Last banking class notes

Interstate banks provide convenience to customers. Lower cost due to economies of scales. More competition in banking sectors.
Drawbacks of branching of banks:
(1) we see a draining of deposit funds from local communities to other parts of the country.
(2) Banks become much larger and resemble "too big to fail".

Regulation in financial sectors may be the clearest test of how regulation works in a market. In other words, if regulation works anywhere, it must be the case that it works best in terms of financial market. Reason: Compared to other sectors, transparency in financial market is higher. Banks report vast quantities of data to regulators, and it is very easy for regulators to check those numbers.

Why is financial regulation doomed to fail?
(1) Ordinary people don't care about risks in their banks---- most people cite location as the most important reason for choosing a bank.
(2) Standardization: getting a mortgage or a loan is the same process no matter the banks are. Different banks evaluate them in the same way, following the guide lines of the Fed. The influence of the Fed goes beyond banks' balance sheets because banks follow the guidelines of the Fed.
(3) Less competition--regulation puts barrier in the way of starting a new bank.
(4) Less choice--can't share its own currency. (But most banks still provide checking account, which is private money, consisting a large chunk of the whole money supply in the economy.)

The creation of derivatives doesn't eliminate the risks. What we should care about is to when risks will explode and harm other people. It's not possible to prevent crisis from happening.

The point of regulation is to protect the sanctity of the payment system.
How to regulate
Bank of International Settlements:central bank to all the world's central banks
Issuance of guideline: Basel I, II and III. Suggested guidelines that are supposed to be adopted by central banks.

The most important thing that BIS does is to set up the capital adequacy requirement to prevent banks from recklessly investing with insufficient risk capital.

Basel I: any government issued securities are 100 percent risk-free. any country securities are safe.
A                                L
Greek bonds           deposits
100                          100
Capital requirement for the most risky lending: commercial loan 8% capital requirement (100% risk weight)
Mortgage loans are deemed to be safer: capital requirement is 4% (50% risk weight)
GSE securities: capital requirement 1.6% (20% risk weight)

For a bank, if it originates a mortgage, sells it to Fannie, (btw get a fee for selling the mortgage), and buys it back in a bundle of MBS, that very same mortgage would only require 1.6% of the capital requirement.

NOW the capital requirement for all mortgage is 1.6% requirement, including prime and subprime mortgages.
Commercial banks get money in 3 ways from this process: interest on mortgage, fee for selling mortgage to the Fannie in the first place, a lower capital requirement

SPV: off-balance sheet activities to avoid any capital requirement. (Bearstone)

Investment banks were not totally reckless:
(1)double A and triple A mortgages were demanded the same capital requirement, and double A mortgages had a higher yield, but most investment banks still chose triple A mortgages
(2) greed is about making money rather than losing money
(3) the problem may be overconfidence
(4) they bought CDSs for protection

In a free market, banks will use different algorithms to evaluate the mortgages, there may even be speicalization. Besides, with support of FDIC, banks will compete for deposits and tend to self regulate better. The bank runs are disciplining them.

Book review of Crisis Economics

Since the 2008 financial meltdown, there have been a lot of debates and discussions on what happened and what should be done to check the next financial crisis. The book Crisis Economics by professor Nouriel Roubini, nicknamed Dr. Doom due to his bearish economic view, and journalist Stephen Mihm, contains review of the 2008 crisis and pro-regulation suggestions to fix the market.

The central thesis of Crisis Economics is that financial crises are inherent in capitalism and predictable¹. After a recap of significant financial crises in history, they claimed that they found patterns of a typical financial crisis. In their model, a financial crisis starts with an asset bubble, which results from excessive credit supply or optimism about one technological innovation. Believing that asset price will never go down, investors borrow more and buy more. At some point, the bubble implodes, sending some highly leveraged investors to bankruptcy. Creditors realize the problem of bad loans and demand investors to put up more funds and collateral to compensate for falling price, which incentivizes them to fire sell the asset. A sudden increase in asset supply drives down price further and stirs panics in the market. More and more investors default, and banks are unwilling to loan out. As a result, liquidity crunches and crisis occurs.

This model seems compelling, but it doesn’t elaborate a couple of important aspects. First, where does excessive credit supply come from? A lax regulation of government or a loose monetary policy by Fed? If this is the case, can we blame market for being greedy? Besides, just because it is cheaper for investors to get credits doesn’t necessarily mean that people will demand a whole lot of them. In other words, what the authors missed in their model is a discussion of elasticity of credit demand curve. In addition, what is the crucial turning point? The authors just said that we could use various economic indicators to discern the turning point, but they didn’t articulate how to do the prediction. It is easy to deduce what would happen after bubble implosion, but predicting the timing of bust is a totally different issue. In my opinion, this lack of discussion attenuates their argument that financial crises are predictable.

In the next couple of chapters, the authors turned to analyze the financial meltdown in 2008. They claimed that lots of parties were culpable for the crisis. Considering that the reasons are manifold, I will first lay out their arguments, and then present what other economists think and my thoughts.

Alan Greenspan’s monetary policies

In the book, Alan Greenspan was blamed for adopting an easy-money policy by keeping interest rate too low for too long, which help expand the credit, incentivize irresponsible investment and foster the housing bubble.²  But some economists argue that Greenspan’s policy was actually tight and that critics made a classic mistake for using interest rates to evaluate monetary policy. ³ After a check of monetary base during Greenpan’s period, economist David Henderson found out that the inflation rate was stable and the change between the amount and velocity of M2 coincided with scenarios within a free banking system.⁴ In other words, though the interest rate during Greenspan’s era was low, it didn’t necessarily inject a huge amount of money in the housing market and start the bubble. In defend of his actions, Greenspan was actually right in attributing the low interest rate to a massive flow of savings from Asian economies and Latin America⁵. One problem of Crisis Economics is that the authors didn’t mention much statistical measure of monetary bases. Layman readers thus are very easy to be frightened by the unusually low interest rate and guided to believe that money and credit exploded during Greenspan’s period.

