453 - lecture notes

Question 1

Why we talk about banking regulation:

Answer 1

When you get a crisis in the banking system, it can shut down a whole economy. Regulation matters. We also have to care about history.
—One of the fatal flaws to a representative republic is the difficulty of passing tough legislation. Banking regulation can be one of those hard things, so generally we have knee jerk legislation when a crisis hits

Our American Heritage– our ancestors were motivated to come to America– the catholic church dominated Europe, so if somebody wanted to start a covenant community, you couldn’t do it in Europe. The people who started America were looking for FREEDOM:

1. Religious freedom
2. Economic opportunity/freedom
3. Government freedom (from oppression & individual rights)
   a. According to Locke (right to life, liberty and property), so we created the constitution to put strict parameters around the Fed government to make sure your rights are protected and not infringed.

more than anything we wanted FREEDOM - didn’t pass laws at first - when almost 100 years w/o banking regulations (meaning we tried the CAPITALIST approach with no gov. intervention….it was hard - proving we need gov. involved) (very libertarian mindset at first)

Question 2

Free banking era

Answer 2

National Banking Act of 1863

• -meant to address the major problems that persisted in banking system before 1863
• -prior to this regulation was time called WILDCAT BANKING ERA (1836-1863) - called the “FREE BANKING ERA” bc no central bank or national banking regulation

during time - there was bad behavior of people who started banks
–no regulation or national currency so people would trade gold or silver

in Frontier communities, ppl started banks and exchange gold/silver deposits for bank notes - began to be means of pmt. in communities

2 reasons this is called wildcat banking era

• -1. banks would sometimes set up shop, accept gold/silver deposits in exchange for note that would only be redeemable at a distance location so high up in mountains that only wildcats lived there
• —no federal laws and also no Universal Am. currency - so bank would make it so you couldn’t redeem bank note
• -2. there were thieves who would start banks and ride off with deposits as quietly as wildcars

Question 3

First federal banking law

Answer 3

National Banking Act of 1863

• –required ALL BANKS TO GET A CHARTER either frmo state or to become a state bank or fed gov. to become a national bank
• -this was during Civil War, and option btwn state and national charters meant to serve as a compromise with the south
• -charters not used to stop thieves from starting banks

with law biggest provision is that you need a charter and 2nd is that Fed Gov. began to issue its own currency
–provide US dollar so if indiv. banks failed and indiv. banks notes stop floating around communities

to provide econ. incentive to switch from bank notes to new currency, gov. imposed 10% tax on indiv. bank notes
–banks didn’t want to adopt the national currency, so they started issuing checks which served same function as bank notes without 10% tax

So national banking act of 1863 was first piece of fed. banking which we still have today - still have dial banking system which req. a charter from state/national gov. and we still have checking system

3 things of national banking aact 1863

1. now have to have a charter with National or state gov.
2. implement a national currency
3. impose a 10% tax on community bank notes

(doesn’t fix problem - 1863 - 1907 there were 5 major recessions in 50 years!)

Question 4

post 1863

Answer 4

Post 1863, things didn’t get much better

• –inflation was still problematic, but more problematic was from 1863-1907 there were 5 major crisis in the banking system
• –1907 represented a breaking point for the US
• –In 1907 our entire banking system teetered on the brink of total collapse and was rescued by JP Morgan
• –this really scared America and they realized JP Morgan wasn’t always going to be around…so everybody started to wonder who would be their financial savior next time a banking crisis hit?
• -They didn’t expect that there would always be a private citizen who would save everything every time
• –the crisis slowly changed the minds of the citizens about what the government could and should do (instead of stay out of our business and make sure our rights were secure).
• —People started to realize government could be used as a tool for good and benefitting the citizens

Question 5

1913 act

Answer 5

1913 passed Federal Reserve. Act of 1913 - created the Fed

• –instituted a safety net bc one of their primary responsibilites in addition to triple mandate (stable prices, full employent, moderate interest rates) was to be a lender of last resort
• -bank run can turn a solvent bank into an insolvent bank - if a sovent bank has a bank run, instead of selling assets at fire sale prices, they get a loan from lender of last resort to get through a bank run
• -things started to get better with Fed…then Great Depression came and changed things

MOST IMP. was creating Fed as lender of last resort - to give access to liquidity for solvent (A>L) banks during times of crisis

• –without access to liquity during times of crisis - becomes insolvent
• -leads to CONTAGION, which leads to BANK PANICS
• -lender of last resort heps solvent institutions withstand bank run

act of 1913 - created fed - gives authority and power to serve as lender of last resort - and gives the triple mandate

1. full employment
2. stable prices
3. moderate interest rates

Question 6

1913 and 1927 banking acts

Answer 6

Federal Reserve Act of 1913 (lender of last resort) was first safety net we put int

• -1927 pss McFadden ACT OF 1927
• -Put geographic restrictions around banks - prev. state banks in most banks could branch, but national banks coudl only ave one location - so McFadden act said national banks get same branching priveleges as state banks - so whatever laws governed state banks applied to national banks in borders
• -said no branch across state borders (no banks could have multi state holdings)

big picture - don’t want banking system to have heart attacks - want to optimize without allowing for excessive risk taking

• -build up model that puts tons of restrictions on banks
• -in 1929 Great depression starts - changes social contract btwn citizens and gov.

Question 7

Glass Steagall Act

Answer 7

1933 Glass Steagall - MOST influential piece of banking regulation in our country!!
—GS creates FIRE WALLS around hte banks - bc if one bank catches fire it doesn’t set other banks on fire

1. Created FDIC insurance (second safety net)
2. institutions regulation Q
3. instiuting scop of services restrictions
4. instituted asset composition restrictions

GS was a huge success!! for 30 years omly single digit bank failures (from 4000 to 9)

Question 8

reg Q (GS)

Answer 8

put ceilings on deposit rates that banks could offer to depositors

• –meant to help banks who compete on deposit rates and loan rates, giving margins that are very tight
• –The types of institutions that should take on leverage are those with a reliable interest rate spread
• –There is risk if you let banks compete on both of those rates because those margins could get squeezed. The logic was keep deposit rates low and guarantee some spread, it would reduce some systemic risk (helping to secure the spread)

Question 9

Asset composition restrictions (GS) and scope of services restrictions

Answer 9

said banks could own stocks or corporate bonds

• –The argument was simple: the implosion of the stock market was one of the catalysts for the great depression, and we didn’t want to the most important component of the financial system have a lot of money invested in the stock market if it has the potential to blow up
• –Equally, the risk will be correlated between stocks and bonds, so forced banks to have safer assets on their BS

Scope of services restrictions

• -ifyou’re a commercial bank, you are forced to only be a commercial bank - can’t be involved with IB, fin. advising, insurance, broker/dealer activities
• -if you are a commercial bank that is all you are!! (accept deposits and make loans)

Question 10

prisoner dilemma and bankruns

Answer 10

wy we got so many bank runs: prisoner dilemma
–the optimal thing is for everyone to go home whenever they see a bank run, but ppl wait in line - bank run turns into CONTAGION and leads to bank panis

