1. Week-7 Economic Analysis of Financial Structure, Bank Failures,& Bank Management Money and Banking Econ 311 Instructor: Thomas L. Thomas

2. o Stocks are not the most important external funding source for companies: Between 1970 -2000 only accounted for 11%. o Marketable debt and securities (bonds) are not the most important source of external funding: 32% over the same period. o Only large, well established corporations have access to the securities market to finance their activities. o Financial Intermediaries like banks are the most used source for external finance accounting for 56% in the US and up to 70% in Europe. o The financial system is among the most regulated sectors in the economy. Basic Facts

3. Asymmetric Information: Adverse Selection and Moral Hazard o Adverse selection occurs before the transaction o Adverse selection is a problem created when there is asymmetric information before a transaction occurs. It occurs when borrowers who are most likely to default are the ones most actively seeking to obtain loans and are thus selected. o Moral hazard arises after the transaction o Moral hazard in the financial markets is the risk or hazard that the borrower might engage in activities that are undesirable (immoral) from the lenders point of view. o Moral hazard can also occur from the lending perspective where management engages in activities that benefit themselves at the expense of the owners shareholders. o Agency theory analyses how asymmetric information problems affect economic behavior

4. How Moral Hazard Affects the Choice Between Debt and Equity Contracts Called the Principal-Agent Problem Principal: less information (stockholder) Agent: more information (manager) Separation of ownership and control of the firm Managers pursue personal benefits and power rather than the profitability of the firm – this is called the separation theorem All of this applies to what phenomenon?

5. The Lemons Problem: How Adverse Selection Influences Financial Structure If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality Sellers of good quality items will not want to sell at the price for average quality The buyer will decide not to buy at all because all that is left in the market is poor quality items Similar problems are exhibited in the bond market – Often buyers cannot distinguish good firms with high expected profits and low risk against firms with low expected profit and high risks. If owners of a good firm have better info on their firm’s performance they will be unwilling to sell stock at an average market price. The only firms that will be willing to sell at an average market price are high risk low profit firms where the average price is higher than the company’s actual stock value. Since investors are not stupid and will not want to purchase poor performing stocks they will decide to not to purchase anything thereby retarding the market.

6. Tools to help solve the problem One solution to reduce asymmetric information is by supplying more information and details about individuals and firms seeking financing – Private companies like Standard and Poor’s and Moody’s Investment services specialize in selling such information. However this does not completely solve the problem. A free-rider problem occurs when people who take advantage of the private information without paying for it (how do they do this). The free rider – problem prevents the private market from producing enough information to eliminate asymmetry. One way is for the government to release information to help investors distinguish good and bad firms. SEC Filings and GAAP accounting are examples. What are some examples ? Note discloser agreements do not always work as some still cheat – give an example?

7. Financial Intermediation o Just like used car dealers become experts at looking at a used car and determining its value – financial intermediaries are experts at producing information about firms and individuals who want to borrow money. o An important element is a bank’s ability to profit from information it produces by not making it public thereby eliminating the free rider problem. o Banks also exhibit economies of scale thereby reducing transaction costs (give some examples). o Banks also spread risk though diversification.

8. Tools to Help Solve Moral Hazard in Debt Contracts Monitoring and Enforcement of Restrictive Covenants Discourage undesirable behavior Encourage desirable behavior Keep collateral valuable Provide information

9. o Covenants discourage undesirable behavior – they can be designed to keep the borrower from engaging in risky behavior. o Covenants encourage desirable behavior – for example cash flow covenants encourage borrowers to engage in activities that maintain sufficient cash flow to pay debt. o Covenants keep collateral valuable – a covenant to monitor collateral and keep in good condition (like rental property) protects the lender against loss. o Convents provide information – generally require borrowers to provide financial information in the form of quarterly accounting reports. (Still some moral hazard – why) Financial Covenants & Moral Hazard

10. o Studies by AMIR SUFI of he University of Chicago Graduate School of Business suggest that banks provide credit lines that are contingent on maintenance of cash flow. o Coverage covenants, are the most common financial covenant (70%) which are written on a measure of cash flow divided by interest, debt service, or fixed charge expense. o Reductions in cash flow lead to covenant violations, which in turn lead to a restriction in the availability of a line of credit. o when a firm violates a covenant, it loses access to a substantial portion of its line of credit. o In terms of magnitudes, a covenant violation is associated with a 15 to 30% drop in the availability of both total and unused lines of credit. Financial Covenants Reduce Exposure

11. o Collateral is a prevalent feature of debt contracts for both households and business. o Collateral is property that is pledged to the lender to guarantee payment in the event of default. Collateralized debt is called a secured transaction. (Note the importance of seniority) o Debt that is not guaranteed with collateral like a credit card is called unsecured transaction. o The primary sources of repayment is three fold – What are they? Collateral

12. o Expected Credit Loss composed of three items: o Probability of Default (PD) o Exposure at Default = [Outstanding Balance + CCF (Unused Line)] o Loss Given Default = (1-Recovery Rate) PD x Exposure X LGD = Expected Loss → ALLL o ALLL = Allowance for Loan and Lease Losses (e.g. Credit Loss Reserves) Expected Credit Loss

13. What is a Financial Crisis?  A financial crisis occurs when there is a particularly large disruption to information flows in financial markets, with the result that financial frictions increase sharply and financial markets stop functioning  Asset Markets Effects on Balance Sheets  Stock market decline  Decreases net worth of corporations.  Unanticipated decline in the price level  Liabilities increase in real terms and net worth decreases.  Unanticipated decline in the value of the domestic currency  Increases debt denominated in foreign currencies and decreases net worth.  Asset write-downs.

