Financial Regulation

From 1933 Glass Steagall Act

1) FDIC (Federal Deposit Insurance Corporation)
2) Separation of financial institutions (repealed 1999)
3) Created Securities and Exchange Commission (SEC)

1940s Investment Company Act-strict rules for Mutual Funds (no

leverage, no shorting)
Hedge funds exempt as qualified investors only

2004 SEC eliminated 15x leverage rule for securities firms

Too many opaque, unregistered securities like CMOs, Credit
Default swaps, and many derivatives.
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 FDIC insures deposits at
commercial banks

When banks failed, FDIC bailed out their depositors (to $250,000 each
depositor.) In 2010, 157 banks with approximately $92 billion in total assets
failed.
New responsibilities under Dodd-Frank to liquidate systemically significant
financial companies (not just banks)
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(Dodd-Frank may be modified by new Congress)
 The Federal Reserve
 The Federal Reserve, the central bank of the United
States, was established in 1913 (under President
Wilson)
 The Fed is controlled by a 7-person Board of

Governors, who sit for 14-year terms.

 The President of US designates 1 of the

7 as Chair for 4 year terms. Ben

Bernanke was reappointed by Pres.
Obama for 2010 to January, 2014,
Janet Yellen is Chair for 2014-2018
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 The Fed’s Role
 The Fed is the monetary agent (it affects MS and interest rates
(and credit easing in 2008-09 in financial markets).
 The Fed exercises its role by buying and selling U.S. Treasury
securities and regulating banks and using its emergency powers to
help financial markets
 The U.S. Treasury is the fiscal agent; it sells Bonds, Bills,

and Notes to finance deficits.

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The Federal Reserve Districts
 The Fed’s T-Account
Assets Liabilities + Net Worth
Gold certificates Currency outstanding
U.S. Government Securities, (outside the Fed)
Agency backed mortgage securities
Reserve Deposits of banks
Loans to banks TAF: Loans to other
financial institutions (brokers, dealers.
MMMF)
Deposits of foreign banks
Other loans Deposits of U.S. Treasury
Special Drawing Rights (SDR’s are
loans to IMF)
Foreign currency for dollar swaps Net Worth
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 The Fed’s Tools for Affecting
the Money Supply
 The Fed has several tools for affecting the money
supply (and affecting interest rates).
I. Traditional Open Market Operations:
1. The Fed buys U.S. government securities to expand
the money supply (and temporarily reduce interest
rates).
2. The Fed sells from its holdings of U.S. government
securities to contract the money supply (and
temporarily increase interest rates).
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 The Fed’s Tools continued
II. Change the Reserve Requirement (not used in
decades)
III. Loans to Banks not just discount window, but
new lending facility auctions (Term Auction
Facility) 2007-08 and from March 2008-2009 loans
to Investment banks too

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Monetary and Credit Policy responses
2007-09—increases in Fed loans
IV. Fed had only to invoke emergency powers (13.3) to make loans to
nonbank financial institutions. (Didn’t have to ask Congress or
Treasury. Under Dodd-Frank (2010) would have to ask Treasury)
Extensions of Fed Credit (loans from Fed i.e. money creation)
Primary Dealer Credit Facility (3/08) and Term Securities
Lending Facility
Loans to Money Market Mutual Funds (fall 2008) Money Market
Investor Funding Facility( run through JPMorgan-Chase)--lend
up to $540 billion to MMMF (and Treasury guaranteed assets
in MMMF)

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Monetary and Credit Policy responses
2007-09—increases in Fed loans-2
Extensions of Fed Credit (loans from Fed i.e. money creation)
continued
Commercial Paper Funding Facility (CPFF) (fall 2008) bought
Commercial Paper---self liquidated as short term loans
Term Asset-Backed Securities Loan Facility (TALF created in
11/’08, but operational March ‘09) aimed to restore securitization
markets in student loans, credit card debt, auto loans, loans
guaranteed by the Small Business Administration
Agency-backed Mortgage-backed securities ---purchases helped
hold down mortgage rates and provide funds to Fannie-Mae and
Freddie Mac
Quantitative easing=> an announced securities purchasing plan
V. Moral suasion
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 The Fed’s Control of MS Is Not Exact

The Fed directly controls the monetary base.

