2012 Pearson Education, Inc.

Publishing as Prentice Hall

R. GLENN
HUBBARD
ANTHONY PATRICK
OBRIEN
Money,
Banking, and
the Financial
System
2012 Pearson Education, Inc. Publishing as Prentice Hall
Introducing Money and the
Financial System
C H A P T E R
1
1.1
1.2
1.3
Identify the key components of the financial system
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Provide an overview of the financial crisis of 20072009
Explain the key issues and questions the financial crisis raises
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CAN THE FED RESTORE THE FLOW OF MONEY?

During the economic crisis that began in 2007, the financial system was
disrupted as it hadnt been since the 1930s.

Large sections of the U.S. economy were cut off from the flow of funds they
needed to thrive.

Some government intervention was necessary to pull the economy out of a
deep recession.

During the recession, more than 8 million jobs were lost, GM declared
bankruptcy, and some Wall Street investment houses disappeared.

Introducing Money and the
Financial System
C H A P T E R
1
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1.1 Learning Objective
Identify the key components of the financial system.
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Key Components of the Financial System
1. Financial assets

An asset is anything of value owned by a person or a firm.

A financial asset is an asset that represents a claim on someone else for a
payment.

2. Financial institutions

3. The Federal Reserve and other financial regulators
Three major components of the financial system:
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Financial Assets
Economists divide financial assets into those that are securities and those that
arent.

A security is a financial asset that can be bought and sold in a financial market.

Financial markets are places or channels for buying or selling stocks, bonds,
and other securities.
Key Components of the Financial System
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Financial Assets
Five key categories of financial assets:

1. Money

2. Stocks

3. Bonds

4. Foreign exchange

5. Securitized loans
Key Components of the Financial System
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Financial Assets
Money Anything that is generally accepted in payment for goods and services
or to pay off debts.
The money supply is the total quantity of money in the economy.
Money
Key Components of the Financial System
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Financial Assets
Stocks are financial securities that represent partial ownership of a firm; also
called equities.
Dividend A payment that a corporation makes to its shareholders.
Stocks
Key Components of the Financial System
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Financial Assets
Bond A financial security issued by a corporation or a government that
represents a promise to repay a fixed amount of money.
Interest rate The cost of borrowing funds (or the payment for lending funds),
usually expressed as a percentage of the amount borrowed.
Bonds
Key Components of the Financial System
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Financial Assets
Foreign exchange Units of foreign currency.
Foreign Exchange
To buy foreign goods and services or foreign assets, a domestic business or a
domestic investor must first exchange domestic currency for foreign currency.
Banks engage in foreign currency transactions on behalf of investors and
business firms.
Key Components of the Financial System
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Financial Assets
Securitized Loans
Before markets for loans were created, it wasnt possible to sell loans. Loans
were financial assets but not securities.

Securitization The process of converting loans and other financial assets that
are not tradable into securities.

Note that what a saver views as a financial asset a borrower views as a
financial liability.

Financial liability A financial claim owed by a person or a firm.
Key Components of the Financial System
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Financial intermediary A financial firm, such as a bank, that borrows
funds from savers and lends them to borrowers.
Financial Institutions
The financial system matches savers and borrowers through two channels:

(1) Banks and other financial intermediaries




(2) Financial markets

Funds flow from lenders to borrowers indirectly through financial
intermediaries, such as banks, or directly through financial markets, such
as the New York Stock Exchange.
Key Components of the Financial System
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Figure 1.1
Moving Funds Through the Financial System
The financial system transfers funds from savers to borrowers. Borrowers transfer
returns back to savers through the financial system. Savers and borrowers include
domestic and foreign households, businesses, and governments.
Key Components of the Financial System
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Commercial bank A financial firm that serves as a financial intermediary by
taking in deposits and using them to make loans.

Households rely on borrowing money from banks to purchase big ticket items.

Firms rely on banks to meet their short- and long-term needs for credit.

Some financial intermediaries, such as savings and loans, savings banks, and
credit unions, are legally distinct from banks.

Financial Institutions
Financial Intermediaries
Key Components of the Financial System
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Making the Connection
Pawn Shop Finance: What Happens to Small Businesses
When Bank Lending Dries Up?
Pawn shops typically make small loans at high interest rates.

Before the financial crisis of 2007-2009, banks loosened lending
requirements. During the crisis, defaults by households and firms increased
dramatically.

Loan losses during 20072009 were by far the largest since the Great
Depression of the 1930s.

