Topic: The difference between Nominal and Real interest rates.

Discuss as a team the major concepts of the week.

Review any complicated or confusing concepts. Strive to provide fresh insight to each other.

Summarize the discussion in 350 to 525 words.

Format your paper consistent with APA guidelines.

Submit your assignment as a Microsoft® Word document.

Topic: The difference between Nominal and Real interest rates.

Discuss as a team the major concepts of the week.

Review any complicated or confusing concepts. Strive to provide fresh insight to each other.

Summarize the discussion in 350 to 525 words.

Format your paper consistent with APA guidelines.

Submit your assignment as a Microsoft® Word document.

18 Bank Regulation

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the key regulations imposed on commercial banks,

· ▪ explain capital requirements of banks,

· ▪ explain how regulators monitor banks,

· ▪ explain the issues regarding government rescue of failed banks, and

· ▪ describe how the Financial Reform Act of 2010 affects the regulation of commercial bank operations.

Bank regulations are designed to maintain public confidence in the financial system by preventing commercial banks from becoming too risky.

18-1 BACKGROUND

Because banks rely on funds from depositors, they have been subject to regulations that are intended to ensure the safety of the financial system. Many of the regulations are intended to prevent banks from taking excessive risk that could cause them to fail. In particular, regulations are imposed on the types of assets in which banks can invest, and the minimum amount of capital that banks must maintain. However, there are trade-offs due to bank regulation. Some critics suggest that the regulation is excessive, and it restricts banks from serving their owners. Banks might be more efficient if they were not subject to regulations. Given these trade-offs, regulations are commonly revised over time in response to bank conditions, as regulators seek the optimal level of regulation that ensures the safety of the banking system, but also allows banks to be efficient.

   Many regulations of bank operations were removed or reduced over time, which allowed banks to become more competitive. Because of deregulation, banks have considerable flexibility in the services they offer, the locations where they operate, and the rates they pay depositors for deposits.

   Yet some banks and other financial institutions engaged in excessive risk taking in the 2005–2007 period, which is one the reasons for the credit crisis in the 2008–2009 period. Many banks failed as a result of the credit crisis, and government subsidies were extended to many other banks in order to prevent more failures and restore financial stability. This has led to much scrutiny over existing regulations and proposals for new regulations that can still allow for intense competition while preventing bank managers from taking excessive risks. This chapter provides a background on the prevailing regulatory structure, explains how bank regulators attempted to resolve the credit crisis, and describes recent changes in regulations that are intended to prevent another crisis.

18-2 REGULATORY STRUCTURE

The regulatory structure of the banking system in the United States is dramatically different from that of other countries. It is often referred to as a dual banking system because it includes both a federal and a state regulatory system. There are more than 6,000 separately owned commercial banks in the United States, which are supervised by three federal agencies and 50 state agencies. The regulatory structure in other countries is much simpler.

WEB

www.federalreserve.gov/bankinforeg/reglisting.htm

Detailed descriptions of bank regulations from the Federal Reserve Board.

   A charter from either a state or the federal government is required to open a commercial bank in the United States. A bank that obtains a state charter is referred to as a state bank; a bank that obtains a federal charter is known as a national bank. All national banks are required to be members of the Federal Reserve System (the Fed). The federal charter is issued by the Comptroller of the Currency. An application for a bank charter must be submitted to the proper supervisory agency, should provide evidence of the need for a new bank, and should disclose how the bank will be operated. Regulators determine if the bank satisfies general guidelines to qualify for the charter.

   State banks may decide whether they wish to be members of the Federal Reserve System. The Fed provides a variety of services for commercial banks and controls the amount of funds within the banking system. About 35 percent of all banks are members of the Federal Reserve. These banks are generally larger than the norm; their combined deposits make up about 70 percent of all bank deposits. Both member and nonmember banks can borrow from the Fed, and both are subject to the Fed’s reserve requirements.

WEB

www.federalreserve.gov

Click on “Banking Information ft Regulation” to find key bank regulations at the website of the Board of Governors of the Federal Reserve System.

18-2a Regulators

National banks are regulated by the Comptroller of the Currency; state banks are regulated by their respective state agency. Banks that are insured by the 

Federal Deposit Insurance Corporation (FDIC)

 are also regulated by the FDIC. Because all national banks must be members of the Federal Reserve and all Fed member banks must hold FDIC insurance, national banks are regulated by the Comptroller of the Currency, the Fed, and the FDIC. State banks are regulated by their respective state agency, the Fed (if they are Fed members), and the FDIC. The Comptroller of the Currency is responsible for conducting periodic evaluations of national banks, the FDIC holds the same responsibility for state-chartered banks and savings institutions with less than $50 billion in assets, and the Federal Reserve is responsible for state-chartered banks and savings institutions with more than $50 billion in assets.

18-2b Regulation of Bank Ownership

Commercial banks can be either independently owned or owned by a 

bank holding company (BHC)

. Although some multibank holding companies (owning more than one bank) exist, one-bank holding companies are more common. More banks are owned by holding companies than are owned independently.

18-3 REGULATION OF BANK OPERATIONS

Banks are regulated according to how they obtain funds, how they use their funds, and the types of financial services they can offer. Some of the most important regulations are discussed here.

18-3a Regulation of Deposit Insurance

Federal deposit insurance has existed since the creation in 1933 of the FDIC in response to the bank runs that occurred in the late 1920s and early 1930s. During the 1930–1932 period of the Great Depression more than 5,000 banks failed, or more than 20 percent of the existing banks. The initial wave of failures caused depositors to withdraw their deposits from other banks, fearing that the failures would spread. These actions actually caused more banks to fail. If deposit insurance had been available, depositors might not have removed their deposits and some bank failures might have been avoided.

   The FDIC preserves public confidence in the U.S. financial system by providing deposit insurance to commercial banks and savings institutions. The FDIC is managed by a board of five directors, who are appointed by the President. Its headquarters is in Washington, D.C., but it has eight regional offices and other field offices within each region. Today, the FDIC’s insurance funds are responsible for insuring deposits of more than $3 trillion.

Insurance Limits
 The specified amount of deposits per person insured by the FDIC was increased from $100,000 to $250,000 as part of the Emergency Economic Stabilization Act of 2008, which was intended to resolve the liquidity problems of financial institutions and to restore confidence in the banking system. The $250,000 limit was made permanent by the Financial Reform Act of 2010. Large deposit accounts beyond the $250,000 limit are insured only up to this limit. Note that deposits in foreign branches of U.S. banks are not insured by the FDIC.

   In general, deposit insurance has allowed depositors to deposit funds under the insured limits in any insured depository institution without the need to assess the institution’s financial condition. In addition, the insurance system minimizes bank runs on deposits because insured depositors believe that their deposits are backed by the U.S. government even if the insured depository institution fails. When a bank fails, insured depositors normally have access to their money within a few days.

Risk-Based Deposit Premiums
 Banks insured by the FDIC must pay annual insurance premiums. Until 1991, all banks obtained insurance for their depositors at the same rate. Because the riskiest banks were more likely to fail, they were being indirectly subsidized by safer banks. This system encouraged some banks to assume more risk because they could still attract deposits from depositors who knew they would be covered regardless of the bank’s risk. The act of insured banks taking on more risk because their depositors are protected is one example of what is called a 

moral hazard problem

. As a result of many banks taking excessive risks, bank failures increased during the 1980s and early 1990s. The balance in the FDIC’s insurance fund declined because the FDIC had to reimburse depositors who had deposits at the banks that failed.

   This moral hazard problem prompted bank regulators and Congress to search for a way to discourage banks from taking excessive risk and to replenish the FDIC’s insurance fund. As a result of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, risk-based deposit insurance premiums were phased in. Consequently, bank insurance premiums are now aligned with the risk of banks, thereby reducing the moral hazard problem.

Deposit Insurance Fund

 Before 2006, the Bank Insurance Fund was used to collect premiums and provide insurance for banks and the Savings Association Insurance Fund was used to collect premiums and provide insurance for savings institutions. In 2006 the two funds were merged into one insurance fund called the 
Deposit Insurance Fund
, which is regulated by the FDIC.

   The deposit insurance premiums were increased in 2009 because the FDIC had used substantial reserves during the credit crisis to reimburse depositors of failed banks. The range of premiums is now typically between 13 and 53 cents per $100, with most banks paying between 13 and 18 cents. The FDIC’s reserves are currently about $45 billion, or about 1 percent of all insured deposits. The FDIC also has a large credit line against which it can borrow from the Treasury.

Bank Deposit Insurance Reserves
 The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010 requires that the Deposit Insurance Fund should maintain reserves of at least 1.35 percent of total insured bank deposits, to ensure that it always has sufficient reserves to cover losses. If the reserves fall below that level, the FDIC is required to develop a restoration plan to boost reserves to that minimum level. The act also requires that if the reserves exceed 1.50 percent of total insured bank deposits, the FDIC should distribute the excess as dividends to banks.

18-3b Regulation of Deposits

Three regulatory acts created more competition for bank deposits over time, as discussed next.

DIDMCA
 In 1980, the 

Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

 was enacted to (1) deregulate the banking (and other depository institutions) industry and (2) improve monetary policy. Because this chapter focuses on regulation and deregulation, only the first goal is discussed here.

   The DIDMCA was a major force in deregulating the banking industry and increasing competition among banks. It removed interest rate ceilings on deposits, allowing banks and other depository institutions to make their own decisions on what interest rates to offer for time and savings deposits. In addition, it allowed banks to offer NOW accounts.

   The DIDMCA has had a significant impact on the banking industry, most importantly by increasing competition among depository institutions.

Garn-St. Germain Act

 Banks and other depository institutions were further deregulated in 1982 as a result of the 
Garn-St. Germain Act
. The act came at a time when some depository institutions (especially savings institutions) were experiencing severe financial problems. One of its more important provisions permitted depository institutions to offer money market deposit accounts (MMDAs), which have no minimum maturity and no interest ceiling. These accounts allow a maximum of six transactions per month (three by check). They are similar to the traditional accounts offered by 

money market mutual funds

 (whose main function is to sell shares and pool the funds to purchase short-term securities that offer market-determined rates). Because MMDAs offer savers similar benefits, they allow depository institutions to compete against money market funds in attracting savers’ funds.

   A second key deregulatory provision of the Garn-St. Germain Act permitted depository institutions (including banks) to acquire failing institutions across geographic boundaries. The intent was to reduce the number of failures that require liquidation, as the chances of finding a potential acquirer for a failing institution improve when geographic barriers are removed. Also, competition was expected to increase because depository institutions previously barred from entering specific geographic areas could now do so by acquiring failing institutions.

Interstate Banking Act In September 1994, Congress passed the Reigle-Neal Interstate Banking and Branching Efficiency Act, which removed interstate branching restrictions and thereby further increased the competition among banks for deposits. Nationwide interstate banking enabled banks to grow and achieve 

economies of scale

. It also allowed banks in stagnant markets to penetrate other markets where economic conditions were more favorable. Banks in all markets were pressured to become more efficient as a result of the increased competition.

18-3c Regulation of Bank Loans

Since loans represent the key asset of commercial banks, they are regulated to limit a bank’s exposure to default risk.

Regulation of Highly Leveraged Transactions
 As a result of concern about the popularity of highly leveraged loans (for supporting leveraged buyouts and other activities), bank regulators monitor the amount of highly leveraged transactions (HLTs). HLTs are commonly defined as loan transactions in which the borrower’s liabilities are valued at more than 75 percent of total assets.

Regulation of Foreign Loans
 Regulators also monitor a bank’s exposure to loans to foreign countries. Because regulators require banks to report significant exposure to foreign debt, investors and creditors have access to more detailed information about the composition of bank loan portfolios.

Regulation of Loans to a Single Borrower
 Banks are restricted to a maximum loan amount of 15 percent of their capital to any single borrower (up to 25 percent if the loan is adequately collateralized). This forces them to diversify their loans to some degree.

Regulation of Loans to Community
 Banks are also regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate. The Community Reinvestment Act (CRA) of 1977 (revised in 1995) requires banks to meet the credit needs of qualified borrowers in their community, even those with low or moderate incomes. The CRA is not intended to force banks to make high-risk loans but rather to ensure that qualified lower-income borrowers receive the loans that they request. Each bank’s performance in this regard is evaluated periodically by its respective regulator.

18-3d Regulation of Bank Investment in Securities

Banks are not allowed to use borrowed or deposited funds to purchase common stock, although they can manage stock portfolios through trust accounts that are owned by individuals. Banks can invest only in bonds that are investment-grade quality. This was measured by a Baa rating or higher by Moody’s or a BBB rating or higher by Standard & Poor’s. The regulations on bonds are intended to prevent banks from taking excessive risks.

   However, during the credit crisis, the ratings agencies were criticized for being too liberal with their ratings. The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010 changed the rules to require that banks use not only credit ratings assigned by credit rating agencies, but also other methods to assess the risk of debt securities, including their own assessment of risk. This is intended to ensure that banks do not rely exclusively on credit rating agencies when investing in debt securities. Thus, even if the credit rating agencies apply liberal ratings, the bank should be able to detect when debt securities are too risky when using its own analysis or other methods to assess risk.

18-3e Regulation of Securities Services

The Banking Act of 1933 (better known as the Glass-Steagall Act) separated banking and securities activities. The act was prompted by problems during 1929 when some banks sold some of their poor-quality securities to their trust accounts established for individuals. Some banks also engaged in insider trading: buying or selling corporate securities based on confidential information provided by firms that had requested loans. The 

Glass-Steagall Act

 prevented any firm that accepted deposits from underwriting stocks and bonds of corporations.

   The separation of securities activities from banking activities was intended to prevent potential conflicts of interest. For example, the concern was that if a bank were allowed to underwrite securities, it might advise its corporate customers to purchase these securities and could threaten to cut off future loans if the customers did not oblige.

WEB

www.federalreserve.gov/bankinforeg/default.htm

Links to regulations of securities services offered by banks.

Financial Services Modernization Act

 In 1999, Congress passed the 
Financial Services Modernization Act
 (also called the Gramm-Leach-Bliley Act), which essentially repealed the Glass-Steagall Act. The 1999 act allows affiliations between banks, securities firms, and insurance companies. It also allows bank holding companies to engage in any financial activity through their ownership of subsidiaries. Consequently, a single holding company can engage in traditional banking activities, securities trading, underwriting, and insurance. The act also requires that the holding company be well managed and have sufficient capital in order to expand its financial services. The Securities and Exchange Commission regulates any securities products that are created, but the bank subsidiaries that offer the securities products are overseen by bank regulators.

   Although many commercial banks had previously pursued securities services, the 1999 act increased the extent to which banks could offer these services. Furthermore, it allowed securities firms and insurance companies to acquire banks. Under the act, commercial banks must have a strong rating in community lending (which indicates that they have actively provided loans in lower-income communities) in order to pursue additional expansion in securities and other nonbank activities.

   Since the passage of the Financial Services Modernization Act, there has been much more consolidation of financial institutions. Many of the larger financial institutions are able to offer all types of financial services through their various subsidiaries. Because individuals commonly use financial institutions to deposit funds, obtain mortgage loans and consumer loans (such as an automobile loan), purchase shares of mutual funds, order stock transactions (brokerage), and purchase insurance, they can obtain all their financial services from a single financial conglomerate. And because firms commonly use financial institutions to maintain a business checking account, obtain loans, issue stocks or bonds, have their pension fund managed, and purchase insurance services, they can obtain all of their financial services from a single financial conglomerate.

   The Financial Services Modernization Act also offers benefits to financial institutions. By offering more diversified services, financial institutions can reduce their reliance on the demand for any single service that they offer. This diversification may result in less risk for the institution’s consolidated business provided the new services are not subject to a much higher degree of risk than its traditional services.

   The individual units of a financial conglomerate may generate some new business simply because they are part of the conglomerate and offer convenience to clients who already rely on its other services. Each financial unit’s list of existing clients represents a potential source of new clients for the other financial units to pursue.

   The consolidation of banks and securities firms continued during the credit crisis in 2008, as some major securities firms (e.g., Bear Stearns and Merrill Lynch) were acquired by commercial banks while others (e.g., Goldman Sachs and Morgan Stanley) applied and were approved to become bank holding companies. This consolidation improved the stability of the financial system because regulations on bank holding companies are generally more stringent than the regulations on independent securities firms.

18-3f Regulation of Insurance Services

As with securities services, banks have been eager to offer insurance services. The arguments for and against bank involvement in insurance are quite similar to those regarding bank involvement in securities. Banks could increase competition in the insurance industry by offering services at a lower cost. In addition, they could offer their customers the convenience of one-stop shopping (especially if the bank could also offer securities services).

   In 1998, regulators allowed the merger between Citicorp and Traveler’s Insurance Group, which essentially paved the way for the consolidation of bank and insurance services. Passage of the Financial Services Modernization Act in the following year confirmed that banks and insurance companies could merge and consolidate their operations. These events encouraged banks and insurance companies to pursue mergers as a means of offering a full set of financial services.

18-3g Regulation of Off-Balance Sheet Transactions

Banks offer a variety of off–balance sheet commitments. For example, banks provide letters of credit to back commercial paper issued by corporations. They also act as the intermediary on interest rate swaps and usually guarantee payments over the specified period in the event that one of the parties defaults on its payments.

   Various off–balance sheet transactions have become popular because they provide fee income. That is, banks charge a fee for guaranteeing against the default of another party and for facilitating transactions between parties. Off–balance sheet transactions do expose a bank to risk, however. If a severe economic downturn causes many corporations to default on their commercial paper or on payments specified by interest rate swap agreements, the banks that provided guarantees would incur large losses.

   Bank exposure to off–balance sheet activities has become a major concern of regulators. Banks could be riskier than their balance sheets indicate because of these transactions. Therefore, the risk-based capital requirements are higher for banks that conduct more off–balance sheet activities. In this way, regulators discourage banks from excessive involvement in such activities.

Regulation of Credit Default Swaps
 Credit default swaps are a type of off– balance sheet transaction that became popular during the 2004–2008 period as a means of protecting against the risk of default on bonds and mortgage–backed securities. A swap allows a commercial bank to make periodic payments to a counterparty in return for protection in the event that its holdings of mortgage-backed securities default. While some commercial banks purchased these swaps as a means of protecting their assets against default, other commercial banks sold them (to provide protection) as a means of generating fee income. By 2008, credit default swaps represented more than $30 trillion of mortgage-backed securities or other types of securities ($60 trillion when counting each contract for both parties).

   When commercial banks purchase credit default swaps to protect their assets against possible default, these assets are not subject to capital requirements. But if the sellers of the credit default swaps are overexposed, they may not be able to provide the protection they promised. Thus the banks that purchased credit default swaps might not be protected if the sellers default. As the credit crisis intensified in 2008 and 2009, regulators became concerned about credit default swaps because of the lack of transparency regarding the exposure of each commercial bank and the credibility of the counterparties on the swaps. They increased their oversight of this market and asked commercial banks to provide more information about their credit default swap positions.

18-3h Regulation of the Accounting Process

Publicly traded banks, like other publicly traded companies, are required to provide financial statements that indicate their recent financial position and performance. The Sarbanes-Oxley (SOX) Act was enacted in 2002 to ensure a more transparent process for reporting on a firm’s productivity and financial condition. It was created following news about how some publicly traded firms (such as Enron) inflated their earnings, which caused many investors to pay a much higher stock price than was appropriate. The act requires all firms (including banks) to implement an internal reporting process that can be easily monitored by executives and makes it impossible for executives to pretend that they were unaware of accounting fraud.

   Some of the key provisions of the act require banks to improve their internal control processes and establish a centralized database of information. In addition, executives are now more accountable for a bank’s financial statements because they must personally verify the accuracy of the statements. Investors may have more confidence in the financial statements now that there is greater accountability that could discourage accounting fraud.

   Nevertheless, questionable accounting practices may still occur at banks. Some types of assets do not have a market in which they are actively traded. Thus banks have some flexibility on valuing these assets. During the credit crisis, many banks assigned values to some types of securities they held that clearly exceeded their proper market values. Consequently, they were able to hide a portion of their losses.

   One negative effect of the SOX Act is that publicly traded banks have incurred expenses of more than $1 million per year to comply with its provisions. Such a high expense may encourage smaller publicly traded banks to go private.

18-4 REGULATION OF CAPITAL

Banks are subject to capital requirements, which force them to maintain a minimum amount of capital (or equity) as a percentage of total assets. They rely on their capital as a cushion against possible losses. If a bank has insufficient capital to cover losses, it will not be able to cover its expenses and will fail. Therefore, regulators closely monitor bank capital levels.

   Some bank managers and shareholders would prefer that banks hold a lower level of capital, because a given dollar level of profits would represent a higher return on equity if the bank holds less capital. This might allow for larger bonuses to managers and higher stock prices for shareholders during strong economic conditions. However, regulators are more interested in the safety of the banking system than managerial bonuses, and have increased bank capital requirements in recent years as a means of stabilizing the banking system.

18-4a How Banks Satisfy Regulatory Requirements

When a bank’s capital declines below the amount required by regulators, it can increase its capital ratio in the following ways.

Retaining Earnings
 As a bank generates new earnings, and retains them rather than distributing them as dividends to shareholders, it boosts its capital. However, it cannot retain earnings if it does not generate earnings. If it incurs losses, it needs to use some of its existing capital to cover some of its expenses, because its revenue was not sufficient to cover its expenses. Thus losses (negative earnings) result in a lower level of capital. Poorly performing banks cannot rely on retained earnings to boost capital levels because they may not have any new earnings to retain.

Issuing Stock
 Banks can boost their capital by issuing stock to the public. However, a bank’s capital level becomes deficient when its performance is weak; under these conditions, the bank’s stock price is probably depressed. If the bank has to sell stock when its stock price is very low it might not receive a sufficient amount of funds from its stock offering. Furthermore, investors may not have much interest in purchasing new shares in a bank that is weak and desperate to build capital because they might reasonably expect the bank to fail.

Reducing Dividends
 Banks can increase their capital by reducing their dividends, which enables them to retain a larger amount of any earnings. However, shareholders might interpret a cut in dividends as a signal that the bank is desperate for capital, which could cause its stock price to decline further. This type of effect could make it more difficult for the bank to issue stock in the future.