GLASS STEAGALL of 1933 made things a lot better

• -in 1933 we lost 4000 banks and in 1934 we have 9 bank failures
• –but this model creates a system of lots of small banks
• -means if one bank goes down, won’t take the whole system down - probability of systematic risk given a single bank failure is low
• -means it isn’t great for consumers though (Reg Q put ceilings on deposit rates) - but most importantly is lack of geographic diversification
• -problem is banks don’t have diversified revenue streams bc only take deposits and make loans w/o diversification in scope of services and no geographic diversifiation
• -so if you are a bank in Texas - have extreme hurricane risk that can’t be offset w/ another location
• -probability of systematic failure if one bank fails is low, but probability of a single bank failing is really high bc no diversification

Question 11

During S&L crisis

Answer 11

during 1944-1966, we never have more than 7 banks fail in one year

• –we have thousands of banks fail in S&L crisis - caused in 1980 when there was deregulation act called DIDMCA got rid of Reg Q (geting rid of caps on deposit rates bc of inflation in late 70s)
• -bc weren’t subject to reg Q, banks lost their funding when everyone pulled money from banks to put them in momney mkt. mutual banks
• -so banks lobbied congress to compete with deposit rates - so got rid of Reg Q
• -then oil prices skyrocket during 70s!!! then oil prices plummet in mid 80s
• -when oil prices plummet, all oil workers get laid off and can’t pay their loans
• -at same times loans default, yield curve inverts in early 80s
• -wouldn’t have been problem if still had reg Q bc deposit rates wouldn’t change, but without it, yield curve inverts and deposit rates shoot up and loan rates go down and people default on loans in TX and OK
• -wipes out their banking system in those states

Savings and loans crisis - in 70s - staglation!!!
—huge problem bc inflation HIGH (10-11%) and economy stagnate - so problem for depositers bc deposit rates were set so locked deposit rates causesd real return to be non-existent bc of inflation

1. MAJOR CAUSE OF S&L CRISIS WAS OIL CRISIS (in Texas)
2. grain and agriculture prices - farmers in mid-west
3. a SECOND inverted yield curve
   - -FSLIC goes bankrupt

Question 12

DIDMICA

Answer 12

glass stegall had huge impact on reducing # of bank failures - had very few from 1933-80

• -get pressure in 80s bc inflation put pressure on banks - lead depositors to withdraw funds from banks bc banks did not inc. deposit rates above what is outlined in reg. Q - so money mkt. mutual funds start competing against banks for funds
• -Reg Q eliminated by DIDMCA of 1980 - which was WORST TIME TO ELIMINATE BC DURING 1980 THE YIELD CURVE WAS INVERTED (spread btwn treasuries at diff. times of maturity —inverted means a negative interest rate spread)
• -eliminating reg Q was the kiss of death
• -Same time - have inversion of yield curve
• -taught us coming out of GD that current banking structure had no geographic diversification in banking istitutions
• -saw it wasn’t optimizing what banks coud do for the economy - profibits banks from taking advantage of economies of scale and scope
• -the only benefit from model is that prob. of systematic risk gien s bank failure is low

Question 13

1981 Legislation - FDICIA - in response to S&L crisis

Answer 13

coming out of S&L crisis of 80s/90s - pass one piece of inc. regulation then start DEREGULATION

1991 - pass FDICIA (Fed. deposit insurance corp. improvement act
–means that every regularory who does onsight visit at a bank calculates a CALMELS score which says how risky a bank is/how close it is to having insolvency problems (5 riskiest)
–this then determines how much you pay in FDIC premiums
–so now banks pay prem. based on their CAMEL score - 5 pay highest bc riskiest
C - capital quality
A - asset quality (how risky are assets)
M - Management
E - earnings quality
L - liquidity - how liquid are assets
S - snesitive to mkt. risk

begins a model of RISK-BASED CAPITAL - so regulators impose capital standards based on how risky the bank is -
—then we realize may have over regulated

CAMELS used for

• -FDIC insurance - premium based on risk level
• -capital requirements

Question 14

contemplating deregulation - pass Reigle Neal act in 1994 - and Gramm-leach Bliley Financial services modernization - go to bottom of notes for more details

Answer 14

1. Pass Riegle-Neal in 1994
   - -help banks take advantage of economies of scope and scale that prev. didn’t
   - -got rid of McFadden act of 27 (geographic barriers on banks)
   - –there wasn’t such thing as a national bank until 24 years ago!!! triggered an M&A wave - intense consolidation
   - –gets rid of state
2. Gramm-leach Bliley Financial Services Modernization act of 1999
   - –1998 City and Traverers group (insurance) announce they were going to mergeg 0 merger was illegal according to glass-steagall of 1933 bc bank can’t get involved in insurance - but they say they’ll do it anyway
   - -when annouence their merger, they said they don’t believe in Congress’ laws, the regularoty agency said they wouldn’t stop it
   - -congress responds and passes GRAM-LEACH-BLILEY FIN. SERVICES MODERNIZATION OF 1999
   - -this gets rid of economis of scope restrictions

starts huge race to get big geographically and in terms of scope of services - commercial banks still prevented from owning stocks/corp. bonds

Question 15

after de-regulation cont.

Answer 15

after Gram Leach Bliley - means only parameter that stil exists post glass stegall is asset composition restrictions (stocks corp. bonds)

• –now instead of small and may model…banks merged and have large and few model
• –large banks with lots of geo. and scope of services diversification and tons of synergies
• -part of boom from 92-97 was deregulation
• -needed to have a mechanism to transfer capital from net savers to net borrows - one of authors of bull mkt. narrative from 92-02 was deregulation

now prob. single bank failing is low but prob. of systematic risk if one bank fails is really high!!

Question 16

during fin. crisis of 08 - bank failures - Dod Frank Act 2010

Answer 16

During the financial crisis of ‘08, we had a few really big institutions that started to fail–Lehman Brothers, Bear Stearns, Indie Mac, Wacovia.

• —Comign out of the ‘08 financial crisis, we get knee jerk regulation Dodd-Frank Act of 2010.
• –This was thoughtful knee-jerk legislation
• –big problem it tries to solve is that there are a few giant banks… that are too big to fail (it would be too districture to our economy to let these insitituins fail)
• –Dodd-Frank is LATEST ATEMPT in - trying to helps us get our arms around the too big to fail notion
• –Dodd-Frank created the FSOC has the responsibilty to identify SIFIs (companies that are too big to fail). SIFIs have tons of additional regulation you’re subject to. Now a committee that identifies companies that are too big to fail and have additional; regulation and you could be broken up
• –Also institutes Volker rule which prohibits banks from prop trading (using commercial bank’s money for prop trading)

Question 17

first central bank and events leading up to free banking era

Answer 17

Alexander Hamilton and Thomas Jefferson disagreed on Constitution and how to interpret it

