involves borrowing in large amounts but lending in small amounts—a process quite different from that of banking institutions, which collect deposits in small amounts and then often make large loans.

A key feature of finance companies is that although they lend to many of the same customers that borrow from banks, they are virtually unregulated compared to com- mercial banks and thrift institutions. States regulate the maximum amount that finance companies can loan to individual consumers and the terms of the debt contract, but no restrictions are placed on how they pursue branching, the assets they hold, or how they raise their funds. The lack of restrictions enables finance companies in many cases to tailor their loans to meet customer needs better than banking institutions can.

Finance companies are of three types: sales, consumer, and business.

1. Sales finance companies are owned by a particular retailing or manufacturing company and make loans to consumers so that they can purchase items from that company. Sears Roebuck Acceptance Corporation, for example, finances consumer purchases of goods and services at Sears stores, and General Motors Acceptance Corporation finances purchases of GM cars. Sales finance companies compete directly with banks for consumer loans and are used by consumers because loans frequently can be obtained faster and more conveniently at the location where an item is purchased.

2. Consumer finance companies make loans to consumers who wish to buy particular items such as furniture or home appliances, make home improvements, or refinance small debts. Consumer finance companies are separate corporations (like Household Finance Corporation) or are owned by banks (Citigroup owns Person-to-Person Finance Company, which operates offices nationwide). Typically, these companies make loans to consumers who cannot obtain credit from other sources, and they therefore charge higher interest rates.

3. Business finance companies provide specialized forms of credit to businesses by making loans and purchasing accounts receivable (bills owed to the firm) at a discount; this provision of credit is called factoring. For example, a dressmaking firm might have outstanding bills (accounts receivable) of $100,000 owed by the retail stores that have bought its dresses. If this firm needs cash to buy 100 new sewing machines, it can sell its accounts receivable for, say, $90,000 to a finance company, which is now entitled to collect the $100,000 owed to the firm. Besides factoring, business finance companies also specialize in leasing equipment (such as railroad cars, jet planes, and computers), which they purchase and then lease to businesses for a set number of years.

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securITIes MarkeT OPeraTIOns The smooth functioning of securities markets, in which bonds and stocks are traded, involves several financial institutions, including securities brokers and dealers, invest- ment banks, and organized exchanges. None of these institutions were included in our list of financial intermediaries in Chapter 2 because these institutions do not perform the intermediation function of acquiring funds by issuing liabilities and then using the funds to acquire financial assets. Nonetheless, they are important in the process of channeling funds from savers to spenders and can be thought of as “financial facilitators.”

First, however, we must recall the distinction between primary and secondary securities markets discussed in Chapter 2. In a primary market, new issues of a security are sold to buyers by the corporation or government agency borrowing the funds. A secondary market then trades the securities, which after their initial primary market sale are considered to be “secondhand.” Investment banks assist in the initial sale of securities in the primary market; securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges.

Investment Banking When a corporation wishes to borrow (raise) funds, it normally hires the services of an investment banker to help it sell its securities. (Despite its name, an investment bank is not a bank in the ordinary sense; that is, it is not engaged in financial intermediation that takes in deposits and then lends them out.)

Investment bankers assist in the sale of securities as follows. First, they advise the corporation on whether it should issue bonds or stock. If they suggest that the corpora- tion issue bonds, investment bankers give advice on what the maturity and interest pay- ments on the bonds should be. If they suggest that the corporation sell stock, they give advice on what the price should be. This is fairly easy to do if the firm has prior issues of stock, called seasoned issues, currently selling in the market. However, when a firm issues stock for the first time in an initial public offering (IPO), it is more difficult to determine what the correct price should be. All the skills and expertise of the invest- ment banking firm then must be brought to bear to determine the most appropriate price. IPOs have become very important in the U.S. economy because they are a major source of financing for Internet companies, which became all the rage on Wall Street in the late 1990s. Not only have IPOs helped these companies acquire the capital they needed to substantially expand their operations, but they also have made the original owners of these firms very rich. Many a 20- to 30-year-old became an instant million- aire when his or her stake in an Internet company was given a high valuation after the initial public offering of shares in the company. However, with the bursting of the tech bubble in 2000, many of these same people lost much of their wealth when the value of their shares came tumbling down to earth.

When the corporation decides which kind of financial instrument it will issue, it offers the issue to underwriters—investment bankers that guarantee the corporation a price on the securities and then sell them to the public. If the issue is small, only one investment banking firm underwrites it (usually the original investment banking firm hired to provide advice on the issue). If the issue is large, several investment banking firms form a syndicate to underwrite the issue jointly, thus limiting the risk that any one investment bank must take. The underwriters sell the securities to the general public by contacting potential buyers, such as banks and insurance compa- nies, directly.

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The activities of investment bankers and the operations of primary markets are heavily regulated by the Securities and Exchange Commission (SEC), which was cre- ated by the Securities and Exchange Acts of 1933 and 1934 to ensure that adequate information reaches prospective investors. Issuers of new securities to the general pub- lic (for amounts greater than $1.5 million in a year, with a maturity longer than 270 days) must file a registration statement with the SEC and must provide to potential investors a prospectus containing all relevant information on the securities. The issuer must then wait 20 days after the registration statement is filed with the SEC before it can sell any of the securities. If the SEC does not object during the 20-day waiting period, the securities can be sold.

securities Brokers and Dealers Securities brokers and dealers conduct trading in secondary markets. Brokers act as agents for investors in the purchase or sale of securities. Brokers’ function is to match buyers with sellers, a service for which they are paid brokerage commissions. In contrast to brokers, dealers link buyers and sellers by standing ready to buy and sell securities at given prices. Therefore, dealers hold inventories of securities and make their living by selling these securities for a slightly higher price than they paid for them—that is, on the “spread” between the asked price and the bid price. This can be a high-risk business because dealers hold securities that can rise or fall in price; in recent years, several firms specializing in bonds have collapsed. Brokers, by contrast, are not as exposed to risk because they do not own the securities involved in their business dealings.

Brokerage firms engage in all three securities market activities, acting as brokers, dealers, and investment bankers. The SEC not only regulates the investment banking operations of the firms but also restricts brokers and dealers from misrepresenting securities and from trading on insider information, nonpublic information known only to the managers of a corporation.

The forces of competition led to an important development in the 1970s: Brokerage firms started to engage in activities traditionally conducted by commercial banks. In 1977, Merrill Lynch developed the cash management account (CMA), which provides a package of financial services that includes credit cards, immediate loans, check-writing privileges, automatic investment of proceeds from the sale of securities into a money market mutual fund, and unified record keeping. Similar accounts were created by other brokerage firms, and these accounts’ popularity spread rapidly. As a result, the distinction between banking activities and the activities of nonbank financial institu- tions has become blurred. Another recent development is the growing importance of the Internet in securities markets.

Organized exchanges As discussed in Chapter 2, secondary markets can be organized either as over-the-coun- ter markets, in which trades are conducted through dealers, or as organized exchanges, in which trades are conducted in one central location. The New York Stock Exchange (NYSE), which trades thousands of securities, is the largest organized exchange in the world. A number of smaller regional exchanges, which trade only a small number of securities (fewer than 100), are located in cities such as Boston and Los Angeles.

Organized stock exchanges actually function as a hybrid of an auction market (in which buyers and sellers trade with each other in a central location) and a dealer market (in which dealers establish a market by buying and selling securities at given prices).

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Securities are traded on the floor of the exchange with the help of a special kind of dealer-broker called a specialist. A specialist matches “buy” and “sell” orders submit- ted at the same price and so performs a brokerage function. However, if buy and sell orders do not match up, the specialist buys stocks or sells from a personal inventory of securities, in this manner performing a dealer function. By assuming both functions, the specialist maintains orderly trading of the securities for which he or she is responsible.

Organized exchanges in which securities are traded are regulated by the SEC. Not only does the SEC have the authority to impose regulations that govern the behavior of brokers and dealers involved with exchanges, but it also has the authority to alter the rules set by the exchanges. In 1975, for example, the SEC disallowed rules that set minimum brokerage commission rates. The result was a sharp drop in brokerage com- mission rates, especially for institutional investors (mutual funds and pension funds), which purchase large blocks of stock. The Securities Amendments Act of 1975 sup- ported the SEC’s action by outlawing the setting of minimum brokerage commissions.

Furthermore, the Securities Amendments Act directed the SEC to facilitate a national market system to consolidate the trading of all securities listed on the national and regional exchanges, as well as those traded in the over-the-counter market, using the National Association of Securities Dealers’ automated quotation system (NASDAQ). Computers and advanced telecommunications, which reduce the costs of linking these markets, have encouraged the expansion of a national market system. We thus see that legislation and modern computer technology are leading the way to a more competitive securities industry.

The growing internationalization of capital markets has encouraged another trend in securities trading. Increasingly, foreign companies are being listed on U.S. stock exchanges, and the markets are moving toward international trading of stocks, 24 hours a day.

MuTuaL FunDs Mutual funds are financial intermediaries that pool the resources of many small inves- tors by selling them shares and using the proceeds to buy securities. Through the asset transformation process of issuing shares in small denominations and buying large blocks of securities, mutual funds can take advantage of volume discounts on bro- kerage commissions and can purchase diversified holdings (portfolios) of securities. Mutual funds allow the small investor to enjoy the benefits of lower transaction costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held. Many mutual funds are run by brokerage firms, but others are run by banks or independent investment advisers such as Fidelity or Vanguard.

Mutual funds have seen a large increase in their market share since 1980 (see Table 1), due primarily to the then-booming stock market. Another source of growth has been mutual funds that specialize in debt instruments, which first appeared in the 1970s. Before 1970, mutual funds invested almost solely in common stocks. Funds that purchase common stocks may specialize even further and invest solely in foreign securities or in specialized industries, such as energy or high technology. Funds that purchase debt instruments may specialize further in corporate, U.S. government, or tax-exempt municipal bonds or in long-term or short-term securities.

Mutual funds are primarily held by households (nearly 90%), with the rest held by other financial institutions and nonfinancial businesses. Mutual funds have become increasingly important in household savings. In 1980, only 6% of households held mutual fund shares; this number has risen to nearly 50% in recent years.

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Mutual funds, pension funds and hedge funds, known jointly as institutional investors, now control more than 25% of the outstanding stock in the United States. Increased ownership of stocks means that institutional investors have more clout with corporate boards, often forcing changes in leadership or in corporate policies. Particu- larly controversial recently has been a type of institutional investor called a sovereign wealth fund. Sovereign wealth funds are state-owned investment funds that invest in foreign assets (see the FYI box, “Sovereign Wealth Funds: Are They a Danger?”).

Mutual funds are structured in two ways. The more common structure is an open- end fund, from which shares can be redeemed at any time at a price that is tied to the asset value of the fund. A mutual fund also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering and then are traded like a common stock. The market price of these shares fluctuates with the value of the assets held by the fund. In contrast to the open-end fund, however, the price of the shares may be above or below the value of the assets held by the fund, depending on factors such as the liquidity of the shares or the quality of the management.

FYI Sovereign Wealth Funds: Are They a Danger?

Sovereign wealth funds have been around a long time; the first, the Kuwait Investment Authority, was established in 1953. When governments accumulate a substantial amount of foreign exchange earnings, as has happened in oil-rich countries, they often recognize that it would be wiser to put these earn- ings into investments in foreign countries rather than keep them at home. The largest sovereign wealth funds are the Abu Dhabi Investment Authority, the Government Pension Fund of Norway, the Gov- ernment of Singapore Investment Corporation, the Kuwait Investment Authority, the China Investment Corporation, Singapore’s Temasek Holdings, and the Stabilisation Fund of the Russian Federation.

Until recently, these funds were relatively uncon- troversial because they were comparatively small and were primarily invested in government bonds issued by industrialized countries. In recent years, however, sovereign wealth funds have grown in size—they now hold over $5 trillion in assets—and, in the search for higher returns, they invest in a much broader set of assets. This shift in size and focus has led to serious concerns about them among industrialized countries.

One concern is that as the sizes of these funds increase, they may play a more important role in asset markets. Because some of these funds are very large—Norway’s and Abu Dhabi’s soverign

wealth funds each have close to $800 billion of assets—the decision of one fund to pull out of a par- ticular asset market could cause market instability. Sovereign wealth funds also raise national security issues because they might use their investments for political purposes. They might buy up strategically important industries or use their clout to get political concessions. This is a particular concern because the governments of Russia, China, and the Arab coun- tries control many of the largest of these funds. A third concern is that many of these funds, with the exception of the Norwegian fund, provide very little information about their operations and the assets in which they invest.

Although sovereign wealth funds do pose some dangers, these dangers are probably overplayed. Xenophobia often plays well in politics, and foreign purchase of domestic assets is often prevented under the banner of national security in order to protect domestic companies from unwanted takeovers. The lack of transparency associated with some of these large funds, however, is a serious problem. This is why organizations like the International Monetary Fund (IMF) and the Organisation for Economic Co- operation and Development (OECD) have proposed the implementation of rules to increase the amount of information these funds must disclose to the markets.

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The greater popularity of open-end funds is explained by the greater liquidity of their redeemable shares relative to the liquidity of the nonredeemable shares held by closed- end funds.

Originally, shares of most open-end mutual funds were sold by salespeople (usually brokers) who were paid a commission. Because this commission is paid at the time of purchase and is immediately subtracted from the redemption value of the shares, these funds are called load funds. Most mutual funds are currently no-load funds; they are sold directly to the public with no sales commissions. In both types of funds, the managers earn their living from management fees paid by the shareholders. These fees amount to approximately 0.5% of the asset value of the fund per year.

Mutual funds are regulated by the Securities and Exchange Commission, which was given almost complete control over them by the Investment Company Act of 1940. Regulations require periodic disclosure of information on these funds to the public and restrictions on the methods of soliciting business.

Money Market Mutual Funds An important addition to the family of mutual funds born of the financial innovation process described in earlier chapters is the money market mutual fund. Recall that this type of mutual fund invests in short-term debt (money market) instruments of very high quality, such as Treasury bills, commercial paper, and bank certificates of deposit. There is some fluctuation in the market value of these securities, but because their maturity term is typically less than six months, the change in the market value is small enough that these funds allow their shares to be redeemed at a fixed value. (Changes in the market value of the securities are figured into the interest paid out by the fund.) Because these shares can be redeemed at a fixed value, the funds allow shareholders to redeem shares by writing checks on the fund’s account at a commercial bank. In this way, shares in money market mutual funds effectively function as checkable deposits that earn market interest rates on short-term debt securities.

In 1977, the assets in money market mutual funds were less than $4 billion; by 1980, they had climbed to more than $50 billion. They now stand at nearly $3 trillion, with a share of financial intermediary assets that has grown to 5.1% (see Table 1). Cur- rently, money market mutual funds account for about one-fifth of the asset value of all mutual funds.

HeDge FunDs Hedge funds are a special type of investment fund, with estimated assets of more than $2 trillion. Well-known hedge funds include Tudor Investment Corporation and the Quantum Group of funds associated with George Soros. Investors in hedge funds, who are limited partners, give money to managing (general) partners to invest on their behalf. Several features distinguish hedge funds from mutual funds. Hedge funds have a minimum investment requirement between $100,000 and $20 million, with the typical minimum investment being $1 million. Federal law mandates that hedge funds have no more than 99 investors (limited partners), and these partners must have steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes. Hedge funds are largely unregulated by the government, on the theory that the rich can look out for themselves. Many of the 5,000 hedge funds are located offshore to escape regulatory restrictions.

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Hedge funds also differ from traditional mutual funds in that they usually require that investors commit their money for long periods of time, often several years. This requirement is meant to give managers breathing room to pursue long-run strategies. Hedge funds typically charge large fees to investors. The typical fund charges a 2% annual fee on the assets it manages, plus 20% of profits.

The term hedge fund is highly misleading, because the word “hedge” typically implies the use of strategies to avoid risk. Despite their name, these funds can and do take big risks. Many hedge funds engage in what are called “market-neutral” strategies wherein they buy a security, such as a bond, that seems cheap and sell an equivalent amount of a similar security that appears to be overvalued. If interest rates as a whole go up or down, the fund is hedged, because the decline in value of one security is matched by the rise in value of the other. However, the fund is speculating on whether the spread between the prices on the two securities will move in the direction predicted by the fund managers. If the fund bets wrongly, it can lose a lot of money, particularly if it has leveraged up its positions—that is, has borrowed heavily against these positions so that its equity stake is small relative to the size of its portfolio.

PrIvaTe equITy anD venTure caPITaL FunDs Another type of investment fund is the private equity fund, which makes long-term investments in companies that are not traded in public markets and has a similar struc- ture to the hedge fund. In a private equity fund, investors who are limited partners (e.g., high-wealth individuals, pension funds, financial institutions, and college endow- ments) place their money with the managing (general) partners who make the private equity investments. Private equity funds are of two types. Venture capital funds make investments in new start-up businesses, often in the technology industry. Capital buyout funds, on the other hand, make investments in established businesses. In many cases, capital buyout funds buy publicly traded firms through a so-called leveraged buyout (LBO), in which the publicly traded firm is taken private when the fund buys all of its shares and finances the purchase by increasing the leverage (debt) of the firm. Among the best-known companies that set up venture capital and capital buyout funds are KKR (Kohlberg, Kravis, Roberts and Co.), Bain Capital, and Blackstone Group.

Investing in private equity funds has several advantages over investing in publicly traded companies. First, private companies are not subject to the controversial and costly regulations prescribed in the Sarbanes-Oxley Act (described in Chapter 15). Second, managers of private companies do not feel the pressure to produce immedi- ate profits that managers at publicly traded companies do, and thus can manage their companies with their eyes on longer-term profitability. Third, because private equity funds give their managers larger stakes in the firm than is usually the case with publicly traded corporations, these managers have greater incentives to work hard to maximize the value of the firm. Fourth, private equity overcomes the free-rider problem that we discussed in Chapter 8. In contrast to publicly traded companies, which have a diverse set of owners who are happy to free-ride off of each other, venture capital and capital buyout funds are able to garner almost all of the benefits of monitoring the firm and therefore have strong incentives to make sure the firm is run properly.

In both venture capital and capital buyout funds, once the start-up or the pur- chased company is successful, the fund earns its returns either by selling the firm to another company or by selling it off to the public through an initial public offering

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(IPO). The managing partners of private equity funds are well compensated for their activities: Like the partners of hedge funds, they typically earn approximately a 2% fee for management of the equity fund investments and also earn 20% of the profits, an amount that is called carried interest. Carried interest has been particularly contro- versial of late because it is taxed at the lower long-term capital gains rate (15%) rather than at the higher income tax rate (35%). This is considered to be patently unfair by many members of Congress, who have proposed raising the tax rate on carried interest to the higher income tax rate. Those in the industry have countered that raising the tax rate on carried interest would stifle investment and therefore hinder economic growth.

Both venture capital and capital buyout funds have been highly profitable. Venture capital firms have been an especially important driver of economic growth in recent years because they have funded so many successful high-tech firms, including Apple Computer, Cisco Systems, Genentech, Microsoft, and Sun Microsystems (acquired by Oracle).

gOvernMenT FInancIaL InTerMeDIaTIOn The government has become involved in financial intermediation in two basic ways: by setting up federal credit agencies that directly engage in financial intermediation and by supplying government guarantees for private loans.

Federal credit agencies To promote the purchase of residential housing, the government has created a number of government agencies that provide funds, either directly or indirectly, to the mortgage market. Three agencies—the Government National Mortgage Association (GNMA, or “Ginnie Mae”), the Federal National Mortgage Association (FNMA, or “Fannie Mae”), and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”)— provide funds to the mortgage market by selling bonds and using the proceeds to buy mortgages or mortgage-backed securities. Except for Ginnie Mae, which is a federal agency and thus is an entity of the U.S. government, the other agencies, known as government-sponsored enterprises (GSEs), are federally sponsored agencies that function as private corporations with close ties to the government. Another set of GSEs, the Federal Home Loan Banks, indirectly provide funds to the mortgage markets by selling bonds and then lending the proceeds to banking institutions that make mortgage loans. Although the U.S. government does not explicitly back the debt of the GSEs, as is the case for government-sponsored Treasury bonds, in practice the federal government has not allowed a default on their securities.

Agriculture is another area in which financial intermediation by government agencies plays an important role. The Farm Credit System (composed of Banks for Cooperatives, Farm Credit Banks, and various farm credit associations) and the Federal Agricultural Mortgage Corporation (“Farmer Mac”) issue securities and then use the proceeds to make loans to farmers.

Unfortunately, the implicit government backing of GSE debt has led to a moral haz- ard problem. Because the government in effect guarantees GSE debt, market discipline to limit excessive risk taking by GSEs is quite weak. The GSEs therefore have incentives to take on excessive risk, and this is exactly what they did, leaving the taxpayer hold- ing the bag. The federal government bailed out the Farm Credit System in 1987, for

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example, because of the rising tide of farm bankruptcies. The agency was authorized to borrow up to $4 billion, to be repaid over a fifteen-year period, and received over $1 billion in assistance. This bailout pales, however, when compared to the recent bailouts of Fannie Mae and Freddie Mac, which involved $200 billion of government funds (see the FYI box, “The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac”).

FYI The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac

Because it encouraged excessive risk taking, the peculiar structure of Fannie Mae and Freddie Mac— private companies sponsored by the government— was an accident waiting to happen. Earlier editions of this textbook, as well as many economists, predicted exactly what came to pass: a government bailout of both companies, with huge losses for American taxpayers.

As we learned in Chapter 10, when financial institutions are backed by a government safety net, appropriate government regulation and supervision are needed to make sure these institutions do not take on excessive risk. Legislation passed in 1992 assigned Fannie and Freddie a federal regulator and supervisor, the Office of Federal Housing Enterprise Oversight (OFHEO), but this regulator was quite weak and had only a limited ability to rein these companies in. The weakness of OFHEO was not surprising. These GSEs had strong incentives to resist effective regulation and supervision because such supervision would cut into their profits. And they did resist regulation, often flagrantly: Fannie and Freddie were legendary for their lobbying machine in Congress, about which they were not apologetic. In 1999, Franklin Raines, Fannie’s CEO at the time, said, “We manage our political risk with the same intensity that we manage our credit and interest-rate risks.”* Between 1998 and 2008, Fannie and Fred- die jointly spent over $170 million on lobbyists, and from 2000 to 2008, they and their employees made over $14 million of political campaign contributions.

The lobbying efforts paid off: Attempts by both the Clinton and Bush administrations to strengthen the GSEs’ regulator, OFHEO, came to naught, and remarkably things did not change even when major accounting scandals were revealed at both firms in 2003 and 2004, scandals in which the firms cooked

the books to smooth out their earnings. (It was only in July 2008, after the cat was let out of the bag and Fannie and Freddie were in serious trouble, that leg- islation was passed to put into place a stronger regu- lator, the Federal Housing Finance Agency, which superseded OFHEO.)

With weak regulation and strong incentives to take on risk, Fannie and Freddie grew wildly, and by 2008 these firms had purchased or were guaranteeing over $5 trillion of mortgages and mortgage-backed securities. The accounting scandals might even have pushed Fannie and Freddie to take on more risk. With the 1992 legislation, Fannie and Freddie had been given the mission of promoting affordable housing. What better way to do this than to purchase subprime and Alt-A mortgages and mortgage-backed securities (discussed in Chapter 12)? The accounting scandals provided even stronger motivation for such purchases because they weakened political support for Fannie and Freddie, giving them even greater incentives to please Congress and to support afford- able housing through the purchase of these assets. By the time the global financial crisis hit in full force, Fannie and Freddie had over $1 trillion of subprime and Alt-A assets on their books. Furthermore, they had extremely low ratios of capital relative to their assets. Indeed, their capital ratios were far lower than those of other financial institutions like commercial banks.

By 2008, after many subprime mortgages had gone into default, Fannie and Freddie had booked large losses. Their small capital buffer meant that they had little cushion to withstand these losses, and investors started to pull out their money. Because Fannie and Freddie played such a dominant role in mortgage markets, the U.S. government could not afford for them to go out of business, since this

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C h a P t e r 1 3 Nonbank Finance 311

1. Insurance providers, which are regulated by the states, acquire funds by selling policies that pay out ben- efits to the policyholder if catastrophic events occur. Property and casualty insurance companies hold more liquid assets than life insurance companies because of greater uncertainty regarding the benefits they will have to pay out. All insurers face moral hazard and adverse selection problems, which explain the use of insurance management tools, such as information collection and screening of potential policyholders, risk-based premi- ums, restrictive provisions, prevention of fraud, insur- ance cancellation provisions, deductibles, coinsurance, and limits on the amount of insurance.

2. Pension plans provide income payments to people when they retire after contributing to the plans for many years. Federal tax policies have encouraged the rapid growth of pension funds, and these funds now play an important role in the stock market. Many pension plans are underfunded, which means that in future years they will have to pay out benefits worth more than the value of their contributions and earn- ings. The problem of underfunding is especially acute for public pension plans such as Social Security. To prevent abuses, Congress enacted the Employee Retirement Income Security Act (ERISA), which estab- lished vesting and minimum standards for reporting, and limited the degree of underfunding allowed in private pension plans. This act also created the

Pension Benefit Guarantee Corporation, which insures pension benefits.

3. Finance companies raise funds by issuing commercial paper and stocks and bonds and then using the proceeds to make loans that are particularly suited to consumer and business needs. Virtually unregulated in comparison to commercial banks and thrift institutions, finance companies are able to quickly tailor their loans to customer needs.

4. Investment bankers assist in the initial sales of securities in primary markets, whereas securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges. The SEC regulates the financial institutions in the securities markets and ensures that adequate information reaches prospective investors.

5. Mutual funds sell shares and use the proceeds to buy securities. Open-end funds issue shares that can be redeemed at any time at a price tied to the asset value of the firm. Closed-end funds issue nonredeemable shares, which are traded like common stock. They are less popular than open-end funds because their shares are not as liquid. Money market mutual funds hold only short-term, high-quality securities, allowing shares to be redeemed at a fixed value using checks. Shares in these funds effectively function as checkable deposits

would have had a disastrous effect on the availability of mortgage credit, which would have led to further devastating effects on the housing market. With bankruptcy imminent, the Treasury stepped in with a pledge to provide up to $200 billion of taxpayer money to the companies if needed. This largess did not come for free. The federal government in effect took over these companies by putting them into con- servatorship, requiring that their CEOs step down, and insisting that their regulator, the Federal Hous- ing Finance Agency, oversee the companies’ day-to- day operations. In addition, the government received about $1 billion of senior preferred stock and the right to purchase 80% of the common stock if the companies recovered. After the bailout, the prices of

both companies’ common stock fell to less than 2% of their value only a year earlier.

The ultimate fate of these two companies remains unclear. The sad saga of Fannie Mae and Freddie Mac illustrates just how dangerous it was for the govern- ment to set up GSEs that were exposed to the classic conflict of interest problem: they were expected to serve two masters. As publicly traded corporations, they were expected to maximize profits for their share- holders, but as government agencies, they were obliged to work in the interests of the public. In the end, nei- ther the public nor the shareholders were well served.

suMMary

*Quoted in Nile Stephen Campbell, “Fannie Mae Officials Try to Assuage Wor- ried Investors,” Real Estate Finance Today, May 10, 1999.

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312 P a r t 3 Financial Institutions

established companies, often taking publicly traded firms private.

8. To provide credit to residential housing and agri- culture, the U.S. government has created a number of government agencies. Particularly important are government-sponsored enterprises (GSEs), which are federally sponsored agencies that function as private corporations with close ties to the government. Because the government provides an implicit guarantee for GSE debt, market discipline to limit excessive risk taking by GSEs is weak. The resulting moral hazard prob- lem has led to major taxpayer bailouts, especially the recent bailout of Fannie Mae and Freddie Mac, which involved $200 billion of government funds.

that earn market interest rates. All mutual funds are regulated by the Securities and Exchange Commission (SEC).

6. Hedge funds are a special type of investment fund. Investors in hedge funds, who are limited partners, give money to managing (general) partners to invest on their behalf. Hedge funds require large minimum investments and usually require that investors commit their money for long periods of time.

7. Private equity funds make long-term investments in companies that are not traded publicly. Private equity funds are of two types: venture capital funds, which make investments in start-ups, and capital buyout funds, which make investments in

key TerMs

annuities, p. 292 brokerage firms, p. 304 capital buyout funds, p. 308 carried interest, p. 309 closed-end fund, p. 306 coinsurance, p. 298 credit default swap (CDS), p. 294 deductible, p. 298 defined-benefit plan, p. 300 defined-contribution plan, p. 300

fully funded, p. 300 government-sponsored enterprises

(GSEs), p. 309 hedge fund, p. 307 initial public offering (IPO), p. 303 leveraged buyout (LBO), p. 308 load funds, p. 307 monoline insurance companies,

p. 295 no-load funds, p. 307

open-end fund, p. 306 private equity fund, p. 308 reinsurance, p. 294 seasoned issues, p. 303 sovereign wealth fund, p. 306 specialist, p. 305 underfunded, p. 300 underwriters, p. 303 venture capital funds, p. 308

quesTIOns

All questions are available in MyEconLab at www.myeconlab.com.

1. Why do people choose to buy insurance even if their expected loss is less than the payments they will make to the insurance company?

2. How do insurance companies protect themselves against losses due to adverse selection and moral hazard?

3. What is the difference between term life insurance and whole life insurance?

4. What is the purpose behind reinsurance?

5. Why do property and casualty insurance companies have large holdings of municipal bonds, whereas life insurance companies do not?

6. Why did the Federal Reserve and the government intervene to bail out AIG?

7. “In contrast to private pension plans, government pen- sion plans are rarely underfunded.” Is this statement true, false, or uncertain? Explain your answer.

8. Why is Social Security in danger of eventually going bankrupt?

9. What are the three main proposals for privatizing Social Security? What are their advantages and disad- vantages?

10. What is ERISA, and why was it established?

11. If you needed to take out a loan, why might you first go to your local bank rather than a finance company?

12. How are securities brokers/dealers, investment banks, and organized exchanges different from financial inter- mediaries?

13. What problems or concerns do sovereign wealth funds present? Are they valid?

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C h a P t e r 1 3 Nonbank Finance 313

17. How do hedge funds differ from mutual funds?

18. “Hedge funds are not risky because, as their name indicates, they hedge risks.” Is this statement true, false, or uncertain? Explain.

19. What are the four advantages of private equity funds? How do they help alleviate the free-rider problem?

20. How have GSEs exposed taxpayers to large losses?

14. Why can a money market mutual fund allow its share- holders to redeem shares at a fixed price while other mutual funds cannot?

15. What features of mutual funds and the investment environment have led to mutual funds’ rapid growth in the last three decades?

16. Is investment banking a good career for someone who is afraid of taking risks? Why or why not?

aPPLIeD PrOBLeMs

All applied problems are available in MyEconLab at www.myeconlab.com.

21. Your rich uncle dies, leaving you a life insurance policy worth $100,000. The insurance company offers you the option of receiving $8,225 per year for 20 years, with the first payment due today, or a lump sum. Which option should you choose?

22. Kio Outfitters estimated the following probabilities of loss from past experience:

loss policy with a $1,500 deductible, what is the most that Kio will pay if it files a claim?

23. Paul’s car slid off an icy road, causing $2,500 of dam- age to his car. He was also treated for minor injuries, treatments that cost $1,300. His car insurance has a $500 deductible, after which the full loss is paid. His health insurance has a $100 deductible and covers 75% of medical costs (total). What were Paul’s out-of- pocket costs from the incident?

24. An employee contributes $200 a year (at the end of the year) to her pension plan. What will be the total value of the account after five years? Assume the plan earns 15% per year over the period.

25. Suppose you contribute $20,000 at the beginning of each year into your defined benefit pension plan, and the interest rate is 10%.

a. After 8 years, what will be the total value of the account?

b. Suppose that after 8 years you are eligible to receive benefits of $250,000. Is the pension plan underfunded or fully funded?

c. Suppose the pension plan takes a 2% management fee at the time each contribution is made. How does this change your answer to parts (a) and (b), if at all?

Loss Probability (%)

$30,000 0.25

$15,000 0.75

$10,000 1.50

$5,000 2.50

$1,000 5.00

$250 15.00

$0 75.00

What is the probability that Kio will experience a loss of $5,000 or greater? If an insurance company offers a

DaTa anaLysIs PrOBLeMs

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED database, and find data on the amount of mutual fund shares held by households and nonprofit organizations (HNOMFAQ027S) and the amount of mutual

fund shares held by financial businesses (FBMFT- TQ027S). Which of the two categories currently holds the most assets? Which of the two categories has grown the most in percentage terms over the past five years? (Use the most recent five years of data available.)

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314 P a r t 3 Financial Institutions

companies currently holds the largest dollar amount of mortgages? Which holds the smallest? How do the current volumes of mortgages held by Fannie Mae and Freddie Mac compare to the volumes before 2010?

2. Go to the St. Louis Federal Reserve FRED data- base, and find data on the amount of mortgages held by Ginnie Mae (MDOTHFRAGNMA), Fannie Mae (MDOTHFRAFNMA), and Freddie Mac (MDOTHFRAFHLMC). Which of the three

WeB exercIses

1. In initial public offerings (IPOs), securities are sold to the public for the very first time. Go to http://www.ipo- home.com. This site lists various statistics regarding the IPO market.

a. What was the largest IPO this year, ranked by amount raised?

b. What is the next IPO that will be offered to the public?

c. How many IPOs were priced this year?

2. The Federal Reserve maintains extensive data on finance companies. Go to /www.federalreserve.gov/ releases and scroll down until you find G.20 Finance

Companies. Click on Releases and find the current release.

a. Review the terms of credit for new car loans. What is the most recent average interest rate, and what is the term to maturity? What is the amount of the average new car loan offered by finance companies?

b. Which type of loan do finance companies make most often: consumer loans, real estate loans, or business loans?

c. Which type of loan has grown most rapidly over the past five years?

WeB reFerences

http://www.iii.org

The Insurance Information Institute publishes facts and sta- tistics about the insurance industry.

http://www.federalreserve.gov/releases/Z1/

The Flow of Funds Accounts of the United States reports details about the current state of the insurance industry. Scroll down through the table of contents to find the loca- tion of data on insurance companies.

http://www.pbgc.gov/

The website for the Pension Benefit Guarantee Corporation contains information about pensions and the insurance that it provides.

http://www.ssa.gov/

The website for the Social Security Administration contains information on your Social Security benefits.

http://www.federalreserve.gov/releases/g20/

The Federal Reserve provides information about finance companies.

http://www.ici.org/about_ici/annuals

The Investment Company Fact Book, published by the Investment Company Institute, includes information about the mutual funds industry’s history, regulation, taxation, and shareholders.

http://www.ipoinitialpublicofferings.com/

The site reports initial public offering news and information, and includes advanced search tools for IPOs, venture capital research reports, and so on.

http://www.sec.gov

The Securities and Exchange Commission website contains information on regulatory actions, concept releases, interpretive releases, and more.

http://www.nyse.com

At the New York Stock Exchange home page, you will find listed companies, member information, real-time market indices, and current stock quotes.

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Preview

Starting in the 1970s, and increasingly in the 1980s and 1990s, the world became a riskier place for the financial institutions described in this part of the book. Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility. As a result of these developments, managers of financial institutions became more concerned with reducing the risk their institutions faced. Given the greater demand for risk reduction, the process of financial innovation described in Chapter 11 came to the rescue by producing new financial instruments to help financial institution managers better manage risk. These instruments, called financial derivatives, have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools.

In this chapter, we look at the most important financial derivatives that managers of financial institutions use to reduce risk: forward contracts, financial futures, options, and swaps. We examine not only how the markets for each of these financial derivatives work but also how they can be used by financial institutions to manage risk. We also study financial derivatives because they have become an important source of profits for financial institutions, particularly larger banks, which, as we saw in Chapter 11, have found their traditional business declining.

Hedging Financial derivatives are so effective at reducing risk because they enable financial insti- tutions to hedge—that is, to engage in a financial transaction that reduces or eliminates risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncer- tain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to have taken a short position, and this can also expose the institution to risk. Financial derivatives can be used to reduce risk by invoking the fol- lowing basic principle of hedging: Hedging risk involves engaging in a financial trans- action that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. In other words, if a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver

Learning Objectives • Define a hedge, a long position, and a short position.

• Define a forward contract, and summa- rize its advantages and disadvantages.

• Summarize the dif- ferences between a forward contract and a financial futures contract.

• Identify the different types of options con- tracts, and summarize the three conclusions regarding call and put options.

• Define a swap, and summarize the advan- tages and disadvan- tages of interest-rate swaps.

• Summarize the three types of credit derivatives.

14 Financial Derivatives

315

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316 P a r t 3 Financial Institutions

at a future date, then it conducts a hedge by contracting to buy that security (take a long position) at a future date. We look at how this principle can be applied using forward and futures contracts.

intereSt-rate FOrward COntraCtS A forward contract is an agreement between two parties to engage in a financial transaction at a future (forward) point in time. Here we focus on forward contracts that are linked to debt instruments, called interest-rate forward contracts; later in the chapter, we discuss forward contracts for foreign currencies.

Interest-rate forward contracts involve the future sale (or purchase) of a debt instru- ment and have several dimensions: (1) specification of the actual debt instrument that will be delivered at a future date, (2) the amount of the debt instrument to be delivered, (3) the price (or interest rate) to be paid on the debt instrument when it is delivered, and (4) the date on which delivery will take place. An example of an interest-rate forward contract might be an agreement that the First National Bank will sell to the Rock Solid Insurance Company, one year from today, $5 million face value of the 6s of 2035 Treasury bonds (that is, coupon bonds with a 6% coupon rate that mature in 2035) at a price that yields the same interest rate on these bonds as today’s rate—say, 6%. Because Rock Solid will buy the securities at a future date, it is said to have taken a long position, whereas the First National Bank, which will sell the securities on that date, has taken a short position.

A p p li c At i o n Hedging with Interest-Rate Forward Contracts Why would the First National Bank want to enter into this forward contract with Rock Solid Insurance Company in the first place?

To understand, suppose that you are the manager of the First National Bank and that you have bought $5 million of the 6s of 2035 Treasury bonds. The bonds are cur- rently selling at par value, so their yield to maturity is 6%. Because these are long-term bonds, you recognize that you are exposed to substantial interest-rate risk: If interest rates rise in the future, the price of these bonds will fall, resulting in a substantial capital loss that may cost you your job. How do you hedge this risk?

Knowing the basic principle of hedging, you see that your long position in these bonds can be offset by an equal short position for the same bonds with a forward con- tract. That is, you need to contract to sell these bonds at a future date at the current par value price. To ensure that this happens, you form an agreement with another party— in this case, Rock Solid Insurance Company—in which you promise to sell to Rock Solid the $5 million of the 6s of 2035 Treasury bonds at par one year from today. By entering into this forward contract, you have successfully hedged against interest-rate risk. By locking in the future price of the bonds, you have eliminated the price risk that you face from uncertain interest-rate changes.

Why would Rock Solid Insurance Company want to enter into the forward contract with the First National Bank? Rock Solid expects to receive premiums of $5 million in one year’s time that it will want to invest in the 6s of 2035, but worries that interest rates on these bonds will decline between now and next year. By using the forward

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contract, it is able to lock in the 6% interest rate on the Treasury bonds that it will buy from the First National Bank.

Pros and Cons of Forward Contracts The advantage of forward contracts is that they can be as flexible as the parties involved want them to be. This means that an institution like the First National Bank may be able to hedge completely the interest-rate risk on the exact security it is holding in its portfolio, just as it did in our example.