Selling Assets
 When banks sell assets, they can improve on their capital position. Assuming the assets were perceived to be risky, banks would have been required to maintain some capital to back those assets. By selling the assets, they are no longer required to back those assets with capital.

18-4b Basel I Accord

When bank regulators of various countries develop their set of guidelines for capital requirements, they are commonly guided by the recommendations in the Basel guidelines. These guidelines are intended to guide the banks in setting their own capital requirements.

   In the first Basel Accord (1988, often called Basel I), the central banks of 12 major countries agreed to establish a framework for determining uniform capital requirements. A key provision in the Basel Accord bases the capital requirements on a bank’s risk level. Banks with greater risk are required to maintain a higher level of capital, which discourages banks from excessive exposure to credit risk.

   Assets are weighted according to risk. Very safe assets such as cash are assigned a zero weight, while very risky assets are assigned a 100 percent weight. Because the required capital is set as a percentage of risk-weighted assets, riskier banks are subject to more stringent capital requirements.

18-4c Basel II Framework

WEB

www.federalreserve.gov/bankinforeg/basel/USimplementation.htm

Information about the Basel framework.

A committee of central bank and regulatory authorities of numerous countries (called the Basel Committee on Banking Supervision) created a framework in 2004 called Basel II, which was added to the Basel Accord. It has two major parts: revising the measurement of credit risk and explicitly accounting for operational risk.

Revising the Measurement of Credit Risk
 When banks categorize their assets and assign risk weights to the categories, they account for possible differences in risk levels of loans within a category. Risk levels could differ if some banks required better collateral to back their loans. In addition, some banks may take positions in derivative securities that can reduce their credit risk, while other banks may have positions in derivative securities that increase their credit risk.

   A bank’s loans that are past due are assigned a higher weight. This adjustment inflates the size of these assets for the purpose of determining minimum capital requirements. Thus, banks with more loans that are past due are forced to maintain a higher level of capital (other things being equal).

   An alternative method of calculating credit risk, called the internal ratings-based (IRB) approach, allows banks to use their own processes for estimating the probability of default on their loans.

Explicitly Accounting for Operational Risk
 The Basel Committee defines operational risk as the risk of losses resulting from inadequate or failed internal processes or systems. Banks are encouraged to improve their techniques for controlling operational risk because doing so could reduce failures in the banking system. By imposing higher capital requirements on banks with higher levels of operational risk, Basel II provided an incentive for banks to reduce their operational risk.

   The United States, Canada, and countries in the European Union created regulations for their banks that conform to some parts of Basel II. When applying the Basel II guidelines, many banks underestimated the probability of loan default during the credit crisis. This motivated the creation of the Basel III framework, described next.

18-4d Basel III Framework

In response to the credit crisis, the Basel Committee on Banking Supervision began to develop a Basel III framework in 2011, which attempts to correct deficiencies of Basel II. This framework recommends that banks maintain Tier 1 capital (retained earnings and common stock) of at least 6 percent of total risk-weighted asset. It also recommended a more rigorous process for determining risk-weighted assets. Prior to Basel III, some assets were assigned low risk based on liberal ratings by ratings agencies. Basel III proposed that banks apply scenario analysis to determine how the values of their assets would be affected based on possible adverse economic scenarios.

   Basel III also recommended that banks maintain an extra layer of Tier 1 capital (called a capital conservation buffer) of at least 2.5 percent of risk-weighted assets by 2016. Banks that do not maintain this extra layer could be restricted from making dividend payments, repurchasing stock, or granting bonuses to executives.

   In addition to the increased capital requirements, Basel III also called for liquidity requirements. Some banks that specialize in low-risk loans and have adequate capital might not have adequate liquidity to survive an economic crisis. Basel III proposes that banks maintain sufficient liquidity so that they can easily cover their cash needs under adverse conditions.

18-4e Use of the VaR Method to Determine Capital Levels

To comply with the Basel Accord, banks commonly apply a value-at-risk (VaR) model to assess the risk of their assets, and determine how much capital they should hold. The VaR model can be applied in various ways to determine capital requirements. In general, a bank defines the VaR as the estimated potential loss from its trading businesses that could result from adverse movements in market prices. Banks typically use a 99 percent confidence level, meaning that there is a 99 percent chance that the loss on a given day will be more favorable than the VaR estimate. When applied to a daily time horizon, the actual loss from a bank’s trading businesses should not exceed the estimated loss by VaR on more than 1 out of every 100 days. Banks estimate the VaR by assessing the probability of specific adverse market events (such as an abrupt change in interest rates) and the sensitivity of responses to those events. Banks with a higher maximum loss (based on a 99 percent confidence interval) are subject to higher capital requirements.

   This focus on daily price movements forces banks to monitor their trading positions continuously so that they are immediately aware of any losses. Many banks now have access to the market values of their trading businesses at the end of every day. If banks used a longer-term horizon (such as a month), larger losses might build up before being recognized.

Limitations of the VaR Model
 The VaR model was generally ineffective at detecting the risk of banks during the credit crisis. The VaR model failed to recognize the degree to which the value of bank assets (such as mortgages or mortgage-backed securities) could decline under adverse conditions. The use of historical data from before 2007 did not capture the risk of mortgages because investments in mortgages during that period normally resulted in low defaults. Thus, the VaR model was not adequate for predicting the possible estimated losses.

Limitations of the VaR Model
 The VaR model was generally ineffective at detecting the risk of banks during the credit crisis. The VaR model failed to recognize the degree to which the value of bank assets (such as mortgages or mortgage-backed securities) could decline under adverse conditions. The use of historical data from before 2007 did not capture the risk of mortgages because investments in mortgages during that period normally resulted in low defaults. Thus, the VaR model was not adequate for predicting the possible estimated losses.

18-4f Stress Tests Imposed to Determine Capital Levels

Some banks supplement the VaR estimate with their own stress tests.

EXAMPLE

Kenosha Bank wants to estimate the loss that would occur in response to an extreme adverse market event. First, it identifies an extreme scenario that could occur, such as an increase in interest rates on one day that is at least three standard deviations from the mean daily change in interest rates. (The mean and standard deviation of daily interest rate movements may be based on a recent historical period, such as the last 300 days.) Kenosha Bank then uses this scenario, along with the typical sensitivity of its trading businesses to such a scenario, to estimate the resulting loss on its trading businesses. It may then repeat this exercise based on a scenario of a decline in the market value of stocks that is at least three standard deviations from the mean daily change in stock prices. It may even estimate the possible losses in its trading businesses from an adverse scenario in which interest rates increase and stock prices decline substantially on a given day.

Regulatory Stress Tests during the Credit Crisis
 In 2009, regulators applied stress tests to the largest bank holding companies to determine if the banks had enough capital. These banks account for about half of all loans provided by U.S. banks.

   One of the stress tests applied to banks in April 2009 involved forecasting the likely effect on the banks’ capital levels if the recession existing at that time lasted longer than expected. This adverse scenario would cause banks to incur larger losses farther into the future. As a result, the banks would periodically be forced to use a portion of their capital to cover their losses, resulting in a reduction of their capital over time.

   The potential impact of an adverse scenario such as a deeper recession varies among banks. During the credit crisis, banks that had a larger proportion of real estate assets were expected to suffer larger losses if economic conditions worsened because real estate values were extremely sensitive to economic conditions. Thus banks with considerable exposure to real estate values were more likely to experience capital deficiencies if the recession lasted longer than expected. Regulators focused on banks that were graded poorly on the stress tests in order to ensure that these banks would have sufficient capital even if the recession lasted for a longer period of time. Regulators now impose stress tests on an annual basis for banks with asset levels of $50 billion or larger, but will apply the tests in the future to smaller banks with at least $10 billion in assets.

18-4g Government Infusion of Capital during the Credit Crisis

During the 2008–2010 period, the Troubled Asset Relief Program (TARP) was implemented to boost the capital levels of banks and other financial institutions with excessive exposure to mortgages or mortgage-backed securities. The Treasury injected more than $300 billion into banks and financial institutions, primarily by purchasing preferred stock.

   The injection of funds allowed banks to cushion their loan losses. It was also intended to encourage additional lending by banks and other financial institutions so that qualified firms or individuals could borrow funds. The Treasury also purchased some “toxic” assets that had declined in value, and it even guaranteed against losses of other assets at banks and financial institutions. The financial institutions that received these capital injections were required to make dividend payments to the Treasury, but they could repurchase the preferred stock that they had issued to the Treasury (in essence, repaying the funds injected by the Treasury) once their financial position improved.

   As a result of this program, the government became a large investor in banks and other financial institutions. For example, by February 2009, the Treasury had a 36 percent ownership stake in Citicorp. By June 2010, more than half of the TARP funds that were extended by the federal government were repaid, and the program generated more than $20 billion in revenue that was due primarily to dividends received on preferred stock that was purchased.

   In October 2010, the TARP program stopped extending new funds to banks and other financial institutions. Although the government was subject to some criticism for its intervention in the banking system, it was also complimented for restoring the confidence of depositors and investors in the system.

18-5 HOW REGULATORS MONITOR BANKS

Bank regulators typically conduct an on-site examination of each commercial bank at least once a year. During the examination, regulators assess the bank’s compliance with existing regulations and its financial condition. In addition to on-site examinations, regulators periodically monitor commercial banks with computerized monitoring systems that analyze data provided by the banks on a quarterly basis.

WEB

www.fdic.gov

Information about specific bank regulations.

18-5a CAMELS Ratings

Regulators monitor banks to detect any serious deficiencies that might develop so that they can correct the deficiencies before the bank fails. The more failures they can prevent, the more confidence the public will have in the banking industry. The evaluation approach described here is used by the FDIC, the Federal Reserve, and the Comptroller of the Currency.

   The single most common cause of bank failure is poor management. Unfortunately, no reliable measure of poor management exists. Therefore, the regulators rate banks on the basis of six characteristics that constitute the 

CAMELS ratings

, so named for the acronym that identifies the six characteristics:

· ▪ Capital adequacy

· ▪ Asset quality

· ▪ Management

· ▪ Earnings

· ▪ Liquidity

· ▪ Sensitivity

   Each of the CAMELS characteristics is rated on a 1-to-5 scale, with 1 indicating outstanding and 5 very poor. A composite rating is determined as the mean rating of the six characteristics. Banks with a composite rating of 4.0 or higher are considered to be problem banks. They are closely monitored because their risk level is perceived to be very high.

Capital Adequacy
 Because adequate bank capital is thought to reduce a bank’s risk, regulators determine the 

capital ratio

 (typically defined as capital divided by assets). Regulators have become increasingly concerned that some banks do not hold enough capital, so they have increased capital requirements. If banks hold more capital, they can more easily absorb potential losses and are more likely to survive. Banks with higher capital ratios are therefore assigned a higher capital adequacy rating. Even a bank with a relatively high level of capital could fail, however, if the other components of its balance sheet have not been properly managed. Thus, regulators must evaluate other characteristics of banks in addition to capital adequacy.

   Because a bank’s capital requirements depend on the value of its assets, they are subject to the accounting method that is used in the valuation process. Fair value accounting is used to measure the value of bank assets. That is, a bank is required to periodically mark its assets to market so that it can revise the amount of needed capital based on the reduced market value of the assets. During the credit crisis, the secondary market for mortgage-backed securities and mortgage loans was so illiquid that banks would have had to sell these assets at very low prices (large discounts). Consequently, the fair value accounting method forced the banks to “write down” the value of their assets.

   Given a decline in a bank’s book value of assets and no associated change in its book value of liabilities, a bank’s balance sheet is balanced by reducing its capital. Thus many banks were required to replenish their capital in order to meet the capital requirements, and some banks came under extra scrutiny by regulators. Some banks satisfied the capital requirements by selling some of their assets, but they would have preferred not to sell assets during this period because there were not many buyers and the market price of these assets was low. An alternative method of meeting capital requirements is to issue new stock, but since bank stock values were so low during the credit crisis, this was not a viable option at that time.

   Banks complained that their capital was reduced because of the fair value accounting rules. They argued that their assets should have been valued higher if the banks intended to hold them until the credit crisis ended and the secondary market for these assets became more liquid. If the banks’ assets had been valued in this manner, their write-downs of assets would have been much smaller, and the banks could have more easily met the capital requirements. As a result of the banks’ complaints, the fair value accounting rules were modified somewhat in 2009.

Asset Quality
 Each bank makes its own decisions as to how deposited funds should be allocated, and these decisions determine its level of credit (default) risk. Regulators therefore evaluate the quality of the bank’s assets, including its loans and its securities.

EXAMPLE

The Fed considers “the 5 Cs” to assess the quality of the loans extended by Skyler Bank, which it is examining:

· ▪ Capacity-the borrower’s ability to pay

· ▪ Collateral-the quality of the assets that back the loan

· ▪ Condition-the circumstances that led to the need for funds

· ▪ Capital-the difference between the value of the borrower’s assets and its liabilities

· ▪ Character-the borrower’s willingness to repay loans as measured by its payment history on the loan and credit report

   From an assessment of a sample of Skyler Bank’s loans, the Fed determines that the borrowers have excessive debt, minimal collateral, and low capital levels. Thus, the Fed concludes that Skyler Bank’s asset quality is weak.

Rating an asset portfolio can be difficult, as the following example illustrates.

EXAMPLE

A bank currently has 1 ,000 loans outstanding to firms in a variety of industries. Each loan has specific provisions as to how it is secured (if at all) by the borrower’s assets; some of the loans have short-term maturities, while others are for longer terms. Imagine the task of assigning a rating to this bank’s asset quality. Even if all the bank’s loan recipients are current on their loan repayment schedules, this does not guarantee that the bank’s asset quality deserves a high rating. The economic conditions existing during the period of prompt loan repayment may not persist in the future. Thus, an appropriate examination of the bank’s asset portfolio should incorporate the portfolio’s exposure to potential events (such as a recession). The reason for the regulatory examination is not to grade past performance but rather to detect any problem that could cause the bank to fail in the future.

   Because of the difficulty in assigning a rating to a bank’s asset portfolio, it is possible that some banks will be rated lower or higher than they deserve.

Management
 Each of the characteristics examined relates to the bank’s management. In addition, regulators specifically rate the bank’s management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment. They also assess the bank’s internal control systems, which may indicate how easily the bank’s management could detect its own financial problems. This evaluation is clearly subjective.

Earnings
 Although the CAMELS ratings are mostly concerned with risk, earnings are very important. Banks fail when their earnings become consistently negative. A profitability ratio commonly used to evaluate banks is 

return on assets (ROA)

, defined as after-tax earnings divided by assets. In addition to assessing a bank’s earnings over time, it is also useful to compare the bank’s earnings with industry earnings. This allows for an evaluation of the bank relative to its competitors. In addition, regulators are concerned about how a bank’s earnings would change if economic conditions change.

Liquidity
 Some banks commonly obtain funds from outside sources (such as the Federal Reserve or the federal funds market), but regulators would prefer that banks not consistently rely on these sources. Such banks are more likely to experience a liquidity crisis whereby they are forced to borrow excessive amounts of funds from outside sources. If existing depositors sense that the bank is experiencing a liquidity problem, they may withdraw their funds, compounding the problem.

Sensitivity
 Regulators also assess the degree to which a bank might be exposed to adverse financial market conditions. Two banks could be rated similarly in terms of recent earnings, liquidity, and other characteristics, yet one of them may be much more sensitive than the other to financial market conditions. Regulators began to explicitly consider banks’ sensitivity to financial market conditions in 1996 and added this characteristic to what was previously referred to as the CAMEL ratings. In particular, regulators place much emphasis on a bank’s sensitivity to interest rate movements. Many banks have liabilities that are repriced more frequently than their assets and are therefore adversely affected by rising interest rates. Banks that are more sensitive to rising interest rates are more likely to experience financial problems.

Limitations of the CAMELS Rating System
 The CAMELS rating system is essentially a screening device. Because there are so many banks, regulators do not have the resources to closely monitor each bank on a frequent basis. The rating system identifies what are believed to be problem banks. Over time, other banks are added to the “problem list,” some problem banks improve and are removed from the list, and others may deteriorate further and ultimately fail.

   Although examinations by regulators may help detect problems experienced by some banks in time to save them, many problems still go unnoticed; by the time they are detected, it may be too late to find a remedy. Because financial ratios measure current or past performance rather than future performance, they do not always detect problems in time to correct them. Thus, although an analysis of financial ratios can be useful, the task of assessing a bank is as much an art as it is a science. Subjective opinion must complement objective measurements to provide the best possible evaluation of a bank.

   Any system used to detect financial problems may err in one of two ways. It may classify a bank as safe when in fact it is failing or it may classify a bank as risky when in fact it is safe. The first type of mistake is more costly, because some failing banks are not identified in time to help them. To avoid this mistake, bank regulators could lower their benchmark composite rating. If they did, however, many more banks would be on the problem list and require close supervision, so regulators’ limited resources would be spread too thin.

18-5b Corrective Action by Regulators

WEB

www.occ.treas.gov/interp/monthly.htm

Information on the Latest bank regulations and their interpretation from the Office of the Comptroller.

When a bank is classified as a problem bank, regulators thoroughly investigate the cause of its deterioration. Corrective action is often necessary. Regulators may examine such banks frequently and thoroughly and will discuss with bank management possible remedies to cure the key problems. For example, regulators may request that a bank boost its capital level or delay its plans to expand. They can require that additional financial information be periodically updated to allow continued monitoring. They have the authority to remove particular officers and directors of a problem bank if doing so would enhance the bank’s performance. They even have the authority to take legal action against a problem bank if the bank does not comply with their suggested remedies. Such a drastic measure is rare, however, and would not solve the existing problems of the bank.

18-5c Funding the Closure of Failing Banks

If a failing bank cannot be saved, it will be closed. The FDIC is responsible for the closure of failing banks. It must decide whether to liquidate the failed bank’s assets or to facilitate the acquisition of that bank by another bank. When liquidating a failed bank, the FDIC draws from its Deposit Insurance Fund to reimburse insured depositors. After reimbursing depositors, the FDIC attempts to sell any marketable assets (such as securities and some loans) of the failed bank. The cost to the FDIC of closing a failed bank is the difference between the reimbursement to depositors and the proceeds received from selling the failed bank’s assets.

18-6 GOVERNMENT RESCUE OF FAILING BANKS

The U.S. government periodically rescues failed banks in various ways. The FDIC provides some financial support to facilitate another bank’s acquisition of the failed bank. The financial support is necessary because the acquiring bank recognizes that the market value of the failed bank’s assets is less than its liabilities. The FDIC may be willing to provide funding if doing so would be less costly than liquidating the failed bank. Whether a failing bank is liquidated or acquired by another bank, it loses its identity.

   In some cases, the government has given preferential treatment to certain large troubled banks. For example, the government has occasionally provided short-term loans to a distressed bank or insured all its deposits, even those above the insurance limit, in an effort to encourage depositors to leave their funds in the troubled bank. Or the government might orchestrate a takeover of the troubled bank in a manner that enables the shareholders to receive at least some payment for their shares (when a failed bank is acquired, shareholders ordinarily lose their investment). However, such intervention by the government is controversial.

18-6a Argument for Government Rescue

If all financial institutions that were weak during the credit crisis had been allowed to fail without any intervention, the FDIC might have had to use all of its reserves to reimburse depositors. To the extent that FDIC intervention can reduce the extent of losses at depository institutions, it may reduce the cost to the government (and therefore the taxpayers).

How a Rescue Might Reduce Systemic Risk
 The financial problems of a large bank failure can be contagious to other banks. This so-called systemic risk occurs because of the interconnected transactions between banks. The rescue of large banks might be necessary to reduce systemic risk in the financial system, as illustrated next.

EXAMPLE

Consider a financial system with only four large banks, all of which make many mortgage loans and invest in mortgage-backed securities. Assume that Bank A sold credit default swaps to Banks B, C, and D and so receives periodic payments from those banks. It will have to make a large payment to these banks if a particular set of mortgages default.

   Now assume that the economy weakens and many mortgages default, including the mortgages referenced by the credit default swap agreements. This means that Bank A now owes a large payment to Banks B, C, and D. But since Bank A incurred losses from its own mortgage portfolio, it cannot follow through on its payment obligation to the other banks. Meanwhile, Banks B, C, and D may have used the credit default swap position to hedge their existing mortgage holdings; however, if they do not receive the large payment from Bank A, they incur losses without any offsetting gains.

   If bank regulators do not rescue Bank A, then all four banks may fail because of Bank A’s connections with the other three banks. However, if bank regulators rescue Bank A then Bank A can make its payments to Banks B, C, and D, and all banks should survive. Thus, a rescue may be necessary to stabilize the financial system.

   In reality, the financial system is supported not only by a few large banks, but by many different types of financial institutions. The previous example is not restricted to banks, but extends to all types of financial institutions that can engage in those types of transactions. Furthermore, a government rescue of a bank benefits not only bank executives, but bank employees at all levels. To the extent that a government rescue can stabilize the banking system, it can indirectly stimulate all the sectors that rely on funding from the banking system. This potential benefit was especially relevant during the credit crisis.

18-6b Argument against Government Rescue

Those who oppose government rescues say that, when the federal government rescues a large bank, it sends a message to the banking industry that large banks will not be allowed to fail. Consequently, large banks may take excessive risks without concern about failure. If a large bank’s risky ventures (such as loans to risky borrowers) pay off, the return will be high. If they do not pay off, the federal government will bail the bank out. If large banks can be sure that they will be rescued, their shareholders will benefit because they face limited downside risk.

   Some critics recommend a policy of letting the market work, meaning that no financial institution would ever be bailed out. In this case, managers of a troubled bank would be held accountable for their bad management because their jobs would be terminated in response to the bank’s failure. In addition, shareholders would more closely monitor the bank managers to make sure that they do not take excessive risk.