• -Jefferson thought it didn’t say don’t do it
• -Hamilton said if it isn’t prohibited its fine
• -Hamilton said there’s tons of fCivil war debt so we’d make a central bank that would issue bonds to pay down the war debt so all wealthy people in Am. would buy bonds and pay down debt and also make landowners have vested interest in new gov.
• -Hamilton wins the bank
• -starts first central bank in 1791!!! which was granted a 20 year charter
• -we lost it in 1811 - then after war of 1812, we have a lot of war debtso we start 2nd central bank
• -monitored bank notes - 20 year charter again but Andrew Jackson did not renew charter in 1836
• -thus begins free banking era from 1836-1863 bc no central bank or federal banking laws
• -half banks failed with 1/3 of those unable to redeem their notes - about 16% of free banks in t hos states couldn’t redeem their banknotes - about 16% of free banks existed for less than 1 year wth overall average of about 5 years
• -ave. life 5 years, 16% failed first year, 1/2 of all banks failed in free banking era

three hallmakrs of free banking era

1. wild banking instability
2. money supply fluctuations
3. inflation fluctuation

Question 18

Kirtland Safety society anti-banking company (KSSAC)

Answer 18

1831 - started United Order in Kirtlad which was dissolved 1834

• -matters bc placed church at economic center of Kirtland community
• -long before bank started, we had established precenent for church being at the econ. cetner
• -so by Nov. 1836, Saints decide they’re going to start a bank (bc each frontier city realized the limiting factor in their growth was capita, transfering if from savers to borrowers… they needed a bank)
• –Ohio isn’t a free banking state, and they needed a charter to start the Kirtland Safety Society Banking Company.
• –1836 the Ohio State Legislature only granted 1 charter for a bank.
• –You’ve got a problem now and you can’t issue notes unless you’re a bank.
• –Their idea was to change their name and become an anti bank and they begin to issue their notes in January
• –Joseph Smith was the 2nd largest shareholder and treasurer of the KSSAC.

Question 19

Large macro-economic factors during KSSAC time

Answer 19

The bigger problem– the money supply almost vaporizes and prices decline by 35% and inflation as this bank opens - Across country, the money supply expands rapidly and prices expand too

• –Kirkland expands in population - Lots went from $50 up to $2000. Real estate bubble
• –have to capitalize a bank, and the initial owners capitalized the bank with mortgages on land that was in a real estate bubble (with land that was wildly overvalued) (instead of money because there wasn’t a national currency)
• –Then Andrew Jackson lets the charter for the second central bank expire right after we create the KSSAC
• –Now inflation goes crazy, but Andrew Jackson realizes he needs to do something about inflation so he signs an executive order of a defacto gold standard (if you’re buying land from the US government you have to do so in gold, so all these community bank notes lose their value)
• –The money supply contracts after Andrew Jackson imposes this new gold standard, and so the value of the land plummets if you can only buy with gold (bubble pops)
• -since we didn’t have a charter, couldn’t issue notes

Question 20

Additional KSSAC notes

Answer 20

by Jan 23 of 1837 Sidney Rigdon announces the KSSAC wouldn’t redeem notes

• –On March 24, 1837 Joseph Smith fined 1k for illegally operating a bank
• –Before July 7, Joseph Smith withdraws from the association and then publishes a note in August telling everyone to stay away from the KSSAC because he didn’t like the person running the bank
• –By Nov 1837 it’s shut down
• –The KSSAC gives us a window into understanding the Free Banking Era (16% of banks failed in the first year). They weren’t the only bank that failed or couldn’t get a charter. Not abnormal. Estimate of the losses was ~$100-200 per Mormon family (¼-½ of an annual wage for a family)

Question 21

KSSAC main point

Answer 21

1836 (Joseph Smith, Sidney Rigdon, Orson Hyde, Oliver Cowdery), failed in less than a year because they capitalized the bank with mortgages on land that was in a bubble that popped (because Jackson said you could only buy land from the US government with gold so all the notes issued by community banks become less valuable) lots go from $50-$2000. Jackson had to do this because no central bank now. Other historians say the other reason the anti-bank fell was because they didn’t have a charter (Ohio required charters) which made it hard for them to issue notes. It was bad timing and they didn’t get the charter. By 1863 we pass the National Banking Act of 1863, what’s relevant today is from 1863-1907 things don’t really get better.

Question 22

Bank panic 1907

Answer 22

bc charter for 2nd central bank expired in 1836 - 1863 was closing bookends bc it was first national banking act of 1863
–before - 50% of all banks failed, 16% failed in first year - ave. lifepand 5 years

National banking act of 1863 did not really solve any problems - cont. to have crisis and business cycle fluctuation

bank panic of 2907

• -F. Augustus Heinz owns a copper mine in Montana
• -also owned bank in Montana called Bute Savings Bank
• -Bute, Montana was imp. place supplying lots of metal for industrial revolution across the country

Question 23

F A Heinz and short squeezing

Answer 23

• -F A Heinz decides he wants to corner the market for another company called United Copper
• -wants to pour enough money into stock to trigger a short squeeze to artificially manipulate the stock price
• -at any given point in time, there are ppl with short position - your money makes the stock price go up and you get it to the point where the ave. existing shareholders think its time to pull out - but in order for them to get out they nee dtheir shares - forces all short sellers to buy back the shares
• -you get another kick in price and you get out at the peak

FA Heinz has brother names OttoHeinz - owne brokerage house in NY

• -Augustus brings in $25M of his own money and borrows $25M from brother’s house
• -so they drop $50M into price of United Copper
• -it peaks on Oct. 14th 1907 - at $62, but they thought it could get higher so they drop their $50M and 2 days later on Oct. 16 it closes at $15 - they are never able to trigger the short squeeze and price plummets

Question 24

Problem with United Copper price plummetting

Answer 24

They are never able to trigger the short squeeze, and the price plummets.

• –The problem is this is Pre-Glass Steagall and no FDIC insurance, so Bute Savings Bank was actually holding a lot of Untied Copper Stock…so when that got obliterated, it also put the Bute Savings Bank out of business
• –it failed on October 17. No FDIC, no lender of last resort, so this runs like wildfire
• –FA Heinz was the president of a bank called Mercantile National who had a man on the board of directors named CW Morris
• –If it is heard that FA Heinz has just gone broke and you know he’s the president of your own bank, this triggered a bank run
• –CW Morris was a business associate of Charles Barney who was the president of Knickerbocker Trust
• –People then start running on this bank. Then once you get two banks with bank runs in NY, a full scale bank panic follows

Question 25

FA Heinz after bank run panic

Answer 25

FA Heinz announces his resignation from the Mercantile National the same day the Bute Savings Bank fails

• –CW Morris resigns from the board of directors two days later
• –He also has ties to 6 other banks which he then severs ties with
• –Then the New York Clearing House Committee was meant to be an industry lender of last resort in NY and they announce that Mercantile Exchange was fine but people didn’t listen
• –Huge bank run on KnickerBocker Trust which fails Oct 22

Question 26

JPM during bank panic of 1907

Answer 26

JP Morgan steps in - He establishes a committee and says someone has to be a lender of last resort