However, forward contracts suffer from two problems that severely limit their usefulness. The first is that it may be very hard for an institution like the First National Bank to find another party (called a counterparty) to make the contract with. There are brokers to facilitate the matching up of parties like the First National Bank and the Rock Solid Insurance Company, but few institutions may want to engage in a forward contract specifically for the 6s of 2035. This means that it may prove impossible to find a counterparty when a financial institution (like the First National Bank) wants to make a specific type of forward contract. Furthermore, even if the First National Bank finds a counterparty, it may not get the price it was hoping for because, if the counterparty is not willing to pay the asking price, there may not be anyone else available to make the deal with. A serious problem for the market in interest-rate forward contracts, then, is that it can be difficult for one party to find another party with which to make a particu- lar financial agreement; even if a willing party is found, the transaction may have to be made at a disadvantageous price. In the parlance of financial economists, this market suffers from a lack of liquidity. (Note that this use of the term liquidity, in which it is applied to a market, is somewhat broader than its use when it is applied to an asset. For an asset, liquidity refers to the ease with which the asset can be turned into cash; for a market, liquidity refers to the ease of carrying out financial transactions.)

The second problem with forward contracts is that they are subject to default risk. Suppose that in one year’s time, interest rates rise, and so the price of the 6s of 2035 falls. The Rock Solid Insurance Company might then decide that it would like to default on the forward contract with the First National Bank, because it can now buy the bonds at the lower price. Or perhaps Rock Solid may not have been rock solid after all, and may have gone bust during the year, and therefore is no longer available to complete the terms of the forward contract. Because no outside organization is guaranteeing the contract, the only recourse is for the First National Bank to go to the courts to sue Rock Solid, but this process will be costly. Furthermore, if Rock Solid is already bankrupt, the First National Bank will suffer a loss; the bank can no longer sell the 6s of 2035 at the price it had agreed on with Rock Solid, but instead will have to sell at a price well below that, because the price of these bonds has fallen.

The presence of default risk in forward contracts means that parties to these con- tracts must check that the counterparty is both financially sound and likely to live up to its contractual obligations. Because this type of investigation is costly, and because all the adverse selection and moral hazard problems discussed in earlier chapters apply, default risk is a major barrier to the use of interest-rate forward contracts. If we consider the dual problems of default risk and lack of liquidity, we see that forward contracts may be of limited usefulness to financial institutions. Although a market does exist for interest-rate forward contracts, particularly in Treasury and mortgage-backed securities, it is not nearly as large as the financial futures market, to which we turn next. ◆

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FinanCiaL FutureS COntraCtS and MarketS Given the default risk and liquidity problems inherent in the interest-rate forward market, another solution to hedging interest-rate risk was needed. The solution was provided by the Chicago Board of Trade when it began developing financial futures contracts in 1975.

A financial futures contract is similar to an interest-rate forward contract in that it specifies that a financial instrument must be delivered by one party to another on a stated future date. However, it differs from an interest-rate forward contract in several ways, and these differences help overcome some of the liquidity and default problems of forward markets.

To understand what financial futures contracts are all about, let’s look at one of the most widely traded futures contracts—that for Treasury bonds, which are traded on the Chicago Board of Trade. The contract value is for $100,000 face value of bonds. Prices are quoted in points, with each point equal to $1,000, and the smallest change in price is 1/32 of a point ($31.25). This contract specifies that the bonds to be delivered must have at least fifteen years to maturity at the delivery date (and also must not be callable—that is, redeemable by the Treasury at its option—in less than fifteen years). If the Treasury bonds delivered to settle the futures contract have a coupon rate different from the (for example) 6% specified in the futures contract, the amount of bonds to be delivered is adjusted to reflect the difference in value between the delivered bonds and the 6% coupon bond. In line with the terminology used for forward contracts, parties who have bought a futures contract and thereby have agreed to buy (take delivery of ) the bonds are said to have taken a long position, and parties who have sold a futures contract and thereby have agreed to sell (deliver) the bonds have taken a short position.

To make our understanding of this type of contract more concrete, let’s consider what happens when you buy or sell a Treasury bond futures contract. Let’s say that on February 1, you sell one $100,000 June contract at a price of 115 (that is, $115,000). By selling this contract, you agree to deliver $100,000 face value of the long-term Trea- sury bonds to the contract’s counterparty at the end of June for $115,000. By buying the contract at a price of 115, the buyer has agreed to pay $115,000 for the $100,000 face value of bonds when you deliver them at the end of June. If interest rates on long- term bonds rise, so that when the contract matures at the end of June, the price of these bonds has fallen to 110 ($110,000 per $100,000 of face value), the buyer of the contract will have lost $5,000, because he or she paid $115,000 for the bonds but can sell them only for the market price of $110,000. But you, the seller of the contract, will have gained $5,000, because you can now sell the bonds to the buyer for $115,000 even though you have to pay only $110,000 for them in the market.

It is even easier to describe what happens to the parties who have purchased futures contracts and those who have sold futures contracts if we recognize the following fact: At the expiration date of a futures contract, the price of the contract converges to the price of the underlying asset to be delivered. To see why this is the case, consider what happens on the expiration date of the contract at the end of June when the price of the underlying $100,000 face value Treasury bond is 110 ($110,000). If the futures contract is selling below 110—say, at 109—a trader can buy the contract for $109,000, take delivery of the bond, and immediately sell it for $110,000, thereby earning a quick profit of $1,000. Because earning this profit involves no risk, it is a great deal that everyone would like to get in on. That means that everyone will try to buy the contract, and as a result, its price will rise. Only when the price rises to 110 will the profit opportunity cease to exist and the buying pressure disappear. Conversely, if the

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C h a p t e r 1 4 Financial Derivatives 319

price of the futures contract is above 110—say, at 111—everyone will want to sell the contract. Now the sellers get $111,000 from selling the futures contract but have to pay only $110,000 for the Treasury bonds that they must deliver to the buyer of the contract, and the $1,000 difference is their profit. Because this profit involves no risk, traders will continue to sell the futures contract until its price falls back down to 110, at which price there are no longer any profits to be made. The elimination of riskless profit opportunities in the futures market is referred to as arbitrage, and it guarantees that the price of a futures contract at expiration equals the price of the underlying asset to be delivered.1

Armed with our knowledge that a futures contract at expiration equals the price of the underlying asset, we can see even more easily who profits and who loses from such a contract when interest rates change. If interest rates have risen, so that the price of the Treasury bond is 110 on the expiration day at the end of June, the June Treasury bond futures contract will also have a price of 110. Thus, if you bought the contract for 115 in February, you have suffered a loss of 5 points, or $5,000 (5% of $100,000). But if you sold the futures contract at 115 in February, the decline in price to 110 means that you have gained a profit of 5 points, or $5,000.

A p p li c At i o n Hedging with Financial Futures The First National Bank can also use financial futures contracts to hedge the interest- rate risk on its holdings of $5 million of the 6s of 2035. To see how, suppose that in March 2016, the 6s of 2035 are the long-term bonds that will be delivered in the Chicago Board of Trade’s T-bond futures contract expiring one year in the future, in March 2017. Also suppose that the interest rate on these bonds is expected to remain at 6% over the next year, so that both the 6s of 2035 and the futures contract are selling at par (i.e., the $5 million of bonds is selling for $5 million and the $100,000 futures contract is selling for $100,000). The basic principle of hedging indicates that you, as the manager of the First National Bank, need to offset the long position in these bonds with a short position, so you have to sell the futures contract. But how many contracts should you sell? The number of contracts required to hedge the interest-rate risk is found by dividing the amount of the asset to be hedged by the dollar value of each contract, as shown in Equation 1:

NC = VA/VC (1)

where NC = number of contracts for the hedge VA = value of the asset VC = value of each contract

Given that the 6s of 2035 are the long-term bonds that will be delivered in the CBT T-bond futures contract expiring one year in the future and that the interest rate on these bonds is expected to remain at 6% over the next year, so that both the 6s of 2035 and the futures contract are selling at par, how many contracts must First National sell

1In actuality, futures contracts sometimes set conditions for the timing and delivery of the underlying assets that cause the price of the contract at expiration to differ slightly from the price of the underlying assets. Because the difference in price is extremely small, we ignore it in this chapter.

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320 P a r t 3 Financial Institutions

to remove its interest-rate risk exposure from its $5 million holdings of the 6s of 2035?2 Since VA = $5 million and VC = $100,000,

NC = $5 million>$100,000 = 50 You therefore hedge the interest-rate risk by selling 50 of the Treasury Bond futures contracts.

Now suppose that over the next year, an increased threat of inflation causes interest rates to increase to 8%. The value of the 6s of 2035 that the First National Bank is hold- ing will then fall to $4,039,640 in March 2017.3 Thus the loss from the long position in these bonds is $960,360:

2In the real world, designing a hedge is somewhat more complicated than indicated by the example here, because the bond that is most likely to be delivered might not be a 6s of 2035. 3The value of the bonds can be calculated using a financial calculator as follows: FV = $5,000,000, PMT = $300,000, I = 8%, N = 19, PV = $4,039,640.

Value on March 2017 @ 8% interest rate $4,039,640

Value on March 2016 @ 6% interest rate -$5,000,000 Loss -$960,360

Amount paid to you on March 2017, agreed upon in March 2016 $5,000,000

Value of bonds delivered on March 2017 @ 8% interest rate -$4,039,640 Gain $960,360

However, the short position in the 50 futures contracts that obligate you to deliver $5 million of the 6s of 2035 on March 2017 has a value equal to $4,039,640, the value of the $5 million of bonds after the interest rate has risen to 8%, as we saw before. Yet when you sold the futures contract, the buyer was obligated to pay you $5 million on the maturity date. Thus the gain from the short position on these contracts is also $960,360:

Therefore, the net gain for the First National Bank is zero, indicating that the hedge has been conducted successfully.

The hedge just described is called a micro hedge because the financial institution is hedging the interest-rate risk for a specific asset it is holding. A second type of hedge that financial institutions engage in is called a macro hedge, in which the hedge is for the institution’s entire portfolio. For example, if a bank has more rate-sensitive liabilities than assets, we learned in Chapter 9 that a rise in interest rates will cause the value of the bank’s net worth to decline. By selling interest-rate futures contracts that will yield a profit when interest rates rise, the bank can offset the losses on its overall portfolio from an interest-rate rise and thereby hedge its interest-rate risk.

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Organization of Trading in Financial Futures Markets Financial futures contracts are traded in the United States on organized exchanges such as the Chicago Board of Trade and the Chicago Mercantile Exchange. The futures exchanges and all trades in financial futures in the United States are regu- lated by the Commodity Futures Trading Commission (CFTC), which was created in 1974 to take over the regulatory responsibilities for futures markets from the Depart- ment of Agriculture. The CFTC oversees futures trading and the futures exchanges to ensure that prices in the market are not being manipulated, and it also registers and audits the brokers, traders, and exchanges to prevent fraud and to ensure the financial soundness of the exchanges. In addition, the CFTC approves proposed futures contracts to make sure that they serve the public interest. Table 1 lists the most widely traded financial futures contracts in the United States, along with their contract size and the number of contracts outstanding, called open interest, for August 2014.

Given the globalization of other financial markets in recent years, it is not surpris- ing that increased competition from abroad has been occurring in financial futures markets as well.

Source: CME Group: http://www.cmegroup.com/market-data/volume-open-interest; click on CME Group Open Interest Report.

Type of Contract Contract Size Open Interest, August 2014

Interest-Rate Contracts

Treasury bonds $100,000 984,935

Treasury notes $100,000 2,753,371

Five-year Treasury notes $100,000 2,192,905

Two-year Treasury notes $200,000 1,377,298

Thirty-day Fed funds rate $5 million 544,115

Eurodollar $4 million 12,988,737

Stock Index Contracts    

Standard & Poor’s 500 Index $250 * index 164,586 Standard & Poor’s MIDCAP 400 $500 * index 835 NASDAQ 100 $100 * index 7,001 Nikkei 225 Stock Average $5 * index 62,676 Currency Contracts    

Yen 12,500,000 yen 226,449

Euro 125,000 euros 413,159

Canadian dollar 100,000 Canadian $ 110,965

British pound 100,000 pounds 234,219

Swiss franc 125,000 francs 57,511

Mexican peso 500,000 new pesos 147,059

table 1 Widely Traded Financial Futures Contracts in the United States

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the globalization of Financial Futures Markets Because the United States was the first country to develop financial futures, American futures exchanges dominated the trading of financial futures in the early 1980s. For example, in 1985, all of the top ten futures contracts were traded on exchanges in the United States. With the rapid growth of financial futures markets and the high profits made by the American futures exchanges, foreign exchanges saw a profit opportunity and began to enter this business. By the 1990s, Eurodollar contracts traded on the Lon- don International Financial Futures Exchange, Japanese government bond contracts and Euroyen contracts traded on the Tokyo Stock Exchange, French government bond contracts traded on the Marché à Terme International de France (now Euronext), and Nikkei 225 contracts traded on the Osaka Securities Exchange all were among the most widely traded futures contracts in the world.

Foreign competition has spurred knockoffs of the most popular financial futures contracts initially developed in the United States. These contracts, which are traded on foreign exchanges, are virtually identical to those traded in the United States and have the advantage that they can be traded when the American exchanges are closed. The movement to 24-hour-a-day trading in financial futures has been further stimulated by the development of the Globex electronic trading platform, which allows traders throughout the world to trade futures even when the exchanges are not officially open. Financial futures trading thus has become completely internationalized, and competi- tion between U.S. and foreign exchanges is now intense.

explaining the Success of Futures Markets The tremendous success of the financial futures market in Treasury bonds alone is evi- dent from the fact that the total open interest of Treasury bond contracts was 984,935 in August 2014, for a total value of $98 billion (984,935 * $100,000). There are several differences between financial futures contracts and forward contracts, and between the organizations of their markets, that help explain why financial futures markets such as those for Treasury bonds have been so successful.

Futures contracts were designed to overcome the liquidity problem inherent in for- ward contracts. They do this in several ways. First, in contrast to forward contracts, the quantities delivered and the delivery dates of futures contracts are standardized, mak- ing it more likely that different parties can be matched in the futures market, thereby increasing the liquidity of the market. In the case of the Treasury bond contract, the quantity delivered is $100,000 face value of bonds, and the delivery dates are set to be the last business days of March, June, September, and December. Second, after the futures contract has been bought or sold, it can be traded (bought or sold) again at any time up until the delivery date. In contrast, once a forward contract is agreed on, it typically cannot be traded. Third, in a futures contract, not just one specific type of Treasury bond is deliverable on the delivery date, as is the case in a forward contract. Instead, any Treasury bond that matures in more than fifteen years and is not callable for fifteen years is eligible for delivery. Allowances for continual trading increase the liquidity of the futures market, as does the option to deliver a range of Treasury bonds rather than one specific type of bond.

Another reason why futures contracts specify that more than one bond is eligible for delivery is to limit the possibility that someone might corner the market and “squeeze” traders who have sold contracts. To corner the market, someone buys up all the deliverable securities so that investors with a short position cannot obtain from

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anyone else the securities that they contractually must deliver on the delivery date. As a result, the person who has cornered the market can set exorbitant prices for the securi- ties that investors with a short position must buy to fulfill their obligations under the futures contract. The person who has cornered the market makes a fortune, but inves- tors with a short position take a terrific loss. Clearly, the possibility that corners might occur in the market will discourage people from taking a short position and might therefore decrease the size of the market. By allowing for the delivery of many different securities, the futures contract makes it harder for any one party to corner the market, because a much larger amount of securities would have to be purchased to establish the corner. Corners are of concern to both regulators and the organized exchanges that design futures contracts.

Trading in the futures market has been organized differently from trading in for- ward markets to overcome the default risk problems inherent in forward contracts. In both types of markets, for every contract, there must be a buyer who is taking a long position and a seller who is taking a short position. However, the buyer and seller of a futures contract make their contract not with each other but with the clearinghouse associated with the futures exchange. This setup means that, in contrast to the forward market, the buyer of the futures contract does not need to worry about the financial health or trustworthiness of the seller, and vice versa. As long as the clearinghouse is financially solid, buyers and sellers of futures contracts do not have to worry about default risk.

To make sure that the clearinghouse is financially sound and does not run into financial difficulties that might jeopardize its contracts, buyers or sellers of futures contracts must put an initial deposit, called a margin requirement, of perhaps $2,000 per Treasury bond contract into a margin account kept at their brokerage firm. Futures contracts are then marked to market every day: At the end of every trading day, the change in the value of the futures contract is added to or subtracted from the margin account. Suppose that after you buy a Treasury bond contract at a price of 115 on Wednesday morning, its closing price at the end of the day, the settlement price, falls to 114. You now have a loss of 1 point, or $1,000, on the con- tract, and the seller who sold you the contract has a gain of 1 point, or $1,000. The $1,000 gain is added to the seller’s margin account, making a total of $3,000 in that account, and the $1,000 loss is subtracted from your account, so that you now have only $1,000 in your account. If the amount in this margin account falls below the maintenance margin requirement (which can be the same as the initial requirement, but is usually a little less), the trader is required to add money to the account. For example, if the maintenance margin requirement is also $2,000, you will have to add $1,000 to your account to bring it up to $2,000. Margin requirements and marking to market make it far less likely that a trader will default on a contract, thus protecting the futures exchange from losses.

A final advantage that futures markets have over forward markets is that most futures contracts do not end in delivery of the underlying asset on the expiration date, whereas forward contracts do. A trader who sold a futures contract is allowed to avoid delivery on the expiration date by making an offsetting purchase of a futures contract. Because the simultaneous holding of the long and short positions means that the trader would in effect be delivering the bonds to itself, under the exchange rules the trader is allowed to cancel both contracts. Allowing traders to cancel their contracts in this way lowers the cost of conducting trades in the futures market relative to the forward market: a futures trader can avoid the costs of physical delivery, something that is not so easy to do with forward contracts.

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A p p li c At i o n Hedging Foreign Exchange Risk As we discussed in Chapter 1, foreign exchange rates have been highly volatile in recent years. The large fluctuations in exchange rates subject financial institutions and other businesses to significant foreign exchange risk because such fluctuations generate substantial gains and losses. Luckily for financial institution managers, the financial derivatives discussed in this chapter—forward and financial futures con- tracts—can be used to hedge foreign exchange risk.

To understand how financial institution managers manage foreign exchange risk, let’s suppose that in January, the First National Bank’s customer Frivolous Luxuries, Inc., is due a payment of 10 million euros in two months for $10 million worth of goods it has just sold in Germany. Frivolous Luxuries is concerned that if the value of the euro falls substantially from its current value of $1, the company might suffer a large loss because the 10 million euro payment will no longer be worth $10 million. So Sam, the CEO of Frivolous Luxuries, calls his friend Mona, the manager of the First National Bank, and asks her to hedge this foreign exchange risk for his company. Let’s see how the bank manager could do this by using either forward or financial futures contracts.

Hedging Foreign exchange risk with Forward Contracts Forward markets in foreign exchange have been highly developed by commercial banks and investment banking operations that engage in extensive foreign exchange trading and are widely used to hedge foreign exchange risk. Mona knows that she can use this market to hedge the foreign exchange risk for Frivolous Luxuries. Such a hedge is quite straightforward for her to execute. Because the payment of euros in two months means that Sam will hold a long position in euros at that time, Mona knows that the basic prin- ciple of hedging indicates that she should offset this long position by a short position. Thus she simply enters a forward contract that obligates her to sell 10 million euros two months from now in exchange for dollars at the current forward rate of $1 per euro.4

In two months, when her customer receives the 10 million euros, the forward con- tract ensures that they will be exchanged for dollars at an exchange rate of $1 per euro, thus yielding $10 million. No matter what happens to future exchange rates, Frivolous Luxuries will be guaranteed $10 million for the goods it sold in Germany. Mona calls her friend Sam to let him know that his company is now protected from any foreign exchange movements, and he thanks her for her help.