18-6c Government Rescue of Bear Stearns

The credit crisis led to new arguments about government rescues of failing financial institutions. In March 2008, Bear Stearns (a large securities firm) was about to go bankrupt. Bear Stearns had facilitated many transactions in financial markets, and its failure would have delayed them and so caused liquidity problems for many individuals and firms that were to receive cash as a result of those transactions. The Federal Reserve provided short-term loans to Bear Stearns to ensure that it had adequate liquidity. The Fed then backed the acquisition of Bear Stearns by JPMorgan Chase by providing a loan so that JPMorgan Chase could afford the acquisition.

   At this point, the question was whether the Federal Reserve (a regulator of commercial banks) should be assisting a securities firm such as Bear Stearns that it did not regulate. Some critics (including Paul Volcker, a previous chair of the Fed) suggested that the rescue of a firm other than a commercial bank should be the responsibility of Congress and not the Fed. The Fed’s counter was that it recognized that many financial transactions would potentially be frozen if it did not intervene. Thus, it was acting in an attempt to stabilize the financial system rather than in its role as a regulator of commercial banks.

18-6d Failure of Lehman and Rescue of AIG

In September 2008, Lehman Brothers (another large securities firm) was allowed to go bankrupt without any assistance from the Fed even though American International Group (AIG, a large insurance company) was rescued by the Fed. Some critics asked why some large financial institutions were bailed out but others were not. At what point does a financial institution become sufficiently large or important that it deserves to be rescued? This question will continue to trigger heated arguments.

   Lehman Brothers was a large financial institution with more than $600 billion in assets. However, it might have been difficult to find another financial institution willing to acquire Lehman Brothers without an enormous subsidy from the federal government. Many of the assets held by Lehman Brothers (such as the mortgage-backed securities) were worth substantially less in the market than the book value assigned to them by Lehman.

   American International Group had more than $1 trillion in assets when it was rescued and, like Lehman, had many obligations to other financial institutions because of its credit default swap arrangements. However, one important difference between AIG and Lehman Brothers was that AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the federal government to rescue AIG. From the federal government’s perspective, the risk of taxpayer loss due to the AIG rescue was low. In contrast, Lehman Brothers did not have adequate collateral available and so a large loan from the government could have been costly to U.S. taxpayers.

18-6e Protests of Bank Bailouts

The bailouts during the credit crisis led to the organization of various groups. In 2009, the Tea Party organized and staged protests throughout the United States. Its main theme was that the government was spending excessively, which led to larger budget deficits that arguably could weaken economic conditions. Their proposed solution is to eliminate the bailouts as one form of reducing the excessive government spending.

   In 2011, Occupy Wall Street organized and also staged protests. While this movement also protested government funding decisions, its underlying theme is not as clear. Some protestors within this movement believe that bank bailouts are appropriate, whereas others do not. In addition, many protestors wanted the government to direct more funding to their own specials interests, such as health care, education, or programs to reduce unemployment. This led to the common sign or phrase associated with Occupy Wall Street protests: “Where’s my bailout?” Although the Occupy Wall Street movement gained much support for protesting against the government, there does not appear to be a clear consensus solution among protestors regarding bailouts or the proper use of government funding.

18-7 FINANCIAL REFORM ACT OF 2010

In July, 2010, the Financial Reform Act (also referred to as the Dodd-Frank Act, or the Wall Street Reform and Consumer Protection Act) was implemented. This act contained numerous provisions regarding financial services. The provisions that concern bank regulation are summarized here.

18-7a Mortgage Origination

The Financial Reform Act requires that banks and other financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy, which should minimize the possibility of a future credit crisis. It may seem that this provision would naturally be followed even if there was no law. Yet there were many blatant violations shortly before and during the credit crisis in which mortgages were approved for applicants who were clearly not creditworthy.

18-7b Sales of Mortgage-Backed Securities

The act requires that banks and other financial institutions that sell mortgage-backed securities retain 5 percent of the portfolio unless it meets specific standards that reflect low risk. This provision forces financial institutions to maintain a stake in the mortgage portfolios that they sell. The act also requires more disclosure regarding the quality of the underlying assets when mortgage-backed securities are sold.

18-7c Financial Stability Oversight Council

The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the United States and makes recommendations that regulators can follow to reduce risks to the financial system. The council can recommend methods to ensure that banks do not rely on regulatory bailouts, which may prevent situations where a large financial institution is viewed as too big to fail. Furthermore, it can recommend rules such as higher capital requirements for banks that are perceived to be too big and complex, which may prevent these banks from becoming too risky.

   The council consists of 10 members, including the Treasury Secretary (who chairs the council) and the heads of three regulatory agencies that monitor banks: the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. Because systemic risk in the financial system may be caused by financial security transactions that connect banks with other types of financial institutions, the council also includes the head of the Securities and Exchange Commission and of the U.S. Commodities Futures Trading Commission. The remaining members are the heads of the National Credit Union Association, the Federal Housing Finance Agency, and the Consumer Financial Protection Bureau (described shortly) as well as an independent member with insurance experience who is appointed by the President.

18-7d Orderly Liquidation

The act assigned specific regulators with the authority to determine whether any particular financial institution should be liquidated. This expedites the liquidation process and can limit the losses incurred by a failing financial institution. The act calls for the creation of an orderly liquidation fund that can be used to finance the liquidation of any financial institution that is not covered by the Federal Deposit Insurance Corporation. Shareholders and unsecured creditors are expected to bear most of the losses of failing financial institutions, so they are not covered by this fund. If losses are beyond what can be absorbed by shareholders and unsecured creditors, other financial institutions in the corresponding industry are expected to bear the cost of the liquidation. The liquidations are not to be financed by taxpayers.

18-7e Consumer Financial Protection Bureau

The act established the Consumer Financial Protection Bureau, which is responsible for regulating consumer finance products and services offered by commercial banks and other financial institutions, such as online banking, checking accounts, and credit cards. The bureau can set rules to ensure that bank disclosure about financial products is accurate and to prevent deceptive financial practices.

18-7f Limits on Bank Proprietary Trading

The act mandates that commercial banks must limit their proprietary trading, in which they pool money received from customers and use it to make investments for the bank’s clients. A commercial bank can use no more than 3 percent of its capital to invest in hedge fund institutions, private equity funds, or real estate funds (combined). This requirement has also been referred to as the Volcker rule, and it has led to much controversy.

   The implementation of the limits on proprietary trading has been deferred to July 2014. This gives banks time to sell divisions if they exceed the limit. This provision had a larger impact on securities firms (such as Goldman Sachs and Morgan Stanley) that had converted to bank holding companies shortly before the act, because those firms had previously engaged in heavy proprietary trading.

   The general argument for this rule is that commercial banks should not be making investments in extremely risky projects. If they want to pursue very high returns (and therefore be exposed to very high risk), they should not be part of the banking system, and should not have access to depositor funds, or be able to obtain deposit insurance. That is, if they want to invest like hedge funds, they should apply to be hedge funds and not commercial banks.

   However, some critics believe that the Volcker rule could prevent U.S. banks from competing against other banks on a global basis. In addition, there is much disagreement regarding the degree to which banks should be allowed to take risks. Some critics argue that the Volcker rule would not have prevented some banks from making the risky investments that caused them to go bankrupt during the credit crisis. Furthermore, although JPMorgan Chase posted a trading loss of $2 billion in May 2012 while the Volcker rules were still being developed, it has been argued that the trades that caused that loss would not have been prohibited by the Volcker rule. There are also concerns that the provisions of the Volcker rule are not sufficiently clear, which will allow some banks to circumvent the rule when making investments by using their own interpretations of the rule.

18-7g Trading of Derivative Securities

The act requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter. This provision should enable a more standardized structure regarding margins and collateral as well as more transparency of prices in the market. Consequently, banks that trade these derivatives should be less susceptible to risk that the counterparty posted insufficient collateral.

18-8 GLOBAL BANK REGULATIONS

Although the division of regulatory power between the central bank and other regulators varies among countries, each country has a system for monitoring and regulating commercial banks. Most countries also maintain different guidelines for deposit insurance. Differences in regulatory restrictions give some banks a competitive advantage in a global banking environment.

   Historically, Canadian banks were not as restricted in offering securities services as U.S. banks and therefore control much of the Canadian securities industry. Recently, Canadian banks have begun to enter the insurance industry. European banks have had much more freedom than U.S. banks in offering securities services such as underwriting corporate securities. Many European banks are allowed to invest in stocks.

   Japanese commercial banks have some flexibility to provide investment banking services, but not as much as European banks. Perhaps the most obvious difference between Japanese and U.S. bank regulations is that Japanese banks are allowed to use depositor funds to invest in stocks of corporations. Thus, Japanese banks are not only the creditors of firms but also their shareholders.

SUMMARY

· ▪ Banks must observe regulations on the deposit insurance they must maintain, their loan composition, the bonds they are allowed to purchase, and the financial services they can offer. In general, regulations on deposits and financial services have been loosened in recent decades in order to allow for more competition among banks. When a bank is failing, the FDIC or other government agencies consider whether it can be saved. During the credit crisis, many banks failed and also Lehman Brothers failed, but the government rescued American International Group (AIG). Unlike Lehman brothers, AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the government to rescue AIG.

· ▪ Capital requirements are intended to ensure that banks have a cushion against any losses. The requirements have become more stringent and are risk adjusted so that banks with more risk are required to maintain a higher level of capital.

· ▪ Bank regulators monitor banks by focusing on six criteria: capital, asset quality, management, earnings, liquidity, and sensitivity to financial market conditions. Regulators assign ratings to these criteria in order to determine whether corrective action is necessary.

· ▪ In July 2010, the Financial Reform Act was implemented. It set more stringent standards for mortgage applicants, required banks to maintain a stake in the mortgage portfolios that they sell, and established a Consumer Financial Protection Bureau to regulate consumer finance products and services offered by commercial banks and other financial institutions.

POINT COUNTER-POINT

Should Regulators Intervene to Take Over Weak Bank?

Point
 Yes. Intervention could turn a bank around before weak management results in failure. Bank failures require funding from the FDIC to reimburse depositors up to the deposit insurance limit. This cost could be avoided if the bank’s problems are corrected before it fails.

Counter-Point
 No. Regulators will not necessarily manage banks any better. Also, this would lead to excessive government intervention each time a bank experienced problems. Banks would use a very conservative management approach to avoid intervention, but this approach would not necessarily appeal to their shareholders who want high returns on their investment.

Who is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Regulation of Bank Sources and Uses of Funds How are a bank’s balance sheet decisions regulated?

· 2. Off-Balance Sheet Activities Provide examples of off–balance sheet activities. Why are regulators concerned about them?

· 3. Moral Hazard and the Credit Crisis Explain why the moral hazard problem received so much attention during the credit crisis.

· 4. FDIC Insurance What led to the establishment of FDIC insurance?

· 5. Glass-Stagall Act Briefly describe the Glass-Steagall Act. Then explain how the related regulations have changed.

· 6. DIDMCA Describe the main provisions of the DIDMCA that relate to deregulation.

· 7. CAMELS Ratings Explain how the CAMELS ratings are used.

· 8. Uniform Capital Requirements Explain how the uniform capital requirements established by the Basel Accord can discourage banks from taking excessive risk.

· 9. Value at Risk Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital.

· 10. HLTs Describe highly leveraged transactions (HLTs), and explain why a bank’s exposure to HLTs is closely monitored by regulators.

· 11. Bank Underwriting Given the higher capital requirements now imposed on them, why might banks be even more interested in underwriting corporate debt issues?

· 12. Moral Hazard Explain the moral hazard problem as it relates to deposit insurance.

· 13. Economies of Scale How do economies of scale in banking relate to the issue of interstate banking?

· 14. Contagion Effects How can the financial problems of one large bank affect the market’s risk evaluation of other large banks?

· 15. Regulating Bank Failures Why are bank regulators more concerned about a large bank failure than a small bank failure?

· 16. Financial Services Modernization Acr Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations and changed the competitive landscape among financial institutions.

· 17. Impact of SOX on Banks Explain how the Sarbanes-Oxley Act improved the transparency of banks. Why might the act have a negative impact on some banks?

· 18. Conversion of Securities Firms to BHCs Explain how the conversion of a securities firm to a bank holding company (BHC) structure might reduce its risk.

· 19. Capital Requirements during the Credit Crisis Explain how the accounting method applied to mortgage-backed securities made it more difficult for banks to satisfy capital requirements during the credit crisis.

· 20. Fed Assistance to Bear Stearns Explain why regulators might argue that the assistance they provided to Bear Stearns was necessary.

· 21. Fed Aid to Nonbanks Should the Fed have the power to provide assistance to firms, such as Bear Stearns, that are not commercial banks?

· 22. Regulation of Credit Default Swaps Why were bank regulators concerned about credit default swaps during the credit crisis?

· 23. Impact of Bank consolidation on Regulation Explain how bank regulation can be more effective when there is consolidation of banks and securities firms.

· 24. Concerns about Systematic Risk during the Credit Crisis Explain why the credit crisis caused concerns about systemic risk.

· 25. Troubled Asset Relief Program (TARP) Explain how the Troubled Asset Relief Program was expected to help resolve problems during the credit crisis.

· 26. Financial Reform Act Explain how the Financial Reform Act resolved some problems during the credit crisis.

· 27. Bank Deposit Insurance Reserves What changes to reserve requirements were added by The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010?

· 28. Basel III Changes to Capital and Liquidity Requirements How did Basel III change capital and liquidity requirements for banks?

Interpreting Financial News

Interpret the following comments made by Wall Street analysts and portfolio managers.

· a. “The FDIC recently subsidized a buyer for a failing bank, which had different effects on FDIC costs than if the FDIC had closed the bank.”

· b. “Bank of America has pursued the acquisition of many failed banks because it sees potential benefits.”

· c. “By allowing a failing bank time to resolve its financial problems, the FDIC imposes an additional tax on taxpayers.”

Managing in Financial Markets

Effect of Bank Strategies on Bank Ratings A bank has asked you to assess various strategies it is considering and explain how they could affect its regulatory review. Regulatory reviews include an assessment of capital, asset quality, management, earnings, liquidity, and sensitivity to financial market conditions. Many types of strategies can result in more favorable regulatory reviews based on some criteria but less favorable reviews based on other criteria. The bank is planning to issue more stock, retain more of its earnings, increase its holdings of Treasury securities, and reduce its business loans. The bank has historically been rated favorably by regulators yet believes that these strategies will result in an even more favorable regulatory assessment.

· a. Which regulatory criteria will be affected by the bank’s strategies? How?

· b. Do you believe that the strategies planned by the bank will satisfy its shareholders? Is it possible for the bank to use strategies that would satisfy both regulators and shareholders? Explain.

· c. Do you believe that the strategies planned by the bank will satisfy the bank’s managers? Explain.

FLOW OF FUNDS EXERCISE

Impact of Regulation and Deregulation on Financial Services

Carson Company relies heavily on commercial banks for funding and for some other services.

· a. Explain how the services provided by a commercial bank (just the banking, not the nonbank, services) to Carson may be limited because of bank regulation.

· b. Explain the types of nonbank services that Carson Company can receive from the subsidiaries of a commercial bank as a result of deregulation. How might Carson Company be affected by the deregulation that allows subsidiaries of a commercial bank to offer nonbank services?

INTERNET/EXCEL EXERCISE

Browse the most recent Quarterly Banking Profile at 

www.fdic.gov/bank/analytical/index.html

. Review the information provided about failed banks, and describe how regulators responded to one recent bank failure listed here.

WSJ EXERCISE

Impact of Bank Regulations

Using a recent issue of the Wall Street Journal, summarize an article that discusses a particular commercial bank regulation that has recently been passed or is currently being considered by regulators. (You may wish to use the Wall Street Journal Index to identify a specific article on a commercial banking regulation or bill.) Would this regulation have a favorable or unfavorable impact on commercial banks? Explain.

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. bank AND deposit insurance

· 2. bank AND moral hazard

· 3. bank loans AND regulation

· 4. bank investments AND regulation

· 5. bank capital AND regulation

· 6. bank regulator AND rating banks

·

7. bank regulator AND stress test

· 8. too big to fail AND conflict

· 9. bank regulation AND conflict

· 10. government rescue AND bank

5 Monetary Policy

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the mechanics of monetary policy,

· ▪ explain the tradeoffs involved in monetary policy,

· ▪ describe how financial market participants respond to the Fed’s policies, and

· ▪ explain how monetary policy is affected by the global environment.

The previous chapter discussed the Federal Reserve System and how it controls the money supply, information essential to financial market participants. It is just as important for participants to know how changes in the money supply affect the economy, which is the subject of this chapter.

5-1 MECHANICS OF MONETARY POLICY

Recall from 

Chapter 4

 that the Federal Open Market Committee (FOMC) is responsible for determining the monetary policy. Also recall that the Fed’s goals are to achieve a low level of inflation and a low level of unemployment. This goal is consistent with the goals of most central banks, although the stated goals of some central banks are more broadly defined (e.g., “achieving economic stability”). Given the Fed’s goals of controlling economic growth and inflation, it must assess the prevailing indicators of these economic variables before determining its monetary policy.

5-1a Monitoring Indicators of Economic Growth

The Fed monitors indicators of economic growth because high economic growth creates a more prosperous economy and can result in lower unemployment. Gross domestic product (GDP), which measures the total value of goods and services produced during a specific period, is measured each month. It serves as the most direct indicator of economic growth in the United States. The level of production adjusts in response to changes in consumers’ demand for goods and services. A high production level indicates strong economic growth and can result in an increased demand for labor (lower unemployment).

   The Fed also monitors national income, which is the total income earned by firms and individual employees during a specific period. A strong demand for U.S. goods and services results in a large amount of revenue for firms. In order to accommodate demand, firms hire more employees or increase the work hours of their existing employees. Thus the total income earned by employees rises.

   The unemployment rate is monitored as well, because one of the Fed’s primary goals is to maintain a low rate of unemployment in the United States. However, the unemployment rate does not necessarily indicate the degree of economic growth: it measures only the number and not the types of jobs that are being filled. It is possible to have a substantial reduction in unemployment during a period of weak economic growth if new, low-paying jobs are created during that period.

   Several other indexes serve as indicators of growth in specific sectors of the U.S. economy; these include an industrial production index, a retail sales index, and a home sales index. A composite index combines various indexes to indicate economic growth across sectors. In addition to the many indicators reflecting recent conditions, the Fed may also use forward-looking indicators (such as consumer confidence surveys) to forecast future economic growth.

Index of Leading Economic Indicators
 Among the economic indicators widely followed by market participants are the indexes of leading, coincident, and lagging economic indicators, which are published by the Conference Board. 

Leading economic indicators

 are used to predict future economic activity. Usually, three consecutive monthly changes in the same direction in these indicators suggest a turning point in the economy. 

Coincident economic indicators

 tend to reach their peaks and troughs at the same time as business cycles. 

Lagging economic indicators

 tend to rise or fall a few months after business-cycle expansions and contractions.

   The Conference Board is an independent, not-for-profit, membership organization whose stated goal is to create and disseminate knowledge about management and the marketplace to help businesses strengthen their performance and better serve society. The Conference Board conducts research, convenes conferences, makes forecasts, assesses trends, and publishes information and analyses. A summary of the Conference Board’s leading, coincident, and lagging indexes is provided in 
Exhibit 5.1
.

Exhibit 5.1 The Conference Board’s Indexes of Leading, Coincident, and Lagging Indicators

Leading Index

1. Average weekly hours, manufacturing

2. Average weekly initial claims for unemployment insurance

3. Manufacturers’ new orders, consumer goods and materials

4. Vendor performance, slower deliveries diffusion index

5. Manufacturers’ new orders, nondefense capital goods

6. Building permits, new private housing units

7. Stock prices, 500 common stocks

8. Money supply, M2

9. Interest rate spread, 10-year Treasury bonds less federal funds

10. Index of consumer expectations

Coincident Index

1. Employees on nonagricultural payrolls

2. Personal income less transfer payments

3. Industrial production

4. Manufacturing and trade sales

Lagging Index

1. Average duration of unemployment

2. Inventories to sales ratio, manufacturing and trade

3. Labor cost per unit of output, manufacturing

4. Average prime rate

5. Commercial and industrial loans

6. Consumer installment credit to personal income ratio

7. Consumer price index for services

5-1b Monitoring Indicators of Inflation

The Fed closely monitors price indexes and other indicators to assess the U.S. inflation rate.

Producer and Consumer Price Indexes
 The producer price index represents prices at the wholesale level, and the consumer price index represents prices paid by consumers (retail level). There is a lag time of about one month after the period being measured due to the time required to compile price information for the indexes. Nevertheless, financial markets closely monitor the price indexes because they may be used to forecast inflation, which affects nominal interest rates and the prices of some securities. Agricultural price indexes reflect recent price movements in grains, fruits, and vegetables. Housing price indexes reflect recent price movements in homes and rental properties.

Other Inflation Indicators
 In addition to price indexes, there are several other indicators of inflation. Wage rates are periodically reported in various regions of the United States. Because wages and prices are highly correlated over the long run, wages can indicate price movements. Oil prices can signal future inflation because they affect the costs of some forms of production as well as transportation costs and the prices paid by consumers for gasoline.

   The price of gold is closely monitored because gold prices tend to move in tandem with inflation. Some investors buy gold as a hedge against future inflation. Therefore, a rise in gold prices may signal the market’s expectation that inflation will increase.

   Indicators of economic growth might also be used to indicate inflation. For example, the release of several favorable employment reports may arouse concern that the economy will overheat and lead to 

demand-pull inflation

, which occurs when excessive spending pulls up prices. Although these reports offer favorable information about economic growth, their information about inflation is unfavorable. The financial markets can be adversely affected by such reports, because investors anticipate that the Fed will have to increase interest rates in order to reduce the inflationary momentum.

5-2 IMPLEMENTING MONETARY POLICY

The Federal Open Market Committee assesses economic conditions, and identifies its main concerns about the economy to determine the monetary policy that would alleviate its concerns. Its monetary policy changes the money supply in order to influence interest rates, which affect the level of aggregate borrowing and spending by households and firms. The level of aggregate spending affects demand for products and services, and therefore affects both price levels (inflation) and the unemployment level.