• –committee was designed to vet bank balance sheets and lend liquidity to solvent banks in the challenges of bank runs
• –They go an look at knickerbocker trust and say it’s insolvent and let it fail
• –Lender of Last Resort exists to provide liquidity to SOLVENT banks during times of crisis
• –They draw a line in the sand and the Trust Company of America (another bank) the first bank the JP Morgan syndicate reviews and rescue– the first bank they infuse liquidity into
• –JP put in $25m of his own money. Later Oct 24 JP gets the US government to pledge $25m to help with the crisis
• –John D Rockefeller pledges $10m - A few other big hitters contribute
• –People started blaming Teddy Roosevelt at the time. Trust Company of America survives and this helps the average New Yorker feel a renewed sense of confidence
• –On OCt 25, JP pressures other bankers to provide $25 to further help Trust Company of America

He basically is the money maker forcing people to contribute money to save certain banks

• –On that same day, he reaches out to the clergy to preach their next sermon about trusting in the banks
• –also convinced some people in Europe to send over quotes about their confidence in the US financial system
• –This was about consumer confidence
• –On Oct 30 the city of NY needs to place a $30m bond that JP helps them place
• –Oct 30 JP Morgan locks a bunch of bankers in his library all night until they come up with a plan to rescue the remaining banks and trust companies

Question 27

Fed reserve act of 1913

Answer 27

Fed Reserve Act of 1913, so this was literally the bank panic of 1907 that gives us the political willpower to create the central bank

• –JP Morgan’s role in the bank panic of 1907 was the catalyst that led to the federal reserve act of 1913
• –In this act, we asked the Federal Reserve to be the lender of last resort (because government can tax and print money), a bank regulator (enforcement responsibilities) as well as the triple mandate (specifically to preserve price stability, full employment and moderate interest rates– now the dual mandate)
• –We’ve tried life without a central bank. Another hallmark of the free banking era was incredible business cycle fluctuation (recessions and expansions). Have things gotten better?

Question 28

Improvement since fed reserve act of 1913 - the fed

Answer 28

• Inflation/money supply: with a central bank, average annual inflation was highest at less than 5%. Our federal reserve over the last 30 years has done an incredible job at maintaining price stability.
• Banking stability: we have seen 3 bank panics since 1907: the great depression, the S&L crisis and ‘08 HUGE IMPROVEMENT.
• Business cycles: measures length of expansions and contractions– before the federal reserve we would have contractions for ~21 months followed by expansions for ~26 months. After the federal reserve post-great depression, average contraction 11 months and average expansion 58 months

Question 29

problems before fed and what we got after

Answer 29

The problems before a fed reserve (free banking era 1836-1863) pre 1913 before we got a federal reserve: volatility in the money supply, wild banking instability, business cycle volatility.

Political doctrine that both sides would agree with:
• Protecting human rights or externalities.
• Smoking negative externality/research positive externality

The Federal reserve is the lender of last resort and adheres to the dual mandate (stable prices and full employment) and be a bank regulator, too

• –A lender of last resort and bank regulator are positive externalities
• –To keep prices stable, you have to control the money supply in relation to growth of the economy, which (price stability) is obviously a positive externality
• –Full employment is most debated– could be positive externality or negative externality

Question 30

Video lecture - understanding balance sheet of Fed reserve

Answer 30

Free banking era (1836-1863) no central bank or federal laws are national banking:

1. Bank failures– no lender of last resort, FDIC insurance
2. Money supply fluctuations– Jackson executed a gold standard
3. Volatility in business cycles

From 1791-1811 The first CENTRAL BANk
1816-1836 second central bank of the US (under Jackson let the charter lapse)
—-Role of government: national defense, infrastructure, national single voice with foreign policy, unified judicial system to enforce contract rights and all human rights. From a higher perspective
—government involvement is tolerable to protect human rights and mitigate problems around externalities.

look at the externalities chart

• -top is Macro level and left side is micro
  1. top left is costs > benefits on macro and mirco leve - markets acceptable

2. bottom left benefits greater than costs for micro but costs > benefits for society - negative externality (POLLUTION)
3. top right = positive externality - costs greater than benefits on micro but benefits > costs macro (LIGHTHOUSE)
4. bottom right - markets = acceptation - benefits beter than costs for both

Question 31

roles of federal reserve

Answer 31

1. Monitor banks (positive externality)
2. Lender of Last Resort (positive externality)
3. Balance “Dual Mandate” (stable prices & full employment)

Few key preliminary points:
• The Fed doesn’t actually produce dollar bills (those are produced by the Treasury)
• They are, however, controlled by the Fed reserve
• They represent a L in the eyes of the Federal Reserve (top of dollar says federal reserve note… an IOU)
• Location matters (where it is determines where it sits on the BS) Doesn’t become a L until the dollar is in the hands of someone (instead of in plastic wrap), but if it’s in the at BofA or at deposit at the Fed then that’s a reserve. Federal Reserve Notes (physical cash either in the vault of a bank or on deposit at the Fed) + currency in the hands of the public.
• Fed can create digital liabilities at will

Question 32

how does the fed change its BS?

Answer 32

• -if Fed buys $10M of treasuries from primary market auction, Fed will inc. their securities $10M and their L go up $10M due to deposits of US gov.
• -for gov. their BS would reflect -$10M of securuties but +$10M deposits at Fed

Fed’s response to crisis of 2008 - before crisis BS was total assets $894B mostly in form of treasury securities

• -6 mo. later - it doubled size to $2.2T in 3 main ways
• –1. with big changes in term auction credit facility (intermediate term loans to commercial banks to hvae longer and more stable liquidity)
• -2. ommercial paper funding facility (grew in magnitude super short term borrowing where only safest borrowers can be active in mkt, but people were spooked after Lehman defaulted, so US buys commercial paper bc no one else would even though it was crucial for other companies to keep moving forward)
• —3. other assets also up - most of these were central bank liquidity swaps - everybody houarding US dollars which affects international trade bc most transactions are dollar denominated - so US fed reserve bank woudl send dolars to another central bank in return for equal amt. of their own currency (Currency swap) - with agreement that you’d swap a few months later - attempt to lood international markets with as many dollars as they needed to execute international transactions
• –4. holding treasuries was down - flight to safe assets which are gold and treasuries - reduced treaasury holdings by $300B - tons of buying pressure for massive shock to demand - makes prices go up and yields go down

Question 33

Size of Fed’s BS

Answer 33

Look at the numbers below to see the current size of the Fed’s BS

• -With a supply and demand curve in the bond market, since the crisis, the Fed has been buying treasuries and MBS like crazy, thus shocking demand to the right, raising the prices of them and thus reducing the yields
• –The Fed wanted to get us to full employment by supercharging GDP (pushing down yields pushes up C and I)
• –Fed has mushroomed its BS with the intention of driving prices up and yields down to spur on C &I to rev up GDP to get us at full employment. The $3.5T of added assets are also $3.5T of Ls.

Question 34

Understanding money - to interpret Fed’s BS

Answer 34

To understand the BS of the federal reserve, it’s important to understand money

• –Holding money is an asset for me and a liability for the fed
• –As of Nov 2017, the Assets side has lots of US treasuries ($2.4T) and MBS ($1.7T) $4.5T Asset side, before the crisis they were $850b
• –The L side Fed Reserve Notes $1.5T– the Fed Reserve can create these liabilities at will. $2.6T of deposits (digital dollars)
• –Deposits held by depository institutions is $2.2T

So if cash is in our hands it’s called currency in the hands of the public…if it’s in Zion’s bank vault (owned by a bank) it’s called reserves

• –Fed can create money at will. The fed grows it’s BS through buying securities
• –On the Asset side of BofA they lose $1m and gain $1m of deposits (both assets). The Fed gets $1m of securities (assets) and $1m of deposits (liabilities)
• –The net effect is the fed is infusing $1m of digital currency into the economy
• –Those other assets of 556b central bank liquidity swaps– providing US dollars to other banks. They also started selling treasuries like crazy because there was a massive flight to safety. Expanding the BS means creating digital dollars.