Payment mechanism in Wall Street

Roubini and Mihm criticized that big bonuses in Wall Street incentivize bankers to take more risks and higher leverage on a massive scale⁶. Similarly, celebrities like President Obama and vice president Biden considered big bonuses as “shameful irresponsibility”. However, such fury might have missed the target. Economist Alan Reynold explained that those big figure bonuses were actually paid to a large number of employees within the Commerce Department’s North American Industry Classification System (NAICS) rather than merely high-profile investment bankers⁷.

In addition, a second thought may justify such compensation mechanism. Bonuses, different from fixed salaries, are variable costs for banks doing business in financial industry known for its high volatility. Paying big bonuses and not-that-big salaries does two good things for banks. First, it keeps them from having to predict the future. Instead of having to budget money for all employee pay in at the start of the year, managers can look back at the end of year, figure out what final revenues are, and set pay levels accordingly. Such payment strategy limits the risk of over or underpaying to employees.  A widely ignored fact was that after the financial crisis, many Wall Street firms didn’t cut employees’ overall pay by much; instead, they shrank the cash portion of bonuses and paid more in salaries to compensate for the missing bonuses.⁸

Another advantage of this payment system is that it makes banks easier to cut variable costs very quickly when necessary. When the chips are down, cutting bonuses instead of salaries means that the firms don’t have to lay off too many employees. Recently, increased regulation of employee bonuses compensation has triggered increasing salaries and led to a higher proportion of deferred compensation levels, leading to a concerning highly fixed cost base for a volatile revenue business. 

As for the argument that big bonuses encourage reckless behavior by incentivizing traders to swing for the fences in an effort to juice their own pay, theoretically a bonus-based compensation system should actually reduce the risk of bad behavior, as bonuses can claw back when something goes horribly wrong. What’s more, a recent research conducted by Cheng, Raina and Xiong showed out that mid-level securitization agents were unaware of the danger of housing sectors since they also bought a lot in housing market.⁹ In other words, the reasoning presented by Roubini and Mihm can at most partially explain the over-issuance of toxic securities. In this case, changing the payment system might not check the occurrence of the next financial crisis.

Ownerships and sizes of investment banks

Roubini and Mihm believed that huge principle-agent problems within the investment banks partly led to over-issuance of securities of bad quality. Shareholders didn’t have much incentive to monitor the banking business because firms relied on borrowed money for operations so heavily that shareholders didn’t have much skin in the game.¹⁰ They doubted that managers could manage big and complicated investment banks and suggested that it was a disaster to allow investment banks to go public in 1970s. As a remedy, they called for a more responsible mechanism, namely partnership, to incentivize shareholders to monitor their firms’ business.¹¹

Roubini and Mihm were right that investment banks should have more capital for cushioning the possible liquidity shock, but turning investment banks back to partnership might not be the best way. Back in 1998 when Goldman Sachs decided to go public, some economists had guessed that the decision was a response to technological change and competitors’ expansions.¹² Research later conducted by Morrison and Wilhelm Jr. confirmed the previous conjecture. They discovered that that advances in information technology (especially the fast development of computer technology since the late 1960s) and codification of tacit human capital in financial services increased the cost for investment banks to maintain partnerships and incentivized them to go public to expand and enjoy benefit of economies of scales.¹³ From this perspective, forcing investment banks back to partnership may result in unintended consequences like diseconomies of scales.

One suggestion Roubini and Mihm gave was to break up banks that are “too big to fail”.¹⁴ They reasoned that the collapse of Lehman Brothers and the resulting panic of financial market showed that some financial institutions had become so big and interconnected that their collapse would cause systemic effects. ¹⁵ But some economists present their worry and doubt about such radical move. Peter J. Wallison thought that the idea of too big to fail is at best a plausible theory. ¹⁶ The collapse of Lehman Brothers didn’t drag down any other financial firms. None of the institutions rescued after Lehman—Wachovia, WaMu, and AIG—were made insolvent or unstable or had to be rescued because of exposure to Lehman.¹⁷ Historical evidence revealed that unless the market is already in a panic, with many firms insolvent, the notion of too big to fail lead regulators to overreact. Besides, breaking up big banks may lead to big consequences like lack of diversification of risks and renegotiations of financial contracts. Breaking up big banks may not necessarily be a bad idea, but without a complete cost-benefit analysis the unintended costs may jeopardize the whole financial market.