5-2a Effects of a Stimulative Monetary Policy

The effects of a stimulative monetary policy can be illustrated using the loanable funds framework described in 

Chapter 2

. Recall that the interaction between the supply of loanable funds and the demand for loanable funds determines the interest rate charged on such funds. Much of the demand for loanable funds is by households, firms, and government agencies that need to borrow money. Recall that the demand curve indicates the quantity of funds that would be demanded (at that time) at various possible interest rates. This curve is downward sloping because many potential borrowers would borrow a larger quantity of funds at lower interest rates.

   The supply curve of loanable funds indicates the quantity of funds that would be supplied (at that time) at various possible interest rates. This curve is upward sloping because suppliers of funds tend to supply a larger amount of funds when the interest rate is higher. Assume that, as of today, the demand and supply curves for loanable funds are those labeled D1 and S1 (respectively) in the left graph of 

Exhibit 5.2

. This plot reveals that the equilibrium interest rate is i1. The right graph of 
Exhibit 5.2
 depicts the typical relationship between the interest rate on loanable funds and the current level of business investment. The relation is inverse because firms are more willing to expand when interest rates are relatively low. Given an equilibrium interest rate of i1, the level of business investment is B1.

Exhibit 5.2 Effects of an Increased Money Supply

   With a stimulative monetary policy, the Fed increases the supply of funds in the banking system, which can increase the level of business investment, and hence aggregate spending in the economy.

   The Fed purchases Treasury securities in the secondary market. As the investors who sell their Treasury securities receive payment from the Fed, their account balances at financial institutions increase without any offsetting decrease in the account balances of any other financial institutions. Thus there is a net increase in the total supply of loanable funds in the banking system.

Impact on Interest Rates
 If the Fed’s action results in an increase of $5 billion in loanable funds, then the quantity of loanable funds supplied will now be $5 billion higher at any possible interest rate level. This means that the supply curve for loanable funds shifts outward to S2 in 
Exhibit 5.2
. The difference between S2 and S1 is that S2 incorporates the $5 billion of loanable funds added as a result of the Fed’s actions.

   Given the shift in the supply curve for loanable funds, the quantity of loanable funds supplied exceeds the quantity of loanable funds demanded at the interest rate level i1. The interest rate will therefore decline to i2, the level at which the quantities of loanable funds supplied and demanded are equal.

Logic Behind the Impact on Interest Rates
 The graphic effects are supplemented here with a logical explanation for why the interest rates decline in response to the monetary policy. When depository institutions experience an increase in supply of funds due to the Fed’s stimulative monetary policy, they have more funds than they need at prevailing interest rates. Those depository institutions that commonly obtain very short-term loans (such as one day) in the so-called federal funds may not need to borrow as many funds. Those depository institutions that commonly lend to others in this market may be more willing to accept a lower interest rate (called the federal funds rate) when providing short-term loans in this market. The federal funds rate is directly affected by changes to the supply of money in the banking system. The Fed’s monetary policy is commonly intended to alter the supply of funds in the banking system in order to achieve a specific targeted federal funds rate, such as reducing that rate from 3 to 2.75 percent or to a value within the range from 2.75 to 3 percent.

   The Fed’s monetary policy actions not only have a direct effect on the federal funds rate, but also affect the Treasury yield (or rate). When the Fed purchases a large amount of Treasury securities, it raises the price of Treasury securities, and therefore lowers the yield (or rate) to be earned by any investors who invest in Treasury securities at the higher prevailing price.

   Most importantly, the impact of the Fed’s stimulative monetary policy indirectly affects other interest rates as well, including loan rates paid by businesses. The lower interest rate level causes an increase in the level of business investment from B1 to B2. That is, businesses are willing to pursue additional projects now that their cost of financing is lower. The increase in business investment represents new business spending triggered by lower interest rates, which reduced the corporate cost of financing new projects.

Logic Behind the Effects on Business Cost of Debt
 Depository institutions are willing to charge a lower loan rate in response to the stimulative monetary policy, since their cost of funds (based on the rate they pay on deposits) is now lower. The institutions also reduce their rates on loans in order to attract more potential borrowers to make use of the newly available funds.

   Another way to understand the effects of a stimulative monetary policy on the business cost of debt is to consider the influence of the risk-free rate on all interest rates. Recall from Chapter 3 that the yield for a security with a particular maturity is primarily based on the risk-free rate (the Treasury rate) for that same maturity plus a credit risk premium. Thus the financing rate on a business loan is based on the risk-free rate plus a premium that reflects the credit risk of the business that is borrowing the money. So if the prevailing Treasury (risk-free) security rate is 5 percent on an annualized basis, a business has a low level of risk that pays a 3 percent credit risk premium when borrowing money would be able to obtain funds at 8 percent (5 percent risk-free rate plus 3 percent credit risk premium). However, if the Fed implements a stimulative monetary policy that reduces the Treasury security rate to 4 percent, the business would be able to borrow funds at 7 percent (4 percent risk-free rate plus 3 percent credit risk premium).

   Businesses with other degrees of credit risk will also be affected by the Fed’s monetary policy. Consider a business with moderate risk that pays a credit premium of 4 percent above the risk-free rate to obtain funds. When the Treasury (risk-free) rate was 5 percent, this business would be able to borrow funds at 9 percent (5 percent risk-free rate plus 4 percent credit risk premium). However, if the Fed implements a stimulative monetary policy that reduces the Treasury security rate to 4 percent, the business would be able to borrow funds at 8 percent (4 percent risk-free rate plus 4 percent credit risk premium).

   The point here is that all businesses (regardless of their risk level) will be able to borrow funds at lower rates as a result of the Fed’s stimulative monetary policy. Therefore, when they consider possible projects such as expanding their product line or building a new facility, they may be more willing to implement some projects as a result of the lower cost of funds. As firms implement more projects, they spend more money, and that extra spending results in higher income to individuals or other firms who receive the proceeds. They may also hire more employees in order to expand their businesses. This generates more income for those new employees, who will spend some of their new income, and that spending provides income to the individuals or firms who receive the proceeds.

Effects on Business Cost of Equity
 Many businesses also rely on equity as another key source of capital. Monetary policy can also influence the cost of equity. The cost of a firm’s equity is based on the risk-free rate, plus a risk premium that reflects the sensitivity of the firm’s stock price movements to general stock market movements. This concept is discussed in more detail in 

Chapter 11

, but the main point for now is that the firm’s cost of equity is positively related to the risk-free rate. Therefore, if the Fed can reduce the risk-free by 1 percent, it can reduce a firm’s cost of equity by 1 percent.

Summary of Effects
 In summary, the Fed’s ability to stimulate the economy are due to its effects on the Treasury (risk-free) rate, which influences the cost of debt and the cost of equity in 

Exhibit 5.3

. As the Fed reduces the risk-free rate, it reduces the firm’s cost of borrowing (debt) and the firm’s cost of equity, and therefore reduces the firm’s cost of capital. If a firm’s cost of capital is reduced, its required return on potential projects is reduced. Thus, more of the possible projects that a firm considers will be judged as feasible and will be implemented. As firms in the U.S. implement more projects that they now believe are feasible, they increase their spending, and this can stimulate the economy and create jobs.

   Notice that for the Fed to stimulate the economy and create more jobs, it is not using its money to purchase products. It is not telling firms that they must hire more employees. Instead, its stimulative monetary policy reduces the cost of funds, which encourages firms to spend more money. In a similar manner, the Fed’s stimulative monetary policy can reduce the cost of borrowing for households as well. As with firms, their cost of borrowing is based on the prevailing risk-free rate plus a credit risk premium. When the Fed’s stimulative monetary policy results in a lower Treasury (risk-free) rate, it lowers the cost of borrowing for households, which encourages households to spend more money. As firms and households increase their spending, they stimulate the economy and create jobs.

Exhibit 5.3 How the Fed Can Stimulate the Economy

5-2b Fed’s Policy Focuses on Long-term Maturities

Yields on Treasury securities can vary among maturities. If the yield curve (discussed in 

Chapter 3

) is upward sloping, this implies that longer-term Treasury securities have higher annualized yields than shorter-term Treasury securities. The Fed had already been able to reduce short-term Treasury rates to near zero with its stimulative monetary policy over the 2010–2012 period. However, this did not have much impact on the firms that borrow at long-term fixed interest rates. These borrowers incur a cost of debt that is highly influenced by the long-term Treasury rates, not the short-term Treasury rates.

   To the extent that the Fed wants to encourage businesses to increase their spending on long-term projects, it may need to use a stimulative policy that is focused on reducing the long-term Treasury yields, which would reduce the long-term debt rates. So if the Fed wants to reduce the rate that these potential borrowers would pay for fixed-rate loans with 10-year maturities, it would attempt to use a monetary policy that reduces the yield on Treasury securities with 10-year maturities (which reflects the 10-year risk-free rate).

   In some periods, the Fed has directed its monetary policy at the trading of Treasury securities with specific maturities so that it can cause a bigger change for some maturities than others. In 2011 and 2012, the Fed periodically implemented an “operation twist” strategy (which it also implemented in 1961). It sold some holdings of short-term Treasury securities, and used the proceeds to purchase long-term Treasury securities. In theory, the strategy would increase short-term interest rates and reduce long-term interest rates, which would reflect a twist of the yield curve.

   The logic behind the strategy is that the Fed should focus on reducing long-term interest rates rather than short-term interest rates in order to encourage firms to borrow and spend more funds. Since firms should be more willing to increase their spending on new projects when long-term interests are reduced, the strategy could help stimulate the economy and create jobs. In addition, potential home buyers might be more willing to purchase homes if long-term interest rates were lower. However, there is not complete agreement on whether this strategy would really have a substantial and sustained effect on long-term interest rates. Money flows between short-term and long-term Treasury markets, which means that it is difficult for the Fed to have one type of impact in the long-term market that is different from that in the short-term market. The operation twist strategy was able to reduce long-term Treasury rates, but its total impact may have been limited for other reasons explained later in this chapter.

5-2c Why a Stimulative Monetary Policy Might Fail

While a stimulative monetary policy is normally desirable when the economy is weak, it is not always effective, for the reasons provided next.

Limited Credit Provided by Banks
 The ability of the Fed to stimulate the economy is partially influenced by the willingness of depository institutions to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers; the result is a credit crunch.

   Banks provide loans only after confirming that the borrower’s future cash flows will be adequate to make loan repayments. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank’s qualification standards.

   Banks and other lending institutions have a responsibility to their depositors, shareholders, and regulators to avoid loans that are likely to default. Because default risk rises during a weak economy, some potential borrowers will be unable to obtain loans. Others may qualify only if they pay high risk premiums to cover their default risk. Thus the effects of the Fed’s monetary policy may be limited if potential borrowers do not qualify or are unwilling to incur the high-risk premiums. If banks do not lend out the additional funds that have been pumped into the banking system by the Fed, the economy will not be stimulated.

EXAMPLE

During the credit crisis that began in 2008, the Fed attempted to stimulate the economy by using monetary policy to reduce interest rates. Initially, however, the effect of the monetary policy was negligible. Firms were unwilling to borrow even at low interest rates because they did not want to expand while economic conditions were so weak. In addition, commercial banks raised the standards necessary to qualify for loans so that they would not repeat any of the mistakes (such as liberal lending standards) that led to the credit crisis. Consequently, the amount of new loans resulting from the Fed’s stimulative monetary policy was limited, and therefore the amount of new spending was limited as well.

Low Return on Savings
 Although the Fed’s policy of reducing interest rates allows for lower borrowing rates, it also results in lower returns on savings. The interest rates on bank deposits are close to zero, which limits the potential returns that can be earned by investors who want to save money. This might encourage individuals to borrow (and spend) rather than save, which could allow for a greater stimulative effect on the economy. However, some individuals that are encouraged to borrow because of lower interest rates may not be able to repay their debt. Therefore, the very low interest rates might lead to more personal bankruptcies.

   Furthermore, some savers, such as retirees, rely heavily on their interest income to cover their periodic expenses. When interest rates are close to zero, interest income is close to zero, and retirees that rely on interest income have to restrict their spending. This effect can partially offset the expected stimulative effect of lower interest rates. Some retirees may decide to invest their money in alternative ways (such as in stocks) instead of as bank deposits when interest rates are low. However, many alternative investments are risky, and could cause retirees to experience losses on their retirement funds.

Adverse Effects on Inflation
 When a stimulative monetary policy is used, the increase in money supply growth may cause an increase in inflationary expectations, which may limit the impact on interest rates.

EXAMPLE

Assume that the U.S. economy is very weak, and suppose the Fed responds by using open market operations (purchasing Treasury securities) to increase the supply of loanable funds. This action is supposed to reduce interest rates and increase the level of borrowing and spending. However, there is some evidence that high money growth may also lead to higher inflation over time. To the extent that businesses and households recognize that an increase in money growth will cause higher inflation, they will revise their inflationary expectations upward as a result. This effect is often referred to as the theory of rational expectations. Higher inflationary expectations encourage businesses and households to increase their demand for loanable funds (as explained in Chapter 2) in order to borrow and make planned expenditures before price levels increase. This increase in demand reflects a rush to make planned purchases now.

   These effects of the Fed’s monetary policy are shown in 

Exhibit 5.4

. The result is an increase in both the supply of loanable funds and the demand for those funds. The effects are offsetting, so the Fed may not be able to reduce interest rates for a sustained period of time. If the Fed cannot force interest rates lower with an active monetary policy, it will be unable to stimulate an increase in the level of business investment. Business investment will increase only if the cost of financing is reduced, making some proposed business projects feasible. If the increase in business investment does not occur, economic conditions will not improve.

Exhibit 5.4 Effects of an Increased Money Supply According to Rational Expectations Theory

   Because the effects of a stimulative policy could be disrupted by expected inflation, an alternative approach is a passive monetary policy that allows the economy to correct itself rather than rely on the Fed’s intervention. Interest rates should ultimately decline in a weak economy even without a stimulative monetary policy because the demand for loanable funds should decline as economic growth weakens. In this case, interest rates would decline without a corresponding increase in inflationary expectations, so the interest rates may stay lower for a sustained period of time. Consequently, the level of business investment should ultimately increase, which should lead to a stronger economy and more jobs.

   The major criticism of a passive monetary policy is that the weak economy could take years to correct itself. During a slow economy, interest rates might not decrease until a year later if the Fed played a passive role and did not intervene to stimulate the economy. Most people would probably prefer that the Fed take an active role in improving economic conditions—rather than take a passive role and simply hope that the economy will correct itself.

   Even if the Fed’s stimulative policy does not affect inflation and if banks are willing to lend the funds received, it is possible that firms and businesses will not be willing to borrow more money. Some firms may have already reached their debt capacity, so that they are restricted from borrowing more money, even if loan rates are reduced. They may believe that any additional debt could increase the likelihood of bankruptcy. Thus they may delay their spending until the economy has improved.

   Similarly, households that commonly borrow to purchase vehicles, homes, and other products may also prefer to avoid borrowing more money during weak economies, even if interest rates are low. Households who are unemployed are not in a position to borrow more money. And even if employed households can obtain loans from financial institutions, they may believe that they are already at their debt capacity. The economic conditions might make them worry that their job is not stable, and they prefer not to increase their debt until their economic conditions improve and their job is more secure.

   So while the Fed hopes that the lower interest rates will encourage more borrowing and spending to stimulate the economy, the potential spenders (firms and households) may delay their borrowing until the economy improves. But the economy may not improve unless firms and households increase their spending. While the Fed can lower interest rates, it cannot necessarily force firms or households to borrow more money. If the firms and households do not borrow more money, they will not be able to spend more money.

   One related concern about the Fed’s stimulative monetary policy is that if it is successful in encouraging firms and households to borrow funds, it might indirectly cause some of them to borrow beyond what they can afford to borrow. Thus it might ultimately result in more bankruptcies and cause a new phase of economic problems.

5-2d Effects of Restrictive Monetary Policy

If excessive inflation is the Fed’s main concern, then the Fed can implement a restrictive (tight-money) policy by using open market operations to reduce money supply growth. A portion of the inflation may be due to demand-pull inflation, which the Fed can reduce by slowing economic growth and thereby the excessive spending that can lead to this type of inflation.

   To slow economic growth and reduce inflationary pressures, the Fed can sell some of its holdings of Treasury securities in the secondary market. As investors make payments to purchase these Treasury securities, their account balances decrease without any offsetting increase in the account balances of any other financial institutions. Thus there is a net decrease in deposit accounts (money), which results in a net decrease in the quantity of loanable funds.

   Assume that the Fed’s action causes a decrease of $5 billion in loanable funds. The quantity of loanable funds supplied will now be $5 billion lower at any possible interest rate level. This reflects an inward shift in the supply curve from S1 to S2, as shown in 

Exhibit 5.5

.

   Given the inward shift in the supply curve for loanable funds, the quantity of loanable funds demanded exceeds the quantity of loanable funds supplied at the original interest rate level (i1). Thus the interest rate will increase to i2, the level at which the quantities of loanable funds supplied and demanded are equal.

Exhibit 5.5 Effects of a Reduced Money Supply

   Depository institutions raise not only the rate charged on loans in the federal funds market but also the interest rates on deposits and on household and business loans. If the Fed’s restrictive monetary policy increases the Treasury rate from 5 to 6 percent, a firm that must pay a risk premium of 4 percent must now pay 10 percent (6 percent risk-free rate plus 4 percent credit risk premium) to borrow funds. All firms and households who consider borrowing money incur a higher cost of debt as a result of the Fed’s restrictive monetary policy. The effect of the Fed’s monetary policy on loans to households and businesses is important, since the Fed’s ability to affect the amount of spending in the economy stems from influencing the rates charged on household and business loans.

   The higher interest rate level increases the corporate cost of financing new projects and therefore causes a decrease in the level of business investment from B1 to B2. As economic growth is slowed by this reduction in business investment, inflationary pressure may be reduced.

5-2e Summary of Monetary Policy Effects

Exhibit 5.6

 summarizes how the Fed can affect economic conditions through its influence on the supply of loanable funds. The top part of the exhibit illustrates a stimulative (loose-money) monetary policy intended to boost economic growth, and the bottom part illustrates a restrictive (tight-money) monetary policy intended to reduce inflation.

Exhibit 5.6 How Monetary Policy Can Affect Economic Conditions

Lagged Effects of Monetary Policy
 There are three lags involved in monetary policy that can make the Fed’s job more challenging. First, there is a recognition lag, or the lag between the time a problem arises and the time it is recognized. Most economic problems are initially revealed by statistics, not actual observation. Because economic statistics are reported only periodically, they will not immediately signal a problem. For example, the unemployment rate is reported monthly. A sudden increase in unemployment may not be detected until the end of the month, when statistics finally reveal the problem. Even if unemployment increases slightly each month for two straight months, the Fed might not act on this information because it may not seem significant. A few more months of steadily increasing unemployment, however, would force the Fed to recognize that a serious problem exists. In such a case, the recognition lag may be four months or longer.

   The lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve that problem is known as the 

implementation lag

. Then, even after the Fed implements a policy, there will be an 

impact lag

 until the policy has its full impact on the economy. For example, an adjustment in money supply growth may have an immediate impact on the economy to some degree, but its full impact may not occur until a year or so after the adjustment.

   These lags hinder the Fed’s control of the economy. Suppose the Fed uses a stimulative policy to stimulate the economy and reduce unemployment. By the time the implemented monetary policy begins to take effect, the unemployment rate may have already reversed itself and may now be trending downward as a result of some other outside factors (such as a weakened dollar that increased foreign demand for U.S. goods and created U.S. jobs). Without monetary policy lags, implemented policies would be more effective.

5-3 TRADE-OFF IN MONETARY POLICY

Ideally, the Fed would like to achieve both a very low level of unemployment and a very low level of inflation in the United States. The U.S. unemployment rate should be low in a period when U.S. economic conditions are strong. Inflation will likely be relatively high at this time, however, because wages and price levels tend to increase when economic conditions are strong. Conversely, inflation may be lower when economic conditions are weak, but unemployment will be relatively high. It is therefore difficult, if not impossible, for the Fed to cure both problems simultaneously.

   When inflation is higher than the Fed deems acceptable, it may consider implementing a restrictive (tight-money) policy to reduce economic growth. As economic growth slows, producers cannot as easily raise their prices and still maintain sales volume. Similarly, workers are less in demand and have less bargaining power on wages. Thus the use of a restrictive policy to slow economic growth can reduce the inflation rate. A possible cost of the lower inflation rate is higher unemployment. If the economy becomes stagnant because of the restrictive policy, sales may decrease, inventories may accumulate, and firms may reduce their workforces to reduce production.

   A stimulative policy can reduce unemployment whereas a restrictive policy can reduce inflation; the Fed must therefore determine whether unemployment or inflation is the more serious problem. It may not be able to solve both problems simultaneously. In fact, it may not be able to fully eliminate either problem. Although a stimulative policy can stimulate the economy, it does not guarantee that unskilled workers will be hired. Although a restrictive policy can reduce inflation caused by excessive spending, it cannot reduce inflation caused by such factors as an agreement by members of an oil cartel to maintain high oil prices.

Exhibit 5.7 Trade-off between Reducing Inflation and Unemployment

5-3a Impact of Other Forces on the Trade-off

Other forces may also affect the trade-off faced by the Fed. Consider a situation where, because of specific cost factors (e.g., an increase in energy costs), inflation will be at least 3 percent. In other words, this much inflation will exist no matter what type of monetary policy the Fed implements. Assume that, because of the number of unskilled workers and people “between jobs,” the unemployment rate will be at least 4 percent. A stimulative policy will stimulate the economy sufficiently to maintain unemployment at that minimum level of 4 percent. However, such a stimulative policy may also cause additional inflation beyond the 3 percent level. Conversely, a restrictive policy could maintain inflation at the 3 percent minimum, but unemployment would likely rise above the 4 percent minimum.

   This trade-off is illustrated in 

Exhibit 5.7

. Here the Fed can use a very stimulative (loose-money) policy that is expected to result in point A (9 percent inflation and 4 percent unemployment), or it can use a highly restrictive (tight-money) policy that is expected to result in point B (3 percent inflation and 8 percent unemployment). Alternatively, it can implement a compromise policy that will result in some point along the curve between A and B.