Question 35

so how have we not seen inflation? - money suppy vs. monetary base

Answer 35

• Inflation is a function of the money supply. M1 is cash + checking accounts; M2 is M1 + savings accounts + money markets + time deposits.
• The amount of goods and services relative to the dollars chasing them determines inflation, and if you have more dollars chasing the same goods and services you’ll see inflation.

Inflation driven by money supply NOT monetary base.
• The Fed reserve’s BS (L side) is the monetary base which is currency + reserves

Monetary base = cash + reserves
Money supply = cash + deposits; these chase goods and services; Deposits chase money supply

Question 36

inc. Fed’s BS and monetary base

Answer 36

Difference between reserves and deposits. Required reserves measured against deposits.

Increasing the Fed’s BS increases the monetary base by $3T, but it’s the money supply that creates inflation
—The relationship between the monetary base and the money supply is: the money supply = the monetary base * money multiplier

Over the last 10 years, the Fed has increased the the MB by $3.5 but it hasn’t fully trickled through the money supply because of excess reserves.

Data: excess reserves over time have 1.2b to 19b at 9/11. For 20 years between 1-2b then the financial crisis hits and we are up to now of $2.1T excess reserve

• –Even though the Fed reserve increased the monetary base by $3.5 trillion, excess reserves have gone off the charts meaning the money multiplier has gone way down (from 2.7 to well below 1)
• –We haven’t seen inflation because of excess reserves (money the banks are sitting on that they don’t need to be sitting on), and they are now sitting on $2.1T.

$100k of reserves turns in to $1m of deposits

Question 37

why banks want reserves

Answer 37

We are worried about the Fed’s BS expanding by $3.5T from a base of $850b, this means that there should be some form of inflation

• –Their L side is the monetary base: C + R
• –There is a distinction between monetary base and money supply, but we haven’t seen inflation because excess reserves has increased to $2.2T.
• –The excess reserves to deposit ratio have increased sharply which has decreased money supply which has allowed the Fed Reserve to increase the monetary base without exploding the money supply– why we haven’t seen inflation.

Why do Bank’s want reserves (demand for deserves):
• Reduce liquidity risk
• To lend out
• Required by law

Question 38

How we aren’t seeing inflation

Answer 38

GDP = Y = C + I + NX

• –if GDP contracts then people lose their jobs, so you want to get people back to work, so you want to increase C & I through lowering interest rates
• –But the US budget deficit looks bad so the Fed funds the budget deficit by issuing more bonds, shocking supply to the right, so prices going down and yields going down
• –Central bank doesn’t want that so they have no other choice but to buy bonds so the demand curve offsets the supply shift
• –To push prices up to bring yields down to stimulate C & I, thus mushrooming your BS by $3T and having the risk of inflation
• –The risk of mushrooming your BS is inflation
• –In the bond market, as the Fed reserve, you lower interest rates by buying bonds, but this process explodes the BS, thus increasing the monetary base and then having the risk of increasing the money supply (without a corresponding increase in the goods and services the money supply chases) which would run the risk of inflation
• –Banks will release their $2 reserves if rates go up. But if rates go up and banks reduce their excess reserves, it means the money multiplier could go up, and if nothing changes with the monetary base, the money supply will go up and potentially cause inflation
• –This is the tricky thing though because as the fed, typically when you raise rates, it’s meant to stop inflation

So the balancing act is trying to shrink the monetary base, knowing it could increase the money multiplier and trying to keep the money supply balanced.

Question 39

In normal economic environments, the Fed does 4 policy tools (levers) to fulfill the dual mandate (stable prices and full employment):

Answer 39

1. Fed Funds Rate
2. Discount Rate
3. Deposit Rate
4. Required Reserve Ratio

Question 40

market for reserves

Answer 40

Supply and demand for reserves:
• Total amount of reserves stays the same unless the central bank gets involved.
• Fed Funds Rate: the overnight lending rate between banks
• The supply curve is straight up because no matter what interest rates are, the Q of reserves is fixed. The kink in the straight line comes if the fed funds rate is ever more than the discount rate– the quantity of reserves would run to infinity. The arbitrage move is to borrow from the central bank at 2% and lend it out to another bank at 2.5% (theoretically). People would want to scale this arbitrage move, so that is why it would run to infinity.
• Wells Fargo, for example, when they need to borrow money can either borrow from another bank at the Fed Funds Rate or can borrow from the Fed at the discount rate
• Demand reserves for those 3 reasons above. The cost to obtain funds, the better. But if it gets really expensive, won’t want as much. (the cheaper it gets, the more banks will want reserves for liquidity and profit purposes). But the demand curve also has a kink in it at the deposit rate. The kink exists because there is also an arbitrage opportunity if theoretically the fed funds rate were less than the discount rate, at which point the you could borrow from the another bank at the lower rate then deposit it at the fed for a higher rate
• Deposit rate is the rate the Fed pays any bank that has a deposit with them
• Market fed funds rate bounded by discount rate on top and the deposit rate on the bottom

Question 41

Fed targeting fed funds rate

Answer 41

The Fed sets a target range which means they will set the discount rate and the deposit rate to set the bound, but it’s not just that– they also move the supply

• –If the Fed wants to lift the fed funds rate, you control supply and would decrease it (meaning reduce the supply of reserves and lift the floor and ceiling
• –But you lower the supply of reserves by shrinking the BS which happens through making open market sales (selling bonds– the Fed sells bonds and takes money from whomever it sells them to)
• —An open market sale shifts the S curve back, increases the market fed funds rate (they move the supply curve while moving the ceiling and the floor up)

Moving the Fed Funds Rate impacts the economy because it is the short end of the yield curve (default free yields with shorted time to maturity). When the Fed messes with the fed funds rate, it influences the rest of the curve because the yields move together

Question 42

Fed tools on dual mandate - stable prices and full employment

Answer 42

Dual mandate says stable prices and full employment:

• –If stable prices is the concern, then your goal is to get the money supply down (easiest way is to shrink the monetary base), so you will want to shrink the money supply.
• -= dec. money supply - decrease reservces - open market SALE - inc. discount are = inc. deposit rate = inc. req. reserve = inc. interest rates

If you want to get to full employment, your goal is to decrease rates to stimulate C & I. This means you’d need to increase reserves by shifting the supply to the right. The risk is that prices could go up you decrease interest rates by shifting the red line out, thus increasing reserves and increasing the monetary base. If nothing else changes, then you’d increase the money supply and trigger inflation.
—–= dec. rates = inc. reserves = open market purchase = lower discount rate = lower deposit rate = lower req. reserve = lower int. rates (C & I go up)

Question 43

lists - problems in free banking era

congressional mandate of fed

4 conventional policy tools of fed

3 reasons banks demand reserves - 1st 2 explain downward slope in D curve

Answer 43

Some of the problems we saw in the free banking era:

1. Banking instability
2. Money supply/inflation instability
3. Business cycle volatility (don’t forget the data on this with the months of expan/contract)

Congressional mandate of the federal reserve

1. Stable prices
2. Full employment
3. Moderate interest rates (ignore)

4 Conventional policy tools of the fed:

1. Fed Funds Rate (Open market operations)
2. Discount rate
3. Deposit rate
4. Required reserve ratio

3 Reasons banks demand reserves: *the first two explain the downward slope in the D curve

1. Liquidity
2. To lend it out (profit)
3. Regulation

Question 44

Fed influence on fin. system

Answer 44

The Fed Reserve inserts influence on our financial system through the money supply or interest rates– they are currently using interest rates.

