Chapter 9 & 10 Flashcards
Checkable Deposits- bank accounts on which checks can be written; money in the account belongs to the depositor.
Nontransaction Deposits- savings accounts and time deposits (or CDs); checks cannot be written on these deposits, but they earn a higher interest rate; primary source of bank funds
Borrowings-money borrowed from the Federal Reserve (Fed), other banks and corporations
Discount loans- money that banks borrow from the Federal Reserve
Banks borrow reserves overnight from other banks to meet the level of reserves equired by the Fed; this is known as the federal (fed) funds market.
Bank Capital- banks net worth (equal to assets minus liabilities); it is raised by selling new equity (stock) or from retained earnings; it is included as a liability so the T-account will balance to zero.
Liabilities
Reserves (or total reserves) – vault cash plus deposits in the bank’s account at the Fed
Vault cash – currency in the bank’s vault
Reserve requirement – Fed regulation requiring a fraction of checkable deposits to be kept as reserves
Required reserves (RR) – money a bank must “hold” to meet Fed regulations
Mathematically: required reserves = checkable deposits ×required reserve ratio
Can be held as vault cash or at the Fed; usually kept at the Fed
Required reserve ratio – the fraction of checkable deposits a bank must hold; this percentage is used to calculate required reserves
Excess reserves (ER) – additional money held beyond required reserves
Mathematically: total reserves = required reserves + excess reserves; TR = RR + ER
Cash Items
Cash items in process of collection
Deposits at other banks
Securities – debt instruments held to generate revenue
Loans – money lent to bank customers to generate revenue
Other Assets – physical capital such as the building and office equipment
Assets
- Currency Deposited Into a Bank – Initial Impact
Hank takes $100 from his wallet and deposits it in his checking account at Arlen Bank & Trust.
Assets Liabilities
TR + 100 Checkable Deposits +100
When a bank gains checkable deposits, it gains an equal amount of reserves (total).
Currency Deposited Into a Bank (Example 1) and Fed Regulations
The United States has a fractional reserve banking system meaning only a portion of an increase in checkable deposits must be held as reserves.
Recall that Hank deposited $100 in Arlen Bank & Trust. If the required reserve ratio is 10%, the changes to required reserves and excess reserves for Arlen Bank & Trust are:
Assets
Required reserves + $10
Excess reserves + $90
Liabilities Checkable deposits + $100
Currency Taken Out of a Bank – Initial Impact
Peggy goes to an ATM and takes $100 from her checking account at Arlen Bank.
Changes to total reserves and checkable deposits for Arlen Bank are:
When a bank loses checkable deposits, it loses an equal amount of reserves (total).
Assets Liabilities
TR -$100 Checkable deposits -$100
The bank has a problem because required reserves are 0.10 × $90 million = $9 million, and it has $0 of reserves.
In order to acquire the reserves it needs, the bank has several options:
Borrow $9 million from other banks in the fed funds market or from corporations.
Sell $9 million of its securities.
Borrow $9 million from the Fed (discount loan).
Reduce its loans by $9 million.
the risk that occurs because borrowers may default.
When making loans, banks face the problems of adverse selection and moral hazard which make loan defaults more likely. They try to overcome these problems through:
Screening and monitoring.
Establishing long-term customer relationships.
Credit risk
- Payoff Method- the FDIC allowed the bank to fail and pays off depositors up to the insurance limit.
- Purchase and assumption method- the FDIC reorganizes the bank, typically by finding a merger partner that takes over the failed bank’s liabilities; the net effect is that deposits are “guaranteed” beyond the insurance limit.
Two Primary ways the FDIC manages a failed bank
restricts the holding of risky assets (such as common stock) and promotes diversification.
Restrictions on asset holding
capital provides a cushion when negative shocks occur, and it limits risky behavior because a bank has more to lose if it fails.
Leverage ratios = capital/ total assets; a bank is well capitalized if the ratio exceeds 5%.
Capital requirements
if capital is too low, the FDIC intervenes earlier and more vigorously when a bank gets into trouble.
Prompt corrective action
Screen proposals to open new financial institutions (adverse selection)
Office of the Comptroller of the Currency examines national banks; Fed examines Fed-member state banks; FDIC examines non-Fed member state banks (moral hazard)
Financial Supervision: chartering and examination
Reserve requirements- act as a “tax” on deposits; the tax rises as interest rates rise
Deposit rate ceilings- restrictions on interest that can be paid on deposits
*This led to disintermediation- customers transfer their deposits from banks to nonbanks.
Two innovations that have occurred because of these regulations are:
Money market mutual funds- issue shares that function like a checking account
Avoidance of Existing Regulations
Lack of competition due to state brancihng restrictions and the McFadden Act (prohibited branching across state lines) resulted in the large number of small commercial banks.
Restrictions on Branching
Operates independently but under the supervision of the BOG.
Is a quasi-public institution owned by the Fed member banks in its district
Has a nine-member board of directors
Each of the 12 Reserve Banks:
