CH-3-4 Banks and Other Financial Institutions – Introduction to Finance: Markets, Investments, and Financial Management : Book Guide

This Document Contains Chapters 3 to 4 Chapter 3 Banks and Other Financial Institutions CHAPTER PREVIEW Financial institutions play a major role in directing savings to business firms. The savings of individuals are gathered, pooled, and then lent to or invested in the securities of business firms. A well-operating banking system also is critical to the success of both the monetary system and the broader financial system. We first discuss the types and roles of major financial institutions in carrying out the savings-investment process. We then provide an overview of the banking system including a comparison of commercial banking and investment banking, as well as a discussion of the functions of banks and the banking system. We then review the historical development of the U.S. banking system and discuss how the banking system has been and currently is regulated. Next, we turn our attention to the structure of banks, the bank balance sheet, and how banks are managed. Bank management involves the trade-off between profitability and safety or risk. We discuss both bank liquidity management and the need to maintain adequate capital. We conclude the chapter with a brief discussion of international banking and several other foreign banking systems. LEARNING OBJECTIVES Describe the major financial institutions and their roles in the financial system. Describe the differences between commercial banking and investment banking. Identify the functions of banks and of the banking system. Describe the early history of U.S. depository institutions. Discuss general regulation of the banking system and how depositors’ funds are protected. Describe the structure of banks in terms of bank charters, branch banking, and bank holding companies. Briefly describe the bank balance sheet and the major account categories that it contains. Discuss bank management in terms of bank liquidity and bank solvency. Describe liquidity management in terms of asset management and liabilities management. Briefly explain why and how bank capital is managed. Describe characteristics of several foreign banking systems. CHAPTER OUTLINE TYPES AND ROLES OF FINANCIAL INSTITUTIONS DEPOSITORY INSTITUTIONS CONTRACTUAL SAVINGS ORGANIZATIONS SECURITIES FIRMS FINANCE FIRMS OVERVIEW OF THE BANKING SYSTEM COMMERCIAL, INVESTMENT, AND UNIVERSAL BANKING FUNCTIONS OF BANKS AND THE BANKING SYSTEM HISTORICAL DEVELOPMENT OF THE U.S. BANKING SYSTEM A. BEFORE THE CIVIL WAR 1. Early Chartered Banks 2. First Bank of the United States 3. Second Bank of the United States 4. State Banks from 1836 to the Civil War B. Entry of Thrift Institutions 1. Savings Banks 2. Savings and Loan Institutions Credit Unions IV. REGULATION OF THE BANKING SYSTEM A. General Banking Legislation National Banking Act of 1864 Federal Reserve Act of 1913 3. Depository Institutions Deregulation and Monetary Control Act of 1980 a. Depository Institutions Deregulation b. Monetary Control Garn–St. Germain Depository Institutions Act of 1982 The Savings and Loan Crisis Protection of Depositors’ Funds V. STRUCTURE OF BANKS A. Bank Charters B. DEGREE OF BRANCH BANKING C. BANK HOLDING COMPANIES THE BANK BALANCE SHEET A. ASSETS CASH AND BALANCES DUE FROM DEPOSITORY INSTITUTIONS SECURITIES LOANS OTHER BANK ASSETS B. LIABILITIES AND OWNERS’ CAPITAL DEPOSITS OTHER LIABILITIES OWNERS’ CAPITAL VII. BANK MANAGEMENT A. LIQUIDITY MANAGEMENT ASSET MANAGEMENT LIABILITY MANAGEMENT B. CAPITAL MANAGEMENT C. 2007-09 FINANCIAL CRISIS VIII. INTERNATIONAL BANKING AND FOREIGN SYSTEMS IX. SUMMARY LECTURE notes TYPES AND ROLES OF FINANCIAL INSTITUTIONS THERE ARE FOUR MAJOR TYPES OF FINANCIAL INSTITUTIONS—DEPOSITORY INSTITUTIONS, CONTRACTUAL SAVINGS ORGANIZATIONS, SECURITIES FIRMS, AND FINANCE FIRMS. FINANCIAL INSTITUTIONS PLAY A MAJOR ROLE IN DIRECTING SAVINGS TO BUSINESS FIRMS. INDIVIDUAL SAVERS AND INVESTORS MAKE DEPOSITS IN COMMERCIAL BANKS, PURCHASE SHARES IN MUTUAL FUNDS, PAY PREMIUMS TO INSURANCE COMPANIES, AND MAKE CONTRIBUTIONS TO PENSION FUNDS. COMMERCIAL BANKS MAKE LOANS TO AND PURCHASE DEBT SECURITIES FROM BUSINESS FIRMS. MUTUAL FUNDS, INSURANCE COMPANIES, AND PENSION FUNDS PURCHASE THE DEBT AND EQUITY SECURITIES ISSUED BY BUSINESS FIRMS. INDIVIDUAL SAVERS AND INVESTORS MAY ALSO DIRECTLY PURCHASE THE SECURITIES OF BUSINESS FIRMS THROUGH INVESTMENT BANKS AND BROKERAGE FIRMS. (USE FIGURES 3.1 AND 3.2 AND QUESTION L HERE.) overview of the banking system A COMMERCIAL BANK ACCEPTS DEPOSITS, MAKES LOANS, AND ISSUES CHECK-WRITING ACCOUNTS TO AID THE MAKING OF PURCHASES AND THE PAYING OF BILLS. AN INVESTMENT BANK HELPS BUSINESSES SELL THEIR SECURITIES TO RAISE FINANCIAL CAPITAL. THESE TWO “BANKS” ARE INVOLVED IN THE INDIRECT TRANSFER OF MONEY FROM SAVERS TO AN INVESTOR (E.G., A BUSINESS FIRM). THE COMMERCIAL BANK ACCEPTS THE DEPOSITS OF SAVERS IN EXCHANGE FOR THE BANK’S SECURITIES (E.G., CDS). THE BANK THEN LOANS MONEY TO THE BUSINESS FIRM IN EXCHANGE FOR THE FIRM’S PROMISE TO REPAY THE LOAN. IN CONTRAST, THE INVESTMENT BANK MARKETS THE BUSINESS FIRM’S SECURITIES TO SAVERS EITHER BY FIRST PURCHASING THE SECURITIES FROM THE FIRM AND THEN RESELLING THE SECURITIES OR BY JUST MARKETING THE SECURITIES DIRECTLY TO SAVERS. BANKS AND THE BANKING SYSTEM PERFORM FIVE FUNCTIONS: (1) ACCEPTING DEPOSITS, (2) GRANTING LOANS, (3) ISSUING CHECKABLE DEPOSIT ACCOUNTS, (4) CLEARING CHECKS, AND (5) CREATING DEPOSIT MONEY. AS U.S. BANKING MOVES TO UNIVERSAL BANKING, THE SIXTH FUNCTION WILL BE: (6) RAISING FINANCIAL CAPITAL FOR BUSINESSES THAT WE CALL INVESTMENT BANKING. IN ACCEPTING DEPOSITS, BANKS PROVIDE A SAFE PLACE FOR THE PUBLIC TO KEEP MONEY FOR FUTURE USE. THE BANKING SYSTEM PUTS THE ACCUMULATED DEPOSITS TO USE THROUGH LOANS TO PERSONS AND INDIVIDUALS HAVING IMMEDIATE USE FOR THEM. THIS IS THE FINANCIAL INTERMEDIATION ACTIVITY OF DEPOSITORY INSTITUTIONS IN THE SAVINGS-INVESTMENT PROCESS. ASSUME THAT YOU WRITE A CHECK ON YOUR ACCOUNT AT THE FIRST BANK AND MAIL THE CHECK TO THE ABC FIRM TO PAY FOR THE PURCHASE OF A PRODUCT. THE ABC FIRM, IN TURN, DEPOSITS YOUR CHECK IN ITS ACCOUNT AT THE LAST BANK. HOW DOES THE ABC FIRM COLLECT ITS MONEY FROM YOU? THERE ARE THREE BASIC WAYS FOR PROCESSING OR CLEARING A CHECK. FIRST, THE LAST BANK CAN PRESENT YOUR CHECK DIRECTLY TO THE FIRST BANK FOR COLLECTION. THE FIRST BANK “PAYS” THE CHECK AND DEDUCTS THE AMOUNT OF THE CHECK FROM YOUR CHECKING ACCOUNT. SECOND, THE LAST BANK CAN “CLEAR” YOUR CHECK BY PRESENTING IT THROUGH A BANK CLEARINGHOUSE. THIRD, THE LAST BANK COULD PROCESS YOUR CHECK THROUGH ITS FEDERAL RESERVE BANK. (USE FIGURES 3.3 AND 3.4, AND DISCUSSION QUESTIONS 2 THROUGH 4 HERE.) III. HISTORical development of the U.S. BANKING SYSTEM The history of commercial banks and thrift institutions is part and parcel of the nation’s history. An understanding of the development of these institutions and the legislation affecting them provides a basis for understanding their present status as well as their continuing evolution. Students should be able to relate developments here to historical events studied in their history classes: the nation’s wars, economic booms and busts, productivity advances, political trends, and other major events. During the colonial period there were small unincorporated banks that were established to ease the shortage of financial capital. The First Bank of the U.S. was chartered in 1791 for a period of 20 years. It served the nation by issuing notes, transferring funds from region to region, and curbing the excessive note issues of state banks. After a period of five years of chaotic banking after the charter of the First Bank expired, the Second Bank of the U.S. received a 20-year federal charter in 1816. A period of “wildcat” banking existed from 1836 to the Civil War. Thrift institutions formed in the early 1800s to provide “safe” depository institutions for savers and to provide home financing. You may want to ask students about their personal experiences with depositories. Such things as interest rates, check writing privileges, withdrawal limitations, and insurance protection may be discussed. (Use Discussion Questions 5 and 6 here.) IV. REGULATION OF THE BANKING SYSTEM Legislation to govern the nation’s banking system is particularly important since it has had a profound effect not only on our depositories but also on the citizens in general. It should be noted that some legislative actions are now seen as principal causes of the difficulties depositories in general, and S&Ls in particular, experienced during the 1980s and the first-half of the 1990s. Early laws focused first on establishing a system of federally-chartered and then a system of central banks. More recent legislation has focused on deregulating banking activities and improving the effectiveness of monetary policy. Important legislation includes: National Banking Act of 1864 Federal Reserve Act of 1913 Depository Institutions Deregulation and Monetary Control Act of 1980 Garn-St. Germain Depository Institutions Act of 1982 Legislation passed in the early 1980s was designed to permit both greater competition for deposits and more flexibility in the holding of assets by depository institutions. However, this movement towards deregulation and increased competition led to some major problems. During the last-half of the 1980s and the first-half of the 1990s, well over 2,000 S&Ls were closed or merged into other organizations. Commercial banks also suffered some of the same difficulties as the S&Ls. The S&L industry has always been a difficult one due to lending-long in the form of home mortgages while borrowing-short. Managers and officers were ill prepared for the consequences of deregulation. Thus, mismanagement was a major reason for the S&L collapse. In addition, greed and fraud on the part of some officers and managers contributed to the S&L industry collapse. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to provide for the termination of the Federal Savings and Loan Insurance Corporation (FSLIC) and the formation of the Savings Association Insurance Fund( SAIF). Insurance protection for deposits at depository institutions was started during the Great Depression of the 1930s with the Federal Deposit Insurance Corporation (FDIC) created in 1933 to protect deposits in banks. The FSLIC was formed to protect deposits in S&Ls (later replaced by the SAIF as noted above) and the National Credit Union Share Insurance Fund (NCUSIF) was created to protect deposits in credit unions. The limit on deposit account insurance was increased to $100,000 per account beginning in 1980. (Use Discussion Questions 7 through 12 here.) V. STRUCTURE OF BANKS Bank structure is characterized by how a bank is established, the extent to which branching takes place, and whether a holding company organizational structure is used. A brief review of these structural characteristics should help students to better understand “banking” organizations today. The U.S. is characterized as a “dual banking system” because commercial banks can obtain charters either from the federal government or from a state government. Federally chartered banks must be members of the Federal Reserve System and the Federal Deposit Insurance Corporation. State laws regulate commercial banks in terms of the number of offices they are permitted and where the offices can be located. Today, all states provide either limited branch banking or state-wide branch banking. A bank may be independently owned by investors or it may be owned by a holding company—either a one bank holding company or a multibank holding company. The distinction between branch banking and bank holding companies and the perceived advantages of each makes interesting topics of discussion. Students can be asked to describe the banking arrangement(s) in their home towns—especially interesting if students represent a wide range of geographic areas. An intriguing question to ask is whether students would prefer employment in an independent unit bank, a branch bank, or a bank controlled by a holding company. This is a difficult question, but one that will elicit many of the characteristics of these forms of banks. (Use Discussion Question 13 here.) VI. THE BANK BALANCE SHEET A balance sheet indicates an organization’s financial position as of a particular point in time. In other words, the balance sheet represents a “snap shot” of assets, liabilities, and owners’ capital. The assets and sources of funds (liabilities and owners’ capital) as presented in this section can be considered in reverse chronological order if you wish to discuss the events that must occur to establish a depository. For example, before any enterprise can take form there must be some form of equity investment by the owners. This equity provides the base for attracting liabilities—in the case of depositories, accepting deposits. When there is a flow of funds derived from equity investment and depositors, commitment of the funds follows. Loans to borrowers are the basic element of the depository function; physical facilities for operations require a relatively small investment. Securities may be purchased if loan demand is inadequate or to provide diversity in the pattern of depository commitments. Cash, of course, serves both as a reserve and a source of funds for deposit withdrawals. You may suggest that students obtain recent financial statements for a small and a large bank. This obtained from library sources or via the Internet. Major balance items can be expressed as a percentage of total assets for comparative purposes. (Use Figures 3.5 and 3.6, and Discussion Question 14 here.) VII. BANK MANAGEMENT Banks are managed to make profits an increase the wealth of their owners. However, bank management must also consider the interests of depositors and bank regulators. Profitability often can be increased by taking on more risk at the expense of bank safety. Banks can fail either because of inadequate liquidity or by becoming insolvent. Bank managers manage their bank’s riskiness in terms of bank liquidity (liquidity management) and bank solvency (capital adequacy management). Liquidity management is the management of a bank’s liquidity risk which is the likelihood that the bank will be unable to meet its depositor withdrawal demands and/or other liabilities when they are due. In deciding on how much liquidity risk is appropriate, bank managers make asset management and liability management decisions. Asset management includes the maintaining of adequate primary and secondary reserves. Liability management involves management of interest rate sensitive liabilities (such as negotiable CDs, commercial paper, and federal funds) to maintain a desired level of liquidity. Adequate capital is necessary to ensure that banks remain solvent (i.e., assets are greater than liabilities) and be able to meet depositor demands and pay their debts as they come due. Adequate bank capital represents an important “cushion” against both credit risk and interest rate risk as they impact on bank solvency. Bank regulators set minimum capital ratio requirements for the banks and other depository institutions that they regulate. (Use Figure 3.7 and Discussion Questions 15 through 19 here.) VIII. INTERNATIONAL BANKING AND FOREIGN SYSTEMS This subject continues to receive increased attention. The level of foreign banking operations in this country has increased dramatically, as have our own baking operations abroad. Banks with headquarters in one country may open offices or branches in other countries. When banks operate in more than one country, we call this international banking. While most countries have central banking systems that operate much like the U.S. Federal Reserve System, some countries allow their banks to engage in both commercial banking and investment banking activities which is called universal banking. Germany is a universal banking country. The United Kingdom permits its banks to engage in both commercial and investment banking activities while Japan separates these two banking activities. Banks in the U.S. now can engage in both commercial and investment banking activities. (Use Discussion Question 20 here.) DISCUSSION QUESTIONS AND ANSWERS Describe the major financial institutions engaged in getting the savings of individuals into business firms that want to make investments to maintain and grow their firms. There are four major types of financial institutions—depository institutions, contractual savings organizations, securities firms, and finance firms. Specific types of institutions involved in directing savings to business firms are: Commercial banks collect deposits from individuals and lend these pooled deposits to individuals, businesses, and government units. Insurance companies provide financial protection to individuals and businesses for life, property, liability, and health uncertainties. Policyholders pay premiums to insurance companies that invest these funds until the insured claims must be paid. Pension funds receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees. The purpose of a pension fund is to provide income during an individual’s retirement years. Investment companies sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities. A mutual fund, or open end fund, is the most prevalent form of an investment company. Investment banking firms sell or market new securities issued by businesses to individual and institutional investors. Brokerage firms assist individuals who want to purchase new or existing securities issues or who want to sell previously purchased securities. Compare commercial banking with investment banking. What is universal banking? COMMERCIAL AND INVESTMENT “BANKS” ARE INVOLVED IN THE INDIRECT TRANSFER OF MONEY FROM SAVERS TO AN INVESTOR (E.G., A BUSINESS FIRM). THE COMMERCIAL BANK ACCEPTS THE DEPOSITS OF SAVERS IN EXCHANGE FOR THE BANK’S SECURITIES (E.G., CDS). THE BANK THEN LOANS MONEY TO THE BUSINESS FIRM IN EXCHANGE FOR THE FIRM’S PROMISE TO REPAY THE LOAN. IN CONTRAST, THE INVESTMENT BANK MARKETS THE BUSINESS FIRM’S SECURITIES TO SAVERS EITHER BY FIRST PURCHASING THE SECURITIES FROM THE FIRM AND THEN RESELLING THE SECURITIES OR BY JUST MARKETING THE SECURITIES DIRECTLY TO SAVERS. A UNIVERSAL BANK IS A BANK THAT ENGAGES IN BOTH COMMERCIAL BANKING AND INVESTMENT BANKING ACTIVITIES. Describe the functions of banks and the banking system. BANKS AND THE BANKING SYSTEM PERFORM FIVE FUNCTIONS: (1) ACCEPTING DEPOSITS, (2) GRANTING LOANS, (3) ISSUING CHECKABLE DEPOSIT ACCOUNTS, (4) CLEARING CHECKS, AND (5) CREATING DEPOSIT MONEY. IF, OR WHEN, U.S. BANKING MOVES TO UNIVERSAL BANKING, THE SIXTH FUNCTION WILL BE: (6) RAISING FINANCIAL CAPITAL FOR BUSINESSES WHICH WE CALL INVESTMENT BANKING. IN ACCEPTING DEPOSITS, BANKS PROVIDE A SAFE PLACE FOR THE PUBLIC TO KEEP MONEY FOR FUTURE USE. THE BANKING SYSTEM PUTS THE ACCUMULATED DEPOSITS TO USE THROUGH LOANS TO PERSONS AND INDIVIDUALS HAVING IMMEDIATE USE FOR THEM. THIS IS THE FINANCIAL INTERMEDIATION ACTIVITY OF DEPOSITORY INSTITUTIONS IN THE SAVINGS-INVESTMENT PROCESS. Describe the three basic ways for processing or collecting a check in the United States. ASSUME THAT YOU WRITE A CHECK ON YOUR ACCOUNT AT THE FIRST BANK AND MAIL THE CHECK TO THE ABC FIRM TO PAY FOR THE PURCHASE OF A PRODUCT. THE ABC FIRM, IN TURN, DEPOSITS YOUR CHECK IN ITS ACCOUNT AT THE LAST BANK. HOW DOES THE ABC FIRM COLLECT ITS MONEY FROM YOU? THERE ARE THREE BASIC WAYS FOR PROCESSING OR CLEARING A CHECK. FIRST, THE LAST BANK CAN PRESENT YOUR CHECK DIRECTLY TO THE FIRST BANK FOR COLLECTION. THE FIRST BANK “PAYS” THE CHECK AND DEDUCTS THE AMOUNT OF THE CHECK FROM YOUR CHECKING ACCOUNT. SECOND, THE LAST BANK CAN “CLEAR” YOUR CHECK BY PRESENTING IT THROUGH A BANK CLEARINGHOUSE. THIRD, THE LAST BANK COULD PROCESS YOUR CHECK THROUGH ITS FEDERAL RESERVE BANK. How did the First Bank of the United States serve the nation? Also briefly describe why the Second Bank of the United States was chartered. The First Bank of the U.S. served the nation effectively by issuing notes, transferring funds from region to region, and curbing the excessive not issues of state banks by presenting such notes periodically to the issuing banks for redemption. The Second Bank of the U.S. was chartered primarily to restore order to the chaotic banking situation that had developed after the First Bank of the United States ceased operations. The Second Bank accepted deposits, made loans, and issued notes. Briefly describe why and when thrift institutions were founded. The chaotic banking conditions of the early 1800s left individuals with few safe institutions in which they could place their savings. The lack of safe depository institutions, in turn, inhibited the effective development of home financing. Thrift institutions developed in response to this problem. Savings banks began in 1812 and savings and loan institutions started in 1831. It was not until the 1920s that credit unions became important as a special form of depository institution. 7. Why was it considered necessary to create the Federal Reserve System when we already had the benefits of the National Banking Act? The Federal Reserve System was designed to eliminate many of the weaknesses of the National Banking Act and to increase the effectiveness of commercial banking in general. Many services needed by commercial banks were provided by the system of central banks established under the Federal Reserve Act. 8. Comment on the objectives of the Depository Institutions Deregulation and Monetary Control Act of 1980. The title of the Depository Institutions Deregulation and Monetary Control Act is descriptive in that it refers to both deregulation and control. The objective of deregulation is greater competition among financial depositories and an improvement in banking services. More effective monetary control is achieved by the reserve and reporting requirements of the Board of Governors of the Federal Reserve System that apply to nearly all depository institutions. 