The money supply (currency in circulation + savings deposits + checking accounts) = MB*mm
MB = C + R

The Fed reserve is reluctant to exert changes in the financial system through changes in the money supply because it’s going to be imprecise (the Fed controls the MB because that’s their BS). You make the MB one of their policy tools & the reserve ratio, but you don’t have perfect control over the amount of cash/currency citizens hold or excess reserves. If there are 4 variables that control the money supply, you as the Fed only have precise control over two of them.

When the Fed reserve attempts to influence interest rates, on which side of the yield curve does the yield curve usually focus during normal economic environments– THE SHORT END.

If the Fed reserve wishes to exert influence over all interest rates in the economy, why does it only focus on one specific interest rate (the fed funds rate)– because (the stylized facts of the yield curve are 1: YTM on ST bonds more volatile than LT bonds; 2. Generally slopes up; 3. Rates move together– yields on ST & LT bonds are correlated) if you only want to move the whole yield curve, you just need to change one part of it. The Fed basically grabs the short end of the yield curve to move it and relies on the rest of the stylized facts to move the rest of it.

Question 45

how to influence supply - fed

Answer 45

Supply of reserves only increases in the Fed makes an open market purchase, they are taking securities from another bank in exchange for cash/deposits, thus increasing their reserves. The supply only changes with a purchase or sale. WIth the MS they can only control 2 of the 4 variables, but with the target fed funds rate, they can control everything they need to hit the target fed funds rate. They absolutely control the demand, the lower floor, the upper ceiling, and the supply curve

If you want to get control of inflation, you shrink the money supply. The best way to do that is to shrink the monetary base through decreasing the money supply, thus reserves need to decrease. By selling bonds you reduce the supply of reserves, meaning the ceiling and floor have to increase. All of this would increase interest rates, thus potentially harming C & I, meaning that you could hurt full employment

Question 46

what to do if concerned about inflation - Fed

Answer 46

If you are concerned about inflation, you want to reduce the MS by shrinking the monetary base by reducing reserves. You reduce reserves through open market sale, meaning the s is going to shift left, meaning fed funds rate goes up and the floor and ceiling goes up too.

Question 47

what to do if worried about economic downturn

Answer 47

If you’re worried about economic slowdown, you want to stimulate the economy through decreasing interest rates through open market purchase.

Some data to show where we are on these policy tools– market fed funds rate (anytime it drops it means they are trying to stimulate the economy) and iot rises when they try to fight inflation. Right now the target fed funds rate is between 1-1.25%. Discount Rate is 1.75%. Interest on required reserves 1.25%. Basically have the target fed funds rate and int rate on required reserves, we’d see our floor (deposit rate) is our target fed funds rate. The Fed has done this to encourage banks to keep their money on deposit at the fed to encourage banks to sit on their reserves to keep the money multiplier low so even though the MB is off the charts, we aren’t seeing inflation.

Question 48

unconventional policy tools of the Fed - experimental!!

Answer 48

1. overnight reverse repurchase agreements
   - –sells security to a bank (an eligible counter party) andagrees to buyit back next day at slightly higher price
   - -reduces resreve balances on L side of Fed’s BS and a corresponding inc. in reverse repo obligations with trades outstanding
   - -the FOMC sets overnight repurchase offer rate - helps control fed funds rate without buying or selling reserves
2. term deposit facility - super short term CDs that Fed offers commercial banks
   - -if they can convince banks to keep it there for 7 days - it pulls reserves out of reserve market for 7 days - if they can lock in reserves for 7 days it helps fight inflation

Question 49

why study history?

Answer 49

bound to make errors in the future if not a student of history - very true in the area of banking - history does not repeat itself…but we can make the same mistakes that were made in history that could be avoided if we just understood history

Externalities are the reason for gov. intervention (economics)

• –We have created a banking system in America that is destined to fail (it is levered 9 to 1 D/E)
• –Superpower based on a faulty system - we have the most powerful super economy of the world…but the engine that drives it is faulty and destined to fail
• –GDP is 20T and balance sheet of banks is 17T

Question 50

deregulation con. - Riegle-Neal act

Answer 50

RIEGLE-NEAL ACT 1994

• -gets rid of state boundaries as fire- walls for banks
• -allows bank holding companies to acquire banks in any state and supersedes all state laws
• -geographic barreirs are eliminated
• –BANKS HAVE ONLY BEEN ABLE TO EXPAND ACROSS STATE BORDERS SINCE 1994 - BAML was not BAML until 1994
• –allows banks to become fully national banks
• -ALLOWS THEM TO TAE ADVANTAGE OF ECONOMIES OF SCALE - LOWER LOAN RATES AND HIGHER DEPOSIT RATES (good for consumers)

Question 51

deregulation cont. - GLBFSMA

Answer 51

GRAMM-LEACH-BLILEY FINANCIAL SERVICES MODERNIZATION ACT OF 1999

• -After Citi and travelers announce their illegal merger
• -act breaks down further regulation walls

BHC allowed to hold:
–commercial banks
–insurance comp.
–IB
–asset management firms
(only been able to perform these services for 20 - years)
–banks still not allowed to own stock or corp. bonds

can lead to potential monopolies

• -in 2005-2006 for the FIRST TIME EVER IN AMERICAN HISTORY HAVE 0 BANK FAILURES
• -but also have fewer Q of banks

the few and large system leads to a TOO BIG TOO FAIL PROBLEM

Question 52

Dodd-Frank

Answer 52

passed in aftermath of 2008

• -creates the FSOC (financial stability oversight council)
• -given responsibilty to monitor systematic risk - gov. entity that monitors and given responsibility to TAG SIFIS (systemically important financial institution)
• —–has authority to exercise power to force them towards liquidation if it poses too big of a threat
• —-if you are above $250,000 in asset - you are automatically a SIFI

CAN’T GO BANK - once we choose the “few and large” model - can’t go back to small and many