Many banks cut small businesses off from credit, forcing them to borrow
from pawn shops, family, or friends to operate.
Key Components of the Financial System
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Making the Connection
Pawn Shop Finance: What Happens to Small Businesses
When Bank Lending Dries Up?
Key Components of the Financial System
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Nonbank Financial Intermediaries
Insurance companies





Pension funds
Insurance companies collect premiums from customers then invest the
premiums to obtain the funds necessary to pay claims and other costs.
Pension funds invest contributions from workers and firms in stocks, bonds,
and mortgages to earn the money necessary to make pension benefit
payments.
Key Components of the Financial System
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Nonbank Financial Intermediaries

Mutual funds






Hedge funds




Investment banks
Portfolio A collection of assets, such as stocks and bonds.
A mutual fund obtains money by selling shares to investors and invests the
money in a portfolio of financial assets.
Hedge funds are similar to mutual funds but typically have no more than 99
wealthy investors and make riskier investments.
Investment banks concentrate on providing advice to firms issuing stocks
and bonds or considering mergers with other firms.
Key Components of the Financial System
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Financial Markets
Primary market A financial market in which stocks, bonds, and other securities
are sold for the first time.
Secondary market A financial market in which investors buy and sell existing
securities.
Financial markets are places or channels for buying and selling stocks, bonds,
and other securities.

Today, most securities trading takes place electronically between dealers linked
by computers and is referred to as over-the-counter trading.
Key Components of the Financial System
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Making the Connection
What Do People Do With Their Savings?
Key Components of the Financial System
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The Federal Reserve and Other Financial Regulators
Federal agencies that regulate the financial system:

Securities and Exchange Commission (SEC)

The Federal Deposit Insurance Corporation (FDIC)

Office of the Comptroller of the Currency

The Federal Reserve System (the focus of this book)
Key Components of the Financial System
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The Federal Reserve is the central bank of the United States; usually
referred to as the Fed.

Established by Congress in 1913 to deal with banking problems.

Original role: Serve as a lender of last resort.
What Is the Federal Reserve?
Key Components of the Financial System
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The Fed is responsible for monetary policy. Monetary policy refers to the
actions the Federal Reserve takes to manage the money supply and interest
rates to pursue macroeconomic policy objectives.

The Fed is divided into 12 districts (See Figure 1.2).

The main policymaking body of the Fed is the Federal Open Market
Committee (FOMC).

Chair, Ben Bernanke from 2006 present.

The FOMC meets eight times per year. During these meetings, the Fed
decides on a target for the federal funds rate.
Federal funds rate The interest rate that banks charge each other on short-
term loans.
What Does the Federal Reserve Do?
Key Components of the Financial System
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Figure 1.2
The Federal Reserve System
The Federal Reserve System is divided into 12 districts, each of which has a District
Bank located in the city shown on the map.
Key Components of the Financial System
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Diversification Splitting wealth among many different assets to reduce risk.
Risk sharing A service the financial system provides that allows savers to
spread and transfer risk.
What Does the Financial System Do?
Risk Sharing
The financial system provides three services to savers and borrowers: risk
sharing, liquidity, and information.
Risk is the chance that the value of financial assets will change relative to what
you expect.
Key Components of the Financial System
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Liquidity The ease with which an asset can be exchanged for money.

Financial markets and intermediaries help make financial assets more liquid.
Information Facts about borrowers and about expectations of returns on
financial assets.

Financial markets convey information to both savers and borrowers by
determining the prices of stocks, bonds, and other securities.
Liquidity
Information
Key Components of the Financial System
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Solved Problem
The Services Provided by Securitized Loans

Briefly discuss the extent to which securitized loans embody the key services
of risk sharing, liquidity, and information.
1.1
Key Components of the Financial System
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Solved Problem
The Services Provided by Securitized Loans

Solving the Problem
Step 1 Review the chapter material.

Step 2 Define securitized loans.

Non-securitized loans are financial assets but not financial securities. Securitized loans are
loans that have been bundled with other loans and resold to investors; they are both
financial assets and financial securities.

Step 3 Explain whether securitized loans provide risk sharing, liquidity, and
information.

1.When a mortgage is bundled together with other mortgage-backed securities, the buyers
jointly share the risk of a default.

2.A securitized loan can be resold and so has a secondary market, which makes it liquid.

3.When loans are securitized, investors rely on the bank or other loan originator to have
gathered the necessary information.

So, securitized loans provide all three of these key services.
1.1
Key Components of the Financial System
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1.2 Learning Objective
Provide an overview of the financial crisis of 20072009.
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Bubble An unsustainable increase in the price of a class of assets.
Origins of the Financial Crisis
Overly optimistic expectations, and more importantly, changes in the
mortgage market for made it easier for families to borrow money to buy
houses.

Two government-sponsored enterprises (GSEs), the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac), sold bonds to investors and used the funds to
purchase mortgages from banks.

