1. 12: Regulating Capital

2. IDEA OF THE DAY
Network externalities justify special regulation of banking.

3. FACT OF THE DAY
The 2008 Treasury TARP program of lending to troubled banks made profits for the Treasury except for loans to about half a dozen politically favored companies.

4. A Bank Run

5. Is this a Prisoner’s Dilemma?
Bank Runs
Is this a Prisoner’s Dilemma?

6. Coordination Externalities
Runs on a single bank are problem.
“Systemic Risk”: chain reaction between banks. This is a different problem.
NOT the same as “systematic risk”, which is the part of a stock’s riskiness that is correlated with the entire market’s riskiness and so cannot be escaped by diversification.

7. Systemic Risk
Systemic Risk: The risk of collapse of an entire financial
system because of the troubles of a few firms. Like
the bank run problem, but this spreads from one bank to another.
Bank A can’t pay Bank B.
Can Bank B pay Bank C?
If B can’t, will C be able to pay other banks?
“Too big to fail”: A company with debts to so many other
companies that if it collapses it creates systemic risk, e.g., AIG.
Again: NOT the same as systemATic risk in the CAPM model.

8. Three Government Tools
1. Deposit insurance.
2. The Fed’s discount window--- serving as lender of last resort.
3. Bailouts, even if not authorized by law.
These solve the coordination externality problem. All of these necessitate supervision of banks because they create moral hazard.

9. The Problem with Deposit Insurance: Moral Hazard
Moral hazard in insurance: The driver drives carelessly, knowing that the insurance company will pay if he dents his car.
Moral hazard in the principal-agent model: The worker will choose to slack off if he is paid an annual salary and his boss can’t observe how hard he is working.
Moral hazard in banking: The bank make srisky investments
because it knows someone will rescue them if the investments fail.
The FDIC is the principal; the bank is the agent.

10. “Citizens Bank fails, will reopen as Heartland Bank” (2012)
PRINCETON – Federal banking regulators designated Citizens First National Bank as a failed bank Friday afternoon, ending its business and selling its assets.
Citizens Bank customers can access their money by writing checks or using ATM or debit cards. All checks drawn on the bank will be honored, the Federal Deposit Insurance Corp. said, and all loan customers should continue to make their payments as usual. …
The bank branches will reopen today as branches of Heartland Bank and Trust Company of Bloomington, which has agreed to assume Citizens Bank’s assets, including about $870 million in total deposits, the FDIC said in a news release Friday evening. Customers of Citizens Bank are now customers of Heartland Bank.

11. LEVERAGE RAISES PROFITS: Riskless Arbitrage
Leverage = Assets/Equity

12. Risky Arbitrage— paying back the loan
Average return in Plan 3: 0.8(610) + .2 (-400) = 488%-80%= 408%

13. Risky Arbitrage (corrected for bankruptcy)
Plan 3 Return: .8(610%) + .2 (-100%) = 488%- 20%= 468%.

14. FINAL EXAM
I've Canvassed the Fall 2016 final for G406, with answers. This term's final will also be some short answer, some multiple choice. Many students finished the test early last term. The test will be cumulative over the entire semester. It will include the end-of-chapter readings. I will look at the boldfaced terms, the homework questions, and the other end-of-chapter short answer and multilpe choice questions in writing the test. Do not bring a calculator--- I will try to make the arithmetic easy and give credit even if your addition is wrong. The room is HH1030, NOT our regular classroom.
I will have office hours on Monday and 1-2. I will also watch my Sunday night to see if you have any questions for me. You may of course me or ask for a time to get together at other times too, including Saturday (though not Sunday, when I will be busy most of the day).