9. Why was the Garn–St. Germain Depository Institutions Act thought to be necessary? The Garn–St. Germain Depository Institutions Act of 1982 authorized depositories to offer money market deposit accounts with no regulated interest rate ceiling. The high interest rates that prevailed in late 1980 and 1981 resulted in a withdrawal of deposits from depositories and their reinvestment in nonbanking money market mutual funds (MMMFs). Regulation Q of the Monetary Control Act had prevented depositories from meeting the rate competition from the MMMFs. The removal of the Regulation Q rate ceiling under the Garn–St. Germain Act permitted depositories to raise their rates and compete effectively. This act also broadened the lending power of savings and loan associations. Describe the reasons for the savings and loan crisis that occurred during the 1980s. Mismanagement was a major reason for the collapse of the S&L industry. Officers and Managers did not handle the industry’s basic illiquidity problem (borrowing short-term and lending long-term) very well. Managements also were ill prepared for the consequences of deregulation. Greed also led to fraudulent behavior on the part of some S&L officers and managers. Briefly describe the purpose of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. Also indicate the purpose of the Resolution Trust Corporation (RTC). The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was established as a result of the number and size of S&L failures and the associated bankruptcy of the Federal Savings and Loan Insurance Corporation (FSLIC). FIRREA provided for the termination of the FSLIC and the formation of the Savings Association Insurance Fund (SAIF). FIRREA also required S&Ls to focus more on making home loans, restricted S&Ls from holding high-yield or junk bonds, and allowed commercial banks to purchase S&Ls. The Resolution Trust Corporation (RTC) was created by Congress in 1988 to take over and dispose of the assets of S&Ls by finding acquirers or through liquidations. How are depositors’ funds protected today in the United States? The Federal Deposit Insurance Corporation (FDIC), the Federal Savings and Loan Insurance Corporation (FSLIC), and the National Credit Union Share Insurance Fund (NCUSIF) were established under federal legislation to protect deposits in banks, S&Ls, and credit unions—in that order. However, as a result of the S&L crisis and the associated bankruptcy of the FSLIC, the functions of the FSLIC were transferred to the FDIC in 1989. Describe the structure of banks in terms of bank charters, branch banking, and bank holding companies. The U.S. is characterized as a “dual banking system” because commercial banks can obtain charters either from the federal government or from a state government. Federally chartered banks must be members of the Federal Reserve System and the Federal Deposit Insurance Corporation. State laws regulate commercial banks in terms of the number of offices they are permitted and where the offices can be located. Today, all states provide either limited branch banking or state-wide branch banking. A bank may be independently owned by investors or it may be owned by a holding company—either a one bank holding company or a multibank holding company. 14. What are the major asset categories for banks and identify the most important category. What are a bank’s major liabilities and which category is the largest in size? The major asset categories for banks are: (1) Cash and Balances Due from Depository Institutions, (2) Securities, (3) Loans, and (4) Other Business Assets. Loans account for approximately 60 percent of bank assets which makes this the most important asset account category. The major liabilities categories for banks are: (1) Deposits, (2) Other Liabilities, and (3) Owners’ Capital. Deposits account for approximately 70 percent of commercial bank liabilities and owners’ capital. Of course, it is important to note that the financial crisis of 2007-09 caused the balance sheets of many banks to differ from these historical percentage relationships. 15. What is meant by bank liquidity and bank solvency? Bank liquidity reflects the ability to meet depositor withdrawals and to pay off other liabilities when they come due. Bank solvency reflects the ability to keep the value of a bank’s assets greater than its liabilities. 16. Describe how assets are managed in terms of a bank’s liquidity risk. Also briefly describe how liquidity management is used to help manage liquidity risk. A bank needs cash assets to meet depositor withdrawal requests when demanded. A bank maintains primary reserves (cash and balances due from depository institutions) to meet depositor withdrawal requests. Secondary reserves (short-term securities held by a bank that are quickly converted into cash at little cost to the bank, e.g., U.S. treasury bills) are held to supplement the primary reserves. A bank’s liabilities can be managed because certain types of bank liabilities are very sensitive to changes in interest rates. For example, if a bank needs cash to meet unexpected depositor withdrawals, in could immediately attract more liabilities by raising short-term interest rates it will pay on negotiable CDs. 17. Describe what is meant by liquidity risk, credit risk, and interest rate risk. A bank’s liquidity risk is the likelihood that the bank will be unable to meet its depositor withdrawal demands and/or other liabilities when they are due. Credit risk is the likelihood that borrowers will not make interest and principal payments when they are due. Interest rate risk is the risk associated with changing market interest rates on the value of underlying debt instruments. 18. [Note: Discussion Question 18 should read:] Define and describe the following terms: equity capital ratio, tier 1 ratio, and total capital ratio. How are these used by bank regulators? Note: the former primary capital, total capital, and risk-based capital ratios have been changed or replaced. The equity capital ratio is a bank’s owners’ or equity capital divided by total assets. As a result of the Basel I and II Accords, two capital ratios are calculated using risk-adjusted assets. The tier 1 ratio is Tier 1 capital (common equity plus trust-preferred securities minus intangible assets) divided by risk-adjusted assets. The total capital ratio is Tier 1 plus Tier 2 capital (a bank’s loan-loss reserve amount plus other qualifying securities that include subordinated debt and preferred stock plus net unrealized gains on marketable securities) all divided by risk-adjusted assets. The process for calculating risk-adjusted assets was established by the Bank for International Settlements (BIS) for banks with international operations. There is a strong incentive for bank managers to meet minimum capital ratio requirements. Banks that are classified as being undercapitalized by the FDIC must submit plans indicating how they intend to remedy the situation. Significantly undercapitalized banks may have to replace their bank managers and even their Board of Directors. Critically undercapitalized banks must restructure and may even be seized by the FDIC. 19. What were the Basel Accords and what was their purpose? The central banks and other national supervisory authorities of major industrialized countries met in Basel, Switzerland in mid-1988 (Basel I Accord) and in 2003 (Basel II Accord). The objectives were to improve risk measurements and management of large internationally involved banks, as well as to improve the transparency of bank riskiness to customers and other constituencies. A process for calculating risk-adjusted assets was developed. Two capital ratios (Tier 1 and Total Capital) based on risk-adjusted assets are now in use. 20. Define international banking. Describe how some foreign banking systems differ from the U.S. banking system. When banks operate in more than one country, we call this international banking. European banks dominated international banking until the 1960s. Today, U.S. banks are actively involved throughout the world. U.S. domestic banks were at a competitive disadvantage relative to foreign-owned banks until the passage of the International Banking Act of 1978 and the Foreign Bank Supervision Enhancement Act of 1991. Universal banking allows banks to engage in both commercial banking and investment banking activities. Germany is a universal banking country. The United Kingdom does not restrict its banks from engaging in both commercial banking and investment banking activities. Commercial banking and investment banking are separated in Japan. The U.S. now allows banks to participate in both types of banking activities. EXERCISES AND ANSWERS Go to http://www.stlouisfed.org and identify sources and uses of funds for commercial banks. Sources of funds would be commercial bank liabilities and owners’ capital. Uses of funds would be commercial bank assets. The instructor may choose to ask students to identify broad asset and liabilities/equity accounts similar to those presented in Figure 3.5 and express these broad accounts as a percentage of total bank assets. 2. You are the treasurer of a mid-size industrial manufacturer, your firm’s cash balances vary between $300,000 and $1,000,000. During the last three board meetings a board member has asked how you protect this cash while it is being lodged in banks or other temporary facilities. Your problem is to satisfy the board member, obtain some income from the cash or cash equivalent balances, and has funds available for immediate payout if required. What course of action do you follow? Although business firms have at their disposal a host of alternative short-term investment opportunities, a firm of this size would probably depend largely on its commercial bank or banks. The matter of safety further recommends reliance on the banking system. The treasurer of this firm would emphasize the importance of cash flow analysis in determining the maturities of short-term investments. Having done so, he or she would describe the nature of certificates of deposits (CDs) as issued by the firm’s banks. Such certificates are available for any specified time period to meet cash flow projections. Further, they carry meaningful rates of return to the firm. With respect to safety, CDs, along with other deposits, are protected up to $100,000 by the Federal Deposit Insurance Corporation. Although recently larger deposits have also been covered by the FDIC, it cannot be assumed that this practice will be continued. Insurance protection can be achieved, however, by placing funds with multiple banks in amounts of $100,000 or less. In later chapters, the subject of U.S. Treasury bills and other short-term investments will be discussed. These, too, may serve the purposes of safety, ready availability, and meaningful rates of return. 