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8 Basic Facts
1. Stocks are not the most important sources of external financing for a
business
2. Issuing marketable debt and equity securities are not the primary way
businesses finance their operations
3. Indirect finance is many times more important than direct finance
4. Financial intermediaries (such as banks) are the most important source of
external funds used to finance businesses
5. The financial sector is among the most heavily regulated sectors of the
economy
6. Only large, well-established companies have easy access to securities market
to finance their activities
7. Collateral is a prevalent feature of debt contracts for both businesses and
households.
8. Debt contracts are extremely complicated legal documents that place
substantially restrictive covenants on borrowers
Transaction Costs
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How moral hazard affects choice between debt and equity contract
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Principal-Agent problem
o Principal: less info/stockholder
o Agent: more info/manager
Separation of ownership and control of frim
o Managers pursue power and benefits and not profitability of firm
Tools to help
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Monitoring
o Fact 1, free-rider problem
Government regulation
o Fact 5
Financial Intermediation
o Fact 3
Debt Contracts
o Fact 1
Borrowers have incentive to take on projects that are riskier than lenders
would like
o Prevents them from paying back loan
Tools to solve
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Fin systems in developing and transition countries face difficulties that keep
them from operating efficiently
o System of property rights functions poorly and makes it hard to use
tools effectively
Financial Crises
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Stage
o
o
o
o
Stage
Stage
Brought by:
o Stock market crash
o
o
o
Bank panics
Debt deflation
Continuing decline of stock prices
Causes:
o Financial innovations emerge in mortgage markets
Subprime, alt-A mortgages
Mortgage-backed securities
Collateral debt obligations (CDOs)
o Housing bubble forms
Increase in liquidity from cash flows surging to USA
Innovations increased demand for housing and increased the
prices
o Agency Problems arise
originate to distribute model is subject to principal/investor
and agent/broker problem
Borrowers had little incentive to disclose info about ability to pay
Commercial and investment banks had weak incentive to assess
quality of securities
o Information problems surface
o Bubble bursts
o Crisis spreads globally
Sign of globalization of financial markets
TED spread (3 month interest rate of Eurodollar minus 3 months
treasury bills rate) increased from 40 basis points to almost 240.
o Banks balance sheet deteriorates
Write downs and selling of assets/credit restriction
o High profile firms fall (Bear Sterns, Fannie Mae, Freddie Mac, Lehman
Brothers, Merrill Lynch, AIG, Reserve Primary Fund and Washington
Mutual)
o Bailout package debated
o Stimulus plan
Some argue low interest rate policies by the Fed from 03-06 caused the house
pricing bubble
Taylor argues low rate meant low mortgage rate which cause issuing of subprime
mortgages and bubble
Fed argued that proliferation of innovation that relaxed lending standards that
brought more buyers
Dynamics of Financial Crises in Emerging Market Economies
Stage 1: initiation of financial crisis
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Review application
Banking and Management of Financial Institutions
Liab
Reserves 20m
deposits 90m
Deposits 100m
Loans 80m
Securities 10m
Assets
Liab
Reserves 10m
Loans 80m
securities 10m
If required reserves are 10% and has ample reserves, outflow does not necessitate
change in other parts of balance sheet
Shortfall in Reserves
Assets
Liab
Assets
Liab
Reserves 10m
deposits 90m
Loans 90m
Deposits 100m
Securities 10m
-
Reserves 0m
Loans 90m
securities 10m
Assets
Liab
Borrowing 9m
Securities 10m
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Securities Sale
Reserves 9mdeposits 90m
Loans 90m
Securities 1m
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Federal Reserve
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Reducing loans
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Subtract loans
Antagonizes customers, most costly way, other banks may agree to purchase
loans at a substantial amount
Seek highest possible return on loans and securities, reduce risk and have
adequate liquidity
Shortfall of bank capital led to slower credit growth: huge losses from
mortgages resulted into reduced bank capital
Banks couldnt raise capital in weak economy, tightened lending standards
and reduced lending
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
Lending from the central bank to troubled institutions/ lender of last resort
Financial Supervision
Chartering screening of proposals to open new financial institutions to prevent
adverse selection
Examinations scheduled and unscheduled monitoring of capital requirements and
restrictions on asset holding to prevent moral hazard. Capital adequacy, asset
quality, management, earnings, liquidity, sensitivity to market risk
Filing periodic call reports
Assessment of Risk Management
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Microprudential vs Macroprudential
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Fed and state banking authorities: state banks part of the Fed regulates bank
holding companies
FDIC: insured state banks not part of Fed
State banking authorities: state banks without FDIC insurance
Shadow Banking System Financial innovation is driven by the desire to earn profit
Financial Engineering change in the financial environment will stimulate a search
by financial institutions for innovations that are likely to be profitable
Adjustable rate mortgages: flexible interest rates keep profits high when rates
rise and lower initial rates make it attractive
Financial derivatives: ability to hedge interest pay risk. Payoffs are linked to
previously issued or derived from previous securities
Information Technology
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Bank debit and credit cards: improved tech lowers transaction costs
Electronic banking
Junk bonds and commercial paper market
Securitization: transform illiquid assets to marketable capital market
securities.
o Important role in the development of the subprime mortgages
Mutual Savings Bank: Half are chartered by states, regulated by state where they
are located and FDIC or state insurance
Credit unions: Tax exempt, chartered by fed gov or state
International banking: rapid growth. Eurodollar market and global investment
banking is profitable. Growth in intl trade and multinational corporations
Eurodollar market: Dollar-denominated deposits held in banks outside of the U.S.
Most widely used currency in foreign trade. Offshore deposits not subject to
regulation. Important source of funds for US banks
Structure of US Banking Overseas : shell operations, edge act corps, international
banking facilities
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Agency office of the foreign bank. Can lend and transfer fund in the U.S.
Cannot accept deposits from domestic residents. Not subject to regulations
Subsidiary U.S. bank is subject to U.S. regulations. Owned by a foreign bank.
Branch of foreign bank: limited service maybe allowed in any other state,
branches only in designated home state or in state that allows entry of out of
state banks
Subject to International Banking Act of 1979
Demand
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When the federal funds rate is above the rate paid on excess reserves, ier, as
the federal funds rate decreases, the opportunity cost of holding excess
reserves falls and the quantity of reserves demanded rises. Downward
sloping demand curve that becomes flat (infinitely elastic) at ier
Supply
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above id, banks will borrow more and more at id, and re-lend at if. The supply
curve is horizontal (perfectly elastic) at id.
With excess demand, federal funds rate rises. Opposite for excess supply.
An open market purchase causes the federal funds rate to fall whereas an
open market sale causes the federal funds rate to rise (when intersection
occurs at the downward sloped section).
Open market operations have no effect on the federal funds rate when
intersection occurs at the flat section of the demand curve.
If the intersection of supply and demand occurs on the vertical section of the
supply curve, a change in the discount rate will have no effect on the federal
funds rate.
When the Fed raises reserve requirement, the federal funds rate rises and
when the Fed decreases reserve requirement, the federal funds rate falls.
How the Federal Reserves Operating Procedures Limit Fluctuations in the Federal
Funds Rate
A. Leftward shift of demand makes rate = minimum interest rate of reserve
B. Rightward shift od demand makes rate into a maximum of discount rate
Conventional Monetary Policy Tool
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