Banking notes 2/21

Solvency and liquidity shocks
Piggy bank
Assets                           Liability
reserve 1000                 Deposit 10000
ST assets 2000              LT loans 5000
LT assets 7000              Equity 3000
Bus assets 8000
Total 18000                  18000

The reason why banking regulation is hard is because it is hard to know whether the shock derives from assets side or liability side.

Solvency shocks: long term assets decrease value by 4000. The reasons may be (1) the investment turns out to be bad (2) the perception of the investment turns negative even though the underlying value may be good. The result is that the equity decreases by 4000, coming to an end of -1000.
This bank is insolvent because it has an total asset of 14000, but it owes 15000. (bankruptcy)

Mark-to-market accounting: accounting for the "fair value" of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value.
The reason to introduce mark-to-market accounting: sometimes investors decide to pull out the money even though the underlying condition of the asset is good. Firms have to liquidate the healthy assets at a discount to pay the money. This process is not good. (For assets that are not liquid, the loss is higher)

Another element of systematic risk due to the existence of financial intermediaries:
(1) If the company has crappy investment decision and is insolvent, we should let it fail. Suppose the public owned company faces bankruptcy, it will influence other companies in the market.
For example, if other firms owns equity of this firm, their value of equity turns of to be zero, their assets value go down and influence their balance sheet. Such risk is more of a concern when firms in the market are highly leveraged. 
(2) If in bankruptcy the firm fire sales its assets, price of assets goes down and companies in real economy are negatively affected.
(3) If a company faces bankruptcy, some of its long term creditors will not gain anything back.
Spillover effect, and this is the justification of financial regulation.


Liquidity shocks: 4000 dollars are withdrawn, reserve and short term assets are cashed out, but there is still another 1000. The firm has to liquidate the long term assets or bus assets, or they can borrow money. The problem of liquidating assets is that sensitive people may think the asset is worthless, and people may lose faith in this particular asset. So it is possible that liquidity shock, which has nothing to do with the viability of the firm, may put the firm into bankruptcy.

When the fed does emergency lending to firms, it is supposed to be of only liquidity reasons. 
The major regulatory tools to protect us from insolvency and liquidity shock:
(1) For prevention of liquidity problem: reserve requirement
(2) For prevention of insolvency problem: capital requirement (make sure the number of equity is big)
In addition, government and agents decide what can be considered as reserve and capital.

A few types of intermediaries
When we talk about different types of intermediaries, we are basically distinguishing them as a general function of different liability they issue, and general types of assets they are purchasing.

(1)Some intermediaries only issue liability claim, not issue equity claim: for example, a COMMERCIAL bank. Most of the assets they own are debt (mortgage), most of the liability they owe is debt (saving account).

(2) Stock mutual fund: only issue equity claims but doesn't issue liability. On the assets side, it consists of a bunch of equities.

(3) Investment bank: like the commercial bank, most of the money investment bank is through debt markets. And most of the thing that it invests in is debt.
Difference: investment banks take risks by trading by their own accounts.
1. issue stock
2. issue bonds
3. mergers and acquisitions
A major thing investment bank does is underwriting, pricing and evaluating the firms. Trade, researches. Merchant banking.

Investment banks take the risk away from people who want to raise money to themselves. 
For investment banks, they don't invest mortgage loan; instead, they invest in stock and bonds; besides, less than 25% of the liability is deposits. 
Investment banks are not supposed to be part of the federal reserve system.

The implication of Glass-Steagall Act
The reason of the existence of the banking regulation is that people want investment to have better rate return than mere interest, but they don't want too much risk and illiquidity.
So the Act shows that sectors that handle payment should be separated from sectors that do not.

commercial banks have stricter reserve and capital requirements than investment banks.

Investment banks actually have a safer balance sheet because stock and bonds are transparent and liquid, and a portfolio can diversify the risks.

Insurance company:
assets: debt claim, because insurance companies want to make sure the stream of money is continuous
liability: stocks, bonds, issue contingent debt claims
How does interest rate impact insurance:
When interest is low, insurance premium is high.

Adverse selection and moral hazard