3. You and three other staff members of the U.S. Offices of Comptroller of the Currency have been assigned identical projects. You are to review the various articles that have been written, the various speeches made, and in general the various suggestions that have been offered to revamp the structure of the FDIC in order to render it more stable and financially able to withstand adverse events. Based on the few suggestions offered in this chapter and on the basis of your own ideas, what is your conclusion? One of the fundamental criticisms of our system of deposit insurance as it now exists relates to the need for additional bank regulation. It is claimed that deposit insurance gives insured bankers an incentive to undertake riskier loans than they would in an unregulated and uninsured free market. Along this line of reasoning bankers can benefit by undertaking risks that society as a whole considers excessive. Thus, restrictive bank regulations may be necessary to undo the distortive impact of deposit insurance. It is also contended by some observers that since deposit insurance was created to protect small depositors there is little justification for the frequent increases in protection to the present $250,000 level. Reducing the maximum protection would reduce the liability exposure of the FDIC to bank failures and shift some degree of risk back to bank management. Higher premiums have been advocated as a means of increasing the reserves of the FDIC, and others have suggested that insurance premiums paid by banks vary according to the degree of risk of their portfolios. 4. You are the mayor of a community of 12,000 people. You are active in virtually all of the civic activities of the town and as such your opinion is solicited on political, economic, sociological, and other factors. You have been asked by one of the civic groups to comment on the implications for the community of a prospective purchase of the largest local commercial bank by an out-of-state bank holding company. What is your response? On the positive side, the mayor could suggest that the entry of a large bank holding company in the community could expand the potential lending capacity of the local bank by the importation of funds when needed from banks owned in other areas. Lending limits would also be expanded based on the capital resources of the bank holding company. Further, certain activities such as credit card issuance, insurance, security brokerage facilities, and other accommodations may be provided. The entry of the holding company operation may also result in more vigorous bank competition within the community resulting in a wider range of services and lower fees. On the negative side, the mayor might admit that with the change in bank holding company ownership of the largest local bank, there might also be a replacement of local bank personnel with individuals from outside the community. Further, the holding company might not be as sympathetic to the special needs of the community. Other local banks would try to impress the mayor with the dangers of “big city” control of their banking community and the danger that local funds might be drawn away from the community. Banks provide checking account services, accept savings deposits, and lend to borrowers. In other words, they are in the money business. We all have heard stories of banks or their partner firms “misplacing” or “losing” bags of money. Lending rates are also subject to change periodically. Both of these situations can produce ethical dilemmas or decisions. How would you react to the following scenarios? You are walking down the street and see a large money bag with “First National Bank” printed on it. The bag is sitting on the sidewalk in front of a local office of First National Bank. You are considering whether to pick up the bag, check its contents, and then try to find the owner. Alternatively, you could pick up the money bag and take it to the local police station or return it directly to the bank itself. What would you do? Clearly the money bag belongs to someone else and is “not” yours. Since you’re the lag is imprinted with “First National Bank” and you found it in front of the local office of the First National Bank, it is likely best to return it immediately to the bank’s office. It does not make sense to take the bag to the local police station or check the contents and try to identify the owner. You may also be rewarded by a quick return of the money bag. We all have heard stories of grateful individuals or organizations that have provided “rewards” to those who have returned lost or misplaced money bags. b. You are a loan officer of First National Bank. The owner of a small business has come into the bank today and is requesting an immediate $100,000 loan for which she has appropriate collateral. You also know that the bank is going to reduce its lending interest rate to small businesses next week. You could make the loan now or inform the small business owner that she could get a lower rate if the loan request is delayed. What would you do? First, most banks (and other business firms) would keep planned interest rate changes and other actions confidential until officially announced. This is to avoid what otherwise might compromise their employees from carrying out the bank’s (or firm’s) best business endeavors. Thus, a loan officer would not normally be privy to lending interest rate changes until the changes were actually made. Second, as we also know, “planned” changes or actions sometimes don’t occur. You are in no position to “guarantee” that the small business owner will get a lower rate next week. Bank operating conditions could change and/or the creditworthiness of the small business could change. Furthermore, the small business owner may have an immediate need for the loan proceeds. By suggesting that the loan request be delayed may actually result in a more costly transaction to the small business owner. PROBLEMS AND ANSWERS 1. The following three one-year “discount” loans are available to you: Loan A: $120,000 at a 7 percent discount rate Loan B: $110,000 at a 6 percent discount rate Loan C: $130,000 at a 6.5 percent discount rate a. Determine the dollar amount of interest you would pay on each loan and indicate the amount of net proceeds each loan would provide. Which loan would provide you with the most upfront money when the loan takes place? Loan A: $120,000 x .07 = $8,400 $120,000 - $8,400 = $111,600 Loan B: $110,000 x .06 = $6,600 $110,000 - $6,600 = $103,400 Loan C: $130,000 x .065 = $8,450 $130,000 - $8,450 = $121,550 Loan C would provide the largest upfront money at $121,550 b. Calculate the percent interest rate or effective cost of each loan. Which one has the lowest cost? Loan A: $8,400/$111,600 = 7.53% Loan B: $6,600/$103,400 = 6.38% Loan C: $8,450/$121,550 = 6.95% LOAN B WOULD HAVE THE LOWEST EFFECTIVE INTEREST RATE OR COST AT 6.38% 2. ASSUME THAT YOU CAN BORROW $175,000 FOR ONE YEAR FROM A LOCAL COMMERCIAL BANK. A. THE BANK LOAN OFFICER OFFERS YOU THE LOAN IF YOU AGREE TO PAY $16,000 IN INTEREST PLUS REPAY THE $175,000 AT THE END OF ONE YEAR. $16,000/$175,000 = 9.14% (SIMPLE INTEREST LOAN) B. AS AN ALTERNATIVE YOU COULD GET A ONE-YEAR DISCOUNT LOAN AT 9 PERCENT. $175,000 X 0.09 = $15,750 $175,000 - $15,750 = $159,250 $15,750/$159,250 = 9.89% (DISCOUNT LOAN) C. WHICH LOAN WOULD HAVE THE LOWER EFFECTIVE COST? THE SIMPLE INTEREST LOAN HAS THE LOWER EFFECTIVE COST. D. AT WHAT DISCOUNT LOAN INTEREST RATE WOULD YOU BE INDIFFERENT BETWEEN THE TWO LOANS? Using a trial and error approach, the discount loan rate must equal the simple interest loan rate of 9.14%. Try 8.4%: $175,000 x 0.084 = $14,700 $175,000 - $14,700 = $160,300 $14,700/$160,300 = 9.17% (which is close to 9.14%) 3. ABE Banc has the following asset categories: Cash $1 million Securities $4 million Loans ? Other assets $2 million Total assets ? a. What would be the bank’s total assets if loans were twice the size of the amount of securities? If loans were $8 million ($4 million x 2), total assets would be $15 million ($1 million + $4 million + $8 million + $2 million) b. If total assets were $12 million, what would be the amount of the loans? $12 million (Total assets) - $1 million (Cash) - $4 million (Securities) - $2 million (Other assets) = $5 million (Loans) c. If total assets were $11 million, and $1 million of securities were sold with the proceeds placed in the cash account, what would be the amount of the loans? $11 million (Total assets) - $2 million (Cash) - $3 million (Securities) - $2 million (Other assets) = $4 million (Loans) 4. ATM Banc has the following liabilities and equity categories: Deposits $9 million Other liabilities $4 million Owners’ capital ? Total liabilities and capital ? a. What would be the bank’s total liabilities and capital if owners’ capital were half the size of other liabilities? If Owners’ capital equals $2 million ($4 million x .5), Total liabilities and capital would be $15 million ($9 million + $4 million + $2 million) b. If total liabilities and capital were $15.5 million, what would be the amount of the loans? Note: reference here should be to “owners’ capital” and not “loans” which would be on the assets side of the balance sheet. The amount of “loans” cannot be determined in this problem. $15.5 million (Total liabilities and capital) - $9 million (Deposits) - $4 million (Other liabilities) = $2.5 million (Owners’ capital) c. If total liabilities and capital were $14 million, and $1 million of deposits were withdrawn from the bank, what would be the amount of the owners’ capital? $14 million (Total liabilities and capital) - $8 million (Deposits) - $4 million (Other liabilities) = $2 million (Owners’ capital) 5. FOLLOWING ARE SELECTED BALANCE SHEET ACCOUNTS FOR THE THIRD STATE BANK: VAULT CASH = $2 MILLION; U.S. GOVERNMENT SECURITIES = $5 MILLION; DEMAND DEPOSITS = $13 MILLION; NONTRANSACTIONAL ACCOUNTS = $20 MILLION; CASH ITEMS IN PROCESS OF COLLECTION = $4 MILLION; LOANS TO INDIVIDUALS = $7 MILLION; LOANS SECURED BY REAL ESTATE = $9 MILLION; FEDERAL FUNDS PURCHASED = $4 MILLION; AND BANK PREMISES = $11 MILLION. A. FROM THESE ACCOUNTS, SELECT ONLY THE ASSET ACCOUNTS AND CALCULATE THE BANK’S TOTAL ASSETS. VAULT CASH $2 MILLION CASH IN PROCESS OF COLLECTION 4 U.S. GOVERNMENT SECURITIES 5 LOANS TO INDIVIDUALS 7 LOANS SECURED BY REAL ESTATE 9 BANK PREMISES 11 TOTAL ASSETS $38 MILLION b. Calculate the total liabilities for the Third State Bank. DEMAND DEPOSITS $13 MILLION NONTRANSACTIONAL ACCOUNTS 20 FEDERAL FUNDS PURCHASED 4 TOTAL LIABILITIES $37 MILLION C. BASED ON THE TOTALS FOR ASSETS AND LIABILITIES, DETERMINE THE AMOUNT IN THE OWNERS’ CAPITAL ACCOUNT. TOTAL ASSETS $38 MILLION LESS: TOTAL LIABILITIES 37 EQUALS: OWNERS’ CAPITAL $1 MILLION 6. A bank’s assets consist of: Cash: $1.5 million Loans: $10 million Securities $4.5 million Fixed assets $2 million In addition, the bank’s owners’ capital is $1.5 million. a. Calculate the equity capital ratio. EQUITY CAPITAL = OWNERS’ CAPITAL = $1.5 MILLION TOTAL ASSETS = $18 MILLION ($1.5 MILLION + $10 MILLION + $4.5 MILLION + $2 MILLION) NOTE: IN ORDER FOR THE BANK’S BALANCE SHEET TO BALANCE, IF TOTAL ASSETS ARE $18 AND OWNERS’ CAPITAL IS $1.5 MILLION, THEN TOTAL LIABILITIES MUST BE $16.5 MILLION ASSUMING NO OTHER SECURITIES SUCH AS PREFERRED STOCK. EQUITY CAPITAL RATIO = $1.5 MILLION/$18 MILLION = 8.33% b. If $2 million in bad loans were removed from the bank’s assets, show how the equity capital ratio would change. REVISED TOTAL ASSETS = $16 MILLION ($18 MILLION MINUS $2 MILLION). IF TOTAL LIABILITIES REMAIN AT $16.5 MILLION, THE BANK’S OWNERS’ CAPITAL WOULD BE -$.5 MILLION ($16 MILLION - $16.5 MILLION) AND THE EQUITY CAPITAL RATIO WOULD BE UNDEFINED. OF COURSE, THE IMPACT ON OWNERS’ CAPITAL WOULD BE LESS IF THE BANK HAD PROVIDED A LOAN-LOSS RESERVE. 