   Historical data on annual inflation and unemployment rates show that when one of these problems worsens, the other does not automatically improve. Both variables can rise or fall simultaneously over time. Nevertheless, this does not refute the trade-off faced by the Fed. It simply means that some outside factors have affected inflation or unemployment or both.

EXAMPLE

Recall that the Fed could have achieved point A, point B, or somewhere along the curve connecting these two points during a particular time period. Now assume that oil prices have increased substantially such that the minimum inflation rate will be, say, 6 percent. In addition, assume that various training centers for unskilled workers have been closed, leaving a higher number of unskilled workers. This forces the minimum unemployment rate to 6 percent. Now the Fed’s trade-off position has changed. The Fed’s new set of possibilities is shown as curve CD in 

Exhibit 5.8

. Note that the points reflected on curve CD are not as desirable as the points along curve AB that were previously attainable. No matter what type of monetary policy the Fed uses, both the inflation rate and the unemployment rate will be higher than in the previous time period. This is not the Fed’s fault.

Exhibit 5.8 Adjustment in the Trade-off between Unemployment and Inflation over Time

In fact, the Fed is still faced with a trade-off: between point C (11 percent inflation, 6 percent unemployment) and point D (6 percent inflation, 10 percent unemployment), or some other point along curve CD.

   For example, during the financial crisis of 2008-2009 and during 2010-2013 when the economy was still attempting to recover, the Fed focused more on reducing unemployment than on inflation. While it recognized that a stimulative monetary policy could increase inflation, it viewed inflation as the lesser of two evils. It would rather achieve a reduction in unemployment by stimulating the economy even if that resulted in a higher inflation rate.

   When FOMC members are primarily concerned with either inflation or unemployment, they tend to agree on the type of monetary policy that should be implemented. When both inflation and unemployment are relatively high, however, there is more disagreement among the members about the proper monetary policy to implement. Some members would likely argue for a restrictive policy to prevent inflation from rising, while other members would suggest that a stimulative policy should be implemented to reduce unemployment even if it results in higher inflation.

5-3b Shifts in Monetary Policy over Time

The trade-offs involved in monetary policy can be understood by considering the Fed’s decisions over time. In some periods, the Fed’s focus is on stimulating economic growth and reducing the unemployment level, with less concern about inflation. In other periods, the Fed’s focus is on reducing inflationary pressure, with less concern about the unemployment level. A brief summary of the following economic cycles illustrates this point.

WEB

www.federalreserve.gov/monetarypolicy/openmarket.htm

Shows recent changes in the federal funds target rate.

Focus on Improving Weak Economy in 2001-2003
 In 2001, when economic conditions were weak, the Fed reduced the targeted federal funds rate 10 times; this resulted in a cumulative decline of 4.25 percent in the targeted federal funds rate. As the federal funds rate was reduced, other short-term market interest rates declined as well. Despite these interest rate reductions, the economy did not respond. The Fed’s effects on the economy might have been stronger had it been able to reduce long-term interest rates. After the economy failed to respond as hoped in 2001, the Fed reduced the federal funds target rate two more times in 2002 and 2003. Finally, in 2004 the economy began to show some signs of improvement.

Focus on Reducing Inflation in 2004-2007
 As the economy improved in 2004, the Fed’s focus began to shift from concern about the economy to concern about the possibility of higher inflation. It raised the federal funds target rate 17 times over the period from mid-2004 to the summer of 2006. The typical adjustment in the target rate was 0.25 percent. By adjusting in small increments, as it did during this period, the Fed is unlikely to overreact to existing economic conditions. After making each small adjustment in the targeted federal funds rate, it monitors the economic effects and decides at the next meeting whether additional adjustments are needed.

   During 2004-2007, there were periodic indications of rising prices, mostly due to high oil prices. Although the Fed’s monetary policy could not control oil prices, it wanted to prevent any inflation that could be triggered if the economy became strong and there were either labor shortages or excessive demand for products. Thus the Fed tried to maintain economic growth without letting it become so strong that it could cause higher inflation.

Focus on Improving Weak Economy in 2008-2013
 Near the end of 2008, the credit crisis developed and resulted in a severe economic slowdown. The Fed implemented a stimulative monetary policy in this period. Over the 2008-2013 period, it reduced the federal funds rate from 5.25 percent to near 0. However, even with such a major impact on interest rates, the impact on the recovery was slow. Although monetary policy can be effective, it cannot necessarily solve all of the structural problems that occurred in the economy, such as the excess number of homes that were built based on liberal credit standards during the 2004-2007 period. Thus lowering interest rates did not lead to a major increase in the demand for homes, because many homeowners could not afford the homes that they were in. For those households who were in a position to purchase a home, a massive surplus of empty homes was available. Thus there was no need to build new homes, and no need for construction companies to hire additional employees. Furthermore, even with the very low interest rates, many firms were unwilling to expand. During the 2010-2012 period, the aggregate demand for products and services increased slowly. However, the unemployment rate remained high, because businesses remained cautious about hiring new employees.

5-3c How Monetary Policy Responds to Fiscal Policy

The Fed’s assessment of the trade-off between improving the unemployment situation versus the inflation situation becomes more complicated when considering the prevailing fiscal policy. Although the Fed has the power to make decisions without the approval of the presidential administration, the Fed’s monetary policy is commonly influenced by the administration’s fiscal policies. If fiscal policies create large budget deficits, this may place upward pressure on interest rates. Under these conditions, the Fed may be concerned that the higher interest rates caused by fiscal policy could dampen the economy, and it may therefore feel pressured to use a stimulative monetary policy in order to reduce interest rates.

   A framework for explaining how monetary policy and fiscal policies affect interest rates is shown in 

Exhibit 5.9

. Although fiscal policy typically shifts the demand for loanable funds, monetary policy normally has a larger impact on the supply of loanable funds. In some situations, the administration has enacted a fiscal policy that causes the Fed to reassess its trade-off between focusing on inflation versus unemployment, as explained below.

Exhibit 5.9 Framework for Explaining How Monetary Policy and Fiscal Policy Affect Interest Rates over Time

5-3d Proposals to Focus on Inflation

Recently, some have proposed that the Fed should focus more on controlling inflation than unemployment. Ben Bernanke, the current chairman of the Fed, has made some arguments in favor of inflation targeting. If this proposal were adopted in its strictest form, then the Fed would no longer face a trade-off between controlling inflation and controlling unemployment. It would not have to consider responding to any fiscal policy actions such as those shown in 
Exhibit 5.9
. It might be better able to control inflation if it could concentrate on that problem without having to worry about the unemployment rate. In addition, the Fed’s role would be more transparent, and there would be less uncertainty in the financial markets about how the Fed would respond to specific economic conditions.

   Nevertheless, inflation targeting also has some disadvantages. First, the Fed could lose credibility if the U.S. inflation rate deviated substantially from the Fed’s target inflation rate. Factors such as oil prices could cause high inflation regardless of the Fed’s targeted inflation rate. Second, focusing only on inflation could result in a much higher unemployment level. Bernanke has argued, however, that inflation targeting could be flexible enough that the employment level would still be given consideration. He believes that inflation targeting may not only satisfy the inflation goal but could also achieve the employment stabilization goal in the long run. For example, if unemployment were slightly higher than normal and inflation were at the peak of the target range, then an inflation targeting approach might be to leave monetary policy unchanged. In this situation, stimulating the economy with lower interest rates might reduce the unemployment rate temporarily but could ultimately lead to excessive inflation. This would require the Fed to use a restrictive policy (higher interest rates) to correct the inflation, which could ultimately lead to a slower economy and an increase in unemployment. In general, the inflation targeting approach would discourage such “quick fix” strategies to stimulate the economy.

   Although some Fed members have publicly said that they do not believe in inflation targeting, their opinions are not necessarily much different from those of Bernanke. Flexible inflation targeting would allow changes in monetary policy to increase employment. Fed members disagree on how high unemployment would have to be before monetary policy would be used to stimulate the economy at the risk of raising inflation. In fact, discussion of inflation targeting declined during the credit crisis when the economy weakened and unemployment increased in the United States. This suggests that, though some Fed members might argue for an inflation targeting policy in the long run, they tend to change their focus toward reducing unemployment when the United States is experiencing very weak economic conditions.

5-4 MONITORING THE IMPACT OF MONETARY POLICY

The Fed’s monetary policy affects many parts of the economy, as shown in Exhibit 5.10. The effects of monetary policy can vary with the perspective. Households monitor the Fed because their loan rates on cars and mortgages will be affected. Firms monitor the Fed because their cost of borrowing from loans and from issuing new bonds will be affected. Some firms are affected to a greater degree if their businesses are more sensitive to interest rate movements. The Treasury monitors the Fed because its cost of financing the budget deficit will be affected.

5-4a Impact on Financial Markets

Because monetary policy can have a strong influence on interest rates and economic growth, it affects the valuation of most securities traded in financial markets. The changes in values of existing bonds are inversely related to interest rate movements. Therefore, investors who own bonds (Treasury, corporate, or municipal) or fixed-rate mortgages are adversely affected when the Fed raises interest rates, but they are favorably affected when the Fed reduces interest rates (as explained in 

Chapter 8

).

   The values of stocks (discussed in 
Chapter 11
) also are commonly affected by interest rate movements, but the effects are not as consistent as they are for bonds.

EXAMPLE

Suppose the Fed lowers interest rates because the economy is weak. If investors anticipate that this action will enhance economic growth, they may expect that firms will generate higher sales and earnings in the future. Thus the values of stocks would increase in response to this favorable information. However, the Fed’s decision to reduce interest rates could make investors realize that economic conditions are worse than they thought. In this case, the Fed’s actions could signal that corporate sales and earnings may weaken, and the values of stocks would decline because of the negative information.

Exhibit 5.10 How Monetary Policy Affects Financial Conditions

   To appreciate the potential impact of the Fed’s actions on financial markets, go to any financial news website during the week in which the FOMC holds its meeting. You will see predictions of whether the Fed will change the target federal funds rate, by how much, and how that change will affect the financial markets.

WEB

www.federalreserve.gov/monetarypolicy/fomccalendars.htm

Schedule of FOMC meetings and minutes of previous FOMC meetings.

Fed’s Communication to Financial Markets
 After the Federal Open Market Committee holds a meeting to determine its monetary policy, it announces its conclusion through an FOMC statement. The statement is available at 

www.federalreserve.gov

, and it may offer relevant implications about security prices. The following example of an FOMC statement reflects a decision to implement a stimulative monetary policy.

·  The Federal Open Market Committee decided to reduce its target for the federal funds rate by 0.25% to 2.75%. Economic growth has weakened this year, and indicators suggest more pronounced weakness in the last four months. The Committee expects that the weakness will continue. Inventories at manufacturing firms have risen, which reflects the recent decline in sales by these firms. Inflation is presently low and is expected to remain at very low levels. Thus, there is presently a bias toward correcting the economic growth, without as much concern about inflation. Voting for the FOMC monetary policy action were [list of voting members provided here].

   This example could possibly cause the prices of debt securities such as bonds to rise because it suggests that interest rates will decline.

   The following example of a typical statement reflects the decision to use a restrictive monetary policy.

·  The Federal Open Market Committee decided to raise its target for the federal funds rate by 0.25% to 3.25%. Economic growth has been strong so far this year. The Committee expects that growth will continue at a more sustainable pace, partly reflecting a cooling of the housing market. Energy prices have had a modest impact on inflation. Unit labor costs have been stable. Energy prices have the potential to add to inflation. The Committee expects that a more restrictive monetary policy may be needed to address inflation risks, but [it] emphasizes that the extent and timing of any tightening of money supply will depend on future economic conditions. The Committee will respond to changes in economic prospects as needed to support the attainment of its objectives. Voting for the FOMC monetary policy action were [list of voting members provided here].

   The type of influence that monetary policy can have on each financial market is summarized in 

Exhibit 5.11

. The financial market participants closely review the FOMC statements to interpret the Fed’s future plans and to assess how the monetary policy will affect security prices. Sometimes the markets fully anticipate the Fed’s actions. In this case, prices of securities should adjust to the anticipated news before the meeting, and they will not adjust further when the Fed’s decision is announced.

   Recently, the Fed has been more transparent in its communication to financial markets about its future policy. In the fall of 2012, it emphasized its focus on stimulating the U.S. economy. The Fed also announced that it would continue to purchase Treasury bonds in the financial markets (increase money supply) until unemployment conditions are substantially improved, unless there are strong indications of higher inflation. This statement is unusual because it represents a much stronger commitment to fix one particular problem (unemployment) rather than the other (inflation). The Fed also stated that it planned to keep long-term interest rates low for at least the next three years. This was important because it signaled to potential borrowers who obtain floating-rate loans (such as many firms and some home buyers) that the cost of financing would remain low for at least the next three years.

   Perhaps the Fed was comfortable in taking this position because the unemployment problem was clearly causing more difficulties in the economy than inflation. The Fed’s strong and clear communication may have been intended to restore confidence in the economy, so that people were more willing to spend money rather than worrying that they need to save money in case they lose their job. The Fed was hoping that heavy spending by households could stimulate the economy and create jobs.

Exhibit 5.11 Impact of Monetary Policy across Financial Markets

TYPE OF FINANCIAL MARKET	RELEVANT FACTORS INFLUENCED BY MONETARY POLICY	KEY INSTITUTIONAL PARTICIPANTS
Money market	· • Secondary market values of existing money market securities · • Yields on newly issued money market securities	Commercial banks, savings institutions, credit unions, money market funds, insurance companies, finance companies, pension funds
Bond market	· • Secondary market values of existing bonds · • Yields offered on newly issued bonds	Commercial banks, savings institutions, bond mutual funds, insurance companies, finance companies, pension funds
Mortgage market	· • Demand for housing and therefore the demand for mortgages · • Secondary market values of existing mortgages · • Interest rates on new mortgages · • Risk premium on mortgages	Commercial banks, savings institutions, credit unions, insurance companies, pension funds
Stock market	· • Required return on stocks and therefore the market values of stocks · • Projections for corporate earnings and therefore stock values	Stock mutual funds, insurance companies, pension funds
Foreign exchange	· • Demand for currencies and therefore the values of currencies, which in turn affect currency option prices	Institutions that are exposed to exchange rate risk

Impact of the Fed’s Response to Oil Shocks
 A month rarely goes by without the financial press reporting a potential inflation crisis, such as a hurricane that could affect oil production and refining in Louisiana or Texas, or friction in the Middle East or Russia that could disrupt oil production there. Financial market participants closely monitor oil shocks and the Fed’s response to those shocks. Any event that might disrupt the world’s production of oil triggers concerns about inflation. Oil prices affect the prices of gasoline and airline fuel, which affect the costs of transporting many products and supplies. In addition, oil is also used in the production of some products. Firms that experience higher costs due to higher oil expenses may raise their prices.

   When higher oil prices trigger concerns about inflation, the Fed is pressured to use a restrictive monetary policy. The Fed does not have control over oil prices, but it reasons that it can at least dampen any inflationary pressure on prices if it slows economic growth. In other words, a decline in economic growth may discourage firms from increasing prices of their products because they know that raising prices may cause their sales to drop.

   The concerns that an oil price shock will occur and that the Fed will raise interest rates to offset the high oil prices tend to have the following effects. First, bond markets may react negatively because bond prices are inversely related to interest rates. Stock prices are affected by expectations of corporate earnings. If firms incur higher costs of production and transportation due to higher oil prices, then their earnings could decrease. In addition, if the Fed increases interest rates in order to slow economic growth (to reduce inflationary pressure), firms will experience an increase in the cost of financing. This also would reduce their earnings. Consequently, investors who expect a reduction in earnings may sell their holdings of stock, in which case stock prices will decline.

5-4b Impact on Financial Institutions

Many depository institutions obtain most of their funds in the form of short-term loans and then use some of their funds to provide long-term, fixed-rate, mortgage loans. When interest rates rise, their cost of funds rises faster than the return they receive on their loans. Thus they are adversely affected when the Fed increases interest rates.

   Financial institutions such as commercial banks, bond mutual funds, insurance companies, and pension funds maintain large portfolios of bonds, so their portfolios are adversely affected when the Fed raises interest rates. Financial institutions such as stock mutual funds, insurance companies, and pension funds maintain large portfolios of stocks, and their stock portfolios are also indirectly affected by changes in interest rates. Thus, all of these financial institutions must closely monitor the Fed’s monetary policy so that they can manage their operations based on expectations of future interest rate movements.

5-5 GLOBAL MONETARY POLICY

Financial market participants must recognize that the type of monetary policy implemented by the Fed is somewhat dependent on various international factors, as explained next.

5-5a Impact of the Dollar

A weak dollar can stimulate U.S. exports because it reduces the amount of foreign currency needed by foreign companies to obtain dollars in order to purchase U.S. exports. A weak dollar also discourages U.S. imports because it increases the dollars needed to obtain foreign currency in order to purchase imports. Thus a weak dollar can stimulate the U.S. economy. In addition, it tends to exert inflationary pressure in the United States because it reduces foreign competition. The Fed can afford to be less aggressive with a stimulative monetary policy if the dollar is weak, because a weak dollar can itself provide some stimulus to the U.S. economy. Conversely, a strong dollar tends to reduce inflationary pressure but also dampens the U.S. economy. Therefore, if U.S. economic conditions are weak, a strong dollar will not provide the stimulus needed to improve conditions and so the Fed may need to implement a stimulative monetary policy.

5-5b Impact of Global Economic Conditions

The Fed recognizes that economic conditions are integrated across countries, so it considers prevailing global economic conditions when conducting monetary policy. When global economic conditions are strong, foreign countries purchase more U.S. products and can stimulate the U.S. economy. When global economic conditions are weak, the foreign demand for U.S. products weakens.

   During the credit crisis that began in 2008, the United States and many other countries experienced very weak economic conditions. The Fed’s decision to lower U.S. interest rates and stimulate the U.S. economy was partially driven by these weak global economic conditions. The Fed recognized that the United States would not receive any stimulus (such as a strong demand for U.S. products) from other countries where income and aggregate spending levels were also relatively low.

5-5c Transmission of Interest Rates

Each country has its own currency (except for countries in the euro zone) and its own interest rate, which is based on the supply of and demand for loanable funds in that currency. Investors residing in one country may attempt to capitalize on high interest rates in another country. If there is upward pressure on U.S. interest rates that can be offset by foreign inflows of funds, then the Fed may not feel compelled to use a stimulative policy. However, if foreign investors reduce their investment in U.S. securities, the Fed may be forced to intervene in order to prevent interest rates from rising.

Exhibit 5.12 Illustration of Global Crowding Out

   Given the international integration in money and capital markets, a government’s budget deficit can affect interest rates of various countries. This concept, referred to as global crowding out, is illustrated in 

Exhibit 5.12

. An increase in the U.S. budget deficit causes an outward shift in the federal government’s demand for U.S. funds and therefore in the aggregate demand for U.S. funds (from D1 to D2). This crowding-out effect forces the U.S. interest rate to increase from i1 to i2 if the supply curve (S) is unchanged. As U.S. rates rise, they attract funds from investors in other countries, such as Germany and Japan. As foreign investors use more of their funds to invest in U.S. securities, the supply of available funds in their respective countries declines. Consequently, there is upward pressure on non-U.S. interest rates as well. The impact will be most pronounced in countries whose investors are most likely to find the higher U.S. interest rates attractive. The possibility of global crowding out has caused national governments to criticize one another for large budget deficits.

5-5d Impact of the Crisis in Greece on European Monetary Policy

In the spring of 2010, Greece experienced a weak economy and a large budget deficit. Creditors were less willing to lend the Greece government funds because they feared that the government may be unable to repay the loans. There were even concerns that Greece would abandon the euro, which caused many investors to liquidate their euro-denominated investments and move their money into other currencies. Overall, the lack of demand for euros in the foreign exchange market caused the euro’s value to decline by about 20 percent during the spring of 2010.

   The debt repayment problems in Greece adversely affected creditors from many other countries in Europe. In addition, Portugal and Spain had large budget deficit problems (because of excessive government spending) and experienced their own financial crises in 2012. The weak economic conditions in these countries caused fear of a financial crisis throughout Europe. The fear discouraged corporations, investors, and creditors outside of Europe from moving funds into Europe, and also encouraged some European investors to move their money out of the euro and out of Europe. Thus, just the fear by itself reduced the amount of capital available within Europe, which resulted in lower growth and lower security prices in Europe.

   Since euro zone country governments do not have their own monetary policy, they are restricted from using their own stimulative monetary policy to strengthen economic conditions. They have control of their own fiscal policy, but given that the underlying problems were attributed to heavy government spending, they did not want to attempt stimulating their economy with more deficit spending.

   The European Central Bank (ECB) was forced to use a more stimulative monetary policy than desired in order to ease concerns about the Greek crisis, even though this caused other concerns about potential inflation in the euro zone. The Greek crisis illustrated how the ECB’s efforts to resolve one country’s problems could create more problems in other euro zone countries that are subject to the same monetary policy. The ECB also stood ready to provide credit to help countries in the eurozone experiencing a financial crisis. When the ECB provides credit to a country, it imposes austerity conditions that can correct the government’s budget deficit such as reducing government spending and imposing higher tax rates on its citizens.

   Like any central bank, the ECB faces a dilemma when trying to resolve a financial crisis. If it provides funding and imposes the austerity conditions that force a country to reduce its budget deficit, it may temporarily weaken the country’s economy further. The austerity conditions that reduce a government’s budget deficit may also result in a lower level of aggregate spending and higher taxes (less disposable income for households).

SUMMARY

· ▪ By using monetary policy, the Fed can affect the interaction between the demand for money and the supply of money, which affects interest rates, aggregate spending, and economic growth. As the Fed increases the money supply, interest rates should decline and result in more aggregate spending (because of cheaper financing rates) and higher economic growth. As the Fed decreases the money supply, interest rates should increase and result in less aggregate spending (because of higher financing rates), lower economic growth, and lower inflation.

· ▪ Because monetary policy can have a strong influence on interest rates and economic growth, it affects the valuation of most securities traded in financial markets. Financial market participants attempt to forecast the Fed’s future monetary policies and the effects of these policies on economic conditions. When the Fed implements monetary policy, financial market participants attempt to assess how their security holdings will be affected and adjust their security portfolios accordingly.