Problems of credit rating agencies (CRAs)

Roubini and Mihm were critical of the role CRAs played in the financial crisis. They criticized CRAs for taking hefty fees from issuers of securities and letting toxic derivatives flow to the market. They called for a complete reform in rating system, namely that CRAs should be forbidden to offer any consulting or modeling services, more agencies should be allowed to evaluate the derivatives, and change in payment systems.¹⁸

I agree with the authors that more competition should be introduced in credit evaluation business. Historically, regulators have been using credit evaluation to oversee the financial market. During Great Depression, the Office of the Comptroller of the Currency (OCC) stipulated that banks not obtaining credit evaluation would be panelized, which introduced CRAs into financial regulation framework. In 1970s, regulators set up Nationally Recognized Statistical Rating Organization (NRSRO) to oversee the ever-increasing volume of securitization. Issuers of securities have to obtain rating from NRSRO in order to maintain the operation. This legislation was intended to help investors understanding the underlying risks of various derivatives, but for NRSRO members (S&P, Moody’s and Fitch), lack of competition led to oligarchic profits, which incentivized them to produce worse services. Credit ratings were severely inaccurate in the incidences of WorldCom, Enron, Parmalat and 2008 financial crisis, and it is hard to believe these are just random errors of CRAs. ¹⁹ However, NRSRO CRAs’ fees and profitability increased during 2002 and 2008. ²⁰ This implies that government-granted oligarchy in credit rating business has skewed initial objective as to provide accurate information; instead, issuers pay CRAs in order to issue the derivatives. In my opinion, introducing more competition can incentivize CRAs to develop better models to evaluate the bonds and stocks, and issuers can have more freedom choosing CRAs that provide better services.

“Deregulation” of financial sector

The authors’ argument on deregulation is in fact a widely accepted narrative why 2008 financial crisis. They attributed the cause to the repeal of Glass-Steagall Act and the failure to regulate the shadow banking systems, which incentivized excessive financial innovations like credit default swaps. (CDSs) I think it hilarious that authors argue that regulation was weak. Financial sector is the most regulated sector in America. Any responsible banking textbook would list page-long regulation implemented. During the so-called “free banking” era banks had to observe strict rules. Even the Glass-Steagall Act is only partially repealed: banks are still prohibited from underwriting or dealing with securities (Section 16) and securities firms cannot take deposits (Section 21). ²¹ Roubini and Mihm proposed that investment banks should be regulated like commercial banks and have access to deposit insurance, but I strongly oppose to this idea. Regulation is supposed to protect depositors from bad loans, but it is meant to protect commercial bank investors. Investors of securities should bear cost by themselves rather than rely on the lender of last resort. What’s worse, the new legislations are often superimposed on the current regulation mechanism, leading to massive overlapping and waste of resources.

As for the argument that fancy derivatives sprouted in lieu of loose regulation, I would say the opposite. The regulation has been strong over time, and to gain profit, firms have to figure out other ways to gain profits. Offshore banking emerges for regulatory arbitrage and rent seeking abounds because of tight regulation on branching and banking business. The regulation record is disastrous, but it seems that every time a crisis occurs, people long for another piece of law with no scrutiny of what the real cause is in the first place.

Roubini and Mihm criticized that collapse of CDSs led to market crisis, but such claim is questionable. Lehman Brothers was the biggest CDS player, but its bankruptcy didn’t drag down many of its counterparties. Nor did many firms it guaranteed CDSs for defaulted during the crisis. As for AIG, although most of its CDSs were written to guarantee the CDOs backed by MBS that were backed by toxic assets, it screwed up mainly because it didn’t hedge risk when writing swaps, which was a rather unusual case. Since most of the CDOs AIG was covering had lost value during the crisis and it didn’t sufficient collaterals to pay the counterparties, its bankruptcy would jeopardize market. However, considering that the obligation of the CDSs was between 25 and 41 billion, it might not cause systemic risk, which was the reason why the Fed bailed out AIG. ²² The two incidents might imply that CDSs are not as dangerous as many people assumed, but can we actually find out a way to make them safer? The authors discussed about the idea of having these fancy derivatives traded in a central clearinghouses.²³ Clearinghouses can mandate member banks to put in collaterals, assume the burden of the contracts if counterparty failed. But the authors’ worries were that clearinghouses might fail and investment banks would come up with other ways to avoid clearinghouses’ requirement. Some other economists have proposed some supplement strategies. Jeremy Kress argued that central clearinghouses should have access to emergency credit from central bank. ²⁴ (My worry about this proposal is moral hazard.) Professor Rizzo thinks that bailing out central clearinghouse would be easier than bailing out multiple individual banks. Peter J. Wallison worries about the potential cost for clearinghouse to oversee the CDS trading. ²⁵

Conclusion

One big impression I feel about Crisis Economics is that it is a book from the perspective of legislators. Roubini and Mihm seem to have a craving for legislation and additional regulation. Though they endorse the thinking by acknowledging that a necessary reckoning must take place over the longer term in order to achieve a return to prosperity²⁶, throughout the book I could only read recommendations for more government intervention and the notion that financial sector cannot correct itself, and it seems their mention of Austrian School thoughts was just a superficial courtesy to historical figures.

One problem I find in this book is the shortage of footnotes, making it hard to trace his sources and cross-match them with their arguments. What’s worse, the book is filled with non-innovative and costly solutions to fixing the financial system. I’m not saying that financial market shouldn’t be regulated. My point is that, given that there are already a lot of regulations overlapping one with another, superimposition of another piece of legislation might not be valuable. The causes of the 2008 financial crisis remains a puzzle for me, but some ideas that the authors presented can be excluded after a cross-matching of historical data and researches.

Overall, Crisis Economics is an easy-reading introductory book about what happened in 2008 financial market. However, I’m disappointed about this book because it doesn’t provide many refreshing thoughts and convincing evidence.