7. REARRANGE THE FOLLOWING ACCOUNTS TO CONSTRUCT A BANK BALANCE SHEET FOR THE SECOND NATIONAL BANK. WHAT ARE THE TOTAL AMOUNTS THAT MAKE THE BANK’S BALANCE SHEET “BALANCE”? DEMAND DEPOSITS: $20 MILLION CASH ASSETS: $5 MILLION LOANS SECURED BY REAL ESTATE: $30 MILLION COMMERCIAL AND INDUSTRIAL LOANS: $18 MILLION OWNERS’ CAPITAL: $6 MILLION SECURITIES OWNED: $7 MILLION BANK FIXED ASSETS: $14 MILLION TIME AND SAVINGS DEPOSITS: $40 MILLION FEDERAL FUNDS PURCHASED: $6 MILLION OTHER LONG-TERM LIABILITIES: $2 MILLION ASSETS CASH ASSETS $5 MILLION LOANS SECURED BY REAL ESTATE 30 COMMERCIAL AND INDUS. LOANS 18 SECURITIES OWNED 7 BANK FIXED ASSETS 14 TOTAL ASSETS $74 MILLION LIABILITIES/OWNERS’ CAPITAL DEMAND DEPOSITS $20 MILLION TIME AND SAVINGS DEPOSITS 40 FEDERAL FUNDS PURCHASED 6 OTHER LONG-TERM LIABILITIES 2 OWNERS’ CAPITAL 6 TOTAL LIAB. & OWNERS’ CAPITAL $74 MILLION 8. USE THE DATA FROM PROBLEM 7 FOR THE SECOND NATIONAL BANK AND CALCULATE THE EQUITY CAPITAL RATIO. OWNERS’ CAPITAL = $6 MILLION TOTAL ASSETS = $74 MILLION EQUITY CAPITAL RATIO = $6 MILLION/$74 MILLION = 8.11% 9. TENTH NATIONAL BANK HAS COMMON STOCK OF $2 MILLION, RETAINED EARNINGS OF $5 MILLION, LOAN LOSS RESERVES OF $3 MILLION, AND SUBORDINATED NOTES OUTSTANDING IN THE AMOUNT OF $4 MILLION. TOTAL BANK ASSETS ARE $105 MILLION. CALCULATE THE EQUITY CAPITAL RATIO. OWNERS’ CAPITAL = $7 MILLION ($2 MILLION PLUS $5 MILLION) TOTAL ASSETS = $105 MILLION EQUITY CAPITAL RATIO = $7 MILLION/$105 MILLION = 6.67% 10. Let’s assume that you have been asked to calculate risk-based capital ratios for a bank with the following accounts: Cash = $5 million Government securities = $7 million Mortgage loans = $30 million Other loans = $50 million Fixed assets = $10 million Intangible assets = $4 million Loan-loss reserves = $5 million Owners’ equity =$5 million Trust-preferred securities = $3 million Cash assets and government securities are not considered risky. Loans secured by real estate have a 50 percent weighting factor. All other loans have a 100 percent weighting factor in terms of riskiness. Calculate the equity capital ratio. Owners’ equity capital = $5 million Total assets = $106 million ($5 million cash + $ 7 million government securities + $30 million mortgage loans + $50 million other loans + $10 million fixed assets + $4 million intangible assets.) Note: It is assumed that the mortgage and other loans shown on the asset-side of the balance sheet are net of loan-loss reserves. That is, the gross amounts of mortgage and other loans would be $4 million higher than the net amounts. Equity capital ratio = $5 million/$106 million = 4.72% Calculate the Tier 1 Ratio using risk-adjusted assets . Calculation of risk-adjusted assets: WEIGHTED SELECTED ASSETS $ AMOUNT X WEIGHT = AMOUNT CASH $5 MILLION 0.0 $0.0 MILLION GOVERNMENT SECURITIES 7 0.0 0.0 MORTGAGE LOANS 30 0.5 15.0 OTHER LOANS 50 1.0 50.0 TOTAL 92 MILLION RISK ADJ. $65.0 MILLION Tier 1 capital = $4 million ($5 Million in owners’ equity + $3 million trust-preferred securities - $4 million intangible assets) Risk-adjusted assets = $65 million Tier 1 ratio = $4 million/$65 million = 6.15% Note: In this definition of risk-adjusted assets, fixed assets and intangible assets are excluded from the calculation. Calculate the Total Capital (Tier 1 plus Tier 2) Ratio using risk-adjusted assets. TOTAL CAPITAL = TIER 1 CAPITAL + TIER 2 CAPITAL = $4 MILLION + $5 MILLION LOAN LOSS RESERVES) = $9 MILLION RISK-ADJUSTED ASSETS = $65 MILLION TOTAL CAPITAL RATIO = $9 MILLION/$65 MILLION = 13.85% 11. Challenge Problem This problem focuses on bank capital management and various capital ratio measures. Following are recent balance sheet accounts for Prime First National Bank. Cash assets $ 17 million Demand deposits $50 million Loans secured by real estate 40 Time & savings deposits 66 Commercial loans 45 Federal funds purchased 15 Government securities owned 16 Trust-preferred securities 2 Goodwill 5 Bank fixed assets 15 Owners’ capital 5 Total assets $138 million Total liabs. & owners’ capital $138 million All amounts are in millions of dollars. Note: The bank has loan-loss reserves of $10 million. The real estate and commercial loans shown on the balance sheet are net of the loan-loss reserves. Calculate the equity capital ratio. How could the bank increase its equity capital ratio? Owners’ capital = $5 million Total assets = $138 million Equity capital ratio = $5 million/$138 million = 3.62% The bank could increase its equity capital ratio by selling more stock in the bank and thus increasing the amount in owners’ capital. Likewise, some assets could be sold with the proceeds being paid out in dividends to owners. Risk-adjusted assets are estimated using the following weightings process: cash and government securities = .00; real estate loans = .50; commercial and other loans = 1.00. Calculate the risk-adjusted assets amount for the bank. Weighted Selected Assets Amount x Weight x Amount Cash $17 .00 $0.0 Government securities 16 .00 0.0 Real estate 40 .50 20.0 Commercial loans 45 1.00 45.0 Total $118 Risk-adj. assets = $65.0 million Calculate the Tier 1 Ratio based on the information provided and the risk-adjusted assets estimate from Part b. Tier 1 capital = $2 million ($5 Million in owners’ equity + $2 million trust-preferred securities - $5 million goodwill assets) Risk-adjusted assets = $65 million Tier 1 ratio = $2 million/$65 million = 3.08% Calculate the Total Capital (Tier 1 plus Tier 2) Ratio based on the information provided and the risk-adjusted assets estimate from Part b. TOTAL CAPITAL = TIER 1 CAPITAL + TIER 2 CAPITAL = $2 MILLION + $10 MILLION LOAN LOSS RESERVES) = $12 MILLION RISK-ADJUSTED ASSETS = $65 MILLION TOTAL CAPITAL RATIO = $12 MILLION/$65 MILLION = 18.46% What actions could the bank management team take to improve the bank’s Tier 1 and Total Capital ratios? COMMON STOCK COULD BE SOLD OR ISSUED. IF THE PROCEEDS ARE HELD IN ZERO RISK ASSETS SUCH AS CASH, THIS WOULD INCREASE THE AMOUNT OF TIER 1 CAPITAL (AS WELL AS TOTAL CAPITAL) WHILE THE RISK-ADJUSTED ASSETS WOULD REMAIN THE SAME. FOR EXAMPLE, SELLING $1 MILLION OF COMMON STOCK AND HOLDING THE PROCEEDS IN CASH OR GOVERNMENT SECURITIES WOULD CAUSE TIER 1 CAPITAL TO INCREASE TO $3 MILLION AND TOTAL CAPITAL TO BE $13 MILLION WHILE RISK-ADJUSTED ASSETS WOULD REMAIN THE SAME. LIKEWISE, THE BANK COULD SELL OFF RISKY ASSETS AND HOLD THE PROCEEDS IN CASH OR GOVERNMENT SECURITIES. THIS WOULD LOWER THE AMOUNT OF RISK-ADJUSTED ASSETS AND RAISE THE TIER 1 AND TOTAL CAPITAL RATIOS. OF COURSE, RISKY ASSETS MIGHT HAVE TO BE SOLD AT A DISCOUNT. SUGGESTED QUIZ Identify four major types of financial institutions. Describe each of the following: commercial bank, investment bank, and universal bank. 3. Define and discuss briefly: Dual banking system Branch banking Bank holding companies 4. Bank management involves both “liquidity management” and “capital management.” Explain. Chapter 4 Federal Reserve System CHAPTER PREVIEW A well-developed central banking system is essential to a well functioning financial system. Money must be easily transferred from geographical areas that have excess money to areas that need money. Checks must be processed and “cleared” quickly throughout the banking system. Banks must be regulated and supervised and the money supply controlled. We begin with a brief look at the banking system prior to establishment of the Fed so that we can understand why a central bank was necessary. We then describe how the Federal Reserve System is structured. This is followed by a discussion of the functions of the Fed. Monetary policy functions and instruments include setting reserve requirements, setting interest rates on loans to depository institutions, and through open market operations which involve the buying and selling of government securities in order to alter the money supply. The Fed also performs important supervisory and regulatory functions, as well as service functions. LEARNING OBJECTIVES Identify three weaknesses of the national banking system before the establishment of the Federal Reserve System. Describe Federal Reserve membership in terms of who must join and who may join. Describe the composition of the Fed Board of Governors. Discuss how the Fed uses reserve requirements to carry out monetary policy. Discuss how the discount rate policy is employed by the Fed. Describe the Fed’s use of open market operations to alter bank reserves. Describe the ways in which the Reserve Banks accommodate the clearance and collection of checks. Discuss structural characteristics of central banks located in selected foreign countries. CHAPTER OUTLINE I. The U.S. BANKING SYSTEM PRIOR TO the fed A. Weaknesses of the National Banking System B. The Movement to Central Banking II. STRUCTURE OF THE FEDERAL RESERVE SYSTEM A. Member Banks B. Federal Reserve District Banks 1. Directors and Officers 2. Federal Reserve Branch Banks C. Board of Governors D. Federal Open Market Committee E. Advisory Committees F. Role of the Chair of the FED Board of Governors MONETARY POLICY FUNCTIONS AND INSTRUMENTS Overview of Responsibilities Reserve Requirements Discount Rate Policy Open-Market Operations Implementation of Monetary Policy IV. FED SUPERVISORY AND REGULATORY FUNCTIONS Specific Supervisory Responsibilities Specific Regulatory Responsibilities V. FED SERVICE FUNCTIONS A. The Payments Mechanism 1. Coin and Currency 2. Check Clearance and Collection 3. Check Clearance Among Federal Reserve Districts 4. Check Clearance through Federal Reserve Branch Banks 5. Check Routing B. Transfer of Credit C. Electronic Funds Transfers D. Other Service Activities VI. CENTRAL BANKS IN OTHER COUNTRIES VII. SUMMARY LECTURE notes I. THE U.S. BANKING SYSTEM PRIOR TO THE FED The early history of banking in the U.S. was characterized by frequent and serious difficulties. The First and Second Banks of the United States represented commendable efforts to strengthen banking activity but fell victim to political pressure. The National Banking Act of 1864 was another milestone in legislative attempts to strengthen banking practices. The nation finally came to grips with the need for a central banking system with the creation of the Federal Reserve System in 1913. Among the weaknesses of the banking and monetary system that the Fed was designed to correct was the arrangement for holding reserves and the inflexibility of banks’ ability to expand or contract note issues in response to business conditions. It was common practice for banks to place their reserve funds with other banks. This was especially true of small banks that depended on large city correspondent banks to hold their reserves. Yet, during periods of general economic distress, the large banks were often unable to meet deposit withdrawal requests from their correspondents. One of the characteristics of an effective monetary system is the ability to increase or decrease the supply of credit as required by changing business conditions. There had been no provision for flexibility in notes issued by banks under terms of the National Banking Act. The Fed corrected these two weaknesses by instituting an effective arrangement for holding the reserves of member banks with their Federal Reserve Bank and by assuming the primary responsibility for notes issued and credit management in general. The role of a central bank is to lend money to member banks; to hold reserves of member banks; and to influence the