14. Factors Causing Financial Crises  Deterioration in Financial Institutions’ Balance Sheets  Decline in lending.  Banking Crisis  Loss of information production and disintermediation.  Increases in Uncertainty  Decrease in lending.

15. Factors Causing Financial Crises (cont’d)  Increases in Interest Rates  Increases adverse selection problem  Increases need for external funds and therefore adverse selection and moral hazard.  Government Fiscal Imbalances  Create fears of default on government debt.  Investors might pull their money out of the country.

16. Dynamics of Financial Crises in Advanced Economies  Stage One: Initiation of Financial Crisis  Mismanagement of financial liberalization/innovation  Asset price boom and bust  Spikes in interest rates  Increase in uncertainty  Stage two: Banking Crisis  Stage three: Debt Deflation

17. Dynamics of Financial Crises in Advanced Economies o Stage two: Banking Crisis o Deteriorating Balance Sheets and tougher lead some financial institution’s net worth to a negative position. o Unable to pay depositors and creditors can lead to a bank panic in which multiple banks fail. o Moreover uncertainty about the health of the banking system can lead to bank runs on good as well as bad banks leading called contagion – why o With fewer banks information about the creditworthiness of borrowers disappears increasing adverse selection and moral hazard deepening the financial crisis.

18. Dynamics of Financial Crises in Advanced Economies o Stage three: Debt Deflation o If the economic downturn leads to a sharp decline in the aggregate price level it can short-circuit the a recovery. o This is called debt deflation where a substantial unanticipated decline in the price level sets in leading to a further deterioration in a firm’s net worth because of the increase in the burden of debt. o Due to the decline in the net worth of borrowers from a drop in price levels causes an increase in adverse selection and moral hazard problems facing lenders.

19. Bank Failures of the 1980s and 1990s The distinguishing feature of the history of banking in the 1980s was the extraordinary upsurge in the number of bank failures. Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance far more than in any other period since the advent of federal deposit insurance in the 1930s

20. Common Characteristics 80s & 90S Bank Failures 1. Each followed a period of rapid expansion; in most cases, cyclical forces were accentuated by external factors. 2. In all four recessions, speculative activity was evident..Expert. opinion often gave support to overly optimistic expectations. 3. In all four cases there were wide swings in real estate activity, and these contributed to the severity of the regional recessions. 4. Commercial real estate markets in particular deserve attention because boom and bust activity in these markets was one of the main causes of losses at both failed and surviving banks.

21. Common Characteristics 80s & 90S Bank Failures Yet on the eve of the 1980s most banks gave few obvious signs that the competitive environment was becoming more demanding or that serious troubles lay ahead. At banks with less than $100 million in assets (the vast majority of banks), net returns on assets (ROA) rose during the late 1970s and averaged approximately 1.1 percent in 1980.a level that would not be reached again until 1993.  Large banks, however, showed clearer signs of weakness. In 1980 ROA and equity/assets ratios were much lower for banks with more than $1 billion in assets than for small banks and were also well below the large-bank levels they would reach in the early 1990s.  For the 25 largest bank holding companies in the late 1970s and early 1980s, the market value of capital decreased relative to and fell below its book value, suggesting that to investors, the franchise value of large banks was declining.

22. Common Characteristics 80s & 90S Bank Failures  This relationship between the number of bank failures and regional boom-and-bust patterns of economic activity is illustrated by the data in the attached tables.  Bank failure rates were generally high in states where, in the five years preceding state recessions, real personal income grew faster than it did for the nation as a whole.

23. The Bank Balance Sheet (cont’d) Assets Reserves Cash items in process of collection Deposits at other banks Securities Loans Other assets – give some examples?

24. The Bank Balance Sheet Liabilities Checkable deposits Nontransaction deposits – give some examples Borrowings Bank capital What are core deposits?

25. Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

26. Basic Banking: Cash Deposit Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits First National Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Checkable deposits +$100Reserves+$100Checkable deposits +$100

27. Basic Banking: Check Deposit First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves-$100Checkable deposits -$100 First National Bank AssetsLiabilities Cash items in process of collection +$100Checkable deposits +$100

28. Basic Banking: Making a Profit Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long First National Bank AssetsLiabilitiesAssetsLiabilities Required reserves +$10Checkable deposits +$100Required reserves +$10Checkable deposits +$100 Excess reserves +$90Loans+$90

29. General Principles of Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

30. Liquidity Planning Three Types: Tactical Strategic Contingency

31. Liquidity Management: Ample Excess Reserves Suppose bank’s required reserves are 10% If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital $10M Securities$10MSecurities$10M

32. Liquidity Management: Shortfall in Reserves Reserves are a legal requirement and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows So what could a bank do? AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital $10M Securities$10MSecurities$10M

33. Liquidity Management: Borrowing Cost incurred is the interest rate paid on the borrowed funds What type borrowing can the bank do? AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

34. Liquidity Management: Securities Sale The cost of selling securities is the brokerage and other transaction costs AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

35. Liquidity Management: Federal Reserve Borrowing from the Fed also incurs interest payments based on the discount rate Fed used to be considered the lender of last resort to banks – this is no longer the case. (note the Fed is a profit making institution for its members.) AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrow from Fed$9M Securities$10MBank Capital$10M

36. Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M