Hedging Foreign exchange risk with Futures Contracts As an alternative, Mona can use the currency futures market to hedge the foreign exchange risk. In this case, she will do some research and find that the Chicago Mer- cantile Exchange has a euro contract with a contract amount of 125,000 euros and a price of $1 per euro. To conduct the hedge, Mona must sell euros as with the forward

4The forward exchange rate will probably differ slightly from the current spot rate of $1 per euro because the interest rates in Germany and the United States probably will not be equal. In that case, as we will see from the interest parity condition in the Chapter 20 Appendix, the future expected exchange rate will not equal the current spot rate, and neither will the forward rate. However, since interest differentials have typically been less than 6% at an annual rate (1% bimonthly), the expected appreciation or depreciation of the euro over a two-month period has always been less than 1%. Thus the forward rate is always close to the current spot rate, and our assumption in the example that the forward rate and the spot rate are the same is a reasonable one.

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contract, to the tune of 10 million euros of the March futures. How many of the Chicago Mercantile Exchange March euro contracts must Mona sell to hedge the 10 million euro payment due in March?

Using Equation 1 with VA = 10 million euros and VC = 125,000 euros, we get:

NC = 10 million>125,000 = 80 Thus Mona conducts the hedge by selling 80 of the CME euro contracts. Given the $1-per-euro price, the sale of the contract yields 80 * 125,000 euros = $10 million. This futures hedge enables her to lock in the exchange rate for Frivolous Luxuries so that it gets its payment of $10 million.

One advantage of using the futures market is that the contract size of 125,000 euros, worth $125,000, is quite a bit smaller than the minimum size of a forward contract, which is usually $1 million or more. However, in this case, the bank manager is making a large enough transaction that she can use either the forward or the futures market. Her choice depends on whether the transaction costs are lower in one market than in the other. If the First National Bank is active in the forward market, that market would prob- ably have the lower transaction costs. If First National rarely deals in foreign exchange forward contracts, Mona might do better by sticking with the futures market. ◆

OPtiOnS Another vehicle for hedging interest-rate and stock market risk involves the use of options on financial instruments. Options are contracts that give the purchaser the option, or right, to buy or sell the underlying financial instrument at a specified price, called the exercise price or strike price, within a specific period of time (the term to expiration). The seller (sometimes called the writer) of the option is obligated to buy or sell the financial instrument from or to the purchaser if the owner of the option exer- cises the right to sell or buy. These option contract features are important enough to be emphasized: The owner or buyer of an option does not have to exercise the option; he or she can let the option expire without using it. Hence the owner of an option is not obligated to take any action, but rather has the right to exercise the contract if he or she so chooses. The seller of an option, by contrast, has no choice in the matter; he or she must buy or sell the financial instrument if the owner exercises the option.

Because the right to buy or sell a financial instrument at a specified price has value, the owner of an option is willing to pay an amount, called a premium, for this right. Option contracts are of two types: American options can be exercised at any time up to the expiration date of the contract, and European options can be exercised only on the expiration date.

Option contracts are written on a number of financial instruments. Options on individual stocks are called stock options, and such options have existed for a long time. Option contracts on financial futures, called financial futures options or, more commonly, futures options, were developed in 1982 and have become the most widely traded option contracts.

You might wonder why option contracts are more likely to be written on financial futures than on underlying debt instruments such as bonds or certificates of deposit. As we saw earlier in the chapter, on the expiration date, the price of the futures contract and that of the deliverable debt instrument will be the same because of arbitrage. So it would seem that investors should be indifferent about having the option written on

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the debt instrument or on the futures contract. However, financial futures contracts have been so well designed that their markets are often more liquid than the markets in the underlying debt instruments. So investors would rather have the option contract written on the more liquid instrument—in this case, the futures contract. This explains why the most popular futures options are written on many of the same futures contracts listed in Table 1.

The regulation of options markets is split between the Securities and Exchange Commission (SEC), which regulates stock options, and the Commodity Futures Trad- ing Commission (CFTC), which regulates futures options. Regulation focuses on ensuring that writers of options have enough capital to make good on their contractual obligations and on overseeing traders and exchanges to prevent fraud and to ensure that the market is not being manipulated.

Option Contracts A call option is a contract that gives the owner the right to buy a financial instrument at the exercise price within a specific period of time. A put option is a contract that gives the owner the right to sell a financial instrument at the exercise price within a specific period of time.

Remembering which option is a call option and which is a put option is not always easy. To keep them straight, just remember that having a call option to buy a financial instrument is the same as having the option to call in the instrument for delivery at a specified price. Having a put option to sell a financial instrument is the same as having the option to put up an instrument for the other party to buy at a specified price.

Profits and Losses on Option and Futures Contracts To understand option contracts more fully, let’s first examine the option on the same June Treasury bond futures contract that we looked at earlier in the chapter. Recall that if you bought this futures contract at a price of 115 (that is, $115,000), you agreed to pay $115,000 for $100,000 face value of long-term Treasury bonds when they are delivered to you at the end of June. If you sold this futures contract at a price of 115, you agreed, in exchange for $115,000, to deliver $100,000 face value of the long-term Treasury bonds at the end of June. An option contract on the Treasury bond futures contract has several key features: (1) It has the same expiration date as the underlying futures contract; (2) it is an American option and so can be exercised at any time before the expiration date; and (3) the premium (price) of the option is quoted in points that mimic the futures contract, so each point corresponds to $1,000. If, for a premium of $2,000, you buy one call option contract on the June Treasury bond contract with an exercise price of 115, you have purchased the right to buy (call in) the June Treasury bond futures contract for a price of 115 ($115,000 per contract) at any time until the expiration date of this contract at the end of June. Similarly, if you buy for $2,000 a put option on the June Treasury bond contract with an exercise price of 115, you have the right to sell (put up) the June Treasury bond futures contract for a price of 115 ($115,000 per contract) at any time until the end of June.

Futures option contracts are somewhat complicated, so to explore how they work and how they can be used to hedge risk, let’s first examine how profits and losses occur on the call option on the June Treasury bond futures contract. In February, our old friend Irving the Investor buys, for a $2,000 premium, a call option on the $100,000 June Treasury bond futures contract with a strike price of 115. (We will assume that if

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Irving exercises the option, he does so on the expiration date at the end of June and not before.) Suppose that the underlying Treasury bond for the futures contract has a price of 110 on the expiration date at the end of June. Recall that on the expiration date, arbitrage forces the price of the futures contract to be the same as the price of the underlying bond, so the contract also has a price of 110 on the expiration date at the end of June. If Irving exercises the call option and buys the futures contract at an exercise price of 115, he will lose money by buying at 115 and selling at the lower market price of 110. Because Irving is smart, he will not exercise the option, but he will be out the $2,000 premium he paid. In such a situation, in which the price of the underlying financial instrument is below the exercise price, a call option is said to be “out of the money.” At the price of 110 (less than the exercise price), Irving thus suffers a loss on the option contract of the $2,000 premium he paid. This loss is plotted as point A in panel (a) of Figure 1.

Buyer of Futures

Buyer of Call Option

Price of Futures Contract at Expiration ($)

Profit ($)

Loss ($) Loss ($)

(a) Pro�t or loss for buyer of call option and buyer of futures

A9

A B

B9

C

C9

D9

D

110 120 125 0

2,000

4,000

6,000

8,000

12,000

Profit ($)

12,000

10,000

22,000

24,000

26,000

– 8,000

212,000 212,000

210,000 Seller of Futures

Buyer of Put Option

Price of Futures Contract at Expiration ($)

(b) Pro�t or loss for buyer of put option and seller of futures

A9

A

B

B9

C

C9

D9

D

110 120 125 0

2,000

4,000

6,000

8,000

10,000

22,000

24,000

26,000

28,000

210,000

115 115

Figure 1 Profits and Losses on Options Versus Futures Contracts

MyEconLab Mini-lecture

The futures contract is the $100,000 June Treasury bond contract, and the option contracts are written on this futures contract with an exercise price of 115. Panel (a) shows the profits and losses for the buyer of the call option and the buyer of the futures contract, and panel (b) shows the profits and losses for the buyer of the put option and the seller of the futures contract.

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On the expiration date, if the price of the futures contract is 115, the call option is “at the money,” and Irving is indifferent regarding his option to buy the futures contract, because exercising the option at 115 when the market price is also at 115 produces no gain or loss. Because he has paid the $2,000 premium, at the price of 115 his contract again has a net loss of $2,000, plotted as point B. If the futures contract instead has a price of 120 on the expiration day, the option is “in the money,” and Irving benefits from exercising the option: He will buy the futures contract at the exercise price of 115 and then sell it for 120, thereby earning a 5-point gain ($5,000 profit) on the $100,000 Treasury bond contract. Because Irving paid a $2,000 premium for the option contract, however, his net profit is $3,000 ($5,000 - $2,000). The $3,000 profit at a price of 120 is plotted as point C. Similarly, if the price of the futures contract rises to 125, the option contract will yield a net profit of $8,000 ($10,000 from exercising the option minus the $2,000 premium), plotted as point D. Connecting these points, we get the kinked profit curve for the call option that we see in panel (a).

Suppose that instead of purchasing the futures option contract in February, Irving decides instead to buy the $100,000 June Treasury bond futures contract at the price of 115. If the price of the bond on the expiration day at the end of June declines to 110, meaning that the price of the futures contract also falls to 110, Irving suffers a loss of 5 points, or $5,000. The loss of $5,000 on the futures contract at a price of 110 is plot- ted as point A′ in panel (a). At a price of 115 on the expiration date, Irving will have a zero profit on the futures contract, plotted as point B′. At a price of 120, Irving will have a profit of 5 points on the contract, or $5,000 (point C′), and at a price of 125, the profit will be 10 percentage points, or $10,000 (point D′). Connecting these points, we get the linear (straight-line) profit curve for the futures contract, graphed in panel (a).

Now we can see the major difference between a futures contract and an option contract. As indicated by the profit curve for the futures contract in panel (a), the futures contract has a linear profit function: Profits grow by an equal dollar amount for every point increase in the price of the underlying financial instrument. By contrast, the kinked profit curve for the option contract is nonlinear, meaning that profits do not always grow by an equal dollar amount with a given change in the price of the underlying financial instrument. This nonlinearity indicates that the call option protects Irving from suffering losses that are greater than the amount of the $2,000 premium. In contrast, Irving’s loss on the futures contract is $5,000 if the price on the expiration day falls to 110, and if the price falls even further, Irving’s loss will be even greater. This insurance-like feature of option contracts explains why their purchase price is referred to as a premium. Once the underlying financial instrument’s price rises above the exer- cise price, however, Irving’s profits will grow linearly. Irving has given up something by buying an option rather than a futures contract. As we see in panel (a), when the price of the underlying financial instrument rises above the exercise price, Irving’s profits are always less than the profits he would have made on the futures contract—by exactly the $2,000 premium he paid.

Panel (b) plots the results of the same profit calculations if Irving buys not a call option but a put option (an option to sell) with an exercise price of 115 for a premium of $2,000, and if he sells the futures contract rather than buying it. In this case, if on the expiration date the Treasury bond futures have a price above the 115 exercise price, the put option is “out of the money.” Irving will not want to exercise the put option because by doing so he would have to sell the futures contract he owns at a price below the market price, and he would lose money. He therefore will not exercise his option, and he will be out only the $2,000 premium he paid. Once the price of the futures contract falls below the 115 exercise price, Irving benefits from exercising the put

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option because he can sell the futures contract at a price of 115 but can buy it at a price less than 115. In such a situation, in which the price of the underlying instrument is below the exercise price, the put option is “in the money,” and profits rise linearly as the price of the futures contract falls. The profit function for the put option illustrated in panel (b) of Figure 1 is kinked, indicating that Irving is protected from losses greater than the amount of the premium he paid. The profit curve for the sale of the futures contract is just the negative of the profit curve for the futures contract in panel (a), and is therefore linear.

Panel (b) of Figure 1 confirms the conclusion from panel (a) that profits on option contracts are nonlinear, but profits on futures contracts are linear.

Two additional differences between futures and option contracts must be men- tioned. The first is that the initial investment on the two types of contracts differs. As we saw earlier in the chapter, when a futures contract is purchased, the investor must put a fixed amount, called the margin requirement, into a margin account. But when an option contract is purchased, the initial investment is the premium that is paid for the contract. The second important difference between the contracts is that with a futures contract, money changes hands daily when the contract is marked to market, whereas with an option contract, money changes hands only when the option is exercised.

A p p li c At i o n Hedging with Futures Options Earlier in the chapter, we saw how the First National Bank could hedge the interest- rate risk on its $5 million holdings of 6s of 2035 by selling $5 million of T-bond futures. A rise in interest rates and the resulting fall in bond prices and bond futures contracts would lead to profits on the bank’s sale of the futures contracts that would exactly offset the losses on the 6s of 2035 that the bank is holding.

As suggested in panel (b) of Figure 1, an alternative way for the manager to protect against a rise in interest rates and hence a decline in bond prices is to buy $5 million of put options written on the same Treasury bond futures. As long as the exercise price is not too far from the current price, as in panel (b), the rise in interest rates and decline in bond prices will lead to profits on the futures and the futures put options, profits that will offset any losses on the $5 million of Treasury bonds.

The one problem with using options rather than futures is that the First National Bank will have to pay premiums on the options contracts, thereby lowering the bank’s profits in an effort to hedge the interest-rate risk. Why might the bank manager be willing to use options rather than futures to conduct the hedge? The answer is that the option contract, unlike the futures contract, allows the First National Bank to gain if interest rates decline and bond prices rise. With the hedge using futures contracts, the First National Bank does not gain from increases in bond prices because the prof- its on the bonds it is holding are offset by the losses from the futures contracts it has sold. However, as indicated in panel (b) of Figure 1, the situation when the hedge is conducted with put options is quite different: Once bond prices rise above the exercise price, the bank does not suffer additional losses on the option contracts. At the same time, the value of the Treasury bonds the bank is holding will increase, thereby lead- ing to a profit for the bank. Thus by using options rather than futures to conduct the micro hedge, the bank can protect itself from rises in interest rates but will still benefit from interest-rate declines (although the bank’s profit will be reduced by the amount of the premium).

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Similar reasoning indicates that the bank manager might prefer to use options to conduct the macro hedge to immunize the entire bank portfolio from interest-rate risk. Again, by using options rather than futures, the First National Bank will have to pay the premiums on these contracts up front. By contrast, the use of options allows the bank to keep the gains from a decline in interest rates (which will raise the value of the bank’s assets relative to its liabilities), because these gains will not be offset by large losses on the option contracts.

In the case of a macro hedge, there is another reason why the bank might prefer option contracts to futures contracts. Profits and losses on futures contracts can cause accounting problems for banks because such profits and losses are not allowed to be offset by changes in the value of the rest of the bank’s portfolio that are not yet real- ized by the actual sale of the assets. Consider what happens if interest rates fall. If First National sells futures contracts to conduct the macro hedge, then if interest rates fall and the prices of the Treasury bond futures contracts rise, the bank will suffer large losses on these contracts. Of course, these losses will be offset by profits in the rest of the bank’s portfolio that are not yet realized by actual sale of the assets, but the bank is not allowed to offset these losses in its accounting statements. So even though the macro hedge is serving its intended purpose of immunizing the bank’s portfolio from interest-rate risk, the bank will experience large accounting losses if interest rates fall. Indeed, bank managers have lost their jobs when perfectly sound hedges with interest-rate futures generated large accounting losses. Not surprisingly, for this reason bank managers might shrink from using financial futures to conduct macro hedges.

Futures options, however, can come to the rescue of the managers of banks and other financial institutions. Suppose that First National conducts the macro hedge by buying put options rather than selling Treasury bond futures. Now, if interest rates fall and bond prices rise well above the exercise price, the bank will not suffer large losses on the option contracts because it will just decide not to exercise its options. The bank will not suffer the accounting problems that it would have suffered if it had hedged with financial futures. Because of the accounting advantages of using futures options to conduct macro hedges, option contracts have become important tools for financial institution managers who are looking to hedge interest-rate risk.

Factors affecting Option Premiums Several interesting facts can be noted about how the premiums on option contracts are priced. First, when the strike (exercise) price for a contract is set at a higher level, the premium for the call option is lower and the premium for the put option is higher. For example, in going from a contract with a strike price of 112 to one with a strike price of 115, the premium for a call option for the month of March might fall from 14564 to

16 64,

and the premium for the March put option might rise from 1964 to 1 54 64.

Our understanding of the profit function for option contracts, illustrated in Figure 1, helps explain this fact. As we saw in panel (a), a lower price for the underlying financial instrument (in this case, a Treasury bond futures contract) relative to the option’s exer- cise price results in lower profits on the call (buy) option. Thus, the higher the strike price, the lower the profits on the call option contract and the lower the premium that investors like Irving will be willing to pay. Similarly, we saw in panel (b) that a lower price for the underlying financial instrument relative to the exercise price increases profits on the put (sell) option, so that a higher strike price increases profits and thus causes the premium to increase.

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Second, as the period of time over which the option can be exercised (the term to expiration) increases, the premiums for both call and put options rise. For example, at a strike price of 112, the premium on a call option might increase from 14564 in March to 15064 in April to 2

28 64 in May. Similarly, the premium on a put option might increase

from 1964 in March to 1 43 64 in April to 2

22 64 in May. The fact that the premium increases with

increases in the term to expiration is also explained by the nonlinear profit function for option contracts. As the term to expiration lengthens, there is a greater chance that the price of the underlying financial instrument will be very high or very low on the expiration date. If the price becomes very high and goes well above the exercise price, the call (buy) option will yield a high profit; if the price becomes very low and goes well below the exercise price, the losses will be small because the owner of the call option will simply decide not to exercise the option. The possibility of greater variability of the price of the underlying financial instrument as the term to expiration lengthens raises profits, on average, for the call option.

Similar reasoning tells us that the put (sell) option also becomes more valuable as the term to expiration increases, because the possibility of greater price variability of the underlying financial instrument increases as the term to expiration increases. The greater chance of a low price increases the chance that profits on the put option will be very high. But the greater chance of a high price does not increase the chance of substantial losses on the put option, because the owner again will just decide not to exercise the option.

We can think about this feature of option contracts in another way: Option contracts have an element of “heads, I win; tails, I don’t lose too badly.” The greater variability of the final price on the expiration date increases the value of both kinds of options. Because a longer term to the expiration date leads to greater variability in the final price on the expiration date, a longer term to expiration raises the value of an option contract.

The reasoning we just developed explains another important fact about option premi- ums. When the volatility of the price of the underlying instrument is great, the premiums on both call and put options are higher. Higher volatility of price means that, for a given expiration date, there will again be greater variability in the final price on the expiration date. The “heads, I win; tails, I don’t lose too badly” property of options implies that the greater variability of possible prices on the expiration date increases average profits for the option and thus increases the premium that investors are willing to pay.

Summary Our analysis in this application leads us to the following conclusions about the factors that determine the premium on an option contract:

1. The higher the strike price, everything else being equal, the lower the premium on call (buy) options and the higher the premium on put (sell) options.

2. The greater the term to expiration, everything else being equal, the higher the pre- miums on both call and put options.

3. The greater the volatility of prices of the underlying financial instrument, every- thing else being equal, the higher the premiums on both call and put options.

The results we have derived here appear in more formal models, such as the Black- Scholes model, that analyze how the premiums on options are priced. You might study such models in finance courses. ◆

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SwaPS In addition to forwards, futures, and options, financial institutions use one other impor- tant financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments (not assets) that it owns for another set of payments that are owned by another party. Swaps are of two basic kinds. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency.

interest-rate Swap Contracts Interest-rate swaps are an important tool for managing interest-rate risk. They first appeared in the United States in 1982, when, as we have seen, demand increased for financial instruments that could be used to reduce interest-rate risk. The most common type of interest-rate swap (called the plain vanilla swap) specifies (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges will continue to be made. There are many other, more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap. Figure 2 illustrates an interest-rate swap between the Midwest Sav- ings Bank and the Friendly Finance Company. Midwest Savings agrees to pay Friendly Finance a fixed rate of 5% on $1 million of notional principal for the next ten years, and Friendly Finance agrees to pay Midwest Savings the one-year Treasury bill rate plus 1% on $1 million of notional principal for the same period. Thus, as shown in Figure 2, every year the Midwest Savings Bank will pay the Friendly Finance Company 5% on $1 million, while Friendly Finance will pay Midwest Savings the one-year T-bill rate plus 1% on $1 million.