15. IDEA OF THE DAY
Moral hazard is the big problem with finding good banking regulations.

16. FACT OF THE DAY
The big three, Moody's, S&P and Fitch, all gave Lehman Brothers bonds at least an A rating up to the day Lehman filed for bankruptcy.
Moody's opens Pandora's box on AAA Debt Rating

17. Risk Regulation
1. Capital requirements. There is no one set ratio required; it depends on the riskiness of the bank’s assets. Basel I, II, III are international standards for capitalization ratios– nonbinding advice to each country’s regulators.
2. Restrictions on risky investments. No common stock, limits on options trading, loans to a single borrower can’t be too big, etc.

18. Securitization
Securitization means the bundling together of diverse cash flows into a single asset, pieces of which are then sold.
Someone could approach various banks around the country and buy the rights to the cash flows from 500 mortgages. Then he could sell shares in that to 1,000 other investors.
That way, the risk from the mortgages is pooled, the bank gets cash instead of having to hold loans, and investors get to buy an asset with a high interest rate.
Securitization has a direct effect of reducing risk and making banks safer.

19. Tranching: Creating Safe Assets Out Of Risky Ones
I made up the market prices; they can't be derived from the other information. The prices depend on supply and demand for bonds of different riskiness.

20. The Bond Rating Companies
The bond rating companies such as Moody’s grossly overrated
the safety of mortgage-backed securities. Why?
1. Conflict of interest in getting rating fees?
2. The same reason as the banks and investment companies—
inexperience and folly?
3. Lack of incentive to maintain their reputations?
Would a government agency have rated them more accurately?

21. “Undue credit: Regulation is helping the very firms it is designed to tame”
Fitch, Moody’s and Standard and Poor’s (S&P), had all judged Lehman Brothers a safe bet until the morning of the day it defaulted; they also gave high ratings to securities based on subprime mortgages that turned out to be toxic.
Dodd-Frank bill of 2010: any requirements in regulation for a security to be rated should be expunged.
Justice Dept. began investigating S&P for fraud, claiming it deliberately distorted its ratings to win more business.
The agencies have raised prices 4% a year since The shares of Moody’s, the sole standalone agency, are up more than sixfold since Its board kept Mr McDaniel in the job and paid him $14m last year.

22. “Undue credit: Regulation is helping the very firms it is designed to tame”
The SEC still stipulates what ratings the assets held by moneymarket funds should have, despite Dodd Frank. The Basel Committee, an international club of regulators which sets global rules for banks, still uses ratings to judge the quality of their assets.
S&P settled with Justice in 2015, paying $1.4 billion but not admitting wrongdoing.
Trying to sell a bond without a rating remains really hard; reselling one is even tougher. At the end of 2013 S&P had ratings on 1.1m issues, Moody’s on 900,000. Many big investors, such as CalPERS, an enormous public pension fund, do not allow those managing its money to invest in any unrated securities.
To issue new ratings, a firm must qualify as a “nationally recognised statistical rating organisation” (NRSRO)—a process several potential new rivals to the big three have struggled with. Since 2011, for instance, the SEC has been reviewing the application of R & R Consulting, a firm established by two former employees of big agencies. Rather than try to change ratings as infrequently as possible, the conventional approach, R&R constantly adjusts them in response to new economic data, changes in interest rates and the performance of the underlying assets. It seems to have flummoxed the SEC, says Ann Rutledge, a founding partner.

23. Repo’s and Shadow Banks
If Apple wants to park $20 million dollars somewhere and be able to get it back quickly, what can it do?
Apple could buy a repo, a repurchase agreement, from Apex Hedge Fund. Apple pays Apex $20 million in cash. Apex sells Apple $20 million in securities and agrees to buy them back tomorrow for $ million in cash (about a 2% annual interest rate, $1,000 for the day). Then, Apex lends the money to someone else for $.002 million in interest, or uses it to deal in other securities.
In effect, Apple deposits $20 million with Apex. Apex is a shadow bank, paying interest on Apple’s deposits and using those deposits to make loans.
A feature of this is that if the security income happens to arrive overnight, Apex gets it, not Apple. Apex has legally bought the stock.