References and citations

1.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp19

2.  Ibid, pp33

3.  David R. Henderson and Jeffery Rogers Hummel, “Greenspan’s Monetary Policy in Retrospect”, Cato Institute, November 3, 2008

4.  Ibid

5.  Diego Valderrama, “Are Global Imbalances Due to Financial Under development of Emerging Economies?” Federal Reserve Bank of San Francisco Economic Letter no. 2008-12, April 12, 2008, Alan Greenspan, The Age of Turbulence: Adventures in a new world,(New York, Penguin Press, 2007), pp385-388

6.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp69

7.  Alan Reynolds, “The Truth About Those Billion Bonus”, Forbes, February 10, 2009

8.  Kevin Roose, “In Defense of Wall Street Bonuses”, NY Times, December 12, 2012

9.  Ing-Haw Cheng, Sahil Raina, and Wei Xiong, “Wall Street and the Housing Bubble”, National Bureau of Economic Research, March 2013

10. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp70

11. Ibid, pp197

12. James Suroweicki, “Why Do Investment Banks Go Public”, Slate website, June 19, 1998

13. Alan D. Morrison and William J. Wilhelm, Jr., “The Demise of Investment-Banking Partnerships: Theory and Evidence”, Oxford Financial Research Centre Working Paper, July 2004

14. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp223

15. Ibid

16. Peter J. Wallison, “Breaking Up the Big Banks: Is Anybody Thinking?”, American Enterprise Institute, September 18, 2012 

17. Ibid

18. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp195-19   

19.  Claire A. Hill, “Why Did Anyone Listen to the Rating Agencies after Enron?”, Journal of Business and Technology Law, Vol. 4, pp283, 2009

20.  P. Jenkins, “DBRS to Challenge Big Agencies,” Financial Times (London), January 10, 2006

21.  Gramm-Leach-Bliley Act, Public Law 106-102, U.S. Statutes at Large 113 (1999): 1338.

22.  Peter J. Wallison, “Deregulation and Financial Crisis: An Urban Myth”, American Enterprise Institute, October, 2009

23.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp201

24.  Jeremy C. Kress, “Credit Default Swap, Clearinghouse, and Systemic Risk: Why Centralized Counterparties Must Have Access To Central Bank Liquidity”, Harvard Journal of Legislation, Vol. 48

25.  Peter J. Wallison, “Unnecessary Intervention: The Administration’s Effort to Regulate Credit Default Swap”, American Enterprise Institute, August, 2009

26.  Peter J. Wallison, “Does Shadow Banks Need Regulation?”, American Enterprise Institute, May-June 2012

4/18/2013 Banking notes

The Fed's balance sheet is generally small compared to the size of the real economy.
On the asset side, except for golds, most of the stuff is government securities. It is supposed to be self-financing.

By convention the Fed is extraordinarily leveraged. Capital ratio and reserve ratio. The capital ratio is pretty low, and the reserve ratio is also low. Considering that there are trillions of immediately redeemable hard asset, the amount of reserve of the Fed is too low.

Looking at the US government securities, we see that all the securities are long term.

The government tried to sell the short term bond and buy the long term bond in order to flat out the yield curve,.

Discount window loans. The only mechanism through which the Fed can be allowed to make loans and inject liquidity to member banks when they are in trouble.

Remember what the Fed is meant to? Stabilize the payment system.

Very few commercial banks saw themselves in trouble in 2008 crisis.

The discount window is supposed to make temporary emergency loans to banks that are in the liquidity shock. (short-term liquidity purpose)

Term Asset-Backed Securities Loan Facility (TABSLF) and TALF
The Fed's own special vehicle to make loans to the market. They got back the assets that were collateralized by the other lending facilities that the Fed had set up. Meant to help the non-commerical banks that are in liquidity shock. 

Fannie-Freddie debt goes down over time. Reasons?
(1) the debt pays out. 
Analagy: I have mortgage debt of 10000, and I pay for it. Each time I pay a part of it, the bank will write down the mortgage debt because I pay back a part of it.
(2) If it doesn't pay and turns into crap, it got written down and hits the equity

"Trashy" MBS
the assets of other banks that are in liquidity shock
The reason why the Fed do this?
In crisis, the individual banks have to recapitalize their debts if they do not want to go bankruptcy. But sometimes it is hard for banks to trace the securities and renegotiate the contracts, so one way is to let the Fed buy the assets and let Fed lend deposits to banks for recapitalization. 

Reverse repos:

In 2008 crisis, small banks still had low cost sources of funds than big banks do. 

The government spending identity:
government expenditure= tax revenue + change in government debt held by the public (new borrowing) + the change in monetary base (new money)

Wildcat banking era?

Was free banking in the United States so bad that people would have been better off with no banks at
all?

Free banking opened up note issuance to limited-liability organizations without discretionary approval by a legislature, as in earlier years, or by a banking regulator, as in later years. Free banking
ended in 1865 when the federal government imposed a tax on state banknotes.

The defining characteristic of free banking is that if the requirements of a given state’s free banking law are met, any person or group of persons is permitted to open a bank.

Suffolk System

Dual currency problem in Boston during 1800s.
Country banks' notes are redeemed at a discount due to the cost and inability for them to redeem the notes. Merchants face trouble because they have both country banks notes and Boston bank notes that are of good quality. They have to bear the full cost of any possible fluctuation of the redemption rate changes.

But Gresham's Law didn't kick in this situation.
(1) The notes of Boston Banks didn't disappear though diminished relative to those of country banks in response to the growing reliance on demand deposits and to the increasing competition of country banks agents in Boston.
(2) The value of "bad" notes are changing and the "good" notes are redeemed constantly at par. The purchasing power of the bad notes changed constantly. There is no incentive for arbitrager to drive good notes out of circulation.

A rising preference for deposit banking tends to diminish the importance of city bank notes. The existence of large deposits in city banks restricted the ability of these institutions to increase their issuance of notes.