Investment banks became significant participants in the mortgage market,
bundling and selling mortgage-backed securities.
The Financial Crisis of 20072009
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Origins of the Financial Crisis
Standards for obtaining loans were greatly loosened. By 2005, many
mortgages were being issued to subprime borrowers with flawed credit
histories.

Adjustable-rate mortgages allowed borrowers to pay a very low interest rate.

Both borrowers and lenders anticipated higher housing prices, which would
reduce the chance of default.

Unfortunately, the decline in housing prices that began in 2006 led to rising
defaults and a sharp decline in the value of many mortgage-backed securities.
The Financial Crisis of 20072009
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Figure 1.3 The Housing Bubble
Panel (a) shows that housing bubble resulted in rapid increases in both sales of new
houses and housing prices between 2000 and 2005, followed by sharp decreases in
sales and prices from early 2006 through early 2009 and then a slow revival.
Panel (b) shows that home prices followed a similar pattern to home sales.
Origins of the Financial Crisis
The Financial Crisis of 20072009
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The Deepening Crisis and the Response of the Fed
and Treasury
In October 2008, Congress passed the Troubled Asset Relief Program (TARP),
under which the Treasury provided funds to commercial banks in exchange for
stock in those banks.

Many policies of the Fed and Treasury during the recession of 20072009 were
controversial because they involved:

Partial government ownership of financial firms

Implicit guarantees to large financial firms that they would not be allowed to
go bankrupt

Unprecedented intervention in financial markets

Many feared that the Feds actions might reduce its independence.
The Financial Crisis of 20072009
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Key Topics
Powerful Forces Reshaping the Industry
What Is a Bank?
The Financial System and Competing Financial-Service Institutions
Old and New Services Offered to the Public
Key Trends Affecting All Financial-Service Firms

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The Different Kinds of Financial Service
Firms Calling Themselves Banks
Commercial Banks
Savings Banks
Cooperative Banks
Mortgage Banks
Community Banks
Money Center Banks
Investment Banks
Merchant Banks
International Banks
Wholesale Banks
Retail Banks
Limited Purpose Banks
Bankers Banks
Minority Banks
National Banks
State Banks
Insured Banks
Member Banks
Affiliated Banks
Virtual Banks
Fringe Banks
Universal Banks

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The Financial Service Competitors of Banks
Savings Associations
Credit Unions
Money Market Funds
Mutual Funds (Investment Companies)
Hedge Funds
Security Brokers and Dealers
Investment Companies
Finance Companies
Financial Holding Companies
Life and Property-Casualty Insurance Companies
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Quick Quiz
What is a bank? How does a bank differ from most other financial-
service providers?

Under current U.S. federal law what must a corporation do to qualify
and be regulated as a commercial bank?

What is happening to bankings share of the financial marketplace and
why?

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Traditional Services Offered By Banks
Carrying Out Currency Exchange
Discounting Commercial Notes and Making Business Loans
Offering Savings Deposits
Safekeeping of Valuables
Supporting Government Activities with Credit
Offering Checking Accounts
Offering Trust Services
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More Recent Services Offered by
Banks
Granting Consumer Loans
Providing Financial Advice
Managing Cash
Offering Equipment Leasing
Making Venture Capital* Loans
Selling Insurance Policies
Selling Retirement Plans
*Money provided by investors to start-up firms and small
businesses with perceived long-term growth potential

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Offering Security Brokerage and
Investment Banking Services
Underwriting* Securities
Offering Mutual Funds and Annuities**
Offering Merchant Banking Services
Offering Risk Management and Hedging Services
*The process by which investment bankers raise investment capital
from investors on behalf of corporations and governments that are
issuing securities (both equity and debt).
**Annuities are primarily used as a means of securing a steady cash
flow for an individual during their retirement years.
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Trends Affecting Banks and Other
Financial Service Firms Today
Service Proliferation@increase
Rising Competition
Government Deregulation
Increased Interest Rate Sensitivity
Technological Change and Automation
Consolidation and Geographic Expansion
E-Banking and E-Commerce
Convergence/emerging
Globalization
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Quick Quiz
Why do banks and other financial intermediaries
exist in modern society, according to the theory
of finance?

How have banking and the financial services
market changed in recent years?

What powerful forces are shaping financial
markets and institutions today? Which of these
forces do you think will continue into the future?
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Web Links
Federal Deposit Insurance Company www.fdic.gov
Federal Financial Institutions Examination Council
www.ffiec.gov
Office of Thrift Supervision www.ots.treas.gov
Credit Union National Association www.cuna.org
Morningstar, Inc. http://www.morningstar.com
Security and Exchange Commission www.sec.gov
Careers in Finance www.careers-in-finance.com
Bank Job Search www.bankjobsearch.com
Bank Jobs www.bankjobs.com



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