Question 53

2 biggest mistakes of Kirtland society anti-banking company

Answer 53

1. Capitalized it with real estate that was in a bubble (over-valued real estate as the equity financing) - bubble popped and they were immediately illiquid
2. Didn’t get a charter (needed a charter to start a bank in Ohio)
   - —-So made the decision to turn it from a bank to an “anti-bank” - against the law bc can’t issue bank notes without a charter
   - ——-Anti-Mormons say this was a decision made out of greed - in another lens we say that there were non-LDS attorneys who were counseling us to do this
   - —–Reason it was a bad decision: 1837 we found ourselves operating a bank without a charter financed by real estate that has been devalued in the middle of a financial crisis
   - —-At the time, Sidney Rigdon and Joseph Smith - look at their roles (who was treasurer)
   - —-Average Mormon family loses btwn 10-25,000

Question 54

why book ends of free banking era 1836 and 1863

Answer 54

1836 - 20 year charter on second central bank runs out - so we lose the central bank

1863 - national banking act of 1863 - first federal banking law

Question 55

bank panic of 1907 was the

Answer 55

trigger to create the Fed

role of lender of last resort is to provide liquidity to SOLVENT insitutions in times of crisis

(panic all happened btwn Oct. 14th - Oct. 27th)

Dec. 23rd. 1913 - Fed created!! Birthday of Fed and Joseph Smith

Question 56

4 tools of the Fed - to accomplish dual mandate

Answer 56

1. req. reserve ratio
   - –the % of deposits that bank have to keep as reserves - banks can’t lend out
2. discount rate
   - –int. rate Fed charges when banks borrow from the Fed
3. target fed funds rate
   - –int. rate banks charge each other to borrow/lend money over night (repos)
   - –reason is bc of the req. reserve ratio - bc need to meet these requirements so borrow overnight from other banks
   - —FED sets the first 2 - DOES NOT set the fed funds rate - but they create boundaries for their target range
4. deposit rate
   - -the int. rate Fed will pay banks for any reserves the banks have deposited in the Fed - int. rate to banks Fed pays

Question 57

we had 5 severe panics in years leading up to 1907 - created of Fed - three main issues of period and how they have improved since creating fed

Answer 57

1. bank failures
   - –3 major banking crisis in past 100 years (08 crisis, S&L crisis in 80s, GD)
   - –there were 5! in just 50 years before fed created
   - -Fed and FDIC help
2. inflation volatility
   - –pre fed era
   - -LOTS of volatility in inflation
   - -inflation since 1960s - showed core PCEPI
   - –since creation of Fed - only one problematic inflation period in mid 70s early 80s
   - -highest inflation has been over our lives is 3% and Colby’s 5%
   - -Fed gets all credit for inflation!!! - monitor our money supply
3. business cycle volatility
   - –before fed - ave. about 26 months of good economy (expansion) and 21 months of bad economy (contraction)
   - –post WW11 (with Fed) - about 58 months (5 years!!!) of expansion and only 11 months of contraction
   - –want long expansions and short turndowns

Question 58

when gov. should be involved (2 points)

Answer 58

1. if it involves protecting natural human rights
   - –foundation of our gov. - Preamble to constitution
   - -problem is ppl disagree on what qualifies as a “human right”
   - —-life liberty property - some argue healthcare
   - -they should help with military - with infrastructure (roads and highways) - that we should have a unified single voice on policy in international relations - judicial system to protect rights
2. if it involves significant externalities
   (GRAPH IN NOTES!)

Roles of Fed

1. lender of last resort (positive ext.)
2. bank monitor
   - -preventing neg. ext. bc banks are incentivized to behave poorly but hurst society)
3. stable prices
   - -positive ext. - benefits society but no one has power to do it

Question 59

Fed balance sheet

Answer 59

right side of balance sheet is the MONETARY BASE

• -currency/cash in hands of public + reserves (the LIABILITIES!!!)
• –liabilites whent from $900B to $4T
• -showing monetary base (balance sheet of Fed) has expanded $3T over starting base of $900B

why not inflation?
bc money supply impacts, not monetary base
–the money multiplier up until crisis was 1.5 —> now plummeted after to .6 or .7
—haven’t seen inflation bc money multiplier has gone down dramatically

factors that change money multiplier

1. cash/deposit ratio
2. req. reserve rawtio
3. excess reserves
   - –BIGGEST FACTOR HAS BEEN EXCESS RESERVES

Question 60

fed as lender of last resort

Answer 60

during 9/11 crisis - amt. of excess reserves went from $1B to $19B

• -Greenspan told ppl not to bank run and that Fed would provide liquidity as needed
• -now excess reserves $1T in only one year

haven’t seen inflation bc money is out there but banks are sitting on it - in excess reserves - so it is not out flowing in the money supply
–so monetary base has grown dramatically but money supply hasn’t ot changed much

Question 61

market for reserves - why is there demand? - S/D curves

Answer 61

1. required by law
2. liquidity - hold in case of bank panic - meet depositer demand requests
3. lending - how they make money

2 reasons are (2-3) for dewn sloping demand curve
—bc as the cost of holding reserves decreases the Q/D inc.

supply curve is VERTICAL - bc after intial infusion from the Fed…the amt. of reserves does not change

• –bc Fed put $100,000 in economy - at end of every round there was always still $100,000 of reserves
• -only way to change Q supply of reserves is when BALANCE SHEET OF FED CHANGES - which monetary base is balance sheet of Fed

Question 62

current fed funds and info.

Answer 62

11/8/18 - announced to keep target range of 2-2.25%

• –kept deposit rate at 2.2%
• -announced a discount rate at existing level of 2.75%

short end of yield curve - bc yield curve is not treasuries…it isdefault free int. rates - Fed fund rate is overnight interbank transactions - so IS default free

• –short term treasury (28 days) was 2.32 and fed funds rate was 2.2 - so shortest end
• –component parts of yield curve move together
• –so if change short end would change lond end too

Question 63

currently worried about inflation - what can they do….

Answer 63

would want to drop the ceiling and floor

• –decrease supply of reserves
• –they are going to msot liekly haev to pull supply back and keep raising floor which makes a really high deposit rate (to keep banks holing their reserves) but dec. supply by shrinking balance sheet
• -always have to move ceiling and floor the direction you are taking fed funds rate - so move it up by increasing both or move it down by dec. rate

Inc. fed funds rate = shrinking monetary base — 1980 stagflation problem…where 19% fed. Funds rate!!! Volker (chairman of fed reserve) - Volker recession - he dramatically shrunk the monetary base and caused the recession to stop inflation….but it was good for us because we haven’t had huge inflation problem since

Question 64

issues during free banking era - his VIDEO

Answer 64

–First time expiremented with Lassaiz faire capitalism

1. MASSIVE AMTS. OF BANK FAILURES
   - –16% of all free banks failed during their first year…one of the banks was the Kirtland nonbanking safety society
   - — This was all pre-glass steagall act…so not insurance and no lender of last resort – so if the bank failed…meant the depositors were out of luck
2. Money supply fluctuations
   - –The first 2 periods 1834-37 money expands 21% and we have high inflation!
   - –Pres. Jackson required all public land purchases to be transacted with gold and silver - deflation and money supply shrinks
   - -get 35% deflation!!!
   - —Large fluctuations of money supply out of control!!
3. Volatility in business cycles
   - —Macro-economic volatility

Question 65

federal reserve 1913

Answer 65

JPM died that same year - Dec. 23rd 1913

FED ROLES (all positive externalities)

• Monitor banks
• serve as lender of last result
• balance “dual mandate - full employment, stable prices

fed does not creat the money (Treasury) - but they are responsible for inserting these things into circulation

each dollar bill tells you which Fed. reserve bank put that dollar bill in circulation

Question 66

location of money - for BS

Answer 66

location matters!!! where the
–where $1 bill is determines what it is called in fed balance sheet

if dollar is sitting in plastic wrap in basement of fed…not included on their balance sheet - not a liability on balance sheet until somebody else has it

if dollar is claimed by Bank - at BAML or at Wells fargo or in their vault on DEPOSIT at the fed…it is called a reserve!!