Midwest Savings Bank

Fixed rate over

ten-year period 5% 3 $1 million

Variable rate over

ten-year period (T-bill 1 1%) 3 $1 million

Pays

Receives

Friendly Finance Company

Receives

Pays

Figure 2 interest-rate Swap Payments In this swap arrangement, with a notional principal of $1 million and a term of ten years, the Midwest

Savings Bank agrees to pay a fixed rate of 5% * $1 million to the Friendly Finance Company, which in turn agrees to pay the one-year Treasury bill rate plus 1% * $1 million to the Midwest Savings Bank.

MyEconLab Mini-lecture

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C h a P t e r 1 4 Financial Derivatives 333

A p p li c At i o n Hedging with Interest-Rate Swaps You might wonder why these two parties would find it advantageous to enter into this swap agreement. The answer is that it may help both of them hedge interest-rate risk.

Suppose that Midwest Savings Bank, which tends to borrow short-term and then lend long-term in the mortgage market, has $1 million less of rate-sensitive assets than it has of rate-sensitive liabilities. As we learned in Chapter 9, this situation means that as interest rates rise, the increase in the cost of funds (liabilities) will be greater than the increase in interest payments the bank receives on its assets, many of which are fixed-rate. Rising interest rates thus will lead to a shrinking of Midwest Savings’ net interest margin and a decline in its profitability. As we saw in Chapter 9, to avoid this interest-rate risk, Midwest Savings would like to convert $1 million of its fixed- rate assets into $1 million of rate-sensitive assets, in effect making rate-sensitive assets equal to rate-sensitive liabilities, thereby eliminating the gap. This is exactly what hap- pens when Midwest Savings engages in the interest-rate swap. By taking $1 million of its fixed-rate income and exchanging it for $1 million of rate-sensitive Treasury bill income, it has converted income on $1 million of fixed-rate assets into income on $1 million of rate-sensitive assets. Now, when interest rates rise, the increase in rate- sensitive income on the bank’s assets will exactly match the increase in the rate-sensitive cost of funds on its liabilities, leaving the net interest margin and bank profitability unchanged.

The Friendly Finance Company, which issues long-term bonds to raise funds and uses them to make short-term loans, finds itself in exactly the opposite situation of Midwest Savings: It has $1 million more of rate-sensitive assets than of rate-sensitive liabilities. It is therefore concerned that a fall in interest rates, which will result in a larger drop in income from its assets than the decline in the cost of funds on its liabilities, will cause a decline in profits. By conducting the interest-rate swap, Friendly Finance eliminates this interest-rate risk because it has converted $1 million of rate-sensitive income into $1 million of fixed-rate income. Now the Friendly Finance Company finds that when interest rates fall, the decline in rate-sensitive income is smaller and so is matched by the decline in the rate-sensitive cost of funds on its liabilities, leaving its profitability unchanged.

advantages of interest-rate Swaps To eliminate interest-rate risk, both the Midwest Savings Bank and the Friendly Finance Company could have rearranged their balance sheets by converting fixed-rate assets into rate-sensitive assets, and vice versa, instead of engaging in an interest-rate swap. However, this strategy would have been costly for both financial institutions for sev- eral reasons. First, financial institutions incur substantial transaction costs when they rearrange their balance sheets. Second, different financial institutions have different informational advantages and often make loans to select customers who prefer certain maturities. Thus, by adjusting the balance sheet to eliminate interest-rate risk, the institution might lose these informational advantages, which most financial institutions are unwilling to give up. Interest-rate swaps solve these problems for financial institu- tions because, in effect, they allow the institutions to convert fixed-rate assets into rate- sensitive assets without affecting the balance sheet. Large transaction costs are avoided, and the financial institutions can continue to use their informational advantage to make loans to preferred customers.

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We have learned that financial institutions can also hedge interest-rate risk with other financial derivatives, such as futures contracts and futures options. Interest-rate swaps have one big advantage over these other derivatives: They can be written for very long horizons, sometimes as long as twenty years, whereas financial futures and futures options typically have much shorter horizons, usually not much more than a year. If a financial institution needs to hedge interest-rate risk for a long horizon, financial futures and option markets may not do it much good. Instead, it can turn to the swap market.

disadvantages of interest-rate Swaps Although interest-rate swaps have important advantages that make them very popular with financial institutions, they also have weaknesses that limit their usefulness. Swap markets, like forward markets, can suffer from a lack of liquidity. Let’s return to the swap between the Midwest Savings Bank and the Friendly Finance Company. As is sometimes the case with a forward contract, it might be difficult for the Midwest Sav- ings Bank to link up with the Friendly Finance Company to arrange the swap. In addi- tion, even if the Midwest Savings Bank is able to find a willing counterparty like the Friendly Finance Company, it might not be able to negotiate a good deal because it has no other institution with which to negotiate.

Swap contracts also are subject to the same default risk as forward contracts. If interest rates rise, the Friendly Finance Company would love to get out of the swap contract, because the fixed-rate interest payments it receives are less than the rates it could get in the open market. It might then default on the contract, exposing Midwest Savings to a loss. Alternatively, the Friendly Finance Company could go bust, meaning that the terms of the swap contract would not be fulfilled.

Financial intermediaries in interest-rate Swaps As we have just seen, financial institutions do have to be aware of the possibility of losses from a default on swaps. As with a forward contract, each party to a swap must have a lot of information about the other party to make sure that the contract is likely to be ful- filled. The need for information about counterparties and the liquidity problems in swap markets can limit the usefulness of these markets. However, as we saw in Chapter 8, when informational and liquidity problems crop up in a market, financial intermediaries come to the rescue. That is exactly what happens in swap markets. Intermediaries such as investment banks and especially large commercial banks are able to acquire informa- tion cheaply about the creditworthiness and reliability of parties to swap contracts, and are also able to match parties to a swap. Hence large commercial banks and investment banks have set up swap markets in which they act as intermediaries. ◆

Credit deriVatiVeS In recent years, a new type of derivative to hedge credit risk has arrived on the scene. Like other derivatives, credit derivatives offer payoffs on previously issued securities, but only on securities that bear credit risk. In the past ten years, the markets in credit derivatives have grown at an astounding pace, and the notional amounts of these deriv- atives now number in the trillions of dollars. These credit derivatives take several forms.

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Credit Options Credit options work just like the options discussed earlier in the chapter: For a fee, the purchaser gains the right to receive profits that are tied either to the price of an underlying security or to an interest rate. Suppose you buy $1 million of General Motors bonds but worry that a potential slowdown in the sale of SUVs might lead a credit-rating agency to downgrade (lower the credit rating on) GM bonds. As we saw in Chapter 6, such a downgrade would cause the price of GM bonds to fall. To protect yourself, you could buy an option—for, say, $15,000—to sell the $1 million of bonds at a strike price that is the same as the current price. With this strategy, you would not suffer any losses if the value of the GM bonds declined because you could exercise the option and sell them at the price you paid for them. In addition, you would be able to reap any gains if GM bonds rose in value.

The second type of credit option ties profits to changes in an interest rate, such as a credit spread (the interest rate on the average bond with a particular credit rating minus the interest rate on default-free bonds, such as those issued by the U.S. Trea- sury). Suppose that your company, which has a Baa credit rating, plans to issue $10 million of one-year bonds in three months and expects to have a credit spread of 1 percentage point (i.e., it will pay an interest rate that is 1 percentage point higher than the one-year Treasury rate). You are concerned that the market might start to think that Baa companies in general will become riskier in the coming months. If this were to happen by the time you are ready to issue your bonds in three months, you would have to pay a higher interest rate than the 1 percentage point in excess of the Treasury rate, and your cost of issuing the bonds would increase. To protect yourself against these higher costs, you could buy—for, say, $20,000—a credit option on $10 million of Baa bonds that would pay you the difference between the average Baa credit spread in the market and the 1 percentage point credit spread on $10 million. If the credit spread jumps to 2 percentage points, you would receive $100,000 from the option ( = [2% - 1%] * $10 million), which would exactly offset the $100,000 higher interest costs from the 1 percentage point higher interest rate you would have to pay on your $10 million of bonds.

Credit Swaps Suppose you manage a bank in Houston called Oil Drillers’ Bank (ODB), which spe- cializes in lending to a particular industry in your local area, oil drilling companies. Another bank, Potato Farmers Bank (PFB), specializes in lending to potato farmers in Idaho. Both ODB and PFB have a problem because their loan portfolios are not suf- ficiently diversified. To protect ODB against a collapse in the oil market, which would result in defaults on most of its loans made to oil drillers, you could reach an agree- ment to have the loan payments on, say, $100 million worth of your loans to oil drillers paid to the PFB in exchange for PFB paying you the loan payments on $100 million of its loans to potato farmers. Such a transaction, in which risky payments on loans are swapped for each other, is called a credit swap. As a result of this swap, ODB and PFB have increased their diversification and lowered the overall risk of their loan portfolios because some of the loan payments to each bank are now coming from a different type of loan.

Another form of credit swap is, for arcane reasons, called a credit default swap, although it functions more like insurance. With a credit default swap, one party that wants to hedge credit risk pays a fixed payment on a regular basis in return for a

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336 P a r t 3 Financial Institutions

contingent payment that is triggered by a credit event, such as the bankruptcy of a particular firm or the downgrading of the firm’s credit rating by a credit-rating agency. For example, you could use a credit default swap to hedge the $1 million of General Motors bonds that you are holding by arranging to pay an annual fee of $1,000 in exchange for a payment of $10,000 if the GM bonds’ credit rating is lowered. If a credit event happens and GM’s bonds are downgraded so that their price falls, you will receive a payment that will offset some of the loss you will suffer if you sell the bonds at this lower price.

Credit-Linked notes Another type of credit derivative, the credit-linked note, is a combination of a bond and a credit option. Just like any corporate bond, the credit-linked note makes peri- odic coupon (interest) payments and a final payment of the face value of the bond at maturity. If a key financial variable specified in the note changes, however, the issuer of the note has the right (option) to lower the payments on the note. For example, General Motors could issue a credit-linked note that pays a 5% coupon rate with the specification that if a national index of SUV sales falls by 10%, then GM has the right to lower the coupon rate by 2 percentage points, to 3%. In this way, GM can lower its risk because when it is losing money as SUV sales fall, it can offset some of these losses by making smaller payments on its credit-linked notes.

A p p li c At i o n Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Ticking Time Bomb? Although financial derivatives can be useful in hedging risk, the AIG blowup dis- cussed in the previous chapter illustrates that they can pose a real danger to the finan- cial system. Indeed, Warren Buffet warned about the dangers of financial derivatives by characterizing them as “financial weapons of mass destruction.” Particularly scary are the notional amounts of derivatives contracts—more than $700 trillion world- wide. How can we tell when financial derivatives are likely to be a ticking time bomb that might explode at any minute, bringing down the world financial system? We can find some answers by studying the recent global financial crisis.

Two major concerns surround financial derivatives. The first is that financial derivatives allow financial institutions to increase their leverage; that is, these insti- tutions can, in effect, hold an amount of the underlying asset that is many times greater than the amount of money they had to put up. Increasing their leverage enables them to take huge bets, which, if the bets turn sour, can bring down the institution. This is exactly what AIG did, to its great regret, when it plunged into the credit default swap market. Even more of a problem was the fact that AIG’s specula- tion in the credit default swap (CDS) market had the potential to bring down the whole global financial system. An important lesson from the global financial crisis is that allowing one player to take huge positions in a derivatives market is a highly dangerous move.

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A second concern is that banks often hold huge notional amounts of financial derivatives—in particular, interest-rate and currency swaps—that greatly exceed the amount of bank capital, and so these derivatives might expose the banks to serious risk of failure. Banks are indeed major players in the financial derivatives markets, particu- larly in the interest-rate and currency swaps markets. Our earlier analysis showed that banks are the natural market makers because they can act as intermediaries between two counterparties that would not necessarily be able to make a swap without the bank’s involvement. However, looking at the notional amount of interest-rate and cur- rency swaps at banks gives us a very misleading picture of the banks’ risk exposure. Because banks act as intermediaries in the swap markets, they typically are exposed only to credit risk—the risk of default by one of their counterparties. Furthermore, these swaps, unlike loans, do not involve payments of the notional amount, but rather much smaller payments that are based on the notional amount. For example, in the case of a 7% interest rate, the payment is only $70,000 for a $1 million swap. Estimates of the credit risk exposure from swap contracts indicate that they are on the order of only 1% of the notional value of the contracts and that credit risk exposure at banks from derivatives is generally less than a quarter of their total credit risk exposure from loans. Banks’ credit risk exposures from their derivative positions are thus not out of line with other credit risk exposures they face. Furthermore, an analysis by the GAO (Govern- ment Accountability Office) indicated that actual credit losses incurred by banks from their derivatives contracts have been very small, on the order of 0.2% of their gross credit exposure. Indeed, during the recent global financial crisis, in which the entire financial system was put under great stress, derivatives exposure at banks was not a serious problem.

In conclusion, recent events indicate that financial derivatives pose serious dan- gers to the financial system, but some of these dangers have been overplayed. The biggest danger lies in the trading activities of financial institutions, particularly their trading in credit derivatives, as was illustrated by AIG’s activities in the CDS market. As discussed in Chapter 10, regulators have been paying increased attention to this danger and are continuing to develop new disclosure requirements and regulatory guidelines that outline rules for derivatives trading. Financial institutions need to dis- close their risk exposure in derivatives contracts so that regulators can make sure that a large institution is not playing too big a role in the derivatives market and does not carry too large an exposure to derivatives relative to its capital, as was the case with AIG. Another concern is that derivatives, particularly credit derivatives, must have bet- ter clearing mechanisms, that is, the methods of settling contracts, so that the failure of one institution does not bring down many other institutions whose net derivatives positions are small even though they have many offsetting positions. Better clearing could be achieved either by trading these derivatives in an organized exchange, like a futures market, or by having one clearing organization net out trades. Regulators such as the Federal Reserve Bank of New York have been active in making proposals along these lines.

The credit risk exposure posed by interest-rate derivatives, in contrast, seems to be manageable using the standard methods of dealing with credit risk. New regulations for derivatives markets are sure to come in the wake of the global financial crisis. The industry has been given a wake-up call regarding the potential dangers of derivatives products. Now the hope is that any time bomb arising from derivatives can be defused with appropriate efforts on the parts of markets and regulators. ◆

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SuMMary

1. Interest-rate forward contracts, which are agreements to sell a debt instrument at a future (forward) point in time, can be used to hedge (protect against) interest- rate risk. The advantage of forward contracts is that they are flexible; the disadvantages are that they are subject to default risk and their market is illiquid.

2. A financial futures contract is similar to an interest-rate forward contract in that it specifies that a debt instru- ment must be delivered by one party to another on a stated future date. However, it has advantages over a forward contract in that it is not subject to default risk and is more liquid. Forward and futures contracts can be used by financial institutions to hedge interest- rate risk.

3. An option contract gives the purchaser the right to buy (call option) or sell (put option) a security at the exercise (strike) price within a specific period of time. The profit function for options is nonlinear—profits do not always grow by an equal dollar amount with a given change in the price of the underlying financial instrument. The nonlinear profit function for options explains why their value (as reflected by the premium paid for them) is negatively related to the exercise price for call options, positively correlated to the exercise price for put options, positively related to the term to expiration for both call and put options, and positively related to the volatility of the price of the underlying financial instrument for both call and put options. Financial institutions use futures options to hedge interest-rate risk in a similar fashion to the way they use financial futures and forward contracts. Futures

options may be preferred over futures contracts when conducting macro hedges because futures options lead to fewer accounting problems.

4. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments. They have default risk and liquidity problems similar to those of forward contracts. As a result, interest- rate swaps often involve intermediaries such as large commercial banks and investment banks that make a market in swaps. Financial institutions find that interest-rate swaps are useful ways to hedge interest- rate risk. Interest-rate swaps have one big advantage over financial futures and options: They can be written for very long horizons.

5. Credit derivatives are a new type of derivative that offers payoffs on previously issued securities that have credit risk. These derivatives—credit options, credit swaps, and credit-linked notes—can be used to hedge credit risk.

6. There are two major concerns about derivatives: They allow financial institutions to more easily increase their leverage and take big bets (by effectively enabling them to hold a larger amount of the underlying assets than the amount of money put down), and they expose financial institutions to large credit risks because the huge notional amounts of derivative contracts greatly exceed the capital of these institutions. The second danger seems to have been overplayed, but the danger from increased leverage using derivatives is very real, as was revealed during the global financial crisis.

key terMS

American option, p. 325 arbitrage, p. 319 call option, p. 326 credit default swap, p. 335 credit derivatives, p. 334 credit-linked note, p. 336 credit options, p. 335 credit swap, p. 335 currency swaps, p. 332 European option, p. 325 exercise price (strike price), p. 325

financial derivatives, p. 315 financial futures contract, p. 318 financial futures option (futures

option), p. 325 forward contracts, p. 316 hedge, p. 315 interest-rate forward contracts, p. 316 interest-rate swaps, p. 332 long position, p. 315 macro hedge, p. 320 margin requirement, p. 323

marked to market, p. 323 micro hedge, p. 320 notional principal, p. 332 open interest, p. 321 option, p. 325 premium, p. 325 put option, p. 326 short position, p. 315 stock option, p. 325 swaps, p. 332

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QueStiOnS

All questions are available in MyEconLab at http://www.myeconlab.com.

1. What are the advantages and disadvantages of using forward contracts to hedge?

2. What advantages do futures contracts have over for- ward contracts?

3. What is the difference between a micro hedge and a macro hedge?

4. What are the advantages and disadvantages of using an options contract rather than a futures contract?

5. Explain why greater volatility or a longer term to maturity leads to a higher premium on both call and put options.

6. Why does a lower strike price imply that a call option will have a higher premium and a put option a lower premium?

7. What are the advantages and disadvantages of using interest-rate swaps?

8. If the finance company you manage has a gap of +$5 million (rate-sensitive assets greater than rate-sensitive liabilities by $5 million), describe an interest-rate swap that would eliminate the company’s income gap.

9. If the savings and loan you manage has a gap of -$42 million, describe an interest-rate swap that would elimi- nate the S&L’s income risk from changes in interest rates.

10. How can financial derivatives create excessive risk in the financial system?

aPPLied PrObLeMS

All applied problems are available in MyEconLab at http://www.myeconlab.com.

11. If the pension fund you manage expects to have an inflow of $120 million six months from now, what for- ward contract would you seek to enter into to lock in current interest rates?

12. If the portfolio you manage is holding $25 million of 6s of 2035 Treasury bonds with a price of 110, what forward contract would you enter into to hedge the interest-rate risk on these bonds over the coming year?

13. If you buy a $100,000 June Treasury bond contract for 108 and the price of the deliverable Treasury bond on the expiration date is 102, what is your profit or loss on the contract?

14. If, on the expiration date, the deliverable Treasury bond is selling for 101 but the Treasury bond futures contract is selling for 102, what will happen to the futures price? Explain your answer.

15. If your company has a payment of 200 million euros due one year from now, how would you hedge the for- eign exchange risk in this payment with 125,000-euro futures contracts?

16. If your company has to make a 10 million euro pay- ment to a German company three months from now, how would you hedge the foreign exchange risk in this payment with a 125,000-euro futures contract?

17. Suppose your company will be receiving 30 million euros six months from now, and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract should you enter into?

18. Suppose the pension fund you are managing is expect- ing an inflow of funds of $100 million next year, and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

19. If you buy a put option on a $100,000 Treasury bond futures contract with an exercise price of 95 and the price of the Treasury bond is 120 at expiration, is the contract in the money, out of the money, or at the money? What is your profit or loss on the contract if the premium was $4,000?

20. Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 110 for a premium of $1,500. If, upon expiration, the futures contract has a price of 111, what is your profit or loss on the contract?

21. A hedger takes a short position in five T-bill futures contracts at the price of 98 532. Each contract is for $100,000 principal. When the position is closed, the price is 951232. What is the gain or loss on this transaction?

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340 P a r t 3 Financial Institutions

The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

24. Consider a put contract on a T-bond with an exercise price of 1011232. The contract represents $100,000 of bond principal and has a premium of $750. The actual T-bond price falls to 981632 at the expiration. What is the gain or loss on the position?

25. A swap agreement calls for Durbin Industries to pay interest annually, based on a rate of 1.5% above the one-year T-bill rate, currently 6%. In return, Durbin receives interest at a rate of 6% on a fixed-rate basis. The notional principal for the swap is $50,000. What is Durbin’s net interest for the year after entering into the agreement?

22. Futures are available on three-month T-bills with a contract size of $1 million. If you take a long position at 96.22 and later sell the contracts at 96.87, what is the total net gain or loss on this transaction?

23. A bank customer will be going to London in June to purchase £100,000 in new inventory. The current spot and futures exchange rates are as follows:

data anaLySiS PrObLeMS

The Problems update with real-time data in MyEconLab and are available for practice or instructor assignment.

1. Go to the St. Louis Federal Reserve FRED data- base, and find data on the dollar/euro exchange rate (DEXUSEU). Suppose that one month ago you entered into a forward contract to sell 10 million euros at the forward rate equivalent to the spot rate one month ago. What exchange rate was specified on the forward contract? (Find the most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

2. Go to the St. Louis Federal Reserve FRED database, and find data on the ten-year swap rate (DSWP10) and the three-month LIBOR rate (USD3MTD156N). The ten-year swap rate is the fixed rate reported on a ten-year interest-rate swap contract in return for interest payments based on the three-month LIBOR rate. Suppose that one year ago you entered into a swap contract. (For both data series, find the most recent data available, and then use the data from one year prior.) If you entered into a $10,000,000 notional principal ten-year interest-rate swap with the fixed payment at the ten-year swap rate and the variable payment at the LIBOR rate + 2%, what is the fixed payment? What was the variable payment one year ago, and what is the current variable payment?

web exerCiSeS

1. The following website can be used to demonstrate how the features of an option affect the option’s prices. Go to http:// www.option-price.com/index.php. What happens to the price of an option under each of the following situations?

a. The strike price increases.

b. Interest rates increase.

c. Volatility increases.

d. The time until the option matures increases.

web reFerenCeS

http://www.cmegroup.com

The website of the CME Group reports information on all the contracts traded on its exchanges.

http://www.rmahq.org

The website of the Risk Management Association reports useful information such as annual statement studies, online publications, and so on.

Exchange Rates (dollars/pound)

Period Rate

Spot 1.5342

March 1.6212 June 1.6901 September 1.7549 December 1.8416

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Preview

Since the end of the stock market boom in 2000, financial markets have been jolted by one corporate scandal after another. The cycle began in December 2001 with the spectacular bankruptcy of Enron Corporation (once valued as the seventh- largest corporation in the United States) and the indictment of Enron’s auditor, Arthur Andersen, one of the then-“Big Five” accounting firms. Subsequently, revelations of misleading accounting statements at numerous other corporations, including World- Com, Tyco Industries, and Fannie Mae, increased investors’ doubts about the quality of information coming from the corporate sector. Criminal cases were filed against all of the top investment banks (Morgan Stanley, J. P. Morgan, Merrill Lynch, Lehman Broth- ers, and Goldman Sachs, among others) after these banks encouraged their stock ana- lysts to hype dubious stocks that later proved to be disastrous investments.

These scandals attracted tremendous public attention for several reasons. First, the resulting bankruptcies cost employees of these firms their jobs, their pensions, or both. Sec- ond, these activities are likely to have been an important factor in the massive stock market decline that occurred from March 2000 to September 2002; during this downturn, the value of the S&P 500 index declined by 50%, and NASDAQ’s value declined by 75%. Third, the scandals created doubts about the ethics of those working in the financial services industry.

Conflicts of interest, a type of moral hazard problem that occurs when a person or institution has multiple objectives (interests) with conflicting end goals, may be respon- sible for the corporate scandals discussed above. Conflicts of interest came to the fore again during the global financial crisis of 2007–2009, when they ultimately caused the quality of credit ratings to be compromised. In each case, people who were supposed to be acting in the investing public’s best interest by providing investors with reliable infor- mation had incentives to deceive the public and thereby benefit both themselves and their corporate clients. What are these conflicts of interest, and how serious are they? Under what circumstances do they occur, and why have they been the source of recent woes in the financial markets? What should, and can, we do about them?

This chapter provides a framework for answering these questions. It first explains what conflicts of interest are, why we should care about them, and why they raise ethical issues. It then surveys the different types of conflicts of interest that occur in the financial industry and presents policies to remedy them.1

Learning Objectives • Explain the relationship between economies of scope and conflicts of interest in the financial industry.

• Identify the ways in which conflicts of inter- est can create ethical dilemmas in financial services firms.

• Identify the four areas of financial services most prone to conflicts of interest, and sum- marize why they are so susceptible.

• Summarize how and why markets may self-regulate and limit conflicts of interest.

• Summarize the key features of the three policies enacted to limit conflicts of inter- est in financial markets.

• List and summarize the five approaches used to remedy conflicts of interest in financial markets.

15 Conflicts of Interest in the Financial Industry

341

1For a more detailed treatment of the analysis and research presented in this chapter, see Andrew Crockett, Trevor Harris, Frederic S. Mishkin, and Eugene N. White, Conflicts of Interest in the Financial Services Industry: What Should We Do About Them? Geneva Reports on the World Economy 4 (Geneva and London: International Center for Monetary and Banking Studies and Centre for Economic Policy Research, 2003).

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What are COnfLiCtS Of intereSt, and Why are they imPOrtant?

In Chapters 2 and 8, we saw how financial institutions play a key role in the financial system. Specifically, their expertise in interpreting signals and collecting information from their customers gives them a cost advantage in the production of information. Furthermore, because they collect, produce, and distribute this information, financial institutions can use the information over and over again, in as many ways as they wish, thereby realizing economies of scale. By providing multiple financial services to their customers, financial institutions can also realize economies of scope—that is, they can lower the costs of information production for each service by applying one information resource to many different services. An investment bank, for example, can evaluate a corporation’s credit risk and so arrange to market the corporation’s bonds. In addition, by providing multiple financial services to their customers, financial institutions can develop broader and longer-term relationships with firms. These relationships further reduce the cost of producing information and, therefore, enhance economies of scope.

Although economies of scope can substantially benefit financial institutions, they can also create potential costs in the form of conflicts of interest. Conflicts of interest arise in almost all aspects of our lives, so we need to be precise about the conflicts of interest that concern us here. Given the crucial role that information plays in financial markets, we will focus on the conflicts of interest that arise when financial service firms or their employees serve one interest at the expense of another—that is, they serve their own interest rather than their customers’, or the interest of a firm that wants to sell securities rather than the interest of investors who want to purchase the securities. To accomplish their goals, these firms and their employees might misuse information, provide false information, or conceal information.

Conflicts of interest can occur within a financial institution that provides a special- ized service, but they are most problematic when an institution provides multiple finan- cial services to a given client or to many clients. The competing interests of these clients or services may lead employees, or even an entire department of a financial institution, to conceal information or disseminate misleading information to financial markets. Combinations of services that bring together any group of depository intermediaries, nondepository intermediaries, and brokers, or that allow any of these groups to invest directly in a business, are those most likely to lead to conflicts of interest.

Why do We Care about Conflicts of interest? Conflicts of interest can substantially reduce the quality of information in financial markets, thereby increasing asymmetric information problems. In turn, asymmetric information prevents financial markets from channeling funds into the most productive investment opportunities, thereby decreasing the efficiency of the financial markets and the economy in general.

ethiCS and COnfLiCtS Of intereSt Conflicts of interest raise ethical dilemmas for those engaged in the financial service business by generating incentives for financial service firms and their employees to conceal information or provide misleading information, thereby hurting the customers

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 343

for whom they work. The growing economies of scope in the financial industry, which have led financial institutions to offer more services under one roof, have increased con- flicts of interest and, not surprisingly, led to more unethical behavior. One way to limit unethical behavior is to make those working in the financial industry aware of the ethi- cal issues that might arise when they exploit conflicts of interest; with this awareness, employees are less likely to engage in unethical behavior. In an effort to limit unethical behavior, business schools are now bringing the discussion of ethics into the classroom, and firms are establishing policies (discussed later in this chapter) that make it harder for individuals to exploit conflicts of interest.

tyPeS Of COnfLiCtS Of intereSt Four areas of financial service activities harbor the greatest potential for generating conflicts of interest that will ultimately reduce the amount of information available in financial markets:

• Underwriting and research in investment banking • Auditing and consulting in accounting firms • Credit assessment and consulting in credit-rating agencies • Universal banking

Underwriting and research in investment Banking Investment banks perform two tasks: They research corporations that issue securities, and they underwrite these securities by selling them to the public on behalf of the issu- ing corporation. Investment banks often combine research and underwriting because the information synergies created can lead to economies of scope. In other words, information that is produced to accomplish one task can be used to help accomplish another task. A conflict of interest arises between research and underwriting because the investment bank is attempting to serve the conflicting needs of two client groups— the firms for which it is issuing the securities, and the investors to whom it is selling these securities.

These client groups have different information needs: Issuers benefit from research that reflects favorably on their products, whereas investors desire unbiased research. Due to economies of scope, however, both groups will receive the same information. When the potential revenues from underwriting greatly exceed broker- age commissions, the investment bank has a strong incentive to alter the informa- tion provided to both types of clients so as to favor the issuing firms’ needs. If the information provided is not favorable to the issuing firm, it might take its business to a competitor that is willing to put out more positive information and thereby entice more people to buy the newly issued stock. For example, an internal Morgan Stan- ley memo leaked to the press in 1992 directed its research department not to make negative or controversial comments about their clients. Because of directives such as this one, analysts working for investment banks might be persuaded to distort their research to please the underwriting department of their bank and the corporations issuing the securities, and indeed this seems to have happened during the tech boom of the 1990s. Of course, such actions undermine the reliability of the information that investors use to make their financial decisions and, as a result, diminish the efficiency of securities markets.

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344 P a r t 3 Financial Institutions

Another practice that exploits conflicts of interest is called spinning. Spinning occurs when investment banks allocate “hot” but underpriced initial public offerings (IPOs), shares of newly issued stock, to executives of other companies that might in the future do business with the investment bank. Because hot IPOs typically rise in price immediately after they are first purchased by investors, spinning is a form of kickback to other firms’ executives, luring them to use that investment bank. When the execu- tive’s company plans to issue its own securities, he or she will be more likely to use as an underwriter the investment bank that gave the executive the hot IPO shares, which is not necessarily the investment bank that could get the highest price for the firm’s securities. This action may raise the cost of capital for the firm, and therefore hinder the efficiency of the capital market.

auditing and Consulting in accounting firms Traditionally, an auditor reduces the information asymmetry between a firm’s manag- ers and its shareholders by checking the firm’s books and monitoring the quality of the information the firm produces. Auditors play an important role in financial markets because they help reduce the inevitable information asymmetry between the firm’s managers and its shareholders.

Threats to truthful reporting in an audit are caused by several potential conflicts of interest. The conflict of interest that has received the most attention in the media occurs when an accounting firm provides its client with both auditing services and nonaudit consulting services—commonly known as management advisory services— such as advice on taxes, accounting or management information systems, and business strategies. Accounting firms that provide multiple services enjoy economies of scale and scope, but are subject to two possible conflicts of interest. First, clients may pres- sure auditors into skewing their judgments and opinions by threatening to take their accounting and management services business to another accounting firm. Second, if auditors are analyzing information systems or examining tax and financial advice generated by their nonaudit counterparts within the accounting firm, they may be reluctant to criticize the systems or advice. Both types of conflicts can lead to biased audits. When investors receive less reliable information, it becomes more difficult for financial mar- kets to allocate capital efficiently.

A third type of conflict of interest arises when an auditor provides an overly favor- able audit in an effort to solicit or retain audit business. The unfortunate collapse of Arthur Andersen—once one of the five largest accounting firms in the United States— suggests that this may be the most dangerous form of conflict of interest (see the FYI box, “The Collapse of Arthur Andersen”).

Credit assessment and Consulting in Credit-rating agencies Investors use credit ratings (e.g., Aaa or Baa), which reflect the probability of default, to determine the creditworthiness of particular debt securities. As a consequence, credit ratings provide critical information that credit markets need to operate efficiently. Conflicts of interest can arise when multiple users with divergent interests (at least in the short term) depend on these credit ratings. Investors and regulators seek well- researched, impartial assessments of credit quality; issuers seek favorable ratings. In the credit-rating industry, issuers of securities pay rating firms such as Standard and Poor’s or Moody’s to rate their securities (see the FYI box, “Why Do Issuers of Securities Pay to Have Their Securities Rated?”). Because the issuer is the party that is paying the

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 345

credit-rating agency, investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer.

Other conflicts of interest arise when credit-rating agencies provide ancillary consulting services. Debt issuers often ask rating agencies to advise them on how to structure their debt issues, usually with the ultimate goal of securing a favorable rat- ing. In this situation, the credit-rating agencies are, in effect, auditing their own work and setting up a conflict of interest similar to the one present in accounting firms that provide both auditing and consulting services. Furthermore, credit-rating agencies may deliver favorable ratings because they wish to garner new clients for their ancil- lary consulting business. Possible declines in the quality of the credit assessments issued by rating agencies could increase asymmetric information in financial markets, thereby diminishing their ability to allocate credit appropriately. As we discussed in Chapter 12, such conflicts of interest were an important factor in triggering the global financial crisis of 2007–2009.

Universal Banking Commercial banks, investment banks, and insurance companies were originally cre- ated as distinct financial institutions that offered separate and distinct services. These institutions soon recognized, however, that combining these activities and services would provide economies of scope. In 1933, the Glass-Steagall Act halted the devel- opment in the United States of universal banking, in which, commercial banks pro- vide a full range of banking, securities, real estate, and insurance services, all within

FYI The Collapse of Arthur Andersen

In 1913, Arthur Andersen, a young accountant who had denounced the slipshod and deceptive practices that enabled companies to fool the investing public, founded his own firm. Until the early 1980s, auditing was the most important source of profits for this firm. By the late 1980s, however, the consulting part of Andersen’s busi- ness had begun to experience high revenue growth and high profit margins, even as its audit profits slumped in a more competitive market. Consulting partners began to assume more power within the firm, and the resulting internal conflicts split the firm in two. Arthur Andersen (the auditing service) and Andersen Consult- ing were established as separate companies in 2000.

During the period of increasing conflict before the split, Andersen’s audit partners had faced growing pressure to focus on boosting revenue and profits from audit services. Many of Arthur Andersen’s cli- ents that later went bust—Enron, WorldCom, Qwest, and Global Crossing—were also the largest clients in Arthur Andersen’s regional offices. The combination

of intense pressure to generate revenue and profits from auditing and the fact that certain clients domi- nated the business of regional offices translated into tremendous incentives for regional office managers to provide favorable audits for these large clients. The loss of a client such as Enron or WorldCom would have been devastating for a regional office and its partners, even if that client contributed only a small fraction of the overall revenue and profits of Arthur Andersen as a whole.

The Houston office of Arthur Andersen, for exam- ple, ignored many discrepanices in Enron’s reporting. Arthur Andersen was indicted in March 2002 and then convicted in June 2002 of obstruction of justice for impeding the SEC’s investigation of the Enron collapse (the conviction was overturned by the Supreme Court in May 2005). This conviction—the first ever against a major accounting firm—barred Arthur Andersen from conducting audits of publicly traded firms and so effectively put it out of business.

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346 P a r t 3 Financial Institutions

a single legal entity. Glass-Steagall banned the consolidation of these services under one organization. When the Glass-Steagall Act was repealed by Congress in 1999, universal banking reappeared. Given that the various departments within universal banks serve multiple clients, many potential conflicts of interest exist. If the potential for increased revenue exists in one department, employees in that department will have an incentive to distort information (or to pressure employees in another depart- ment to distort information) so that it is skewed to the advantage of their clients and the profit of their department.

Several types of conflicts of interest can arise within universal banks:

• Securities issuers served by the underwriting department (and the underwrit- ing department itself ) will benefit from aggressive sales of the securities issue to customers of the bank, whereas the customers will expect unbiased investment advice.

• A bank manager may push the issuing firm’s securities to the disadvantage of the customer or may limit losses from a poor IPO by selling the firm’s securities to the bank’s managed trust accounts.

• A bank with an outstanding loan to a firm whose credit or bankruptcy risk has in- creased has private knowledge that may encourage the bank to use its underwriting department to sell bonds to the unsuspecting public, thereby paying off the loan and earning a fee.

• A bank may make loans with overly favorable terms to a firm in order to ob- tain fees from the firm for performing activities such as underwriting the firm’s securities.

• To sell its insurance products, a bank may try to influence or coerce a borrowing or investing customer into buying the products.

All of these conflicts of interest may decrease the amount of accurate information provided by the universal bank, thereby hindering its ability to promote efficient credit allocation. Although there have not been any recent banking scandals involving con- flicts of interest, such scandals did surface in the aftermath of the stock market crash of 1929 (see the FYI box, “Banksters”).

FYI Why Do Issuers of Securities Pay to Have Their Securities Rated?

Prior to the 1970s, credit-rating agencies earned revenues by selling information about securities ratings to subscribers. In the early 1970s, however, the major rating agencies instead began charging issuers of securities for their ratings. Why would the credit-rating agencies do this, given that it seems to set up an obvious conflict of interest? We can answer this question by considering the asym- metric information framework, discussed in Chap- ter 8. By the early 1970s, technological changes,

such as the advent of cheap photocopying, had made it easier to disseminate information. Market participants were able to readily get information on securities ratings without paying for it. The free-rider problem became more widespread. As a result, credit-rating agencies were no longer able to earn enough revenue by selling ratings informa- tion. Their solution was to charge the issuers of the securities for the ratings, and this is the business model that is currently in place.

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 347

Can the market Limit exPLOitatiOn Of COnfLiCtS Of intereSt?

Conflicts of interest become a problem for the financial system when they lead to a decrease in the flow of reliable information, either because information is concealed or because misleading information is disseminated. The decline in the flow of reliable information makes it harder for the financial system to solve adverse selection and moral hazard problems, and this can slow the flow of credit to parties with productive investment opportunities.

Even when conflicts of interest exist, they do not necessarily reduce the flow of reliable information because the incentive to exploit the conflict of interest may not be very high. When the exploitation of a conflict of interest is visible to the market, the market can punish the exploiting financial services firm by denying it business. Given the importance to a financial firm of maintaining and enhancing its reputation, exploiting a conflict of interest will decrease the firm’s future profitability because the firm will have greater difficulty selling its services. In this way, the firm has incentives not to exploit a conflict of interest. These incentives limit conflicts of interest in the long run, but they may not be effective in the short run, depending on structural factors within the firm, such as a lack of transparency and inappropriate monetary incentives.

FYI Banksters

Just as happened after the collapse of the tech bubble in 2000, the stock market crash of 1929 prompted many investors to question why they had been encour- aged to purchase so many securities that declined in value so quickly. The public blamed the universal banks for hyping these securities, and bankers were pejoratively referred to as “banksters,” to equate them with gangsters. Public pressure led the Senate Banking and Currency Committee to hold hearings to inves- tigate potential abuses by the universal banks. These hearings, which became known as the Pecora hearings (so named after the chief counsel who led them), were as famous in their day as the Watergate hearings that led to President Nixon’s resignation in 1974 or the hearings of the 9/11 Commission in 2004.

