Jim’s Notes

Central Banks, Risk, and Regulation

Banks can easily fail

Illiquid (classic ‘bank run’)

Depositor Wants to Withdraw $ but,

Bank Has Too Little Cash (Reserves) Pay the Depositor

not enough cash on hand to pay today’s obligations

reserves are too small to meet the withdrawal demands of depositors or the maturing securities issued

Loss of confidence –> ‘bank run’

when depositors lose confidence they accelerate their withdrawals in order to move their money to safer places
accelerated withdrawals soon overwhelm reserves and other assets are not liquid
a bank can be ‘rescued’ during a run if another bank or the central bank loans it cash to boost reserves, a temporary fix

Examples: most bank failures in 1932 were due to runs and illiquidity; the Savings and Loan in the movie ‘It’s a Wonderful Life’

Runs can be prevented through depositor insurance


losses on exisiting loans that won’t get paid back exceed owners capital

technically ‘bankrupt’

Results from combination of risky and bad lending with too little capital investment (the bank is over-levered)


Loans go bad –>

bank can be ‘rescued’ by new or modified ownership – either sell itself to another bank or accept a new large shareholder (usually the government)

Examples: Lehman Brothers, Bear Stearns, Merrill-Lynch, Washington Mutual, and others in 2008

Typical triggers:

excessive losses on loans wipe-out capital
short-term depositors and lenders to bank (buy the banks’ securities) fear there are unrecognized loan losses and refuse to keep lending short-term money to bank. creating an illiquid condition

Bank Failures


Closure /bankruptcy
Assets Liquidated
Money Distributed to Remaining Depositors
monies are frozen – deposits not available for withdrawal during bankruptcy/liquidation process
Usually less than original deposit –> depositors lose $ unless they are insured or bailed out by government/central bank
Sale of bank to a healthier bank
usually arranged sale by regulatory authority
assets and liabilities absorbed/merged into surviving bank
usually requires some subsidy by outside insurance, government, or central bank
Temporary nationalization
Government/central bank takes over bank, ousts failed management, and invests new capital
Government restructures bank, cleans up bad loans, installs new management
Government then (usually 1-2 years later) recoups investment by selling newly restructured healthy bank to private investors

Social Consequences of bank failures and financial crises:

The Banker’s Dilemma: Safety? or Profits?

To increase Safety (reduce risk of failure):

Keep reserves large –>
but fewer loans, fees, and interest collected (less profits)
Keep capital invested large –>
but profit margin (return on capital) is lower

To increase profits (and management bonuses):

Keep reserves are small —>
more money lent out and earning fees/interest, but increased risk of a bank failure due to a run
Keep capital small relative to total assets (high leverage) –>
profit margin (return on capital) is higher, but a small increase in bad loans can more easily wipe out capital and make insolvent

Banks are ‘playing with other people’s money’

situation ripe for fraud and conflicts of interest

‘innocent’ depositors may lose money

may result in reduced C and I spending, creating a recession

contagion and domino effect

‘bad banks’ likely have borrowed money from healthier banks

bad bank failure results in bad loans at ‘healthier banks’ making them fail

failure at some banks causes fear at other banks, depositors, and securities buyers

short-term funding of otherwise healthy banks dries up as investors seek safety in government bonds or cash

recession in real economy

widespread financial crisis among banks causes banks to sharply cut back lending

reduced lending in real economy causes sharp reductions in C and I, reducing GDP.

recession causes an increase in delinquent loans, further worsening bank solvency crisis

Need for regulation

Governments and Central banks establish rules and regulations

payments processing
minimum capital, reserve, insurance, and lending standards

The larger the bank, the greater the social risk/consequences of failure

Hence, some banks are considered ‘TBTF’ or ‘Too Big to (allow to) Fail’
When bankers know they are TBTF and will be rescued, they take even greater risks
‘heads the banker wins’ and ‘tails the banker sticks the taxpayer with the loss’

Deposit ‘Insurance’

Federal Deposit Insurance Corporation (FDIC)
insures first $100,000 of each
deposit account
‘private’ insurance firm guaranteed by US govt.
Not part of The Federal Reserve System
Banks fail every year, but depositors OK.
sister agency, FSLIC, required bail-out in 1986-89.