cost, availability, and supply of money. In addition, central banks provide many services for members and exercise supervisory and regulatory authority to maintain sound banking practices. The lack of a central banking system in the U.S. for so long in its history was due to an inherent distrust of strong central banks by outlying regions of the country. A compromise to address the critical need for central banking was reached by creating a system of regional central banks. (Use Discussion Questions 1 and 2 here.) II. STRUCTURE OF THE FEDERAL RESERVE SYSTEM The 12 regional Federal Reserve Banks and the Board of Governors of the Federal Reserve System are responsible for the conduct of monetary policy in this country. In addition, many services are provided by the Fed to both the financial community and to businesses. The scope of Fed activities is described fully in a booklet published by the Board of Governors entitled The Federal Reserve System: Purposes and Functions. Copies may be obtained free of charge from Publications Services, Division of Support Services, Board of Governors of the Federal Reserve System, Washington, DC 20551. The responsibilities of the Federal Reserve System may be categorized as relating to monetary policy; supervision and regulation; and services provided for depositories institutions, government, and individuals. The Fed’s exercise of monetary policy promotes economic stability. It is interesting to note that the Fed’s monetary policy activities were not present in 1913 when the Fed was established. This has become basic to its operations because of the increasing need over the years. The chair of the Board of Governors of the Federal Reserve System is generally recognized as the single most powerful influence on monetary policy in the nation. History shows that under the guidance of Paul Volcker (beginning in 1979), a restrictive Fed policy was successful in bringing down the double-digit inflation of the 1970s and the beginning of the 1980s. During Alan Greenspan’s service as Chair of the Fed Board (1987-2006), there was real economic growth in the U.S. economy, interest rates declined to historic lows, and stock prices reached all-time highs. Ben Bernanke (2006-present) was appointed Fed BOG chair in February, 2006. Shortly thereafter, the housing price bubble burst and Bernanke had to steer the U.S. economy through the 2007-09 financial crisis. (Use Figures 4.1 and 4.2, and Discussion Questions 3 through 8 here.) III. MONETARY POLICY FUNCTIONS AND INSTRUMENTS Dynamic actions are Fed actions that stimulate or repress the level of prices or economic activity. Defensive activities are Fed activities that offset unexpected monetary developments and contribute to the smooth everyday functioning of the economy. The accommodative function is Fed efforts to meet credit needs of individuals and institutions, clearing checks, and supporting depository institutions. The Federal Reserve System’s monetary controls are accomplished by influencing the level of bank reserves. It is the reserves of the nation’s depositories that determine their willingness and ability to extend loans. Three principal mechanisms are utilized by the Fed in influencing reserve levels—reserve requirements, discount rate policy, open-market operations. The first, and most important, mechanism is that of open market operations carried out by the Federal Open Market Committee. By purchasing or selling large blocks of obligations (typically U.S. government short-term obligations), funds are placed in or withdrawn from the nation’s depositories. The movement of funds is equivalent to the alteration of reserve levels since the Fed makes payments to, and withdraws from, reserve positions. The purchase of securities by the Fed results in an increase in depository reserves, and with it the ability to extend credit. Excess reserves provide no income to the depository; it is natural for depositories, like other enterprises, to utilize their assets in productive ways. On the other hand, withdrawing reserves from depositories reduces their ability and willingness to extend credit. If the reduction in reserves is severe enough, maturing loans and other credit may not be renewed by the depository. The second mechanism of influencing reserve levels is establishing the percentage level of reserves that must be maintained against various types of deposits. Since the Fed holds the reserves, it is in a position to assure that the percentage levels are maintained. The third mechanism of influencing reserves is lending to depository institutions. It has been suggested that Federal Reserve Banks serve as bankers’ banks. At times when reserve levels are low, depositories may seek loans from the Fed, repaying the loans when conditions permit. It is through the interplay of these three mechanisms—open market operations, legal reserve requirements, and loans—that the Fed exercises its principal controls over reserve levels. (Use Figure 4.3 and Discussion Questions 9 through 12 here.) IV. FED SUPERVISORY AND REGULATORY FUNCTIONS Depository supervision is concerned primarily with the safety and soundness of individual firms and involves overseeing to ensure that depositories are operated prudently. On-site examination of depositories is the way in which most supervision is accomplished. This function is shared with other agencies including the FDIC, the Office of the Comptroller, state examining agencies, the Office of Thrift Supervision, and the National Credit Union Administration. The Fed has broad powers to conduct inspections of parent bank holding companies and to regulate the overseas activities of member banks. Depository regulation relates to the issuance of specific rules or regulations for the structure and conduct of operations. The Fed has statutory responsibility for: the administration of the various bank holding company acts; and writing and enforcing laws relating to consumer protection. It also encourages the flow of credit to neighborhoods with low or moderate income under provisions of the Community Reinvestment Act. (Use Figure 4.4 and Discussion Questions 13 through 15 here.) V. FED SERVICE FUNCTIONS The Fed has a wide range of important services that it provides for depository institutions and the U.S. government. The most important and extensive of these services is the payments mechanism. This mechanism includes responsibility for providing currency and coin for public use, the processing and clearing of checks, and wire transfers of funds. Additional services of the Fed relate to the publication and issuance of reports, the publication of the Federal Reserve Bulletin, and research on a wide range of subjects relating to money and credit. If a Federal Reserve Bank or one of its branches is close enough, a visit to one of them should prove especially rewarding. If this is not possible, consider inviting a Federal Reserve official to describe the System’s operations. In order to better understand the check-clearing process, it may be helpful to have a group of students develop a hypothetical set of business transactions requiring payments by checks drawn on banks in another Federal Reserve district and to work out the process of clearing them. Other Fed activities relate to its role as fiscal agent for the U.S. government. Services include holding the Treasury’s checking accounts, assisting in the collection of taxes, transferring money from one region to another, and selling, redeeming, and paying interest on federal securities. (Use Figures 4.5 and 4.6 and Discussion Questions 16 through 19 here.) VI. CENTRAL BANKS IN OTHER COUNTRIES The instructor also may wish to cover differences among the Federal Reserve System and the central banks in several other developed countries. The central bank in the United Kingdom is the Bank of England (BOE). Japan’s current central bank, the Bank of Japan (BOJ), was created in 1947. Germany’s current central bank is called the Deutsche Bundesbank and was established in 1957. The Bundesbank now functions under the European Central Bank which conducts monetary policy for the twelve European countries that formed the European Monetary Union and adopted the euro as their common currency. (Use Discussion Question 20 here.) DISCUSSION QUESTIONS AND ANSWERS 1. Describe the weaknesses of the national banking system that was in place prior to passage of the Federal Reserve Act of 1913. The three weaknesses under the national banking system were: a) lack of an efficient national payments system, b) lace of an elastic or flexible money supply that could respond to changes in the demand for money, and c) no lending/borrowing mechanism to help alleviate liquidity problems when they occurred. Under the Federal Reserve Act, certain provisions of the National Banking Act were modified to permit greater flexibility of operations. The Federal Reserve Act was, in effect, superimposed on the National Banking Act. What functions and activities do central banks usually perform? A central bank is a government-established organization responsible for supervising and regulating the banking system and for creating and regulating the money supply. Central banks typically play an important role in a country’s payments system. It is also common for a central bank to lend money to its member banks, hold its own reserves, and be responsible for creating money. 3. Describe the organizational structure of the Federal Reserve System in terms of its five major components. The Fed system consists of five components: (1) member banks, (2) Federal Reserve District Banks, (3) Board of Governors, (4) Federal Open Market Committee, and (5) advisory committees. The Federal Reserve System is composed of 12 federal reserve districts, each district being served by a Federal Reserve Bank. Member banks own the stock issued by the Federal Reserve Banks. The Board of Governors in Washington, D.C. directs and coordinates the activities of the Federal Reserve Banks. The Federal Open Market Committee (FMOC) conducts open-market operations by buying and selling U.S. government securities. The Fed’s three major advisory committees are: Federal Advisory Council, Consumer Advisory Council, and the Thrift Institutions Advisory Council. 4. Explain how the banking interests and large, medium, and small businesses are represented on the board of directors of each Reserve Bank. To assure representation of various economic elements in the district, the nine directors must be residents of the district in which they serve. The directors are divided into three groups, Class A, Class B, and Class C directors. Class A directors represent member banks of the district, while Class B directors represent nonbanking interests. These nonbanking interests are commerce, agriculture, and industry. The Class C directors are appointed by the Board of Governors. They may not be stockholders, directors, or employees of existing banks. 5. What is a Reserve Branch Bank? How many such branches exist, and where are most of them located? The 25 Federal Reserve Branch Banks are located in areas not conveniently served geographically by a Federal Reserve Bank. The majority are located in the large Federal Reserve districts in the West and South: Atlanta has five; San Francisco has four; and Dallas, Kansas City, and St. Louis each have three. A map of the location of all branches is given in Figure 4.2 in the text. 6. How are members of the Board of Governors of the Federal Reserve System appointed? To what extent are they subject to political pressures? The seven members of the Board of Governors are appointed by the President with the advice and consent of the Senate. One member is designated as chairperson and another as vice-chairperson. The members are appointed for 14-year terms. One person is appointed every two years, thus staggering the terms which reduces, but does not eliminate, the possibility of partisan political pressure. The Board need not be bipartisan in nature, nor is there any specific provision with respect to the qualifications that a member must have. 7. Discuss the structure, the functions, and the importance of the Federal Open Market Committee. The Federal Open Market Committee is a coordinating body that has full control over all open-market operations, that is, the timing of the purchase and the sale of securities by the Federal Reserve Banks. This committee gives centralized control, which aids the Federal Reserve in carrying out one of its major functions—controlling the cost and the availability of money. 8. Identify the six individuals who served as chairs of the Fed Board of Governors since the early 1950s. Indicate each individual’s approximate time and length of service as chair. The five Fed chairs, along with the period served are: William McChesney Martin, Jr. (1951-1970) Arthur Burns (1970-78) G. William Miller (1978-1979) Paul Volcker (1979-1987) Alan Greenspan (1987-2006) Ben Bernanke (2006-present) 9. Distinguish among the dynamic, defensive, and accommodative responsibilities of the Fed. Dynamic actions stimulate or repress the level of prices or economic activity. Defensive activities contribute to the smooth everyday functioning of the economy. Accommodative activities include helping meet the credit needs of individuals and institutions, clearing checks, and supporting depository institutions. 10. Identify and briefly describe the three instruments that may be used by the Fed to set monetary policy. The three instruments are: (1) changing reserve requirements, (2) changing the discount rate, and (3) conducting open-market operations. Banks are required by the Fed to hold reserves equal to a specified percentage of their deposits. By setting reserve requirements, the Fed establishes the maximum amount of deposits the banking system can support with a given level of reserves. The Fed discount rate is the interest rate that a bank must pay to borrow from its regional Federal Reserve Bank. Higher interest rates will discourage banks from borrowing, and vice versa. Open-market operations is the buying and selling of securities by the Fed to alter the supply of money. 11. Reserve Banks have at times been described as bankers’ banks due to their lending powers. What is meant by this statement? The Federal Reserve Banks may be seen as bankers’ banks. This is because depositories may obtain funds from their Reserve Bank by rediscounting their commercial paper or by obtaining a secured loan. The Federal Reserve also performs the major function of check clearance and collection for depositories. 12. Describe the two “targets” that the Fed can use when establishing monetary policy. Which target has the Fed focused on in recent years? Monetary policy can focus either on: (1) trying to control the rate of change or growth in the money supply, or (2) targeting a level for a specific type of interest rate such as the federal funds rate which the rate on overnight loans from banks with excess reserves to banks with a reserves deficiency. In recent years, the Fed has focused on the level of the federal funds rate to carryout monetary policy. 13. Explain the usual procedures for examining national banks. How does this process differ from the examination of member banks of the Federal Reserve System holding state charters? National banks are subject to examination by the Comptroller of the Currency, the Federal Reserve System, and the Federal Deposit Insurance Corporation. In practice, national banks are seldom examined by the staff of the Federal Reserve System, but a copy of the report by the Comptroller of the Currency is generally forwarded to the district Reserve Bank. Federal Reserve Banks direct their major attention to examining state-chartered member banks of the districts. State-chartered banks are not subject to the supervision of the Comptroller of the Currency, but they are subject to the laws of the states in which they are chartered, as well as the Federal Reserve System and FDIC. 14. What federal agencies are responsible for supervising and regulating depository institutions that are not commercial banks? The National Credit Union Administration (NCUA) supervises and regulates credit unions, and the Office of Thrift Supervision (OTS) oversees S&Ls and other savings institutions. 15. Describe the objectives of the Consumer Credit Protection Act of 1968. What is the Truth in Lending Section of the Act? What is Regulation Z? The Consumer Credit Protection Act of 1968 required clear explanation of consumer credit costs and prohibited overly high-priced credit transactions. The Truth in Lending Act requires disclosure of the finance charge and the annual percentage rate of credit along with certain other costs and terms to permit consumers to compare the prices of credit from different sources. Regulation Z enacted the Truth in Lending section of the Consumer Credit Protection Act with intent to make consumers able to compare costs of alternate forms of credit. 16. Explain the process by which the Federal Reserve Banks provide the economy with currency and coin. The Federal Reserve Banks maintain large amounts of both paper money and coin in their vaults at all times. Member banks obtain currency and coin by having their deposits with their Federal Reserve Bank charged. Nonmember banks obtain money in the same way or through member banks. Although the Federal Reserve Banks issue their own currency, they obtain coin from the United States Treasury. 17. Describe how a check drawn on a commercial bank but deposited for collection in another bank in a distant city might be cleared through the facilities of the Federal Reserve System. A San Francisco distributor orders goods from a Chicago firm and sends a check with the order. The check is deposited in a Chicago bank. The Chicago bank deposits the check for collection with the Federal Reserve Bank of Chicago. That bank sends the check to the Federal Reserve Bank of San Francisco, which in turn presents the check for payment to the bank on which it was drawn. This transaction required interdistrict settlement; that is, two Federal Reserve districts were involved. 18. What is the special role of the Federal Reserve Interdistrict Settlement Fund in the check- clearance process? The Interdistrict Settlement Fund holds substantial deposits from each Federal Reserve Bank. As checks are cleared between Reserve Banks, debit or credit balances resulting from such transfers are adjusted on the books of the Fund rather than through the actual flow of funds between banks. 19. In what way do the Reserve Banks serve as fiscal agents for the U.S. government? The Federal Reserve System provides without charge to the government the following fiscal services: (a) holds the principal checking accounts of the Treasury, (b) assists in the collection of taxes, (c) transfers money from one region to another, (d) sells and redeems federal securities, and (e) pays interest coupons on federal securities. 20. Briefly describe and compare the central banks in the United Kingdom, Japan, and European Monetary Union. The United Kingdom’s central bank is the Bank of England which was established well before the Fed. A Governor and five additional manage it appointed officers. Japan’s central bank is the Bank of Japan which was established in 1947. It has a Governor who heads the Policy Board which is the central decision-making authority. Germany’s central bank is the Deutsche Bundesbank, which was established in 1957, and it is governed by the Central Bank Council. With the forming of the European Monetary Union (also referred to as the European Economic and Monetary Union), a European central bank now overseas the German central bank as well as the central banks of the other members of the union. EXERCISES AND ANSWERS 1. You are a resident of Seattle, Washington, and maintain a checking account with a bank in that city. You have just written a check on that bank to pay your tuition. Describe the process by which the banking system enables your college to collect the funds from your bank. Your college or university will deposit your tuition check with its local bank and receive credit to its account. The local bank, in turn, deposits the check with the Federal Reserve Bank of its district or with a branch of that Reserve Bank. If, for example, the local bank is located in Memphis, Tennessee, the check will be deposited with a branch of the Federal Reserve Bank of St. Louis. Since the check is drawn on a bank in a different Federal Reserve district, it will be forwarded to a Fed bank or branch in that district. Since Seattle has a branch of the San Francisco Fed, the check will be sent to that branch where it will be processed and returned to the bank on which the check was written, reducing that bank’s balance with the Fed. Thus, for check-clearance purposes, the branches operate in the same way as the central banks, and balance adjustments between the branches are made directly through the Interdistrict Settlement Fund. In effect, there are 37 Fed banks for check-clearance purposes. 2. As the executive of a bank or thrift institution you are faced with an intense seasonal demand for loans. Assuming that your loanable funds are inadequate to take care of the demand, how might your Reserve Bank help you with this problem? An important function of the Federal Reserve Banks is to provide loans to depositories at times when additional funds are needed. A loan may be based on the promissory note of the borrowing depository, or, alternatively, the depository may discount certain assets in its portfolio with the Federal Reserve Bank of its district. The loan arrangement is by far the preferable option. 3. The Federal Reserve Board of Governors has decided to “ease” monetary conditions to counter early signs of an economic downturn. Because price inflation had been a burden in recent years, the Board is anxious to avoid any action that the public might interpret as a return to inflationary conditions. How might the Board use its various powers to accomplish the objective of monetary ease without drawing unfavorable publicity to its actions? Monetary ease without drawing unfavorable publicity would admittedly be difficult in these modern times. Professional Fed watchers detect the slightest action and often imagined actions by the Board. The action least subject to immediate observation would be open market operations. To do so, bank reserves would be increased through the purchase of government obligations from dealers. 