24. Runs on Shadow Banks
Apex doesn’t have deposit insurance, but Apple holds the $20 million in securities as collateral. But what if Apple decides not to renew?
Apex has to return the $20 million or come up with an extra $5 million in securities.
Suppose Apex spent the $20 million on other securities, believing Apple would keep renewing the repo. Apex doesn’t have the $20 million cash on hand. If Apex can borrow, fine. But if Apex sells its securities to get cash, securities prices fall. And that reduces the value of securities as collateral. Chain reaction!

25. The Events of 2008
Already, in 2007, some mortgage lenders were failing and the subprime mortgage market was in trouble.
In 2008, the Bear Stearns brokerage firm failed.
Fannie Mae and Freddie Mac were taken over by the Treasury because of insolvency.
The Lehmann Brothers investment bank failed.
The Fed bailed out AIG.
Treasury asked Congress for the TARP program and got it.
Things calmed down again--- but a recession started.

26. Policies for Crises
1. The insolvent banks are liquidated, their assets sold o to new owners.
2. The government nationalizes the insolvent banks, possibly reselling them later.
3. The Fed lends money to banks as lender of last resort.
4. The Treasury or Fed buys preferred stock in banks or in some other way injects capital that is to be repaid.
5. The Treasury or Fed buys toxic assets---the assets of the bank whose prices have collapsed.

27. 2008 Policy Responses
1. The Fed served as lender of last resort. It also bought
dubious assets ($600 billion+) and commercial paper ($350
billion).
2. TARP. The Treasury made loans and bought stock in
banks and nonbanks. (Cost: $435 billion disbursed, $279
returned—old numbers)
3. AIG insurance company bailout. Treasury
bought it to address the CDS problem.
4. Treasury took over Fannie Mae and Freddie Mac, paying
their debts (cost: $145 billion so far, old numbers, $3.7 trillion in
liability exposure!)

28. “Jailed Banker Is Rare Prize for U.S.” (2012)
A total of 463 banks in the U.S. have failed since 2008, typically the victims of the bad economy, soured loans, poor management or a combination of all three. The number of executives now in prison for crimes at those banks is far smaller: about 17, data from the Federal Deposit Insurance Corp. show. And those executives aren't household names. None led financial firms such as Washington Mutual Inc. that dominated headlines before, during and after the banks' deaths. Instead, most of the imprisoned bank executives came from small banks that boomed and then busted. Like Mr. Williams, they were caught hiding bad loans and lying to regulators.
When regulators warned Orion that it needed more capital to survive, Mr. Williams "falsified the books and records...submitted false [financial] reports to the Federal Reserve, falsely categorized nonperforming loans as performing loans, directed the creation of fraudulent documents to 'paper' loan files, and repeatedly lied to state and federal regulators," prosecutors later wrote in a memo.

29. COCHRANE: “Lehman and the Financial Crisis: The lesson is that institutions that take trading risks must be allowed to fail” “
Many people say that letting Lehman fail in fall 2008 was the mistake that caused the financial crisis. To them, the lesson is that the government should never allow any "systemically important" financial institution to fail.
Bear Stearns brokerage was rescued in February had just postponed worse trouble.
If only Lehman had been bailed out, the story goes, we could have avoided much of a 45% drop in the S&P 500, a 4% drop in output, the rise in unemployment to 9.7% from 6.2%, and the $784 billion "stimulus" to top off a $1.59 trillion deficit.

30. “Lehman and the Financial Crisis: The lesson is that institutions that take trading risks must be allowed to fail” “
The TARP speeches amounted to "The financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.
From the 1984 failure of Continental Illinois bank to the S&L crisis of the late 1980s, the Latin American bond defaults of the 1990s, the 1997 Asian crashes, the 1998 collapse of the Long-Term Capital Management hedge fund and now this mess, financial institutions are taking more and more risks, but their bondholders keep getting rescued.

31. “Economists Have Abandoned Principle” (Hart-Zingales,2008)
We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers.
What would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy?
Instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG.
It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court.