· ▪ The Fed’s monetary policy must take into account the global economic environment. A weak dollar may increase U.S. exports and thereby stimulate the U.S. economy. If economies of other countries are strong, this can also increase U.S. exports and boost the U.S. economy. Thus the Fed may not have to implement a stimulative monetary policy if international conditions can provide some stimulus to the U.S. economy. Conversely, the Fed may consider a more aggressive monetary policy to fix a weak U.S. economy if international conditions are weak, since in that case the Fed cannot rely on other economies to boost the U.S. economy.

· ▪ A stimulative monetary policy can increase economic growth, but it could ignite demand-pull inflation. A restrictive monetary policy is likely to reduce inflation but may also reduce economic growth. Thus the Fed faces a trade-off when implementing monetary policy. Given a possible trade-off, the Fed tends to pinpoint its biggest concern (unemployment versus inflation) and assess whether the potential benefits of any proposed monetary policy outweigh the potential adverse effects.

POINT COUNTER-POINT

Can the Fed Prevent U.S. Recessions?

Point
 Yes. The Fed has the power to reduce market interest rates and can therefore encourage more borrowing and spending. In this way, it stimulates the economy.

Counter-Point
 No. When the economy is weak, individuals and firms are unwilling to borrow regardless of the interest rate. Thus the borrowing (by those who are qualified) and spending will not be influenced by the Fed’s actions. The Fed should not intervene but rather allow the economy to work itself out of a recession.

Who Is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Impact of Monetary Policy How does the Fed’s monetary policy affect economic conditions?

· 2. Trade-offs of Monetary Policy Describe the economic trade-off faced by the Fed in achieving its economic goals.

· 3. Choice of Monetary Policy When does the Fed use a stimulative monetary policy, and when does it use a restrictive monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive?

· 4. Active Monetary Policy Describe an active monetary policy.

· 5. Passive Monetary Policy Describe a passive monetary policy.

· 6. Fed Control Why may the Fed have difficulty controlling the economy in the manner desired? Be specific.

· 7. Lagged Effects of Monetary Policy Compare the recognition lag and the implementation lag.

· 8. Fed’s Control of Inflation Assume that the Fed’s primary goal is to reduce inflation. How can it use open market operations to achieve this goal? What is a possible adverse effect of such action by the Fed (even if it achieves the goal)?

· 9. Monitoring Money Supply Why do financial market participants closely monitor money supply movements?

· 10. Monetary Policy during the Credit Crisis Describe the Fed’s monetary policy response to the credit crisis.

· 11. Impact of Money Supply Growth Explain why an increase in the money supply can affect interest rates in different ways. Include the potential impact of the money supply on the supply of and the demand for loanable funds when answering this question.

· 12. Confounding Effects What factors might be considered by financial market participants who are assessing whether an increase in money supply growth will affect inflation?

· 13. Fed Response to Fiscal Policy Explain how the Fed’s monetary policy could depend on the fiscal policy that is implemented.

Advanced Questions

· 14. Interpreting the Fed’s Monetary Policy When the Fed increases the money supply to lower the federal funds rate, will the cost of capital to U.S. companies be reduced? Explain how the segmented markets theory regarding the term structure of interest rates (as explained in 
Chapter 3
) could influence the degree to which the Fed’s monetary policy affects long-term interest rates.

· 15. Monetary Policy Today Assess the economic situation today. Is the administration more concerned with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain.

· 16. Impact of Foreign Policies Why might a foreign government’s policies be closely monitored by investors in other countries, even if the investors plan no investments in that country? Explain how monetary policy in one country can affect interest rates in other countries.

· 17. Monetary Policy during a War Consider a discussion during FOMC meetings in which there is a weak economy and a war, with potential major damage to oil wells. Explain why this possible effect would have received much attention at the FOMC meetings. If this possibility was perceived to be highly likely at the time of the meetings, explain how it may have complicated the decision about monetary policy at that time. Given the conditions stated in this question, would you suggest that the Fed use a restrictive monetary policy, or a stimulative monetary policy? Support your decision logically and acknowledge any adverse effects of your decision.

· 18. Economic Indicators Stock market conditions serve as a leading economic indicator. If the U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator be inaccurate?

· 19. How the Fed Should Respond to Prevailing Conditions Consider the current economic conditions, including inflation and economic growth. Do you think the Fed should increase interest rates, reduce interest rates, or leave interest rates at their present levels? Offer some logic to support your answer.

· 20. Impact of Inflation Targeting by the Fed Assume that the Fed adopts an inflation targeting strategy. Describe how the Fed’s monetary policy would be affected by an abrupt 15 percent rise in oil prices in response to an oil shortage. Do you think an inflation targeting strategy would be more or less effective in this situation than a strategy of balancing inflation concerns with unemployment concerns? Explain.

· 21. Predicting the Fed’s Actions Assume the following conditions. The last time the FOMC met, it decided to raise interest rates. At that time, economic growth was very strong and so inflation was relatively high. Since the last meeting, economic growth has weakened, and the unemployment rate will likely rise by 1 percentage point over the quarter. The FOMC’s next meeting is tomorrow. Do you think the FOMC will revise its targeted federal funds rate? If so, how?

· 22. The Fed’s Impact on the Housing Market In periods when home prices declined substantially, some homeowners blamed the Fed. In other periods, when home prices increased, homeowners gave credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a substantial increase in the general inflation level affect the Fed’s monetary policy and thereby affect home prices?

· 23. Targeted Federal Funds Rate The Fed uses a targeted federal funds rate when implementing monetary policy. However, the Fed’s main purpose in its monetary policy is typically to have an impact on the aggregate demand for products and services. Reconcile the Fed’s targeted federal funds rate with its goal of having an impact on the overall economy.

· 24. Monetary Policy during the Credit Crisis During the credit crisis, the Fed used a stimulative monetary policy. Why do you think the total amount of loans to households and businesses did not increase as much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in the total amount of loans extended to households and businesses?

· 25. Stimulative Monetary Policy during a Credit Crunch Explain why a stimulative monetary policy might not be effective during a weak economy in which there is a credit crunch.

· 26. Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly implements a stimulative monetary policy to lower interest rates, and presumes that firms will be more willing to borrow. Even if banks are willing to lend, why might such a presumption about the willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong?

· 27. Fed Policy Focused on Long-term Interest Rates Why might the Fed want to focus its efforts on reducing long-term interest rates rather than short-term interest rates during a weak economy? Explain how it might use a monetary policy focused on influencing long-term interest rates. Why might such a policy also affect short-term interest rates in the same direction?

· 28. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy on a firm’s cost of capital.

· 29. Effectiveness of Monetary Policy What circumstances might cause a stimulative monetary policy to be ineffective?

· 30. Impact of ECB Response to Greece Crisis How did the debt repayment problems in Greece affect creditors from other countries in Europe? How did the ECB’s stimulative monetary policy affect the Greek crisis?

Interpreting Financial News

Interpret the following statements made by Wall Street analysts and portfolio managers.

· a. “Lately, the Fed’s policies are driven by gold prices and other indicators of the future rather than by recent economic data.”

· b. “The Fed cannot boost money growth at this time because of the weak dollar.”

· c. “The Fed’s fine- tuning may distort the economic picture.”

Managing in Financial Markets

Forecasting Monetary Policy As a manager of a firm, you are concerned about a potential increase in interest rates, which would reduce the demand for your firm’s products. The Fed is scheduled to meet in one week to assess economic conditions and set monetary policy. Economic growth has been high, but inflation has also increased from 3 to 5 percent (annualized) over the last four months. The level of unemployment is so low that it cannot go much lower.

· a. Given the situation, is the Fed likely to adjust monetary policy? If so, how?

· b. Recently, the Fed has allowed the money supply to expand beyond its long-term target range. Does this affect your expectation of what the Fed will decide at its upcoming meeting?

· c. Suppose the Fed has just learned that the Treasury will need to borrow a larger amount of funds than originally expected. Explain how this information may affect the degree to which the Fed changes the monetary policy.

FLOW OF FUNDS EXERCISE

Anticipating Fed Actions

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding the business and by making acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The company may also issue stock to raise funds in the next year.

An economic report recently highlighted the strong growth in the economy, which has led to nearly full employment. In addition, the report estimated that the annualized inflation rate increased to 5 percent, up from 2 percent last month. The factors that caused the higher inflation (shortages of products and shortages of labor) are expected to continue.

· a. How will the Fed’s monetary policy change based on the report?

· b. How will the likely change in the Fed’s monetary policy affect Carson’s future performance? Could it affect Carson’s plans for future expansion?

· c. Explain how a tight monetary policy could affect the amount of funds borrowed at financial institutions by deficit units such as Carson Company. How might it affect the credit risk of these deficit units? How might it affect the performance of financial institutions that provide credit to such deficit units as Carson Company?

INTERNET/EXCEL EXERCISES

· 1. Go to the website 

www.federalreserve.gov/monetarypolicy/fomc.htm

 to review the activities of the FOMC. Succinctly summarize the minutes of the last FOMC meeting. What did the FOMC discuss at that meeting? Did the FOMC make any changes in the current monetary policy? What is the FOMC’s current monetary policy?

· 2. Is the Fed’s present policy focused more on stimulating the economy or on reducing inflation? Or is the present policy evenly balanced? Explain.

· 3. Using the website 

http://research.stlouisfed.org/fred2

, retrieve interest rate data at the beginning of the last 20 quarters for the federal funds rate and the three-month Treasury bill rate, and place the data in two columns of an Excel spreadsheet. Derive the change in interest rates on a quarterly basis. Apply regression analysis in which the quarterly change in the T-bill rate is the dependent variable (see Appendix B for more information about using regression analysis). If the Fed’s effect on the federal funds rate influences other interest rates (such as the T-bill rate), there should be a positive and significant relationship between the interest rates. Is there such a relationship? Explain.

WSJ EXERCISE

Market Assessment of Fed Policy

Review a recent issue of the Wall Street Journal and then summarize the market’s expectations about future Chapter 5: Monetary Policy 129 If the Fed’s effect on the federal funds rate influences other interest rates (such as the T-bill rate), there should be a positive and significant relationship between the interest rates. Is there such a relationship? Explain. interest rates. Are these expectations based primarily on the Fed’s monetary policy or on other factors?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. index of leading economic indicators

· 2. consumer price index AND Federal Reserve

· 3. inflation AND Federal Reserve

· 4. inflation AND monetary policy

· 5. Fed policy AND economy

· 6. federal funds rate AND economy

· 7. federal funds rate AND inflation

· 8. monetary policy AND budget deficit

· 9. monetary policy AND press release

· 10. monetary policy AND value of the dollar

PART 2 INTEGRATIVE PROBLEM: Fed Watching

This problem requires an understanding of the Fed (
Chapter 4
) and monetary policy (

Chapter 5

). It also requires an understanding of how economic conditions affect interest rates and securities’ prices (

Chapters 2

 and 

3

).

Like many other investors, you are a “Fed watcher” who constantly monitors any actions taken by the Fed to revise monetary policy. You believe that three key factors affect interest rates. Assume that the most important factor is the Fed’s monetary policy. The second most important factor is the state of the economy, which influences the demand for loanable funds. The third factor is the level of inflation, which also influences the demand for loanable funds. Because monetary policy can affect interest rates, it affects economic growth as well. By controlling monetary policy, the Fed influences the prices of all types of securities.

   The following information is available to you.

· ▪ Economic growth has been consistently strong over the past few years but is beginning to slow down.

· ▪ Unemployment is as low as it has been in the past decade, but it has risen slightly over the past two quarters.

· ▪ Inflation has been about 5 percent annually for the past few years.

· ▪ The dollar has been strong.

· ▪ Oil prices have been very low.

   Yesterday, an event occurred that you believe will cause much higher oil prices in the United States and a weaker U.S. economy in the near future. You plan to determine whether the Fed will respond to the economic problems that are likely to develop.

   You have reviewed previous economic slowdowns caused by a decline in the aggregate demand for goods and services and found that each slowdown precipitated a stimulative policy by the Fed. Inflation was 3 percent or less in each of the previous economic slowdowns. Interest rates generally declined in response to these policies, and the U.S. economy improved.

   Assume that the Fed’s philosophy regarding monetary policy is to maintain economic growth and low inflation. There does not appear to be any major fiscal policy forthcoming that will have a major effect on the economy. Thus the future economy is up to the Fed. The Fed’s present policy is to maintain a 2 percent annual growth rate in the money supply. You believe that the economy is headed toward a recession unless the Fed uses a very stimulative monetary policy, such as a 10 percent annual growth rate in the money supply.

   The general consensus of economists is that the Fed will revise its monetary policy to stimulate the economy for three reasons: (1) it recognizes the potential costs of higher unemployment if a recession occurs, (2) it has consistently used a stimulative policy in the past to prevent recessions, and (3) the administration has been pressuring the Fed to use a stimulative monetary policy. Although you will consider the economists’ opinions, you plan to make your own assessment of the Fed’s future policy. Two quarters ago, GDP declined by 1 percent. Last quarter, GDP declined again by 1 percent. Thus there is clear evidence that the economy has recently slowed down.

Questions

· 1. Do you think that the Fed will use a stimulative monetary policy at this point? Explain.

· 2. You maintain a large portfolio of U.S. bonds. You believe that if the Fed does not revise its monetary policy, the U.S. economy will continue to decline. If the Fed stimulates the economy at this point, you believe that you would be better off with stocks than with bonds. Based on this information, do you think you should switch to stocks? Explain.

4 Functions of the Fed

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the organizational structure of the Fed,

· ▪ describe how the Fed influences monetary policy,

· ▪ explain how the Fed revised its lending role in response to the credit crisis, and

· ▪ explain how monetary policy is used in other countries.

The 

Federal Reserve System

 (the Fed) is involved (along with other agencies) in regulating commercial banks. It is responsible for conducting periodic evaluations of state-chartered banks and savings institutions with more than $50 billion in assets. Its role as regulator is discussed in 

Chapter 18

.

4-1 OVERVIEW

As the central bank of the United States, the Fed has the responsibility for conducting national monetary policy in an attempt to achieve full employment and price stability (low or zero inflation) in the United States. With its monetary policy, the Fed can influence the state of the U.S. economy in the following ways. First, since the Fed’s monetary policy affects interest rates, it has a strong influence on the cost of borrowing by households and thus affects the amount of monthly payments on mortgages, car loans, and other loans. In this way, monetary policy determines what households can afford and therefore how much consumers spend.

   Second, monetary policy also affects the cost of borrowing by businesses and thereby influences how much money businesses are willing to borrow to support or expand their operations. By its effect on the amount of spending by households and businesses, monetary policy influences the aggregate demand for products and services in the United States and therefore influences the national income level and employment level. Since the aggregate demand can affect the price level of products and services, the Fed indirectly influences the price level and hence the rate of inflation in the United States.

   Because the Fed’s monetary policy affects interest rates, it has a direct effect on the prices of debt securities. It can also indirectly affect the prices of equity securities by affecting economic conditions, which influence the future cash flows generated by publicly traded businesses. Overall, the Fed’s monetary policy can have a major impact on households, businesses, and investors. A more detailed explanation of how the Fed’s monetary policy affects interest rates is provided in 

Chapter 5

.

WEB

www.clevelandfed.org

Features economic and banking topics.

4-2 ORGANIZATIONAL STRUCTURE OF THE FED

During the late 1800s and early 1900s, the United States experienced several banking panics that culminated in a major crisis in 1907. This motivated Congress to establish a central bank. In 1913, the Federal Reserve Act was implemented, which established reserve requirements for the commercial banks that chose to become members. It also specified 12 districts across the United States as well as a city in each district where a Federal Reserve district bank was to be established. Initially, each district bank had the ability to affect the money supply (as will be explained later in this chapter). Each district bank focused on its particular district without much concern for other districts. Over time, the system became more centralized, and money supply decisions were assigned to a particular group of individuals rather than across 12 district banks.

   The Fed earns most of its income from the interest on its holdings of U.S. government securities (to be discussed shortly). It also earns some income from providing services to financial institutions. Most of its income is transferred to the Treasury.

   The Fed as it exists today has five major components:

· ▪ Federal Reserve district banks

· ▪ Member banks

· ▪ Board of Governors

· ▪ Federal Open Market Committee (FOMC)

· ▪ Advisory committees

4-2a Federal Reserve District Banks

The 12 Federal Reserve districts are identified in 
Exhibit 4.1
, along with the city where each district bank is located. The New York district bank is considered the most important because many large banks are located in this district. Commercial banks that become members of the Fed are required to purchase stock in their 

Federal Reserve district bank

. This stock, which is not traded in a secondary market, pays a maximum dividend of 6 percent annually.

   Each Fed district bank has nine directors. There are three Class A directors, who are employees or officers of a bank in that district and are elected by member banks to represent member banks. There are three Class B directors, who are not affiliated with any bank and are elected by member banks to represent the public. There are also three Class C directors, who are not affiliated with any bank and are appointed by the Board of Governors (to be discussed shortly). The president of each Fed district bank is appointed by the three Class B and three Class C directors representing that district.

   Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans (through the so-called discount window) to depository institutions in need of funds. They also collect economic data and conduct research projects on commercial banking and economic trends.

4-2b Member Banks

Commercial banks can elect to become member banks if they meet specific requirements of the Board of Governors. All national banks (chartered by the Comptroller of the Currency) are required to be members of the Fed, but other banks (chartered by their respective states) are not. Currently, about 35 percent of all banks are members; these banks account for about 70 percent of all bank deposits.

4-2c Board of Governors

The 

Board of Governors

 (sometimes called the Federal Reserve Board) is made up of seven individual members with offices in Washington, D.C. Each member is appointed by the President of the United States and serves a nonrenewable 14-year term. This long term is thought to reduce political pressure on the governors and thus encourage the development of policies that will benefit the U.S. economy over the long run. The terms are staggered so that one term expires in every even-numbered year.

WEB

www.federalreserve.gov

Background on the Board of Governors, board meetings, board members, and the structure of the Fed.

Exhibit 4.1 Locations of Federal Reserve District Banks

   One of the seven board members is selected by the president to be the Federal Reserve chairman for a four-year term, which may be renewed. The chairman has no more voting power than any other member but may have more influence. Paul Volcker (chairman from 1979 to 1987), Alan Greenspan (chairman from 1987 to 2006), and Ben Bernanke (whose term began in 2006) were regarded as being highly persuasive.

   As a result of the Financial Reform Act of 2010, one of the seven board members is designated by the president to be the Vice Chairman for Supervision; this member is responsible for developing policy recommendations that concern regulating the Board of Governors. The Vice Chairman reports to Congress semiannually. The board participates in setting credit controls, such as margin requirements (percentage of a purchase of securities that must be paid with no borrowed funds). With regard to monetary policy, the board has the power to revise reserve requirements imposed on depository institutions. The board can also control the money supply by participating in the decisions of the Federal Open Market Committee, discussed next.

WEB

www.federalreserve.gov/monetarypolicy/fomc.htm

Find information about the Federal Open Market Committee (FOMC).

4-2d Federal Open Market Committee

The 

Federal Open Market Committee (FOMC)

 is made up of the seven members of the Board of Governors plus the presidents of five Fed district banks (the New York district bank plus 4 of the other 11 Fed district banks as determined on a rotating basis). Presidents of the seven remaining Fed district banks typically participate in the FOMC meetings but are not allowed to vote on policy decisions. The chairman of the Board of Governors serves as chairman of the FOMC.

   The main goals of the FOMC are to achieve stable economic growth and price stability (low inflation). Achievement of these goals would stabilize financial markets and interest rates. The FOMC attempts to achieve its goals by controlling the money supply, as described shortly.

4-2e Advisory Committees

The Federal Advisory Council consists of one member from each Federal Reserve district who represents the banking industry. Each district’s member is elected each year by the board of directors of the respective district bank. The council meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.

   The Consumer Advisory Council is made up of 30 members who represent the financial institutions industry and its consumers. This committee normally meets with the Board of Governors four times a year to discuss consumer issues.

   The Thrift Institutions Advisory Council is made up of 12 members who represent savings banks, savings and loan associations, and credit unions. Its purpose is to offer views on issues specifically related to these institutions. It meets with the Board of Governors three times a year.

4-2f Integration of Federal Reserve Components

Exhibit 4.2

 shows the relationships among the various components of the Federal Reserve System. The advisory committees advise the board, while the board oversees operations of the district banks. The board and representatives of the district banks make up the FOMC.

4-2g Consumer Financial Protection Bureau

As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established. It is housed within the Federal Reserve but is independent of the other Fed committees. The bureau’s director is appointed by the president with consent of the Senate. The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. In theory, the bureau can act quickly to protect consumers from deceptive practices rather than waiting for Congress to pass new laws. Financial services administered by auto dealers are exempt from the bureau’s oversight. An Office of Financial Literacy will also be created to educate individuals about financial products and services.

WEB

www.federalreserve.gov/monetarypolicy/fomccalendars.htm

Provides minutes of FOMC meetings. Notice from the minutes how much attention is given to any economic indicators that can be used to anticipate future economic growth or inflation.

4-3 HOW THE FED CONTROLS MONEY SUPPLY

The Fed controls the money supply in order to affect interest rates and thereby affect economic conditions. Financial market participants closely monitor the Fed’s actions so that they can anticipate how the money supply will be affected. They then use this information to forecast economic conditions and securities prices. The relationship between the money supply and economic conditions is discussed in detail in the following chapter. First, it is important to understand how the Fed controls the money supply.

Exhibit 4.2 Integration of Federal Reserve Components

4-3a Open Market Operations

The FOMC meets eight times a year. At each meeting, targets for the money supply growth level and the interest rate level are determined, and actions are taken to implement the monetary policy dictated by the FOMC. If the Fed wants to consider changing its targets for money growth or interest rates before its next scheduled meeting it may hold a conference call meeting.

Pre-Meeting Economic Reports
 About two weeks before the FOMC meeting, FOMC members are sent the 
Beige Book
, which is a consolidated report of regional economic conditions in each of the 12 districts. Each Federal Reserve district bank is responsible for reporting its regional conditions, and all of these reports are consolidated to compose the Beige Book.

   About one week before the FOMC meeting, participants receive analyses of the economy and economic forecasts. Thus there is much information for participants to study before the meeting.

Economic Presentations
 The FOMC meeting is conducted in the boardroom of the Federal Reserve Building in Washington, D.C. The seven members of the Board of Governors, the 12 presidents of the Fed district banks, and staff members (typically economists) of the Board of Governors are in attendance. The meeting begins with presentations by the staff members about current economic conditions and recent economic trends. Presentations include data and trends for wages, consumer prices, unemployment, gross domestic product, business inventories, foreign exchange rates, interest rates, and financial market conditions.

   The staff members also assess production levels, business investment, residential construction, international trade, and international economic growth. This assessment is conducted in order to predict economic growth and inflation in the United States, assuming that the Fed does not adjust its monetary policy. For example, a decline in business inventories may lead to an expectation of stronger economic growth, since firms will need to boost production in order to replenish inventories. Conversely, an increase in inventories may indicate that firms will reduce their production and possibly their workforces as well. An increase in business investment indicates that businesses are expanding their production capacity and are likely to increase production in the future. An increase in economic growth in foreign countries is important because a portion of the rising incomes in those countries will be spent on U.S. products or services. The Fed uses this information to determine whether U.S. economic growth is adequate.

   Much attention is also given to any factors that can affect inflation. For example, oil prices are closely monitored because they affect the cost of producing and transporting many products. A decline in business inventories when production is near full capacity may indicate an excessive demand for products that will pull prices up. This condition indicates the potential for higher inflation because firms may raise the prices of their products when they are producing near full capacity and experience shortages. Firms that attempt to expand their capacity under these conditions will have to raise wages to obtain additional qualified employees. The firms will incur higher costs from raising wages and therefore raise the prices of their products. The Fed becomes concerned when several indicators suggest that higher inflation is likely.

   The staff members typically base their forecasts for economic conditions on the assumption that the prevailing monetary growth level will continue in the future. When it is highly likely that the monetary growth level will be changed, they provide forecasts for economic conditions under different monetary growth scenarios. Their goal is to provide facts and economic forecasts, not to make judgments about the appropriate monetary policy. The members normally receive some economic information a few days before the meeting so that they are prepared when the staff members make their presentations.

FOMC Decisions
 Once the presentations are completed, each FOMC member has a chance to offer recommendations as to whether the federal funds rate target should be changed. The target may be specified as a specific point estimate, such as 2.5 percent, or as a range, such as from 2.5 to 2.75 percent.

   In general, evidence that the economy is weakening may result in recommendations that the Fed implement a monetary policy to reduce the federal funds rate and stimulate the economy. For example, 

Exhibit 4.3

 shows how the federal funds rate was reduced near the end of 2007 and in 2008 as the economy weakened. In December 2008, the Fed set the targeted federal funds rate in the form of a range between 0 and 0.25 percent. The goal was to stimulate the economy by reducing interest rates in order to encourage more borrowing and spending by households and businesses. The Fed maintained the federal funds rate within this range over the 2009–2013 period.

   When there is evidence of a very strong economy and high inflation, the Fed tends to implement a monetary policy that will increase the federal funds rate and reduce economic growth. This policy would be intended to reduce any inflationary pressure that is attributed to excess demand for products and services. The participants are commonly given three options for monetary policy, which are intended to cover a range of the most reasonable policies and should include at least one policy that is satisfactory to each member.

Exhibit 4.3 Federal Funds Rate over Time

   The FOMC meeting allows for participation by voting and nonvoting members. The chairman of the Fed may also offer a recommendation and usually has some influence over the other members. After all members have provided their recommendations, the voting members of the FOMC vote on whether the interest rate target levels should be revised. Most FOMC decisions on monetary policy are unanimous, although it is not unusual for some decisions to have one or two dissenting votes.

FOMC Statement
 Following the FOMC meeting, the committee provides a statement that summarizes its conclusion. The FOMC has in recent years begun to recognize the importance of this statement, which is used (along with other information) by many participants in the financial markets to generate forecasts of the economy. Since 2007, voting members vote not only on the proper policy but also on the corresponding communication (statement) of that policy to the public. The statement is clearly written with meaningful details. This is an improvement over previous years, when the statement contained vague phrases that made it difficult for the public to understand the FOMC’s plans. The statement provided by the committee following each meeting is widely publicized in the news media and also can be accessed on Federal Reserve websites.

Minutes of FOMC Meeting
 Within three weeks of a FOMC meeting, the minutes for that meeting are provided to the public and are also accessible on Federal Reserve websites. The minutes commonly illustrate the different points of view held by various participants at the FOMC meeting.

4-3b Role of the Fed’s Trading Desk

If the FOMC determines that a change in its monetary policy is appropriate, its decision is forwarded to the 

Trading Desk

 (or the 

Open Market Desk

) at the New York Federal Reserve District Bank through a statement called the 

policy directive

. The FOMC specifies a desired target for the federal funds rate, the rate charged by banks on short-term loans to each other. Even though this rate is determined by the banks that participate in the federal funds market, it is subject to the supply and demand for funds in the banking system. Thus, the Fed influences the federal funds rate by revising the amount of funds in the banking system.

   Since all short-term interest rates are affected by the supply of and demand for funds, they tend to move together. Thus the Fed’s actions affect all short-term interest rates that are market determined and may even affect long-term interest rates as well.

   After receiving a policy directive from the FOMC, the manager of the Trading Desk instructs traders who work at that desk on the amount of Treasury securities to buy or sell in the secondary market based on the directive. The buying and selling of government securities (through the Trading Desk) is referred to as open market operations. Even though the Trading Desk at the Federal Reserve Bank of New York receives a policy directive from the FOMC only eight times a year, it continuously conducts open market operations to control the money supply in response to ongoing changes in bank deposit levels. The FOMC is not limited to issuing new policy directives only on its scheduled meeting dates. It can hold additional meetings at any time to consider changing the federal funds rate.

WEB

www.treasurydirect.gov

Treasury note and bond auction results.

Fed Purchase of Securities
 When traders at the Trading Desk at the New York Fed are instructed to lower the federal funds rate, they purchase Treasury securities in the secondary market. First, they call government securities dealers to obtain their list of securities for sale, including the denomination and maturity of each security, and the dealer’s ask quote (the price at which the dealer is willing to sell the security). From this list, the traders attempt to purchase those Treasury securities that are most attractive (lowest prices for whatever maturities are desired) until they have purchased the amount requested by the manager of the Trading Desk. The accounting department of the New York Fed then notifies the government bond department to receive and pay for those securities.

   When the Fed purchases securities through government securities dealers, the bank account balances of the dealers increase and so the total deposits in the banking system increase. This increase in the supply of funds places downward pressure on the federal funds rate. The Fed increases the total amount of funds at the dealers’ banks until the federal funds rate declines to the new targeted level. Such activity, which is initiated by the FOMC’s policy directive, represents a loosening of money supply growth.

   The Fed’s purchase of government securities has a different impact than a purchase by another investor would have because the Fed’s purchase results in additional bank funds and increases the ability of banks to make loans and create new deposits. An increase in funds can allow for a net increase in deposit balances and therefore an increase in the money supply. Conversely, the purchase of government securities by someone other than the Fed (such as an investor) results in offsetting account balance positions at commercial banks. For example, as investors purchase Treasury securities in the secondary market, their bank balances decline while the bank balances of the sellers of the Treasury securities increase.

Fed Sale of Securities
 If the Trading Desk at the New York Fed is instructed to increase the federal funds rate, its traders sell government securities (obtained from previous purchases) to government securities dealers. The securities are sold to the dealers that submit the highest bids. As the dealers pay for the securities, their bank account balances are reduced. Thus the total amount of funds in the banking system is reduced by the market value of the securities sold by the Fed. This reduction in the supply of funds in the banking system places upward pressure on the federal funds rate. Such activity, which also is initiated by the FOMC’s policy directive, is referred to as a tightening of money supply growth.

Fed Trading of Repurchase Agreements
 In some cases, the Fed may wish to increase the aggregate level of bank funds for only a few days in order to ensure adequate liquidity in the banking system on those days. Under these conditions, the Trading Desk may trade 

repurchase agreements

 rather than government securities. It purchases Treasury securities from government securities dealers with an agreement to sell back the securities at a specified date in the near future. Initially, the level of funds rises as the securities are sold; it is then reduced when the dealers repurchase the securities. The Trading Desk uses repurchase agreements during holidays and other such periods to correct temporary imbalances in the level of bank funds. To correct a temporary excess of funds, the Trading Desk sells some of its Treasury securities holdings to securities dealers and agrees to repurchase them at a specified future date.

Control of M1 versus M2
 When the Fed conducts open market operations to adjust the money supply, it must also consider the measure of money on which it will focus. For the Fed’s purposes, the optimal form of money should (1) be controllable by the Fed and (2) have a predictable impact on economic variables when adjusted by the Fed. The most narrow form of money, known as M1, includes currency held by the public and checking deposits (such as demand deposits, NOW accounts, and automatic transfer balances) at depository institutions. The M1 measure does not include all funds that can be used for transactions purposes. For example, checks can be written against a money market deposit account (MMDA) offered by depository institutions or against a money market mutual fund. In addition, funds can easily be withdrawn from savings accounts to make transactions. For this reason, a broader measure of money, called M2, also deserves consideration. It includes everything in M1 as well as savings accounts and small time deposits, MMDAs, and some other items. Another measure of money, called M3, includes everything in M2 in addition to large time deposits and other items. Although there are even a few broader measures of money, it is M1, M2, and M3 that receive the most attention. A comparison of these measures of money is provided in 

Exhibit 4.4

.

   The M1 money measure is more volatile than M2 or M3. Since M1 can change owing simply to changes in the types of deposits maintained by households, M2 and M3 are more reliable measures for monitoring and controlling the money supply.

WEB

www.federalreserve.gov

Click on “Economic Research & Data” to obtain Federal Reserve statistical releases.

Consideration of Technical Factors
 The money supply can shift abruptly as a result of so-called technical factors, such as currency in circulation and Federal Reserve float. When the amount of currency in circulation increases (such as during the holiday season), the corresponding increase in net deposit withdrawals reduces funds; when it decreases, the net addition to deposits increases funds. Federal Reserve float is the amount of checks credited to bank funds that have not yet been collected. A rise in float causes an increase in bank funds, and a decrease in float causes a reduction in bank funds.

Exhibit 4.4 Comparison of Money Supply Measures

MONEY SUPPLY MEASURES

M1 = currency + checking deposits

M2 = M1 + savings deposits, MMDAs, overnight repurchase agreements, Eurodollars, no institutional money market mutual funds, and small time deposits

M3 = M2 + institutional money market mutual funds, large time deposits, and repurchase agreements and Eurodollars lasting more than one day

   The manager of the Trading Desk incorporates the expected impact of technical factors on funds into the instructions to traders. If the policy directive calls for growth in funds but technical factors are expected to increase funds, the instructions will call for a smaller injection of funds than if the technical factors did not exist. Conversely, if technical factors are expected to reduce funds, the instructions will call for a larger injection of funds to offset the impact of the technical factors.

Dynamic versus Defensive Open Market Operations
 Depending on the intent, open market operations can be classified as either dynamic or defensive. Dynamic operations are implemented to increase or decrease the level of funds, whereas defensive operations offset the impact of other conditions that affect the level of funds. For example, if the Fed expected a large inflow of cash into commercial banks then it could offset this inflow by selling some of its Treasury security holdings.

4-3c How Fed Operations Affect All Interest Rates

Even though most interest rates are market determined, the Fed can have a strong influence on these rates by controlling the supply of loanable funds. The use of open market operations to increase bank funds can affect various market-determined interest rates. First, the federal funds rate may decline because some banks have a larger supply of excess funds to lend out in the federal funds market. Second, banks with excess funds may offer new loans at a lower interest rate in order to make use of these funds. Third, these banks may also lower interest rates offered on deposits because they have more than adequate funds to conduct existing operations.

   Because open market operations commonly involve the buying or selling of Treasury bills, the yields on Treasury securities are influenced along with the yields (interest rates) offered on bank deposits. For example, when the Fed buys Treasury bills as a means of increasing the money supply, it places upward pressure on their prices. Since these securities offer a fixed value to investors at maturity, a higher price translates into a lower yield for investors who buy them and hold them until maturity. While Treasury yields are affected directly by open market operations, bank rates are also affected because of the change in the money supply that open market operations bring about.

   As the yields on Treasury bills and bank deposits decline, investors search for alternative investments such as other debt securities. As more funds are invested in these securities, the yields will decline. Thus open market operations used to increase bank funds influence not only bank deposit and loan rates but also the yields on other debt securities. The reduction in yields on debt securities lowers the cost of borrowing for the issuers of new debt securities. This can encourage potential borrowers (including corporations and individuals) to borrow and make expenditures that they might not have made if interest rates were higher.

   If open market operations are used to reduce bank funds, the opposite effects occur. There is upward pressure on the federal funds rate, on the loan rates charged to individuals and firms, and on the rates offered to bank depositors. As bank deposit rates rise, some investors may be encouraged to create bank deposits rather than invest in other debt securities. This activity reduces the amount of funds available for these debt instruments, thereby increasing the yield offered on the instruments.

Open Market Operations in Response to the Economy
 During the 2001–2003 period, when economic conditions were weak, the Fed frequently used open market operations to reduce interest rates. During 2004–2007 the economy improved, and the Fed’s concern shifted from a weak economy to high inflation. Therefore, it used a policy of raising interest rates in an attempt to keep the economy from overheating and to reduce inflationary pressure.

   In 2008, the credit crisis began, and the economy remained weak through 2012. During this period, the Fed used open market operations and reduced interest rates in an attempt to stimulate the economy. Its operations brought short-term T-bill rates down to close to zero percent in an effort to reduce loan rates charged by financial institutions, and thus encourage more borrowing and spending. The impact of monetary policy on economic conditions is given much more attention in the following chapter.

4-3d Adjusting the Reserve Requirement Ratio

Depository institutions are subject to a reserve requirement ratio, which is the proportion of their deposit accounts that must be held as required reserves (funds held in reserve). This ratio is set by the Board of Governors. Depository institutions have historically been forced to maintain between 8 and 12 percent of their transactions accounts (such as checking accounts) and a smaller proportion of their other savings accounts as required reserves. The 

Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

 of 1980 established that all depository institutions are subject to the Fed’s reserve requirements. Required reserves were held in a non–interest-bearing form until 2008, when the rule was changed. Now the Fed pays interest on required reserves maintained by depository institutions.

   Because the reserve requirement ratio affects the degree to which the money supply can change, it is considered a monetary policy tool. By changing it, the Board of Governors can adjust the money supply. When the board reduces the reserve requirement ratio, it increases the proportion of a bank’s deposits that can be lent out by depository institutions. As the funds loaned out are spent, a portion of them will return to the depository institutions in the form of new deposits. The lower the reserve requirement ratio, the greater the lending capacity of depository institutions; for this reason, any initial change in bank required reserves can cause a larger change in the money supply. In 1992, the Fed reduced the reserve requirement ratio on transactions accounts from 12 to 10 percent, where it has remained.

Impact of Reserve Requirements on Money Growth
 An adjustment in the reserve requirement ratio changes the proportion of financial institution funds that can be lent out, and this affects the degree to which the money supply can grow.

EXAMPLE

Assume the following conditions in the banking system:

·  Assumption 1. Banks obtain all their funds from demand deposits and use all funds except required reserves to make loans.

·  Assumption 2. The public does not store any cash; any funds withdrawn from banks are spent; and any funds received are deposited in banks.

·  Assumption 3. The reserve requirement ratio on demand deposits is 10 percent.

   Based on these assumptions, 10 percent of all bank deposits are maintained as required reserves and the other 90 percent are loaned out (zero excess reserves). Now assume that the Fed initially uses open market operations by purchasing $100 million worth of Treasury securities.

   As the Treasury securities dealers sell securities to the Fed, their deposit balances at commercial banks increase by $100 million. Banks maintain 10 percent of the $100 million, or $10 million, as required reserves and lend out the rest. As the $90 million lent out is spent, it returns to banks as new demand deposit accounts (by whoever received the funds that were spent). Banks maintain 10 percent, or $9 million, of these new deposits as required reserves and lend out the remainder ($81 million). The initial increase in demand deposits (money) multiplies into a much larger amount.

Exhibit 4.5 Illustration of Multiplier Effect

   This process, illustrated in 

Exhibit 4.5

, will not continue forever. Every time the funds lent out return to a bank, a portion (10 percent) is retained as required reserves. Thus the amount of new deposits created is less for each round. Under the previous assumptions, the initial money supply injection of $100 million would multiply by 1 divided by the reserve requirement ratio, or 1/0.10, to equal 10; hence the total change in the money supply, once the cycle is complete, is $100 million × 10 = $1 billion.

   As this simplified example demonstrates, an initial injection of funds will multiply into a larger amount. The reserve requirement controls the amount of loanable funds that can be created from new deposits. A higher reserve requirement ratio causes an initial injection of funds to multiply by a smaller amount. Conversely, a lower reserve requirement ratio causes it to multiply by a greater amount. In this way, the Fed can adjust money supply growth by changing the reserve requirement ratio.

   In reality, households sometimes hold cash and banks sometimes hold excess reserves, contrary to the example’s initial assumptions. Hence major leakages occur, and money does not multiply to the extent shown in the example. The money multiplier can change over time because of changes in the excess reserve level and in household preferences for demand deposits versus time deposits, as time deposits are not included in the most narrow definition of money. This complicates the task of forecasting how an initial adjustment in bank-required reserves will ultimately affect the money supply level. Another disadvantage of using the reserve requirement as a monetary policy tool is that an adjustment in its ratio can cause erratic shifts in the money supply. Thus the probability of missing the target money supply level is higher when using the reserve requirement ratio. Because of these limitations, the Fed normally relies on open market operations rather than adjustments in the reserve requirement ratio when controlling the money supply.

4-3e Adjusting the Fed’s Loan Rate

The Fed has traditionally provided short-term loans to depository institutions through its discount window. Before 2003, the Fed set its loan rate (then called the “discount rate”) at low levels when it wanted to encourage banks to borrow, since this activity increased the amount of funds injected into the financial system. The discount rate was viewed as a monetary policy tool because it could have been used to affect the money supply (although it was not an effective tool).

Exhibit 4.6 Primary Credit Rate over Time

   Since 2003, the Fed’s rate on short-term loans to depository institutions has been called the primary credit lending rate, which is set slightly above the federal funds rate (the rate charged on short-term loans between depository institutions). Depository institutions therefore rely on the Fed only as a backup for loans, since they should be able to obtain short-term loans from other institutions at a lower interest rate.

   The primary credit rate is shown in 

Exhibit 4.6

. The Fed periodically increased this rate during the 2003–2007 period when economic conditions were strong. It then periodically reduced this rate during the 2008–2010 period when economic conditions were weak, to keep it in line with the targeted federal funds rate.

   In 2003, the Fed began classifying the loans it provides into primary and secondary credit. Primary credit may be used for any purpose and is available only to depository institutions that satisfy specific criteria reflecting financial soundness. The loans are typically for a one-day period. Secondary credit is provided to depository institutions that do not satisfy those criteria, so they must pay a premium above the loan rate charged on primary credit. The Fed’s lending facility can be an important source of liquidity for some depository institutions, but it is no longer used to control the money supply.

4-4 THE FED’S INTERVENTION DURING THE CREDIT CRISIS

During and after the credit crisis, the Fed not only engaged in traditional open market operations (purchasing Treasury securities) to reduce interest rates, but also implemented various nontraditional strategies in an effort to improve economic conditions.

4-4a Fed Loans to Facilitate Rescue of Bear Stearns

Normally, depository institutions use the federal funds market rather than the Fed’s discount window to borrow short-term funds. During the credit crisis in 2008, however, some depository institutions that were unable to obtain credit in the federal funds market were allowed to obtain funding from the Fed’s discount window. In March 2008, the Fed’s discount window provided funding that enabled Bear Stearns, a large securities firm, to avoid filing for bankruptcy. Bear Stearns was not a depository institution, so it would not ordinarily be allowed to borrow funds from the Fed. However, it was a major provider of clearing operations for many types of financial transactions conducted by firms and individuals. If it had gone bankrupt those financial transactions might have been delayed, potentially creating liquidity problems for many individuals and firms that were to receive cash as a result of the transactions. On March 16, 2008, the Fed’s discount window provided a loan to J.P. Morgan Chase that was passed through to Bear Stearns. This ensured that the clearing operations would continue and avoided liquidity problems.

4-4b Fed Purchases of Mortgage-Backed Securities

In 2008 and 2009, the Fed purchased a large amount of outstanding mortgage-backed securities. It normally did not purchase mortgage-backed securities, but implemented this strategy to offset the reduction in the market demand for these securities due to investor fears. These fears were partially triggered by the failure of Lehman Brothers (a very large financial institution) in 2008, which suffered serious losses in its investments in mortgages and mortgage-backed securities. The market values of these securities had weakened substantially due to the high default rate on mortgages. The Fed’s strategy was intended to create a demand for mortgages and securities backed by mortgages in order to stimulate the housing market. The Fed has continued to periodically purchase mortgage-backed securities in recent years.

4-4c Fed’s Purchase of Bonds Backed by Loans

In November 2008, the Federal Reserve created a term asset-backed security loan facility (TALF) that provided financing to financial institutions purchasing high-quality bonds backed by consumer loans, credit card loans, or automobile loans. The market for these types of bonds became inactive during the credit crisis, and this discouraged lenders from making consumer loans because they could not easily sell the loans in the secondary market. The facility provided loans to institutional investors that purchased these types of loans. In this way, the Fed encouraged financial institutions to return to this market and thereby increased its liquidity. This was important because it indirectly ensured that more funding would be available to support consumer loans.