Central Banks: Government-supervised Master Banks

Attempts at ‘free banking’ (unregulated banking) have failed miserably, producing frequent, severe, financial crises

banks must be enabled by legislation

need for frequent bailouts/rescues

Government treasury departments orginally supervised and regulated banking and paper money issue

Eventually ‘independent’ central banks were established

England started with Bank of England, a private bank, being granted special responsibilities and privileges

‘Independent’ Central Banks are responsible for management of a currency

Usually ‘privately’ owned enterprises under limited direction / authority of government, yet perform inherently governmental responsibilities

governments have effectively ‘outsourced’ management of banking industry and issuance of currency and base money to private central banks

rationale for ‘independent’ central banks lies in Classical economic monetary theory, fears of inflation, and private banks’ desire to control their regulators

The Federal Reserve Banks and System

the U.S. central bank

earlier attempts at US central banks shut down in 1830’s

established 1913 in response to 1909 banking crisis

Federal Reserve District Banks

Organization Chart for the FED

really a network of regional banks with a central governance body

a partly governmental and partly private operation


Regional banks have own presidents and directors

Board of Governors

Responsible for monetary policy
Consists of 7 members
14-year staggered non-renewable terms
Chair: renewable 4-year terms
appointed by US President and approved by Senate

Fed Open Market Committee (FOMC)

responsible for implementing BoG policies via open market operations

Federal Reserve Bank Responsibilities

Supervise Banking

Clear Checks between banks

Issue Bank Notes and coins

‘bankers’ bank’

Manage Monetary policy (BoG and FOMC)

set reserve requirements
manage interest rates
open market operations
foreign exchange (currency) operations

The Fed’s policy operations

Background: Interest Rates and Bonds

Interest on Deposit accounts or ordinary loans

interest rate times account balance = interest paid
interest paid increases account balance
interest rate times amount of loan balance = interest payment due for each year
interest due increases the loan balance until paid

Bonds and securities do NOT increase

sold at discount to reflect ‘interest’ – face amount of bond represents the payment that will be made at maturity
price paid to own the bond (lend) now is less than the face amount to be paid at maturity
‘interest’ (also called yield) paid is the difference between price of the bond now and the face amount or resale price later
suppose Borrower B sells a face amount $1000 bond due exactly one year from now to Lender A.
this means B will pay exactly $1000 to A one year from now – the ‘bond’ is evidence of the right to collect this $1000 payment at that date.
Lender A buys the bond now from Borrower B for an amount less than the face amount to be paid back
the difference between the bond price now and the face amount when mature is the ‘discount’
the discount is equivalent of receiving an interest payment.
Bigger discounts mean effectively higher interest rates and lower bond prices

Bond prices and effective interest rates MUST MOVE IN OPPOSITE DIRECTIONS

if the current prices on bonds drop –> interest rates are increasing
if the current prices on bonds rise –> interest rates are dropping

manage interest rates

Discount Rate vs. Fed Funds Rate

Discount rate: loans Fed makes to banks
Fed Funds rate: loans banks make to each other
Fed Funds rates are set in a competitive open market as banks loan to each other

Fed sets discount rate

Fed sets interest rate paid by Fed on excess bank reserves

Fed only creates a target range for Fed Funds rates

manipulate discount rate and/or open market operations to achieve Fed Funds target rate range

The Fed does NOT ‘SET’ any other rates

Open Market Operations

used to manage / manipulate interest rates or stimulate bank lending

Buying/selling of U.S. gov’t. bonds in the open market

Fed buys bonds (open-market purchase)

Fed gets the bonds, the banks get increased bank reserves (payment from Fed)
Increased demand for buying bonds (from The Fed) drives up bond prices –> interest rates drop

Fed sells bonds (open-market sale)

Banks get the bonds, but their bank reserves at The Fed are reduced to pay for the bonds
Increased supply of bonds to be sold (from The Fed) drives down prices of bonds –> interest rates rise

Unlimited capacity to buy bonds

Since bonds are paid for by increasing (crediting) bank deposit accounts at The Fed, The Fed has unlimited ability to buy bonds.

Quantitative Easing – name for attempts by Fed to manipulate short-term vs. long-term interest rates by buying longer-term securities

Benefit of open market operations

Easy and quick
No change in laws or regulations
Any amount
Discreet and quiet