Base = R + C The Fed: A Powerful But
Not Omnipotent Guardian
The Base is also called “high-powered money”

The Fed sets RR, but banks may change their holdings of excess
reserves, and the public can change the amount of currency it holds.
If banks are afraid existing loans might default, they won’t make more
loans when get excess reserves.
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 A comment on interest rates from
page 151 in Packet
Short term interest rates: 3 month Treasury bills, 90 day commercial
paper, bank rate for prime customers, The Fed often does OMO with
Treasury bills
Long term interest rates: US Treasury bonds, Corporate bonds,
mortgages (Fed was actively in this market 2008-09 with purchases of
agency backed mortgage securities, most recent quantitative easing
ended)
Long rates will be more affected by inflationary expectations and foreign
demand for our bonds, but in general most interest rates move together.
When they are rising we say, “the interest rate is rising”
Macroeconomic factors like Fed policy, the supply and demand to hold
money, inflationary expectations, and the supply of domestic (and
foreign dollar) savings compared to the profitable opportunities for
investment can all affect interest rates.
Spreads between instruments change if default risks change 12
 Normal Fed procedures: The Fed Sets
Fed Funds Rate Targets (but 0 12/08-12/15)
If the Fed wants to tighten, it sells Treasury securities, which directly puts
upward pressure on their interest rates.
To loosen it buys Treasury securities, which pushes interest rates down
(unless near zero).
The Fed watches the Fed Funds Rate to see how much pressure it is
putting on Banks’ Reserves
It pre-announces in FOMC meetings how much it intends to tighten or
loosen by giving its new Fed Funds Target Rate.
Financial Markets then know what the Fed is doing
To tighten it raises the Fed Funds target rate and sells Treasury
securities, which makes reserves scarce and drives up the actual fed
funds rate.
To loosen it lowers the Fed Funds target rate and buys Treasury
securities, which increases reserves and drives down the actual fed
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funds rate. (Since 12/08 does quantitative easing to loosen)
Fed loosened to fight recession of 2001

From January 1, 2001 to June 25, 2003 Fed decreased Fed

Funds target rate from 6.50% to 1% to fight recessionary
gap

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Getting back to a neutral Fed funds rate, i.e.
preventing inflationary gap (2004-2006)
Held 1% too long=>housing price boom
Beginning in June of 2004 with the rate down to
1%, the Fed raised the Fed Funds Target Rate
by .25% (called 25 basis points) at every
regularly scheduled meeting of the FOMC (17
times)
Last increase was June 29, 2006 when Fed
raised FFTR to 5.25%

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Zero FFTR meant securities buying
was only Fed tool to stimulate
Fed not much further affect on interest rates
except on long rates by buying bonds.
Quantitative easing helped keep long rates down
and added to money supply
Recessionary gap of 2009 meant needed
Countercyclical Fiscal Policy too

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II. The Fed can change Reserve Requirements
(last changed in 1992 from 12% to 10%)
doesn’t change amount of reserves
Suppose the required reserve ratio is 20% and the banking
system has no excess reserves.

U.S. BANKS

Assets L + NW

Reserves and vault Checking deposits:

cash: $200 $1,000
loans: $1000 Net Worth: $200

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 The Potential Multiplier Effect of
Changing the Reserve Requirement
Then the Fed reduces the required reserve ratio to 10%. U.S.
Banks now have $100 of excess reserves. Assume the banks lend
out their excess reserves,
 Thus at the end of the process, if there were no excess reserves
and no currency drain, there would be another $1,000 of loans
and another $1,000 of deposits.

U.S. BANKS
M = (1/RR) ( excess reserves)
Assets L + NW
Reserves and Checking $1,000 = (1/.10)(100)
vault cash: deposits: $2,000
$200
Net Worth: $200
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loans: $2,000
Fed didn’t lower reserve
requirement in 2008

Banks would not have made loans as wanted excess

reserves. Banks were afraid that new loans might
default.

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 IV. Increases in other Fed loans

Driving the Fed Funds Target Rate to near zero in

Dec. 2008 was not enough to close the recessionary
gap
The Fed made new loans as given in slides 12 and 13
The Fed also worked with the Treasury on TARP.
Congress had to pass this authorization and delayed while
markets collapsed in late Sept and early October ‘08.
TARP Funds given to major banks to give them more
reserves, so not insolvent. (also used for AIG, GM, GMAC.
and Chrysler)
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