The fundamental plan of Suffolk System
(1) each country bank was required to maintain a permanent deposit at Suffolk Bank of 2000 bucks or more depending on their sizes, plus an added deposit sufficient to redeem all its notes that were received by the Suffolk Bank

(2) Boston banks were required only to maintain permanent deposits

(3) no interest was paid on any of these deposits

(4) in return the Suffolk Bank agreed to accept at par from depositor banks all the bank notes they received from other New England banks in good standing and to credit such deposits to the account to the depositor bank on the day following receipt.

The principal motive was the desire of Boston banks to increase their bank note circulation.

The Suffolk System increased the acceptablity of the country notes by making them acceptable at par.
 The most striking achievement of the Suffolk System for Boston was the ultimate elimination of the discount on country banknotes.

 Membership in the Suffolk System was restricted to banks whose notes could be accepted safely by the public.

Although the Suffolk could not prevent the undesirable newcomer from issuing notes, it could prevent the wayward bank notes from getting extensive circulation, by withholding membership in the Suffolk System.16 This acted as an effective safeguard when State legislatures were extremely lenient in granting bank charters and when State banking legislation was inadequate.

By requiring that members' deposits represent reserves against their notes in circulation, the Suffolk Bank centralized the reserves of the system.

There is some evidence that the Suffolk System contributed to banking stability; at least it served to avert greater disaster to New England banks during economic panics.

How, then, did a system that seemed so entrenched in 1851, collapse seven years later? This end was, to a considerable extent, due to the populous desire of country banks for over–expansion of their notes.

Within a banking system where every bank possesses the ability to issue notes which circulate as money there is a tendency for over–issue by many individual banks, leading to discounting of bank notes and a general deterioration of sound credit.

Systems of bank note clearing and redemption are a necessity for the smooth operation of relatively free banking with a gold coin standard, whether the system is privately operated as with the Suffolk System or governmentally operated as the Safety Fund System in New York.

Banking history

The Civil War brought four major pieces of monetary legislation: the legal-tender laws, in 1862; the National BankingAct, in 1863; an act outlawing private coinage, in 1864; and an act imposing a prohibitive 10 percent tax on state-banknote issues, in 1865. The combined effect of the last three acts was to place the entire currency supply under federaljurisdiction. Together with the legal-tender laws, these acts comprised a program for securing means other than directtaxation to pay for the war against the South.

Free banking overview

Historically, even some of the staunchest proponents of laissezfaire have viewed banking as inherently unstable and so requiring government intervention. According to this view, left to unfettered market forces, banks are prone to periodic runs and failures simply because of unpredictable private decisions about the form in which individuals hold their money.

In particular, the Free Banking Era (1837—63) is often cited as an example of what would happen if banking were unregulated. It was a period when banks were subject to few restrictions, fewer than any other period in U.S. banking history. And it has often been characterized as chaotic, with many different kinds of paper money, with numerous bank runs and failures, and with substantial losses and inconvenience to holders of bank notes.

problems were caused by economic shocks that caused many banks to fail but did not lead to bank runs or panics.

Before 1837, all new U.S. banks had to be chartered by a state legislature. In practice, the chartering system was a cumbersome and very political process that severely limited the number of banks opened.

Free entry meant that a legislative charter was no longer required for a bank to be established. The free banking laws essentially allowed anyone to open a bank, issue their own currency (bank notes), take deposits, and make loans. The Free Banking Era was not a period of laissez-faire banking, however, since banks established under the free banking laws were subject to certain restrictions.

 State governments were jealous of the financial favors they had garnered from their banking systems. In order to retain these favors while allowing freedom of entry into the banking business, they supported the inclusion of "bond deposit" provisions in the laws regulating bank-note issues.

 • Free banks had to deposit designated state bonds with the state banking authority (state auditor or treasurer) as security for all notes issued. (Some states also allowed federal bonds.)

• Free banks had to pay specie (gold or silver) for notes on demand. Failure to redeem even one note meant that the state banking authority would close the bank and sell all of the assets deposited with it to pay off note holders. Further, in many states, note holders had preference over other bank creditors in terms of legal claims on the remaining assets of the bank.

• In general, free bank stockholders were liable for bank losses in an amount up to the value of their stock even though free banks were limited liability companies. This double liability provision meant that, if a bank failed, someone with, say, $25,000 of free bank stock not only might lose this investment, but also would be liable for an additional $25,000 of personal wealth to cover bank losses (including those on notes).

 • Very few free bank closings involved losses to note holders; that is, by our definition, very few failed. Between 1838 and 1863, 709 free banks operated in the four states and 48 percent of them
closed. However, only about one-third of the closings resulted in any losses to note holders.

• Free bank notes were quite safe. For most years and most states, the expected loss from holding a randomly selected bank note for one year was zero. Further, when noteholders suffered losses, they ranged from an average of about 25 cents on the dollar in New York and Wisconsin to an average between 10 and 15 cents on the dollar in Indiana.

 • Most of the free banks were not short-lived. Between 1838 and 1863, New York, Wisconsin, and Indiana free banks were in business a mean of 6.3 years.

 for a banking system to be inherently unstable, a run on one or more banks and their subsequent
failure must lead to the failure of other banks.

Why were free bank failures not contagious? That is, why did the bank failures in one state not spread to other states? A possible explanation is that the requirement that free banks keep a reserve of state bonds behind their notes provided some public information about free bank portfolios which helped note holders distinguish good banks from bad ones when local real shocks occurred.

4/9/2013 Banking notes

The origin of the First Bank of United States
It wasn't a central bank.
Wasn't granted monopoly privileges to issue notes
No regulatory power on commercial banking system
But it was the only bank exempt from tax imposed on other banks which do business in different states. It also had a large amount of reserves, which implied its strong influence in the financial market.

Second Bank of United States
Mission is to bring order to banking system by restoring specie payment by state chartered banks. (socialize depositor losses)

It didn't regulate banks and it didn't act as lender of last resort, but it was big and conducted monetary policies.

Did these banks serve to improve the quality of the US means of payment or not?
Favorable view: they served to discipline and restrain state banks by actively redeeming their notes.
Unfavorable view: rather than restraint, they often encouraged state banks to expand by reissuing bank notes.

Free banking
States (not federal) charters
No federal law governing banking system
Freer entry
No note issue without discretionary approval

Myths about state banking
(1) state banks are free
(2) wildcat banks are ubiquitous
(3) poor quality of state banks and banknotes is a result of lax regulation and oversight

How to open a bank
(1) meet the capital requirement
Asset                                                                                     Liabilities
Bonds deposited with                                                          Notes
state banking authority                                                        $50000
$50000

Loans to stockholders                                                        Equity
15000                                                                                  $50000

specie
5000

loans
30000

have to buy bonds from state you live (collateral)
pay-in capital : 50000-15000=35000

Note issuance
Banks are allowed to issue their own notes, but have to make security deposit with the state banking authority.  (Typically in the form of state bonds)
Notes should be issued up to face value of the deposit
States can close banks if the deposit values fall below the value of notes outstanding

Panics in2007
Repo market (regulation Q and restriction on interstate branching)

Par conversion
Banks are not allowed to make arrangement with customers on how much to redeem. The legislation makes bank runs possible.

State chartering restricted entry and competition of banks. Banks are small and undiversified.
Wildcat banking is exaggerated. Most banks were honest. 

Interstate Banking: The Reform That Won’t Go Away

Of the policies that have actually weakened the U.S. banking system, among the most important are long-standing restrictions against interstate branching. Its long history of unit banking places the United States in a unique position among nations with developed banking systems.

  Current law, based on the McFadden Act of 1927, the Banking Act of 1933, and the Bank Holding Company Act of 1956, with their amendments, allows each state to establish its own policies concerning the ability of out-of-state banks to enter the state’s market. Some 30 states and the District of Columbia have reached reciprocal interstate banking agreements with states or other groups of states. Four other states permit banks from any state to operate within their boundaries. Over three-fourths of these 34 states limit such interstate banking to purchases of in-state banks by out-of-state bank holding companies as opposed to allowing out-of-state banks to set up completely new branches. The other one-fourth permit de novo branching. The remaining 16 states allow no interstate banking at all.

 After the panic of 1907, branch banking was considered as a means of avoiding future crises, but it lost out in the political battle to the formation of a central bank.

When the banking industry collapsed in the early 1930s, nationwide branch banking wasproposed again but was rejected in favor of federal deposit insurance.

 The National Banking Act of 1863 created the national banking system, andwhile it did liberalize many banking laws, it did not form a branch banking system. The states retained control overbranching, and most of them prohibited it. Although branching regulations were subsequently relaxed in many states,they were never made liberal enough to contribute to the national system's stability.

With limited country-bank support, the law approved in 1913 to deal with the recurring panics called for 12 FederalReserve banks, with partial federal government control but with control really based on the New York Fed.

In brief, central banking was a compromise erected in response to theNew York banks' desire for continued hegemony, plus the country bankers' opposition to branch banking.

The establishment of the Federal Deposit Insurance Corporation (FDIC) "weakened theprevious sense of urgency to modify federal statutes regulating branching."

deposit insurance was not new. It had been tried in several states after the panic of 1907, and in each casewhere it was introduced, problems quickly arose. First, by making banks pay into a fund out of their own assets, thestates faced an incentive problem. Because they bore only a fraction of the added risk of failure, banks began to holdmore risky portfolios. Second, deposit insurance could do little to save banks when the economy turned bad. Asagricultural prices fell in the late 1920s, banks in states with insurance plans began to collapse, and the insurancefunds dried up. By early 1930 all eight state funds had gone bankrupt.

The McFadden Act of 1927 and the Banking Act of 1933, which are still in effect, prohibit banks headquartered in onestate from operating additional deposit-taking offices in any other state.

Douglas Amendment to the Bank Holding Company Act of 1956,which prevented holding companies from owning a bank in another state without that state's permission. Until around1980, this legislation effectively checked interstate operation of full-service banks or branches.

Taken together, diverse portfolios and easier funds movement help explain the superiority ofbranch banking in preventing and handling crises and panics. Restrictions on branching kept the bank small and prevented them from adequately diversifying, thereby increasing their risk of failure. In the absence of these restrictions, bank failures in the 1920s and1930s would have been significantly reduced.

 thatmonopolization of the banking industry is not a likely outcome of nationwide branching.

 Branch banking encourages a higher quality ofmanagement, thereby reducing the risk of crises and failure. In Canada, it should be noted, the Canadian BankersAssociation has historically been ahead of its U.S. counterpart in providing the educational and training programsneeded to develop the qualified bankers necessary for branch banking.

 loan decisionsare usually left up to local branch managers and loan officers; only in cases of very risky or large loans do suchdecisions go to the head office

 Econometric evidence on market shares in states that permit unrestricted branching indicates that branches do not increase market shares to any potentially troublesome degree. Although the number of firms shrinks, the number of offices increases, and any possible adverse effect on prices is compensated for by increases in services and office hours.

 only at market shares and concentration ratios, many of the previously cited studiesunderstate the degree of competition in a branched banking industry.

4/4/2013 Banking notes

Classic gold standard:
a monetary system in which the standard economic unit of account is based on the fixed weight of gold.

Redemption pressure stopped countries from printing too much money in gold standard.
A gold standard is a fixed exchanged rate system.

The impossible trinity in international trade
(1) fixed exchanged rate
(2) domestic control of money supply
(3) free trade and capital flows

Why are central banks and gold standard incompatible?
Because the only way for central banks to get around people's redemption of notes for gold is to suspend the redeemibility of their notes into species.

At first, the suspension was only temporary, but during the 1930s, many central banks permanently suspended the redeembility and converted notes into fiat money.

Central bank is a central bank because it monopolizes note issuance.

Fiat money
(1) inflation is more common after the abandonment of gold standard
(2) cheaper to produce
(3) senioriage accrues to government

Article 1 section 10 denies states from issuing fiat money. But it doesn't specify whether Congress could do so. In this way does the government inverts section 10. 

4/2 Banking notes

Self regulation of private banking system
(1) consumers will redeem deposits and notes, imposing pressure on banks to be more prudent in their daily operations
(2) Other banks can redeem deposits and notes, either because of strategic or profit reason.
(3) To lower transaction costs, banks come up with the institution of clearinghouse, which functions like like central bank and imposes regulation among member banks.
(4) ownership. Typically the private banking the ownership is partnership. The bankers are the people that work there. And they share something in the bank. Doubly liable.

Why is it that the banks in the clearinghouses never thought it make sense to take all the golds that are each in their own bank, and deposit them in one larger bank and thus have on their balance sheet reserve credits?

Local bank                            Regional Bank
A      L
Gold   Notes & Checks

Local bank deposits some gold in the regional bank, in return it gets a reserve balance. Regional bank deposits some gold in the reserve bank in return for some reserve balance. The reason is to lower the reliance on gold in transaction.

What characteristics does a stylized freely evolved monetary system look like?
(1) Competition reduces natural monopoly in private banking sectors. There was a concentration in clearinghouse system.
(2) Inside money at that time was of good quality and reputation.
(3) Interest rate tended not to be paid on banknotes
(4) Commodity money is driven out of circulation. But international trades still need commodity money to make payments.
(5) Commodity money and bank reserve end up consisting of only a small fraction of the deposits. The reserve ratio is low. (2%)
(6) What assets does an unregulated bank hold? Short-term commercial paper, large amount in their balance sheets are bonds of governments and corporations, smaller loans that are collateralized.
(7) What liabilities does it hold? Deposits.
(8) Banks are involved in related business.

Why don't reserve disappear in the free banking system?
(1) Existence of liabilities presupposes something promised
(2) Banks have a competitive incentive to redeem others' liabilities
(3) reserves are scarce

There isn't much evidence showing that market forces will lead to the spontaneous emergence of a central bank.

How do banks today issue banknotes?

What is a Central Bank?
Functional definitions
(1) lender of last resort
Central bank                                                        Commercial bank
A                                L                                         A                                       L
                                                                           Gold 40                         M 10
                                                                          Long term 160              R 10
                                                                                                               notes 100
                                                                                                                capital 40
Now investors want to redeem 60$, the commercial bank doesn't have that many cashes.
The bank will turn to the central bank, the central bank will take gold 20, issue reserve note or reserve credit, and give it to the bank.

For the central bank, asset is loan to the bank,  and the liab is the deposit account for the bank
For commercial bank, gold 20 is added on their asset, and loan from Fed 20 is added on their liab. The equity is not changed. Later the commercial bank will return the money and interest to the Fed. The Fed will lend money at a penalty rate
(a) the only banks that can afford higher interest rate are good banks
(b) You don't want banks to come to Fed for daily borrowing. The Fed is an emergency window.

 (2) controller of money supply
Confused with positive and normative description of central banks' duty
Evidence shows that Fed fails to manage money supply and credit supply.

A structural definition:
A bank that enjoys government privileges, generally including a monopoly of paper currency.

Why is it good to have monopoly power on paper currency?
(1) central bank doesn't face the competition from other banks of note redemption.
(2) monetary policy
(3) Seiniorage
(4) short-run lending power

Central bank will suppress private inside money by either banning them or prohibiting payment of interest. Central bank can also tax the bank (reserve ratio)

Why do government favor central banks?
(1) For poor countries, central bank is the only way to generate the revenues.
(2) Fiscal reasons. To get senioriage and for government to gain loans of favorite terms that otherwise wouldn't be got naturally.

Banking let people escape risks of holding debased government coins.
Some banks were involved in debasement business too.
Banks took step to get profit from government debasement

The rest read the ppt

Benefit of clearinghouse

(1) It economizes collateral.
(2) A reduction of the "replacement" losses in the event of a default.
the ccp typically has a better picture of each member’s overall position risk than any dealer in a bilateral market possesses.

It is important to note that many of the benefits of clearing are captured by the members of a clearinghouse. The member firms benefit from declines in the amount of collateral they must hold, reductions in replacement costs, and improvements in the terms of trade and reductions in collateral that result from increases in the amount of information available. Thus, the benefits of a clearinghouse are largely private, and profit-motivated firms have an incentive to take them into
account when deciding whether to form a clearinghouse

 

Clearinghouse

A modern futures clearinghouse is a “central counterparty” (CCP). That is, the clearinghouse becomes the buyer to every seller, and the seller to every buyer, through a process sometimes known as “novation.”