32. The GM and Chrysler Bailouts: Systemic Risk?
In 2009 the government and union medical fund bought
a majority interest in Chrysler and in General Motors.
Why was this more controversial than buying stock in AIG
or Citigroup?

33. The Bagehot Rule
In a financial crisis, the lender of last resort should:
1. Lend freely to anyone
2. At a penalty rate of interest
3. On collateral that is good in normal times.

34. Walter Bagehot on Penalty Interest Rates
“The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose there are two rules:—First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.”
Lombard Street: A Description of the Money Market
Chapter 7, ``A More Exact Account of the Mode in Which the Bank of England Has Discharged Its Duty of Retaining a Good Bank Reserve.'' \url{

35. Bagehot on Collateral
Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere.
Lombard Street: A Description of the Money Market
Chapter 7, ``A More Exact Account of the Mode in Which the Bank of England Has Discharged Its Duty of Retaining a Good Bank Reserve.'‘

36. The Euro Debt Crisis
With the Euro Debt Crisis, ECB is trying to reduce bond yield spreads and address the fragmentation of the Eurozone’s financial markets. As necessary as these effort may be, they appear to jeopardize ECB’s credibility...For instance, accepting collateral that’s perceived to be in default, such as government paper issued by Greece or Ireland, significantly batters ECB’s reputation with negative implications for monetary policy effectiveness....
The ECB also actively lowered its already lax collateral standards, including assets that have been downgraded by ratings agencies, such as peripheral sovereign debt. Although extending the range of eligible collateral to include default-risk could be considered as against Bagehot’s traditional principle of lending against secure collateral, in this case the ECB acted as the LLR for banks that were unable to obtain financing from the market...
The Changed Role of the Lender of
Last Resort: Crisis Responses of the
Federal Reserve, European Central
Bank and Bank of England,Gayane Oganesyan

37. Why the Lax Regulation of 2005?
Barney Frank, the Chairman of the House Banking Committee,
in 2003:
“I do think I do not want the same kind of focus
on safety and soundness that we have in OCC and
OTS. I want to roll the dice a little bit more in this
situation towards subsidized housing.”

38. Republic Windows and Doors: Systemic Risk?
In 2008, Bank of America cut off the line of credit of
Chicago’s Republic Windows and Doors. Republic laid off
its workers. Under state law the company was supposed to
give two months notice, with continued pay and benefits.
Politicians jumped in.
Bank of America surrendered and gave Republic $1.35
million in the form of a “loan”.

39. Media Clippings
1. “Urban Partnership Bank in Bailout Talks with FDIC, Sources Say,” Crain’s
Chicago Business (2015).
2. “Minneapolis Fed Chief Proposes Eliminating Too Big to Fail Banks,” The New York Times (2016).
3. “Undue Credit: Regulation Is Helping the Very Firms It Is Designed to Tame,”
The Economist (2015).
4. “Lehman and the Financial Crisis The Lesson Is That Institutions That Take
Trading Risks Must Be Allowed to Fail,” John H. Cochrane and Luigi Zingales,
The Wall Street Journal (2009).
5. “Narrow-Minded” The Economist (2014).

40. “Urban Partnership Bank in Bailout Talks with FDIC, Sources Say”
In 2011 the FDIC seized $2.2 billion-asset Chicago ShoreBank and transferred its assets and deposits to newly created Urban Partnership Bank launched with more than $140 million from Wall Street titans including Goldman Sachs Holdings and JPMorgan Chase. The agency agreed to share losses on ShoreBank's souring commercial loans and residential loans till 2015.
Congressional Republicans demanded a probe by the FDIC's inspector general, who concluded in 2011 that the intervention wasn't politically motivated.
UPB has yet to generate a profit; it has burned through nearly $90 million of the $144 million in equity it had at the end of In the first six months of 2015, UPB posted an $11.2 million loss.