• -that is a liability on the fed. balance sheet
• —if dollar is in ATM machine and customer grabs it and puts in pocket - called currency in the hands of the public
• –usually not separated as reserves and cash in hands of public - just called “federal reserve notes”

Question 67

Fed balance sheet

Answer 67

Fed can create digital liabilites at will

• –fed in certain transasctions
• -ex. buys US treasuries from BAM they can create digital dollars = creating liabilities
• -at this time balance sheet assets is 4.5T and 2.5T is US treasuries
• -shows that national debt is $19T…so Fed owns more than 10% of the debt
• –also of the 4.5 T on balance sheet. also have 1.7T in MBS
• -primary assets on fed balance sheet are treasuries and MBS

liabilties
–federal reserve notes
–deposits (digital dollars - not physical federal reserve notes) is the largest item on their liability side of balance sheet - most of these are held by fin. institutions (WF, BAM, Chase)
Fed reserve is the bankers bank and the US gov.’s bank

Question 68

how does the fed change its balance sheet

Answer 68

1. assume Fed buys $10M of treasury securities from a primary-market auction
   - -BUYS $10M treasuries from US gov.
   - -so ASSETS side goes up in treasury securities by $10M
   - -liabilities side - they just type in to inc. deposits - so they inc. the deposits of the US treasury on account at the Fed. reserve by $10M - then the US gov. can use the $10M DIGITAL DOLLARS as they like

(took a picture of the T charts - accountign!! look at it!)

on Fed accounts
–debits treasury securities by $10M = assets go up
–credits $10M as deposits of
US gov. at the fed. reserve - liability bc will owe to the gov.

on US gov. side

• -debits = +$10M deposits at the Fed - bc is an asset to them and earn deposit rate int.
• -credits +$10M bonds payable bc owes to the Fed

Question 69

balance sheet changes #2

• -fed buys $10M of treasury securities from BAML
• -bank of America requests $1M in cash
• -customer withdraws $100M from ATM

Answer 69

On Fed reserve balance sheet

• -Debits +$10M treasury securities
• -credits - liabilites up +$10M deposits of BAML - bc owes to BAML

on Bank of America BS

• -debits +$10M deposits at the Fed - asset bc money that is owed to them
• -then also debits -$10M in treasury securities going down - bc their asset of treasury securities (account) went down

2ND STAGE
Fed transfers $1M in cash to BAML
FED BS (Transforming liabilities side)
–credits +$1M fed. reserve notes (replacing withdrawal with fed. reserve notes)
–also credits -$1M deposits of BAML (bc they just withdraw from their deposit account)

on BAML account (transforming asset side)

• –debits +$1M cash reserves (bc rec. from Fed)
• -debits -$1M deposits at fed - accounts fall bc no longer have that asset in fed

4RD STAGE (customer withdraws BAML from ATM)
on Bank customer BS (changing assets)
—debit +$100 cash
—debit -$100 deposits at BAML

BAML BS

• • credits -$100 in cash reserves (have less in reserves)
• • credits liability -$100 cash deposits (bc no longer owe that liability to the customer)

Question 70

Fed’s response to crisis of 2008

Answer 70

going into crisis…total assets = $900B — most of which was treasury securities ($500B in treasuries)

massive leaks in the dam came up - can see in the federal reserve balance sheet - dam literally starts leaking and breaking–Dec. 2008 - signifcant changes
—fed. reserve BS doubled in size from June to Dec. (2.2T)

Question 71

biggest changes in fed BS in 6 months during crisis (from June 2008 to Dec) - 4 areas!!

Answer 71

–biggest changes in
1. term auction credit facility
–intermediate term loans to commercial banks (diff. than ST discount lending to help banks meet reserve req.)
–gave banks longer and more stable liquidity - $400B worth of term loans to banks in 6 months - just relief to banks!!!
(the epicenter of crisis was real estate…but the focus was banks!! Hemorrhage - heart of fin. system

2. net portfolio holdings of commercial paper funding facility LLC (new - created in the crisis)
   - -$300B - usually only SAFEST and VERY BEST borrowers can use this market (Lehman brothers defaulted here…so spooked everyone!! didn’t trust this market) - and some of BEST companies in Am. NEED this commercial paper market to fund their operations and projects…so no one else was buying commercial paper so the Fed stepped in and bought it $300B worth
3. other assets = major inc.
   - -one of the biggest changes!! inc. by $500B - central bank liquidity swaps
   - –US crisis triggered a global crisis!! - bc everyone were hoarding US dollars and US dollar denominated assets
   - -so there were no dollars flowing - which halts international trade
   - -comes to a halt bc most transactions are DOLLAR dominated - but dollars were scarce bc ppl were hoarding it
   - -CURRENCY SWAP - US will send dollars to Japan and Japan will send Yen back at a certain date later - put dollars in criculation
4. holding of US treasuries DOWN from time before actually - down by $300B
   - –ppl are hoarding dollars and there is flight to safety - gold and US treasuries are the safe assets - but no one wants to sell so there is MASSIVE shock to DEMAND
   - -when demand gets shocked - prices shoot up and yields go down!!!
   - - at one point during crisis the yield even went NEGATIVE!!! (meaning people were paying the US gov. to keep their money safe and hold on to money!)
   - -so fed became mkt. maker to make sure ppl could buy - became seller of $300B

Question 72

balance sheet changes in those 6 months - liability side

Answer 72

if assets inc. that much (1.3T) have to change L side as well
–L hanges was fed. reserve notes and even more was DEPOSITS from commercial banks

as of recording of lecture

• -now at 4.5T at end of 2016
• -a lot of problems have been healed though - term auction credit loan and commercial paper helping is gone now - not on balance sheet
• -the other assets thing (of international crisis) is low now
• -means all of the holes in the dam have been patched now

the biggest inc. today is US TREASURIES

• -now they sit at 2.4 T!!
• -more than 2x of the entire SIZE of the balance sheet before the crisis
• -MBS now 1.7T - NO WHERE BEFORE THE CRISIS would you find MBS on the balance sheet

why did they buy treasury and MBS
–S and D in bond market

since crisis Fed. has been buying treasuries and MBS like crazy which SHOCKS demand and shifts it right (bought about 3T worth of bonds)

• -this has raised prices of bonds like crazy - which drives the yields down!!
• -WHY? drive yields down - dual mandate is full employment and stable prices
• -to get full employment - they have dec. yields which has inc. C and I in GDP equation

now unemployment at 4.9% rather than high of 10%