Once the details of the contract between S and B are confirmed by the clearinghouse, the clearinghouse creates a contract to buy from S and a contract to sell to B. S still has a contract to sell, and B has a contract to buy, but the clearinghouse is substituted as the counterparty to each contract. With clearing, if B defaults, the CCP bears the loss. It draws on its financial resources to pay S what he is owed.

Clearinghouses almost always have members who are large trading firms, including brokerages and banks.

The clearing members provide the financial resources for the clearinghouse to cover the losses that result from a default of another member.

Require CCP members to post collateral, called margin, with the clearinghouse. The collateral amounts reflect the risk of the members’ trading positions.

Buyers must post more margin when prices decline, to offset the risk that a buyer might walk away from a futures contract in which the agreed-upon price now seems too high; sellers must post more when prices rise to offset the risk that the seller might walk away from an agreed-upon price that now seems too low.

Default risks arise from two sources. The first is the risk of the positions that the trader holds. A default occurs only if the losses on a member’s positions are larger than his capital.

The financial intermediaries who are clearinghouse members invest in other risky assets, and they may default if the losses on the other assets on their balance sheets are sufficiently great to make it impossible for them to cover their obligations to the clearinghouse.

It is often overlooked, but essential to remember, that default risks are also shared in “bilateral” over-the-counter markets.

Over-the-counter market participants often require their counterparties to post collateral. Dealer firms usually adjust their collateral demands to reflect their assessment of both the position and balance sheet risks of their counterparties.

(Indeed, one of the factors that brought the Lehman Brothers crisis to a head was the decision of J.P. Morgan Chase to demand an additional $5 billion in collateral based on its appraisal of Lehman’s deteriorating financial condition; J. P. Morgan’s demand for collateral from Merrill Lynch was reportedly the catalyst for Merrill’s sale to Bank of America.)

It is typically the case that the margining process in over the- counter markets is less mechanically rule driven than at clearinghouses.

A consideration of the nature of credit derivatives and the firms that trade them demonstrates that the potential for information asymmetries is particularly acute for those products.

In particular, it is highly likely that dealer firms have far better information on the risks and values of CDSs than a clearinghouse, and also have better information on the balance sheet risks that they impose on the clearinghouse.

It is difficult to assess the risk of and value credit derivatives because of their complexity. Dealer firms use “rocket science” quantitative models to assess risks and value derivatives. The dealers have a strong incentive to develop accurate models because the models enable the dealers to quantify and manage their market risk more effectively, price their derivatives more accurately and earn trading profits as a result, and evaluate the default risk posed by their customers.

A clearinghouse doesn’t have much incentive to develop a more accurate model. Public good problem. It is true that current models of these firms are flawed, but the question I want to pursue is whether clearinghouse could have a better model.

Given the lack of trading activity in many CDS products, determination of market values for the purpose of updating margins is not a trivial task. Indeed, many products have to be “marked to model” rather than marked to market, because of the lack of market prices.

Information-intensive financial intermediaries have substantially better information about the risks on their balance sheets than outsiders. In particular, they have better information than a CCP could obtain.

This has important implications. Recall that futures CCPs do not explicitly price member balance sheet risks. This reflects the prohibitive information costs that they incur to do so, and the strains that any attempt to discriminate between members would place on a cooperative organization. CCP members do not pay a cost for adding balance sheet risk, which creates an incentive to take on additional amounts of such risk. This creates a potential moral hazard that reduces the benefits of sharing risks.

In contrast, dealers that supply information-intensive intermediation have a comparative advantage in appraising the balance sheet risks of their counterparties. Dealer firms expend considerable effort and money to determine and manage counterparty risk, including that of other dealer firms they trade with. Recall, moreover, that dealers do adjust collateral levels to reflect their estimates of counterparty balance sheet risks.

In sum, complicated products traded by complex, information-intensive intermediaries pose serious challenges to central clearing.

Advocates of cds clearing argue that it is necessary to reduce systemic risk, that is, the risk that the failure of a large dealer will threaten the stability of the wider financial system.

Over-the-counter derivatives dealers are so interconnected, the argument goes, that the failure of one can trigger the failure of many others. Multiple failures would jeopardize the payment system and create economic chaos. The threat to the payment system is an externality, which provides a justification.

If interconnectedness among big financial institutions is the source of a systemic risk problem, creating a central counterparty is an odd way to “solve” it.

“Interconnection” is a synonym for “risk sharing mechanism,” and as noted above, bilateral markets and a ccp are just different ways of sharing that risk.

Indeed, the lack of pricing of balance sheet risks in ccps (in contrast to the fact that such risks are priced in over-the-counter markets) creates a moral hazard that encourages greater risk taking in a cleared market than in a bilateral one. Moreover, reductions in collateral that would likely accompany the formation of a clearinghouse would actually tend to encourage firms to trade more, as with a clearinghouse the netting of positions saves collateral, allowing a larger scale of trading activity for a given amount of liquid capital. Thus, the support for the view that a clearinghouse would reduce systemic risk is shaky, at best.\

Balance sheet risks are a matter of particular concern in evaluating the pros and cons of clearing of credit derivatives.

Severing the derivatives market-making part of dealer firms from their other intermediation activities would sacrifice those scope economies. Compulsory separation of market- making activities from the other forms of intermediation performed by big financial institutions could only be justified by the existence of some externality from joining them together that imposes social costs that exceed the private scope economies.