The Pecora hearings revealed several cases of severe exploitation of conflicts of interest in the banking industry. An affiliate of National City Bank (the pre- cursor to Citibank) was accused of selling “unsound and speculative securities,” particularly bonds from

the Republic of Peru that went into default, to the bank’s customers. Chase National Bank and National City Bank were accused of converting bad loans to companies such as General Theaters and Equipment and the General Sugar Company into securities that were sold to the public and to investment trusts man- aged by these banks. The president of National City Bank, Charles E. Mitchell, and the head of Chase National Bank, Albert H. Wiggin, were accused of setting up pool operations, operations in which resources from the banks were used to prop up the bank’s stock price for the benefit of these executives and their associates.

The resulting scandals led to passage of the Glass- Steagall Act in 1933, which eliminated the possibility of these conflicts of interest by mandating complete separation of commercial banking from investment banking activities. It was not until 1999 that this act was repealed by Congress to enable banks to become more competitive.

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348 P a r t 3 Financial Institutions

One enlightening example of how the market can limit exploitation of conflicts of interest involves credit-rating agencies. At first glance, the fact that rating agencies are paid by firms issuing securities to produce ratings for these securities looks like a serious conflict of interest. Rating agencies would seem to have powerful incentives to gain business by providing security-issuing firms with higher credit ratings than they deserve, making it easier for the firms to sell their securities at higher prices. In reality, little evidence suggests that rating agencies take advantage of this conflict of interest, despite prominent exceptions such as Enron. Much research has shown that a reason- ably close correlation exists between ratings and default probabilities. Ratings agencies do not exploit this conflict of interest because, by giving higher credit ratings to firms that pay for the ratings, they would lower the credibility of the ratings, making them less valuable to the market. The market is able to recognize biased ratings because it can observe poor performance by individual securities. Furthermore, credit-rating agencies themselves provide evidence on the relationship between their ratings and the securi- ties’ subsequent default history. If a rating agency has a history of giving high ratings to firms that eventually default, investors in the market will no longer trust its ratings; its reputation will become tarnished, and good, nondefaulting firms will go elsewhere for their ratings. For this reason, the rating agency has an incentive not to exploit this conflict of interest and not to overrate the bonds of its customers.

Commercial banks that underwrote securities prior to the enactment of the Glass- Steagall Act do not seem to have exploited this conflict of interest. When a commercial bank underwrites securities, the bank may have an incentive to market the securities of financially troubled firms to the public, because the firms will then be able to pay back the loans they owe to the bank, while at the same time the bank will earn fees from the underwriting services. The evidence suggests that in the 1920s, markets found securities underwritten by bond departments within commercial banks to be less attrac- tive than securities underwritten in separate affiliates where the conflict of interest was more transparent. To maintain their banks’ reputations, commercial banks shifted their underwriting to separate affiliates over time, with the result that securities underwritten by banks became as highly valued as those underwritten by independent investment banks. When the affiliates were unable to certify the absence of conflicts of interest, they focused on underwriting securities issued by well-known firms, firms in which infor- mation asymmetry and conflicts of interest were less pronounced. Again, the market provided incentives to control potential conflicts of interest. However, it is important to note that the market solution was not immediate, but took some time to develop.

The responsiveness of the market is also evident in the apparent conflict of interest that is present in investment banks when underwriters who have incentives to favor issuers over investors pressure research analysts to provide more favorable assessments of issuers’ securities. Analysts at an investment bank that is underwriting particular IPOs tend to make more “buy” recommendations for these IPOs than do analysts at other investment banks, and the market takes account of this tendency in pricing these securities. Over a two-year period, the performance of other analysts’ recommended securities was 50% better than the performance of the securities recommended by analysts at the investment banks that underwrote these IPOs. The market appears to recognize the difference in the quality of information when the potential for a conflict of interest exists.

Fewer empirical studies have examined how the market addresses conflicts of inter- est that arise in accounting firms, but the limited evidence available does suggest that the market adjusts securities’ prices to account for potential conflicts of interest. The evidence indicates that clients, who are concerned about the conflicts of interest that

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 349

might arise from the joint provision of auditing and management advisory services, ascribe less value to such accounting firms’ audit opinions and limit their nonaudit purchases from the accounting firms in which these conflicts of interest are present.

Although the market can sometimes ameliorate the effects of conflicts of interest in financial services firms, it cannot always constrain the incentives to exploit conflicts of interest. For the market to prevent this type of exploitation, it needs to have enough information to accurately assess whether an exploitation of conflicts of interest is actu- ally occurring. In some cases, parties who want to take advantage of conflicts of interest will try to hide this information from the market. In other cases, alerting the market to potential conflicts of interest would reveal proprietary information that would benefit a financial firm’s competitors, thus reducing the firm’s incentives to reveal its true position.

The scandals described in this chapter demonstrate that the exploitation of a con- flict of interest often leads to large gains for some members of the financial firm even while it reduces the value of the firm as a whole. Inappropriately designed compen- sation plans (the result of poor management), for example, may produce conflicts of interest that not only reduce the flow of reliable information to credit markets but also end up destroying the firm. Indeed, the collapse of Arthur Andersen illustrates how the compensation arrangements in one line of business, such as auditing, can create seri- ous conflicts of interest. In the Arthur Andersen case, the partners in regional offices had incentives to please their largest clients even if their actions were detrimental to the firm as a whole. The conflict of interest problem can become even more hazardous when several lines of business are combined and the returns from one of the business activities—such as underwriting or consulting—are very high for only a brief amount of time. Also, a compensation scheme that works reasonably well in the short term might become poorly aligned over time.

The extraordinary surge in the stock market in the late 1990s created huge tempo- rary rewards, making it possible for well-positioned analysts, underwriters, and audit firm partners to exploit conflicts of interest before incentives could be realigned. Often, these conflicts of interest were not readily visible to the market, and they may have been invisible even to the top management of a firm. In the most severe cases, opportunistic individuals were able to capture a firm’s reputational rents, profits that a firm earns because it is trusted by the marketplace. The exploitation of conflicts of interest clearly damaged the reputations of such investment banks as Merrill Lynch, Salomon Smith Barney of Citigroup, and Credit Suisse First Boston—and perhaps the credibility of analysts in general. Audit firms have lost much of their nonaudit business, while Arthur Andersen was destroyed completely.

What haS Been dOne tO remedy COnfLiCtS Of intereSt?

Three major policy initiatives have been implemented to deal with conflicts of interest in financial markets: the Sarbanes-Oxley Act of 2002, the Global Legal Settlement of 2002, and the Dodd-Frank “Wall Street Reform and Consumer Protection Act” of 2010.

Sarbanes-Oxley act of 2002 In 2002, public outcry over recent corporate and accounting scandals led to the passage of the Public Accounting Reform and Investor Protection Act, more commonly referred

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350 P a r t 3 Financial Institutions

to as the Sarbanes-Oxley Act, a name that reflects its two principal authors in Congress. This act had four major components.

1. Sarbanes-Oxley increased supervisory oversight to monitor and prevent conflicts of interest:

• It established a Public Company Accounting Oversight Board (PCAOB), overseen by the SEC, that supervises accounting firms and ensures independent audits that are controlled for quality.

• It increased the SEC’s budget for supervising securities markets.

2. Sarbanes-Oxley also directly reduced conflicts of interest:

• The act made it unlawful for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an audit not allowed by the PCAOB.

3. Sarbanes-Oxley provided incentives for investment banks not to exploit conflicts of interests:

• It beefed up criminal charges for white-collar crime and obstruction of official investigations.

4. Sarbanes-Oxley included measures to improve the quality of information in the financial markets:

• It required that a corporation’s chief executive officer (CEO) and chief financial officer (CFO), as well as its auditors, certify that periodic financial statements and disclosures of the firm (especially regarding off-balance-sheet transactions) are accurate (Section 404).

• It required members of the audit committee (the subcommittee of the board of directors that oversees the company’s audit) to be “independent”—that is, they could not be managers in the company and they could not receive any consulting or advisory fee from the company.

Global Legal Settlement of 2002 The second policy arose from a lawsuit brought by New York Attorney General Eliott Spitzer against the ten largest investment banks (Bear Stearns, Credit Suisse First Bos- ton, Deutsche Bank, Goldman Sachs, J. P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and UBS Warburg). Spitzer alleged that these firms had allowed their investment banking departments to have inappropriate influ- ence over their research analysts, thereby creating a conflict of interest. On December 20, 2002, the SEC, the New York Attorney General, NASD, NASAA, NYSE, and state regulators reached a global agreement with these investment banks. The agreement included three key elements:

1. Like Sarbanes-Oxley, the Global Legal Settlement directly reduced conflicts of interest:

• It required investment banks to sever the links between research and securities underwriting.

• It banned spinning.

2. The Global Legal Settlement provided incentives for investment banks not to exploit conflicts of interest:

• It imposed $1.4 billion of fines on the accused investment banks.

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 351

3. The Global Legal Settlement included measures to improve the quality of informa- tion in financial markets:

• It required investment banks to make public their analysts’ recommendations. • It required investment banks, for a five-year period, to contract with no fewer

than three independent research firms that would provide research to their bro- kerage customers.

dodd-frank Bill of 2010 Conflicts of interest, particularly within credit-rating agencies, played a prominent role in the global financial crisis. In an effort to prevent such conflicts of interest in the future, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This act included a number of provisions that deal with conflicts of interest in the credit-rating industry.

1. The bill created an Office of Credit Ratings (OCR) at the SEC. The OCR has its own staff and has the authority to fine credit-rating agencies if they misbehave and to deregister an agency if it produces bad ratings.

2. Under Dodd-Frank, credit-rating agencies must provide reports to the SEC when their employees go to work for a company that has been rated by the agency in the past twelve months.

3. The act prohibits compliance officers from being involved in the production or sale of credit ratings.

4. The act requires the SEC to prevent issuers of asset-backed securities from hiring the credit-rating agencies that will give them the highest ratings and supports earlier initiatives by the SEC to limit conflicts of interest.

5. Dodd-Frank authorized investors to bring lawsuits against credit-rating agencies for reckless failure to get accurate information when providing a credit rating.

a frameWOrk fOr evaLUatinG POLiCieS tO remedy COnfLiCtS Of intereSt

Our analysis in this chapter provides a framework for evaluating whether conflicts of interest require public policy actions to eliminate or reduce them. Combining financial services activities may result in incentives for agents to conceal information, but such combinations of services may also result in synergies that make it easier to produce information. Thus, eliminating conflicts of interest by preventing firms from combining financial activities may actually make financial markets less efficient. In evaluating propo- sitions to lessen conflicts of interest, we must take into account the following critical facts.

1. The existence of a conflict of interest does not necessarily mean that it will have serious adverse consequences. Even though a conflict of interest exists, the incentives to exploit the conflict of interest may not be very high. An exploitation of a conflict of interest that is visible to the market will typically tarnish the reputation of the finan- cial firm at which the exploitation takes place. Given the importance to the firm of maintaining and enhancing its reputation, exploiting the conflict of interest would decrease the firm’s future profitability because the firm would have greater difficulty selling its services. As a consequence, firms try to structure their salary and reward

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352 P a r t 3 Financial Institutions

systems to include incentives that will discourage employees from exploiting con- flicts of interest. Hence, the marketplace may be able to control conflicts of interest because a high value is placed on financial firms’ reputations. When evaluating rem- edies to lessen conflicts of interest, we need to ask whether the market has adequate information and incentives to control conflicts of interest.

2. Even if incentives to exploit conflicts of interest remain strong, eliminating the economies of scope that create the conflicts of interest may be harmful in the long run, because such actions can reduce the flow of reliable information. Thus, in evaluating possible remedies, we need to examine whether the proposed remedy will do more harm than good by examining whether it will curtail the flow of reliable information in financial markets.

approaches to remedying Conflicts of interest In thinking about remedies to reduce conflicts of interest, it is worthwhile to discuss five generic approaches. These approaches are discussed in the order of their intrusive- ness, from least intrusive to most intrusive.

Leave it to the market This approach has powerful appeal to many economists and may be a sufficient response in many cases. Market forces to lessen conflicts of interest work through two mechanisms. First, the market can penalize a financial ser- vices firm if it exploits a conflict of interest. For example, a penalty may be imposed by the market in the form of higher funding costs or lower demand for the firm’s services, even to the point of forcing the demise of the firm. Second, market forces can promote new institutional means to contain conflicts of interest. For example, they can generate a demand for information from nonconflicted organizations. This is exactly what hap- pened in the United States in the 1920s, when security affiliates took preeminence over in-house bond departments in universal banks.

One advantage of market-driven solutions is that they can hit where it hurts the most, through pecuniary penalties. Moreover, such solutions may help avoid the risk of overreaction. It can be hard to resist the temptation to adopt nonmarket solutions, which may reduce information production in financial markets, to appease public outcry. Conversely, market-based solutions will not work if the market cannot obtain sufficient information to appropriately punish financial firms that are exploiting conflicts of inter- est. Memories can be short in financial markets, as suggested by the new field of behav- ioral finance discussed in Chapter 7. Once a triggering event has faded from memory, conflicts may creep back in unless reforms have been “hard-wired” into the system.

regulate for transparency A competitive market structure does not always ad- equately reduce information asymmetries. The gathering of information is costly, and any individual economic agent will gather information only if the personal benefit out- weighs the cost. When the information collected is immediately available to the market, the free-rider problem can reach serious levels. Information has the attribute of a public good in that it will be undersupplied in the absence of some public intervention. To some extent, mandatory information disclosure can alleviate information asymmetries, and thus it is a key element of regulation of the financial system.

When mandatory disclosure of information reveals conflicts of interest, the market is able to discipline the financial firm that fails to ameliorate these conflicts of interest. In addition, if a financial institution is forced to provide information about potential conflicts of interest, the user of the institution’s information services will be better able to judge the quality of the information supplied by the institution.

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 353

At the same time, mandatory disclosure can create problems if such disclosure reveals so much proprietary information that the financial institution is unable to profit- ably engage in the information production business. The result will be less information production rather than more. Also, mandatory disclosure will not work if financial firms are able to avoid the regulation and continue to hide relevant information about potential conflicts of interest. The free-rider problem can result in insufficient monitoring of con- flicts of interest because the benefits of monitoring and constraining these conflicts accrue only partially to the monitors. Finally, complying with mandatory disclosure regulations can be costly for financial firms, possibly exceeding the costs of conflicts of interest.

Supervisory Oversight If mandatory disclosure does not work and firms continue to hide relevant information, either because the free-rider problem is severe or because mandatory disclosure would reveal proprietary information, supervisory oversight can come to the rescue and contain conflicts of interest. Supervisors can observe proprietary information about conflicts of interest without revealing it to a financial firm’s competi- tors, so that the firm can continue to engage profitably in information production activi- ties. Armed with this information, the supervisor can take actions to prevent financial firms from exploiting conflicts of interest. As part of this supervisory oversight, stan- dards of practice could be developed, either by the supervisor or by the firms engaged in a specific information production activity. Enforcement of these standards would then be placed in the hands of the supervisor.

As we saw in Chapter 10, supervisory oversight of this type is very common in the banking industry. In recent years, bank supervisors have sharpened their focus on risk management. They now examine banks’ risk management procedures to ensure that appropriate internal controls on risk taking have been established at the bank. In a similar fashion, supervisors can examine banks’ internal procedures and controls to restrict conflicts of interest. Supervisors can require financial institutions to modify weak internal controls so that incentives to exploit conflicts of interest are eliminated.

Although supervisory oversight has proved successful in improving internal controls in financial firms in recent years, if the incentives to exploit conflicts of interest are sufficiently strong, financial institutions still may be able to hide conflicts of interest from supervisors. Furthermore, supervisors have not always done their jobs well, as we saw in Chapter 10.

Separation of functions Where the market cannot obtain enough information to constrain conflicts of interest—because there is no satisfactory way of inducing in- formation disclosure through market discipline or supervisory oversight—incentives to exploit conflicts of interest can be reduced or eliminated by regulations that enforce separation of functions. Several degrees of separation are possible. First, activities can be separated into different in-house departments with firewalls between them. Second, firms can assign different activities to separately capitalized affiliates. Third, regulations can be used to prohibit certain combinations of activities within an organization.

The goal of separation of functions is to ensure that agents are not held accountable to multiple principals. As firms move from relaxed to more stringent separation of functions, conflicts of interest are reduced to an increasing degree. Of course, more stringent sepa- ration of functions also reduces synergies of information collection, thereby preventing financial firms from taking advantage of economies of scope. The higher cost of produc- ing information then might lead to a decreased flow of reliable information, because such information will become more expensive to produce. Deciding on the appropriate level of separation therefore involves comparing the benefits of reducing conflicts of interest with the costs of reducing economies of scope.

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354 P a r t 3 Financial Institutions

Socialization of information Production The most radical way to reduce conflicts of interest generated by asymmetric information problems is through the gov- ernment provision or funding of the information. For example, macroeconomic infor- mation is often provided by publicly funded agencies because this particular public good is likely to be undersupplied if left to private providers. It is conceivable that other information-providing services—for example, credit ratings and audits—could also be publicly supplied. Alternatively, if information-generating services were left to the private sector, they could be funded by public sources or by a publicly mandated levy, which would help ensure that the information was not tainted by obligations to fee-paying entities with special interests.

Of course, the problem with this approach is that a government agency or publicly funded entity might not have the same strong incentives to produce high-quality infor- mation as a private financial institution. Putting information production into the hands of a government or quasi-government entity, although it might diminish conflicts of interest, could also reduce the flow of reliable information to financial markets. Further- more, government agencies might have difficulty paying the market wages necessary to attract the “best” people. This problem could become even more serious if economies of scope were affected. For example, analysts in an investment banking firm are likely to receive additional compensation when their research has multiple uses. By contrast, a government agency that is interested in only one use of the research may not offer a level of compensation sufficient to produce high-quality information. In addition, the government might not provide sufficient funding for information collection. Indeed, federal provision of important series of macroeconomic data has already been discon- tinued because of a lack of funding.

A p p lI c At I o n Evaluating Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill Using the analytic framework just discussed, we now can evaluate the Sarbanes-Oxley Act, the Global Legal Settlement, and the Dodd-Frank bill of 2010.

We have seen that policies regulating conflicts of interest can help increase the amount of information available in financial markets. Sarbanes-Oxley did exactly this when it required the CEO and CFO of a firm to certify the periodic financial statements and disclosures of the firm. Sarbanes-Oxley thereby increased the likelihood that these statements would provide reliable information. In addition, Sarbanes-Oxley mandated disclosure of off-balance-sheet transactions and other relationships with special-purpose entities. Again, this step helped increase information in the marketplace because these off-balance-sheet transactions were often used, as in the Enron case, to hide what was really going on inside the firm. However, the costs of complying with the new regula- tions imposed by Sarbanes-Oxley were not cheap. Small firms were hit particularly hard at the time: The estimated costs of complying with Sarbanes-Oxley exceeded $800,000 for smaller firms with revenues of less than $100 million, amounting to nearly 1.5% of their sales. Sarbanes-Oxley might have severely hurt such companies’ profitability and made it harder for them to make productive investments.

We have also seen that the market is often able to constrain conflicts of interest when it has sufficient information with which to do so. The Global Legal Settlement included a provision that required investment banking firms to make their analysts’

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recommendations public. This policy helped the market assess whether the analysts were acting in good faith. The Dodd-Frank bill requires every credit-rating agency to report on employees who go to work for companies that the agency has previously rated, and it supports the SEC’s rules to increase disclosure by investment analysts, credit-rating agencies, and auditors, rules that force these parties to reveal any interests they have in the firms they analyze. Enforced provision of this information makes it more likely that financial institutions will develop internal rules to ensure that conflicts of interest are minimized, so that the institutions’ reputations remain high and they remain profitable. Importantly, the Dodd-Frank bill did not prohibit companies that issued securities from paying credit-rating agencies to rate them, thereby accepting the view that the market could successfully constrain this particular conflict of interest.