4. An economic contraction (recession) is now well under way and the Fed plans to use all facilities at its command to halt the decline. Describe the measures that it may take. An all-out effort to counter a recession would bring into play a reduction of bank reserve requirements, a lowering of the discount (interest) rates on Fed loans to banks, and the purchase of government obligations through open market operations. Public releases of information relating to these actions and frequent speeches by prominent members of the Fed would serve to reinforce the various actions. 5. You have recently retired and are intent on extensive travel to many of the exotic lands you have only read about. You will not only be receiving a pension check and Social Security check but also dividends and interest from several corporations. You are concerned about the deposit of these checks during your several months of absence and you have asked your banker if there is an arrangement available to solve this problem. What alternative might the banker suggest? Irrespective of long absences from home, an excellent case can be made for the electronic transfer of various payments from the payer to your bank account. Authorization would have to be granted to each payer. The advantages are numerous, including safety, speed, and convenience. 6. The prime rate, and other interest rates, offered by banks often change in the same direction as a change in the Fed’s target for the federal funds rate. As an employee of a Federal Reserve District Bank you have been told that your District Bank will be increasing its discount rate early next week. Expectations are that an increase in the discount rate will lead to an increase in the federal funds rate, which will lead to an increase in the prime rate and other bank lending rates. You have been thinking about buying a new automobile for the past couple of months. Given this information of a planned discount rate increase, you are considering buying your new automobile before the end of the week. What are the ethical issues, if any, involved in this scenario? What would you do? You should not benefit from inside information before it is disseminated to the public. With this said, probably no legal liability could be established between your knowing that a discount rate increase will occur next week and your decision of buying a new automobile this week. You have already been thinking about an automobile purchase. In fact, it is likely that increases in auto loan rates will lag increases in Fed discount rates and may not even increase proportionally. Furthermore, the discount rate increase is still only “planned” and might not even occur. With all this said, the ethical issue revolves around whether you are making your new automobile purchase decision solely on the basis of inside information that the discount rate will increase early next week. It seems unlikely that this would be the case because any increase would likely be small and may not occur for sometime in the future, it at all. Most of us would likely make our automobile purchase decisions only after considering a number of factors. PROBLEMS and answers 1. A new bank has vault cash of $1 million and $5 million in deposits held at its Federal Reserve District Bank. a. If the required reserves ratio is 8 percent, what dollar amount of deposits can the bank have? Bank reserves = $6 million $6 million/.08 = $75 million in bank deposits b. If the bank holds $65 million in deposits and currently holds bank reserves such that excess reserves are zero, what required reserves ratio is implied? $6 million/$65 million = 9.2 required reserves ratio 2. Assume a Bank has $5 million in deposits and $1 million in vault cash. If the bank holds $1 million in excess reserves and the required reserves ratio is 8 percent, what level of deposits are being held? ($6 million/.08) + $1 million = $75 million + $1 million = $76 million 3. A bank has $110 million in deposits and holds $10 million in vault cash. a. If the required reserves ratio is 10 percent, what dollar amount of reserves must be held at the Federal Reserve Bank? $110 million x .10 = $11 million required reserves $11 million - $10 million vault cash = $1 million in reserves at Federal Reserve Bank b. How would your answer in Part (a) change if the required reserves ratio was increased to 12 percent? $110 million x .12 = $13.2 million required reserves $13.2 million - $10 million vault cash = $3.2 million in reserves at Federal Reserve Bank 4. A bank has $10 million in vault cash and $110 million in deposits. If total bank reserves were $15 million with $2 million considered to be excess reserves, what required reserves ratio is implied? $15 million - $2 million = $13 million $13 million/$110 million = 11.8 required reserves ratio 5. The Friendly National Bank holds $50 million in reserves at its Federal Reserve District Bank. The required reserves ratio is 12 percent. a. If the bank has $600 million in deposits, what amount of vault cash would be needed for the bank to be in compliance with the required reserves ratio? $600 million x .12 = $72 million required reserves $72 million - $50 million reserves at Federal Reserve Bank= $22 million vault cash b. If the bank holds $10 million in vault cash, determine the required reserves ratio that would be needed for the bank to avoid a reserves deficit. ($10 million + $50 million)/$600 million $60 million/$600million = 10 percent c. If the Friendly National Bank experiences a required reserves deficit, what actions can it take to be in compliance with the existing required reserves ratio? The Friendly National Bank could borrow the amount of its required reserves deficit from another bank that has excess reserves. Alternatively, the Bank might tighten credit to reduce deposits. 6. ASSUME THAT BANKS MUST HOLD A 2 PERCENT RESERVE PERCENTAGE AGAINST TRANSACTION ACCOUNT BALANCES UP AND INCLUDING $40 MILLION. FOR TRANSACTION ACCOUNTS ABOVE $40 MILLION, THE REQUIRED RESERVE PERCENTAGE IS 8 PERCENT. ALSO ASSUME THAT THE DELL NATIONAL BANK HAS TRANSACTION ACCOUNT BALANCES OF $200 MILLION. CALCULATE THE DOLLAR AMOUNT OF REQUIRED RESERVES THAT THE DELL NATIONAL BANK MUST HOLD. $40 MILLION X .02 = $.8 MILLION 160 X .08 = 12.8 $200 MILLION $13.6 MILLION WHAT PERCENTAGE OF DELL’S TOTAL TRANSACTION ACCOUNT BALANCE MUST BE HELD IN THE FORM OF REQUIRED RESERVES? $13.6 MILLION/$200 MILLION = 6.8% ASSUME THAT THE FED DECIDES TO INCREASE THE REQUIRED RESERVE PERCENTAGE ON TRANSACTION ACCOUNTS ABOVE $40 MILLION FROM 8 PERCENT TO 10 PERCENT. ALL OTHER INFORMATION REMAINS THE SAME AS GIVEN IN PROBLEM 4, INCLUDING THE TRANSACTION ACCOUNT BALANCES HELD BY DELL NATIONAL BANK. A. WHAT WOULD BE THE DOLLAR AMOUNT OF REQUIRED RESERVES? $40 MILLION X .02 = $.8 MILLION 160 MILLION X .10 = 16.0 $200 MILLION $16.8 MILLION B. WHAT PERCENTAGE OF TOTAL TRANSACTION ACCOUNT BALANCES HELD BY DELL WOULD BE HELD AS REQUIRED RESERVES? $16.8 MILLION/$200 MILLION = 8.4% 8. SHOW HOW YOUR ANSWERS IN PROBLEM 6 WOULD CHANGE IF THE FED LOWERED THE CUT-OFF BETWEEN THE 2 PERCENT RATE AND THE 8 PERCENT RATE FROM $40 MILLION IN TRANSACTION ACCOUNT BALANCES DOWN TO $20 MILLION. $20 MILLION X .02 = $.4 MILLION 180 MILLION X .08 = 14.4 $200 MILLION $14.8 MILLION $14.8 MILLION/$200 MILLION = 7.4% 9. Challenge Problem You have been asked to assess the impact of possible changes in reserve requirement components on the dollar amount of reserves required. Assume the reserve percentages are currently set at 2 percent on the first $50 million of traction account amounts; 4 percent on the second $50 million; and 10 percent on transaction amounts over $100 million. The First National Bank has transaction account balances of $100 million, while the Second National Bank’s transaction balances are $150 million and the Third National Bank’s transaction balances are $250 million. a. Determine the dollar amounts of required reserves for each of the three banks. Dollar First Second Third Amount Percent National National National $50 million 0.02 $1 million $1 million $1 million $50 million 0.04 $2 million $2 million $2 million $50 million 0.10 $5 million $150 million 0.10 $15 million Required Reserves $3 million $8 million $18 million b. Calculate the percentage of reserves to total transactions accounts for each of the three banks. First National: $3 million/$100 million = 3.00% Second National: $8 million/$150 million = 5.33% Third National: $18 million/$250 million = 7.20% The Central Bank wants to slow the economy by raising the reserve requirements for member banks. To do so, the reserve percentages will be increased to 12 percent on transaction balances above $100 million. Simultaneously, the 2 percent rate will apply on the first $25 million. Calculate the reserve requirement amount for each of the three banks after these changes have taken place. Dollar First Second Third Amount Percent National National National $25 million 0.02 $.5 million $.5 million $.5 million $75 million 0.04 $3.0 million $3.0 million $3.0 million $50 million 0.12 $6.0 million $150 million 0.12 $18.0 million Required Reserves $3.5 million $9.5 million $21.5 million Show the dollar amount of changes in reserve requirement amounts for each bank. Calculate the percentage of reserve requirement amounts to transaction account balances for each bank. First National: $.5 million increase. $3.5 million/$100 million = 3.50% Second National: $1.5 million increase. $9.5 million/$150 million = 6.33% Third National: $3.5 million increase. $21.5 million/$250 million = 8.60% Which of the two reserve requirement changes discussed in Part “c” causes the greatest impact on the dollar amount of reserves for all three of the banks? The drop in the 0.02% rate from the first $50 million to $25 million causes reserve requirements to increase by $.5 million for each bank for a total increase of $1.5 million. The increase from 10% to 12% on amounts in excess of $100 million results in an overall increase of $4 million. Now assume that you could either: (1) lower the transactions account amount for the lowest category from $50 million down to $25 million, or (2) increase the reserve percentage from 10 percent to 12 percent on transactions account amounts over $200 million. Which choice would you recommend if you were trying to achieve a moderate slowing of economic activity? Change (1) increases required reserves by $.5 million for each bank for a total increase of $1.5 million. Change (2) increase required reserves only for the Third National Bank by $1 million ($50 million x 0.02). As a result, Change (2) has a lower total impact on the banking system. SUGGESTED QUIZ 1. Define or discuss briefly: a. Federal Reserve branch banks b. Central banks c. Open market operations d. The Federal Reserve’s “accommodative function” 2. What were some of the weaknesses of the national banking system that gave rise to the Federal Reserve Act? 3. Briefly describe the monetary policy functions and instruments used by the Fed. 4. Describe the process by which the Federal Reserve System assists commercial banks in the clearance and collection of checks. Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288