The Dodd-Frank bill also eliminated activities that increase conflicts of interest. For example, Dodd-Frank restricts compliance officers from working on ratings and prevents issuers of asset-backed securities from shopping for the agency that will give the highest rating to the securities. It also enhances the market’s ability to reign in conflicts of interest because it authorizes investors to sue credit-rating agencies for reckless failure to produce accurate ratings. However, because this measure makes credit-rating agencies liable for the accuracy of their ratings, it may discourage the agencies from allowing companies to use the agencies’ ratings in the documents that accompany new bond issues.

Of course, mandatory disclosure may not be enough to get markets to control con- flicts of interest, because firms still have incentives to hide information so that they can profitably exploit conflicts of interest. Disclosure may reveal so much proprietary infor- mation that the financial institution will be unable to profitably engage in the information production business. Some of the most damaging conflicts of interest have been caused by poorly designed internal compensation mechanisms, and such mechanisms are difficult for markets to observe. Supervisory oversight can focus on exactly these issues.

Increased supervisory oversight was a key feature of both the Sarbanes-Oxley Act and the Dodd-Frank bill. Sarbanes-Oxley established the PCAOB to supervise accounting firms, and Dodd-Frank created the Office of Credit Ratings at the SEC. The PCAOB monitors compensation mechanisms to verify that they are in accord with the best practices to control conflicts of interest. Sarbanes-Oxley and Dodd-Frank also allocated substantially more resources to the SEC. A supervisory agency cannot do its job properly without adequate resources. Indeed, one reason the SEC may have failed to provide adequate supervisory oversight during the boom of the 1990s is that it was starved for resources. A similar problem occurred in the savings and loan industry in the 1980s, and in this case the lack of supervisory resources was partly to blame for the scandals that followed and the eventual bailout that cost taxpayers more than $100 bil- lion. By keeping the audit committee independent from management, Sarbanes-Oxley eliminated the conflict of interest that occurs when the management of a firm hires the firm’s auditor. PCAOB regulations ensure that auditors report to, are hired by, and are compensated by an independent audit committee that is expected to represent share- holders other than those in management.

The Global Legal Settlement directly eliminated one Wall Street practice that led to obvious conflicts of interest—namely, spinning. Recall that spinning occurs when executives receive hot IPO shares in return for their companies’ future business with the investment bank underwriting the new issue. The Global Legal Settlement pun- ished investment banks that exploited conflicts of interest by imposing a collective fine of more than $1.4 billion on them. This tough punishment, along with the harsher criminal penalties established by Sarbanes-Oxley, provided incentives for investment banking firms to avoid taking advantage of conflicts of interest in the future.

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The more radical parts of Sarbanes-Oxley and the Global Legal Settlement involved separation of functions and socialization of information. Sarbanes-Oxley restricted accounting firms from providing nonaudit consulting services to their audit customers. However, this law might reduce the economies of scope available to auditing firms that also offer consulting services. It is unlikely that the proscription of nonauditing services in this situation, as envisioned by Sarbanes-Oxley, would have prevented the recent audit failures. However, greater mandated transparency about the nature and role of nonaudit services is a valuable aid in controlling a firm’s temptation to exploit this conflict of interest. Similarly, the Global Legal Settlement required investment banking firms to sever the link between research and investment banking. This divestiture also has the potential to eliminate economies of scope in information production. After all, analysts can obtain much more information on firms they cover when the investment banking arm of the firm can share information with them.

The Global Legal Settlement required that, for a five-year period, brokerage firms must contract with independent research firms to provide information to their customers. In addition, the settlement decreed that part of the $1.4 billion fine paid by the invest- ment banks must be used to fund independent research and investor education. This measure has both potentially positive and potentially negative features. Independent research may produce unbiased information. However, if research is socialized, firms can no longer compete for customers on the basis of the quality of their research. Because they are being taxed to fund independent research, firms might be tempted to decrease their investment in their own research analysis. Indeed, this is exactly what appears to have happened, with research budgets at the seven largest securities firms cut almost in half after the settlement. If the investment banks do not control the information they are being forced to acquire, the analysis produced by outside resources may be of a lower quality. ◆

SUmmary

1. Conflicts of interest arise when financial services firms or their employees are serving multiple interests and develop incentives to misuse or conceal information needed for the effective functioning of financial markets. If taking advantage of conflicts of interest substantially reduces the amount of reliable information available in financial markets, asymmetric information increases, and financial markets are unable to channel funds to those firms with the most productive investment opportunities.

2. Four combinations of financial services activities have the greatest potential to create conflicts of interest that reduce reliable information in financial markets: (1) underwriting and research in investment banking, (2) auditing and consulting in accounting firms, (3) credit assessment and consulting in credit-rating agencies, and (4) universal banking.

3. Even when conflicts of interest exist, they do not nec- essarily reduce the flow of reliable information because

the market provides strong incentives for financial services firms to act in ways that will avoid damage to their reputations. The evidence suggests that the market often succeeds in constraining the incentives to exploit conflicts of interest. However, conflicts of interest still pose a threat to the efficiency of financial markets.

4. Three major policy measures were passed recently to address conflicts of interest: the Sarbanes-Oxley Act of 2002; the 2002 Global Legal Settlement, which arose from the lawsuit filed by the New York Attorney General against the ten largest investment banks; and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

5. Two basic facts must be considered when evaluating proposals to reduce conflicts of interest: (1) The fact that a conflict of interest exists does not mean that the conflict will necessarily have serious adverse

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C h a P t e r 1 5 Conflicts of Interest in the Financial Industry 357

consequences; (2) even if incentives to exploit conflicts of interest remain strong, eliminating the conflict of interest may be harmful if it destroys economies of scope, thereby reducing the flow of reliable informa- tion. Five approaches to remedying conflicts of interest, listed from least intrusive to most intrusive, have been suggested: (1) leave it to the market, (2) regulate for transparency, (3) provide supervisory oversight, (4) mandate separation of functions, and (5) require socialization of information.

6. The passage of Sarbanes-Oxley and the Global Legal Settlement helped increase the flow of reliable informa- tion in financial markets in several ways. These acts require the CEO and CFO of a firm to certify the firm’s financial statements; they require corporations to dis- close off-balance-sheet transactions and entities; they require investment banks to make public their analysts’ recommendations; and they mandate increased disclo- sure of potential conflicts of interest. The Dodd-Frank bill supports increases in the flow of information by requiring credit-rating agencies to report on employees who go to work for companies that the agency has pre- viously rated. Dodd-Frank also supports SEC rulings that mandate increased disclosure by investment ana- lysts, credit-rating agencies, and auditors, rulings that force these parties to reveal any interests they have in

the firms they analyze. Sarbanes-Oxley increased super- visory oversight by establishing the Public Company Accounting Oversight Board (PCAOB) and by increas- ing the resources available to the SEC. Similarly, the Dodd-Frank bill increased regulatory oversight through the creation of the Office of Credit Ratings at the SEC. Sarbanes-Oxley reduced conflicts of interest in audit- ing by making the audit committee independent of management. The Global Legal Settlement eliminated the conflict of interest inherent in spinning. The $1.4 billion fine and harsher criminal penalties imposed by Sarbanes-Oxley provided incentives for investment banks not to exploit conflicts of interest in the future. The more radical parts of Sarbanes-Oxley and the Global Legal Settlement, which dictate separation of functions (research from underwriting, and auditing from nonaudit consulting) and socialization of research gathering, may ultimately reduce the information available in financial markets. The Dodd-Frank bill restricts activities that increase conflicts of interest. It prevents compliance officers from working on ratings and prevents issuers of asset-backed securities to shop for the agency that will give the security the highest rating. It also enhances the market’s ability to reign in conflicts of inter- est by authorizing investors to sue credit-rating agencies for reckless failure to produce accurate ratings.

key termS

conflicts of interest, p. 341 economies of scope, p. 342

initial public offerings (IPOs), p. 344 management advisory services, p. 344

reputational rents, p. 349 spinning, p. 344

QUeStiOnS

All questions are available in MyEconLab at http://www.myeconlab.com.

1. How does the provision of several types of financial services by one firm lead to a lower cost of information production for the firm?

2. How does the provision of several types of financial services by one firm lead to conflicts of interest?

3. How can conflicts of interest make financial markets less efficient?

4. How can conflicts of interest lead to unethical behavior?

5. Describe two conflicts of interest that occur when underwriting and research are provided by a single investment banking firm.

6. How does spinning lead to a less efficient financial market?

7. Describe two conflicts of interest that occur in accounting firms.

8. Some commentators have attributed the demise of Arthur Andersen to the combination of auditing and consulting activities provided by the firm. Is this assessment correct?

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358 P a r t 3 Financial Institutions

9. Describe two conflicts of interest that occur in credit- rating agencies.

10. Describe two conflicts of interest that occur in universal banks.

11. “Conflicts of interest always reduce the flow of reliable information.” Is this statement true, false, or uncertain? Explain your answer.

12. Give two examples of conflicts of interest that do not seem to have been exploited and thus have not led to a reduction of reliable information in the financial markets.

13. When is it more likely that conflicts of interest will be exploited?

14. How can poorly designed compensation schemes in financial service firms lead to conflicts of interest?

15. What are “reputational rents,” and how are they significant?

16. “Sarbanes-Oxley significantly raises compliance costs for firms. Since it dramatically decreases market effi- ciency, it should be abolished.” Do you agree with this statement? Why or why not?

17. Which provisions of the Sarbanes-Oxley Act do you think are beneficial, and which do you think are not?

18. Which provisions of the Global Legal Settlement do you think are beneficial, and which do you think are not?

19. Why might the market be the best mechanism for minimizing conflicts of interest?

20. What are the advantages and disadvantages of manda- tory disclosure when dealing with conflicts of interest?

21. How can supervisory oversight help reduce conflicts of interest?

22. What are the disadvantages of separating financial activities into different firms in an effort to avoid conflicts of interest?

23. What are the advantages and disadvantages of govern- mental provision of information as a solution to the problems created by conflicts of interest?

24. Why is a conflict of interest present when compliance officers are involved in the production of credit ratings?

25. In what ways is the Dodd-Frank legislation designed to reduce conflicts of interest?

WeB exerCiSeS

1. Go to http://www.soxlaw.com/. This site tracks issues and news related to the Sarbanes-Oxley Act.

a. Summarize in two or three sentences the primary reason for the passage of the Sarbanes-

Oxley Act.

b. Summarize one of the articles discussed in the news/current events section. Discuss how this article relates to conflicts of interest in the financial markets.

2. Go to http://www.sec.gov/ and click on “Press Releases.”

a. Summarize the major types of issues that the SEC addresses in these press releases.

b. Review the past three months of releases, and count how many appear to be enforcement actions aimed at firms or individuals who have violated SEC regu- lations. From this review, does the SEC appear to be actively trying to prevent fraud and misrepresentation in the securities industry?

WeB referenCeS

http://dodd-frank.com/

A website devoted to the discussion of and the dissemina- tion of information about the Dodd-Frank Act.

http://www.moodys.com

Moody’s is a major rating agency for company debt. To view the Moody’s website and learn more about how it evaluates company credit, you must register.

http://www.sarbanes-oxley.com/

A website devoted to the discussion of and the dissemina- tion of information about the Sarbanes-Oxley Act.

http://www.sec.gov/

The SEC is responsible for preventing fraud in the securities markets. Click on “What We Do” to learn what role the SEC envisions for itself in the securities industry.

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Central Banking and the Conduct of Monetary Policy

Crisis and Response: The Federal Reserve and the Global Financial Crisis

When the Federal Reserve was confronted with what former Chairman Alan Greenspan described as a “once-in-a-century credit tsunami,” it resolved to come to the rescue. Starting in September 2007, the Federal Reserve lowered the federal funds rate target, bringing it down to zero by the end of 2008. At the same time, the Fed implemented large liquidity injections into the credit markets to encourage them to lend again. In mid-August 2007, the Fed lowered the discount rate at which it lent to banks to just 50 basis points above the federal funds rate target, from the normal 100 basis points. Over the course of the crisis, the Fed broadened its provision of liquidity to the financial system well outside its traditional lending to depository institutions. Indeed, after the Fed made loans to assist in the takeover of Bear Stearns by J.P. Morgan in March 2008, Paul Volcker, a former chairman of the Federal Reserve, described the Fed’s actions as going to the “very edge of its lawful and implied powers.” The number of new Fed lending programs over the course of the crisis spawned a whole new set of acronyms—TAF, TSLF, PDCF, AMLF, CPFF, and MMIFF—making the Fed sound like the Pentagon with code-named initiatives and weapons. Like the Pentagon, the Fed was fighting a war, although its weapons were financial rather than guns, tanks, or aircraft.

The recent global financial crisis demonstrated the importance of central banks like the Federal Reserve to the health of the financial system and the economy. Chapter 16 outlines what central banks are trying to achieve, what motivates them, and how they are set up. Chapter 17 describes how the money supply is determined. In Chapter 18, we look at the tools that central banks like the Fed have at their disposal and how they use them. Chapter 19 extends the discussion of the conduct of monetary policy to focus on the broader picture of central banks’ strategies and tactics.

4 Part

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16 Preview

Among the most important players in financial markets throughout the world are central banks, the government authorities in charge of monetary policy. Central banks’ actions affect interest rates, the amount of credit available, and the money supply, all of which have direct impacts not only on financial markets but also on aggregate output and inflation. To understand the role that central banks play in financial markets and the overall economy, we need to understand how these organiza- tions work. Who controls central banks and determines their actions? What motivates their behavior? Who holds the reins of power?

In this chapter, we look at the institutional structure of major central banks and focus particularly on the Federal Reserve System, one of the most important central banks in the world. We start by examining the elements of the Fed’s institutional struc- ture that determine where the true power within the Federal Reserve System lies. By understanding who makes the decisions, we will have a better idea of how they are made. We then examine the reasons behind central bank behavior and whether it is a good idea to make central banks independent by insulating them from politicians. Finally, we look at the structure and independence of other major central banks, par- ticularly the European Central Bank. With this context in place, we will be prepared to comprehend the actual conduct of monetary policy described in the following chapters.

Origins Of the federAl reserve system Of all the central banks in the world, the Federal Reserve System probably has the most unusual structure. To understand how this structure arose, we must go back to before 1913, when the Federal Reserve System was created.

Before the twentieth century, a major characteristic of American politics was the fear of centralized power, as seen in the checks and balances provisions of the Constitution and the preservation of states’ rights. This fear of centralized power was one source of American resistance to the establishment of a central bank. Another source was the traditional American distrust of moneyed interests, the most prominent symbol of which was a central bank. The open hostility of the American public to the existence of a central bank resulted in the demise of the first two experiments in central banking, whose function it was to police the banking system: The First Bank of the United States was disbanded in 1811, and the national charter of the Second Bank of the United States expired in 1836 after its renewal was vetoed in 1832 by President Andrew Jackson.

Central Banks and the Federal Reserve System

learning Objectives • Recognize the historical context of the develop- ment of the Federal Reserve System.

• Describe the key features and functions of the Federal Reserve System.

• Assess the degree of independence of the Federal Reserve.

• Summarize the argu- ments for and against the independence of the Federal Reserve.

• Identify the ways in which the theory of bureaucratic behavior can help explain Federal Reserve actions.

• Identify the similarities and distinctions in structure and inde- pendence between the European Central Bank and the Federal Reserve.

• Assess the degree of independence of other major central banks around the world.

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C h a P t e r 1 6 Central Banks and the Federal Reserve System 361

The termination of the Second Bank’s national charter in 1836 created a severe prob- lem for American financial markets because there was no lender of last resort that could provide reserves to the banking system in order to avert a bank panic. Hence, in the nineteenth and early twentieth centuries, nationwide bank panics became a regular event, occurring every twenty years or so, culminating in the panic of 1907. The 1907 panic resulted in such widespread bank failures and such substantial losses to depositors that the public was finally convinced that a central bank was needed to prevent future panics.

The hostility of the American public to banks and centralized authority meant great opposition to the establishment of a single central bank like the Bank of England. Fear was rampant that the moneyed interests on Wall Street (including the largest corpora- tions and banks) would be able to manipulate such an institution to gain control over the economy, and that federal operation of the central bank might result in too much government intervention in the affairs of private banks. Serious disagreements existed over whether the central bank should be a private bank or a government institution. Because of the heated debates on these issues, a compromise was struck. In the great American tradition, Congress wrote an elaborate system of checks and balances into the Federal Reserve Act of 1913, which created the Federal Reserve System with its twelve regional Federal Reserve Banks (see the Inside the Fed box, “The Political Genius of the Founders of the Federal Reserve System”).

structure Of the federAl reserve system The writers of the Federal Reserve Act wanted to diffuse power along regional lines, between the private sector and the government, and among bankers, business people, and the public. This initial diffusion of power resulted in the evolution of the Federal Reserve System to include the following entities: the Federal Reserve Banks, the Board of Governors of the Federal Reserve System, the Federal Open Market

Inside the Fed The Political Genius of the Founders of the Federal Reserve System

The history of the United States has been one of pub- lic hostility to banks and especially to a central bank. How were the politicians who founded the Federal Reserve able to design a system that has become one of the most prestigious institutions in the United States?

The answer is that the founders recognized that if power was too concentrated in either Washington, DC, or New York, two cities that many Americans loved to hate, an American central bank might not have enough public support to operate effectively. They thus decided to set up a decentralized system with twelve Federal Reserve Banks spread through- out the country, to make sure that all regions of the

country were represented in monetary policy delib- erations. In addition, they made the Federal Reserve Banks quasi-private institutions overseen by directors from the private sector living in each district. These directors would represent the views of their indi- vidual regions and would be in close contact with the president of their Federal Reserve Bank. The unusual structure of the Federal Reserve System ensured that regional issues would be addressed, as is evident in Federal Reserve Bank publications. Without this unusual structure, the Federal Reserve System might have been far less popular with the public, making the institution far less effective.

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362 P a r t 4 Central Banking and the Conduct of Monetary Policy

Committee (FOMC), the Federal Advisory Council, and around 2,000 member com- mercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements), discussed in Chapters 17 and 18.

federal reserve Banks Each of the twelve Federal Reserve districts defined by the Federal Reserve Act of 1913 has one main Federal Reserve Bank, which may have branches in other cities in the

Open market operations

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Reviews and determines

Appoints three directors to each FRB

Elect six directors to each FRB

Discount rate

Reserve requirements

Select

Sets (within limits)

Directs

Advises Advises

Establish

Member BanksTwelve Federal Reserve Banks (FRBs)

Each with nine directors, six of whom appoint president and other of�cers of the FRB

Board of Governors

Seven members, including the chairman, appointed by the president of the United States and con�rmed by the Senate

Federal Advisory Council

Twelve members (bankers), one from each district

Federal Open Market Committee (FOMC)

Seven members of Board of Governors plus presidents of FRB of New York and four other FRBs

Around 2,000 member commercial banks

FIgure 1 structure and responsibility for Policy tools in the federal reserve system The relationships of the Federal Reserve Banks, the Board of Governors of the Federal Reserve System, and the

FOMC to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements). Dashed lines indicate that the FOMC “advises” on the setting of reserve requirements and the discount rate.

MyEconLab Mini-lecture

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C h a P t e r 1 6 Central Banks and the Federal Reserve System 363

district. The locations of these districts, the Federal Reserve Banks, and the Federal Reserve Bank branches are shown in Figure 2. The three largest Federal Reserve Banks in terms of assets are those of New York, Chicago, and San Francisco—combined, they hold more than 50% of the assets (discount loans, securities, and other holdings) of the Federal Reserve System. The New York bank, with around one-quarter of the assets, is the most important of the Federal Reserve Banks (see the Inside the Fed box, “The Special Role of the Federal Reserve Bank of New York”).

Each of the Federal Reserve Banks is a quasi-public (part private, part government) institution owned by the private commercial banks in its district that are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve Bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors.

The directors of a district bank are classified into three categories: A, B, and C. The three A directors (elected by the member banks) are professional bankers, and the three B directors (also elected by the member banks) are prominent leaders from industry, labor, agriculture, or the consumer sector. The three C directors, who are appointed by the Board of Governors to represent the public interest, are not allowed to be officers, employees, or stockholders of banks.

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