4-4d Fed’s Purchase of Commercial Paper

During 2008 and 2009, the Fed purchased a large amount of commercial paper. It normally did not purchase commercial paper, but implemented this strategy to offset the reduction in the market demand for commercial paper due to investor fears of defaults on commercial paper. Those fears were partially triggered by the failure of Lehman Brothers, which caused Lehman to default on the commercial paper that it had previously issued. Investors presumed that if Lehman’s asset quality was so weak that it could not cover its payments on commercial paper, other financial institutions that issued commercial paper and had large holdings of mortgage-backed securities might have the same outcome.

   Furthermore, the issuance of commercial paper and other debt securities in the primary market declined because institutional investors were unwilling to purchase securities that could not be sold in the secondary market. Hence credit was no longer easily accessible, and this made the credit crisis worse. The Fed recognized that some of these debt securities had low risk, yet the financial markets were paralyzed by fear of potential default. The Fed’s willingness to purchase commercial paper and other debt securities restored trading and liquidity in some debt markets.

4-4e Fed’s Purchase of Long-term Treasury Securities

In 2010, the Fed purchased a large amount of long-term Treasury notes and bonds, which was different from its normal open market operations that focused on purchasing short-term Treasury securities. The emphasis on purchasing long-term securities was intended to reduce long-term Treasury bond yields, which would indirectly result in lower long-term borrowing rates. The Fed was attempting to reduce long-term interest rates to encourage more long-term borrowing by corporations for capital expenditures, or more long-term borrowing by individuals to purchase homes. This strategy is discussed in more detail in the following chapter.

4-4f Perception of Fed Intervention During the Crisis

Most people would agree that the Fed took much initiative to improve economic conditions during the credit crisis. However, opinions vary on exactly what the Fed should have done to improve the economy. Many of the Fed’s actions during the credit crisis reflected the purchasing of securities to either lower interest rates (traditional monetary policy) or to restore liquidity in the markets for various types of debt securities. The Fed’s focus was on improving conditions in financial markets, which can increase the flow of funds from financial markets to corporations or individuals.

   However, some critics argue that the actions taken by the Fed were focused on the financial institutions and not on other sectors in the economy. A portion of the criticism is linked to the very high compensation levels paid by some financial institutions (such as some securities firms) to their employees. Critics contend that if these securities firms can afford to pay such high salaries, they should not need to be bailed out by the government.

   The Fed might respond that it did not bail out Lehman Brothers (a securities firm), which is why Lehman failed. In addition, the Fed’s actions to restore liquidity in debt markets did not just help financial institutions, but were necessary to ensure that all types of corporations and individuals could obtain funding. That funding is needed for corporations and individuals to increase their spending, which can stimulate the economy and create jobs.

   It might seem from the previous discussion that there are primarily two opinions regarding the Fed’s intervention. In reality, there are many other opinions not covered here. Consider a classroom exercise in which all students are allowed to express their opinion about what the Fed (or U.S. government in general) should have done to correct the credit crisis. Answers will likely range from “the U.S. government should do nothing and let the market fix itself” to “the U.S. government should completely manage all banks and should control salaries.” Many students might suggest that the U.S. government should intervene by directing more of its funds to the automotive, health care, or other industries in which they have a personal interest. Some answers might even suggest that major trade barriers should be imposed to correct the credit crisis, which leads to another set of opposing arguments. The point is that during a severe credit crisis, many critics will believe that intervention taken by the Fed is not serving their own interests because they have diverse special interests. Students would likely agree more on the causes of the credit crisis (which are discussed in detail in 

Chapter 9

) than on how the Fed or U.S. government in general should have resolved the crisis.

4-5 GLOBAL MONETARY POLICY

Each country has its own central bank that conducts monetary policy. The central banks of industrialized countries tend to have somewhat similar goals, which essentially reflect price stability (low inflation) and economic growth (low unemployment). Resources and conditions vary among countries, however, so a given central bank may focus more on a particular economic goal.

   Like the Fed, central banks of other industrialized countries use open market operations and reserve requirement adjustments as monetary tools. They also make adjustments in the interest rate they charge on loans to banks as a monetary policy tool. The monetary policy tools are generally used as a means of affecting local market interest rates in order to influence economic conditions.

   Because country economies are integrated, the Fed must consider economic conditions in other major countries when assessing the U.S. economy. The Fed may be most effective when it coordinates its activities with those of central banks of other countries. Central banks commonly work together when they intervene in the foreign exchange market, but conflicts of interest can make it difficult to coordinate monetary policies.

4-5a A Single Eurozone Monetary Policy

One of the goals of the European Union (EU) has been to establish a single currency for its members. In 2002, the following European countries replaced their national currencies with the euro: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Since that time, five more countries have also adopted the euro: Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, and Estonia in 2011. When the euro was introduced, three of the EU’s members at that time (Denmark, Sweden, and the United Kingdom) decided not to adopt the euro, although they may join later. Since the euro was introduced, 12 emerging countries in Europe have joined the EU (10 countries, including the Czech Republic and Hungary, joined in 2004; Bulgaria and Romania joined in 2007). Five of these new members have already adopted the euro, and others may eventually do so after satisfying the limitations imposed on government deficits.

   The European Central Bank (ECB), based in Frankfurt, is responsible for setting monetary policy for all European countries that use the euro as their currency. This bank’s objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies. Thus the ECB’s monetary goals of price and currency stability are similar to those of individual countries around the world; they differ in that they are focused on a group of countries rather than a single country. Because participating countries are subject to the monetary policy imposed by the ECB, a given country no longer has full control over the monetary policy implemented within its borders at any given time. The implementation of a common monetary policy may lead to more political unification among participating countries and encourage them to develop similar national defense and foreign policies.

WEB

www.ecb.int

Provides links on the European Central Bank and other foreign central banks.

Impact of the Euro on Monetary Policy
 As just described, the use of a common currency forces countries to abide by a common monetary policy. Changes in the money supply affect all European countries that use the euro as their currency. A single currency also means that the risk-free interest rate offered on government securities must be similar across the participating European countries. Any discrepancy in risk-free rates would encourage investors within these countries to invest in the country with the highest rate, which would realign the interest rates among the countries.

   Although having a single monetary policy may allow for more consistent economic conditions across the euro zone countries, it prevents any participating country from solving local economic problems with its own unique monetary policy. Euro zone governments may disagree on the ideal monetary policy for their local economies, but they must nevertheless agree on a single monetary policy. Yet any given policy used in a particular period may enhance economic conditions in some countries and adversely affect others. Each participating country is still able to apply its own fiscal policy (tax and government expenditure decisions), however.

   One concern about the euro is that each of the participating countries has its own agenda, which may prevent unified decisions about the future direction of the euro zone economies. Each country was supposed to show restraint on fiscal policy spending so that it could improve its budget deficit situation. Nevertheless, some countries have ignored restraint in favor of resolving domestic unemployment problems. The euro’s initial instability was partially attributed to political maneuvering as individual countries tried to serve their own interests at the expense of the other participating countries. This lack of solidarity is exactly the reason why there was some concern about using a single currency (and therefore monetary policy) among several European countries. Disagreements over policy intensified as the European economies weakened during 2008 and 2009.

4-5b Global Central Bank Coordination

In some cases, the central banks of various countries coordinate their efforts for a common cause. Shortly after the terrorist attack on the United States on September 11, 2001, the central banks of several countries injected money denominated in their respective currencies into the banking system to provide more liquidity. This strategy was intended to ensure that sufficient money would be available in case customers began to withdraw funds from banks or cash machines. On September 17, 2001, the Fed’s move to reduce interest rates before the U.S. stock market reopened was immediately followed by similar decisions by the Bank of Canada (Canada’s central bank) and the European Central Bank.

   Sometimes, however, central banks have conflicting objectives. For example, it is not unusual for two countries to simultaneously experience weak economies. In this situation, each central bank may consider intervening to weaken its home currency, which could increase foreign demand for exports denominated in that currency. But if both central banks attempt this type of intervention simultaneously, the exchange rate between the two currencies will be subject to conflicting forces.

EXAMPLE

Today, the Fed plans to intervene directly in the foreign exchange market by selling dollars for yen in an attempt to weaken the dollar. Meanwhile, the Bank of Japan plans to sell yen for dollars in the foreign exchange market in an attempt to weaken the yen. The effects are offsetting. One central bank can attempt to have a greater impact by selling more of its home currency in the foreign exchange market, but the other central bank may respond to offset that force.

Global Monetary Policy during the Credit Crisis
 During 2008, the effects of the credit crisis began to spread internationally. During August-October, stock market prices in the United States, Canada, China, France, Germany, Italy, Japan, Mexico, Russia, Spain, and many other countries declined by more than 25 percent. Each central bank has its own local interest rate that it might influence with monetary policy in order to control its local economy. 

Exhibit 4.7

 shows how the targeted interest rate level by various central banks changed over time. Notice how these banks increased their targeted interest rate level during the 2006–2007 period because their economies were strong at that time. However, during the financial crisis in 2008, these economies weakened, and the central banks (like the Fed) reduced their interest rates in an effort to stimulate their respective economies.

Exhibit 4.7 Targeted Interest Rates by Central Banks over Time

SUMMARY

· ▪ The key components of the Federal Reserve System are the Board of Governors and the Federal Open Market Committee. The Board of Governors determines the reserve requirements on account balances at depository institutions. It is also an important subset of the Federal Open Market Committee (FOMC), which determines U.S. monetary policy. The FOMC’s monetary policy has a major influence on interest rates and other economic conditions.

· ▪ The Fed uses open market operations (the buying and selling of securities) as a means of adjusting the money supply. The Fed purchases securities to increase the money supply and sells them to reduce the money supply.

· ▪ In response to the credit crisis, the Fed provided indirect funding to Bear Stearns (a large securities firm) so that it did not have to file for bankruptcy. It also created various facilities for providing funds to financial institutions and other corporations. One facility allowed primary dealers that serve as financial intermediaries for bonds and other securities to obtain overnight loans. Another facility purchased commercial paper issued by corporations.

· ▪ Each country has its own central bank, which is responsible for conducting monetary policy to achieve economic goals such as low inflation and low unemployment. Seventeen countries in Europe have adopted a single currency, which means that all of these countries are subject to the same monetary policy.

POINT COUNTER-POINT

Should There Be a Global Central Bank?

Point
 Yes. A global central bank could serve all countries in the manner that the European Central Bank now serves several European countries. With a single central bank, there could be a single monetary policy across all countries.

Counter-Point
 No. A global central bank could create a global monetary policy only if a single currency were used throughout the world. Moreover, all countries would not agree on the monetary policy that would be appropriate.

Who Is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. The Fed Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks.

· 2. FOMC What are the main goals of the Federal Open Market Committee (FOMC)? How does it attempt to achieve these goals?

· 3. Open Market Operations Explain how the Fed increases the money supply through open market operations.

· 4. Policy Directive What is the policy directive, and who carries it out?

· 5. Beige Book What is the Beige Book, and why is it important to the FOMC?

· 6. Reserve Requirements How is money supply growth affected by an increase in the reserve requirement ratio?

· 7. Control of Money Supply Describe the characteristics that a measure of money should have if it is to be manipulated by the Fed.

· 8. FOMC Economic Presentations What is the purpose of economic presentations during an FOMC meeting?

· 9. Open Market Operations Explain how the Fed can use open market operations to reduce the money supply.

· 10. Effect on Money Supply Why do the Fed’s open market operations have a different effect on the money supply than do transactions between two depository institutions?

· 11. Discount Window Lending during Credit Crisis Explain how and why the Fed extended its discount window lending to nonbank financial institutions during the credit crisis.

· 12. The Fed versus Congress Should the Fed or Congress decide the fate of large financial institutions that are near bankruptcy?

· 13. Bailouts by the Fed Do you think that the Fed should have bailed out large financial institutions during the credit crisis?

· 14. The Fed’s Impact on Unemployment Explain how the Fed’s monetary policy affects the unemployment level.

· 15. The Fed’s Impact on Home Purchases Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers?

· 16. The Fed’s Impact on Security Prices Explain how the Fed’s monetary policy may indirectly affect the price of equity securities.

· 17. Impact of FOMC Statement How might the FOMC statement (following the committee’s meeting) stabilize financial markets more than if no statement were provided?

· 18. Fed Facility Programs during the Credit Crisis Explain how the Fed’s facility programs improved liquidity in some debt markets.

· 19. Consumer Financial Protection Bureau As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established and housed within the Federal Reserve. Explain the role of this bureau.

· 20. Euro zone Monetary Policy Explain why participating in the euro zone causes a country to give up its independent monetary policy and control over its domestic interest rates.

· 21. The Fed’s Power What should be the Fed’s role? Should it be focused only on monetary policy? Or should it be allowed to engage in the trading of various types of securities in order to stabilize the financial system when securities markets are suffering from investor fears and the potential for high default risk?

· 22. The Fed and Mortgage-Backed Securities How has the Fed used mortgage-backed securities in recent years, and what has it been trying to accomplish?

· 23. The Fed and Commercial Paper Why and how did the Fed intervene in the commercial paper market during the credit crisis?

· 24. The Fed and Long-term Treasury Securities Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed’s usual operations?

· 25. The Fed and TALF What was T ALF, and why did the Fed create it?

Interpreting Financial News

Interpret the following statements made by Wall Street analysts and portfolio managers.

· a. “The Fed’s future monetary policy will be dependent on the economic indicators to be reported this week.”

· b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.”

· c. “Inflation will likely increase because real short-term interest rates currently are negative.”

Managing in Financial Markets

Anticipating the Fed’s Actions As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve implements monetary policy-and that the federal government implements spending and tax policies, or fiscal policy-to affect economic growth and inflation. However, it is difficult to achieve high economic growth without igniting inflation. Although the Federal Reserve is often said to be independent of the administration in office, there is much interaction between monetary and fiscal policies.

   Assume that the economy is currently stagnant and that some economists are concerned about the possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this year than in the previous five years. Assume that the Federal Reserve chairman’s term will expire in four months and that the President of the United States will have to appoint a new chairman (or reappoint the existing chairman). It is widely known that the existing chairman would like to be reappointed. Also assume that next year is an election year for the administration.

· a. Given the circumstances, do you expect that the administration will be more concerned about increasing economic growth or reducing inflation?

· b. Given the circumstances, do you expect that the Fed will be more concerned about increasing economic growth or reducing inflation?

· c. Your firm is relying on you for some insight on how the government will influence economic conditions and hence the demand for your firm’s products. Given the circumstances, what is your forecast of how the government will affect economic conditions?

FLOW OF FUNDS EXERCISE

Monitoring the Fed

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making acquisitions. The company expects that it will need substantial long-term financing, and it plans to borrow additional funds either through loans or by issuing bonds. The Carson Company is also considering issuing stock to raise funds in the next year.

   Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets. It recently received an alert from the service that suggested the Fed has been selling large holdings of its Treasury securities in the secondary Treasury securities market.

· a. How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on the price of Treasury securities? Explain.

· b. Will these actions place upward or downward pressure on Treasury yields? Explain.

· c. Will these actions place upward or downward pressure on interest rates? Explain.

INTERNET/EXCEL EXERCISE

Assess the current structure of the Federal Reserve System by using the website 
www.federalreserve.gov/monetarypolicy/fomc.htm
.

   Go to the minutes of the most recent meeting. Who is the current chairman? Who is the current vice chairman? How many people attended the meeting? Describe the main issues discussed at the meeting.

WSJ EXERCISE

Reviewing Fed Policies

Review recent issues of the Wall Street Journal and search for any comments that relate to the Fed. Does 

Chapter 4

: Functions of the Fed 101 downward pressure on the price of Treasury securities? Explain. b. Will these actions place upward or downward pressure on Treasury yields? Explain. c. Will these actions place upward or downward pressure on interest rates? Explain. Go to the minutes of the most recent meeting. Who is the current chairman? Who is the current vice chairman? How many people attended the meeting? Describe the main issues discussed at the meeting. it appear that the Fed may attempt to revise the federal funds rate? If so, how and why?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. Federal Reserve AND interest rate

· 2. Federal Reserve AND monetary policy

· 3. Board of Governors

· 4. FOMC meeting

· 5. FOMC AND interest rate

· 6. Federal Reserve AND policy

· 7. Federal Reserve AND open market operations

· 8. money supply AND interest rate

· 9. open market operations AND interest rate

· 10. Federal Reserve AND economy

3

 

Structure of Interest Rates

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe how characteristics of debt securities cause their yields to vary,

· ▪ demonstrate how to estimate the appropriate yield for any particular debt security, and

· ▪ explain the theories behind the term structure of interest rates (relationship between the term to maturity and the yield of securities).

The annual interest rate offered by debt securities at any given time varies among debt securities. Individual and institutional investors must understand why quoted yields vary so that they can determine whether the extra yield on a given security outweighs any unfavorable characteristics. Financial managers of corporations or government agencies in need of funds must understand why quoted yields of debt securities vary so that they can estimate the yield they would have to offer in order to sell new debt securities.

3-1 WHY DEBT SECURITY YIELDS VARY

Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered. In general, securities with unfavorable characteristics will offer higher yields to entice investors. Some debt securities have favorable features; therefore, they can offer relatively low yields and still attract investors. The yields on debt securities are affected by the following characteristics:

· ▪ Credit (default) risk

· ▪ Liquidity

· ▪ Tax status

· ▪ Term to maturity

The yields on bonds may also be affected by special provisions, as described in 

Chapter 7

.

3-1a Credit (Default) Risk

Because most securities are subject to the risk of default, investors must consider the creditworthiness of the security issuer. Although investors always have the option of purchasing risk-free

Treasury

securities, they may prefer other securities if the yield compensates them for the risk. Thus, if all other characteristics besides credit (default) risk are equal, securities with a higher degree of default risk must offer higher yields before investors will purchase them.

EXAMPLE

Investors can purchase a Treasury bond with a

10-year

maturity that presently offers an annualized yield of 7 percent if they hold the bond until maturity. Alternatively, investors can purchase bonds that are being issued by Zanstell Co. Although Zanstell is in good financial condition, there is a small possibility that it could file for bankruptcy during the next 10 years, in which case it would discontinue making payments to investors who purchased the bonds. Thus there is a small possibility that investors could lose most of their investment in these bonds. The only way in which investors would even consider purchasing bonds issued by Zanstell Co. is if the annualized yield offered on these bonds is higher than the Treasury bond yield. Zanstell’s bonds presently offer a yield of 8 percent, which is 1 percent higher than the yield offered on Treasury bonds. At this yield, some investors are willing to purchase Zanstell’s bonds because they think Zanstell Co. should have sufficient cash flows to repay its debt over the next 1 0 years.

   Credit risk is especially relevant for longer-term securities that expose creditors to the possibility of default for a longer time. Credit risk premiums of 1 percent, 2 percent, or more may not seem significant. But for a corporation borrowing $30 million through the issuance of bonds, an extra percentage point as a premium reflects $300,000 in additional interest expenses per year.

   Investors can personally assess the creditworthiness of corporations that issue bonds, but they may prefer to rely on bond ratings provided by rating agencies. These ratings are based on a financial assessment of the issuing corporation, with a focus on whether the corporation will receive sufficient cash flows over time to cover its payments to bondholders. The higher the rating on the bond, the lower the perceived credit risk.

   As time passes, economic conditions can change, which can influence the ability of a corporation to repay its debt. Thus bonds previously issued by a firm may be rated at one level,

where

as a subsequent issue from the same firm is rated at a different level. The ratings can also differ if the collateral provisions differ among the bonds. Rating agencies can also change bond ratings over time in response to changes in the issuing firm’s financial condition or to changes in economic conditions.

3-1b Assessing Credit Risk

To assess the credit risk of a corporation that issues bonds, investors can evaluate the corporation’s financial statements. Specifically, investors use financial statements to predict the level of cash flows a corporation will generate over future periods, which helps determine if the company will have sufficient cash flows to cover its debt payments. However, financial statements might not indicate how a corporation will perform in the future. Many corporations that were in good financial condition just before they issued debt failed before they repaid their debt.

Rating Agencies
 Many investors rely heavily on the ratings of debt securities assigned by rating agencies, so that they do not have to assess the financial statements of corporations. The rating agencies charge the issuers of debt securities a fee for assessing the credit risk of those securities. The ratings are then provided through various financial media outlets at no cost to investors. The most popular rating agencies are Moody’s Investors Service and Standard & Poor’s Corporation. A summary of their rating classification schedules is provided in 
Exhibit 3.1
. The ratings issued by Moody’s range from Aaa for the highest quality to C for the lowest quality, and those issued by Standard & Poor’s range from AAA to D. Because these rating agencies use different methods to assess the creditworthiness of firms and state governments, a particular bond could be rated at a different quality level by each agency. However, the differences are usually small.

   Commercial banks typically invest only in 

investment-grade bonds

, which are bonds rated as Baa or better by Moody’s and as BBB or better by Standard & Poor’s. Other financial institutions, such as pension funds and insurance companies, invest in bonds that are rated lower and offer the potential for higher returns.

WEB

www.moodys.com

Credit rating information.

Exhibit 3.1 Rating Classification by Rating Agencies

Accuracy of Credit Ratings
 The ratings issued by the agencies are opinions, not guarantees. Bonds that are assigned a low credit rating experience default more frequently than bonds assigned a high credit rating, which suggests that the rating can be a useful indicator of credit risk. However, credit rating agencies do not always detect firms’ financial problems.

   Credit rating agencies were criticized for being too liberal in their assignment of ratings on debt issued shortly before the credit crisis, as many highly rated debt issues defaulted over the next few years. The credit rating agencies might counter that they could not have anticipated the credit crisis and that they used all the information available to them when assigning ratings to new securities. Yet because credit rating agencies are paid by the issuers of debt securities and not the investors who purchase those securities, agencies may have a natural incentive to assign a high rating. Doing so facilitates a firm’s issuing of debt securities, which in turn should attract more business from other issuers of debt securities.

   In response to the criticism, credit rating agencies made some changes to improve their rating process and their transparency. They now disclose more information about how they derived their credit ratings. In addition, employees of each credit rating agency that promote the services of the agency are not allowed to influence the ratings assigned by the rating agency. They are giving more attention to sensitivity analysis in which they assess how creditworthiness might change in response to abrupt changes in the economy.

Oversight of Credit Rating Agencies
 The Financial Reform Act of 2010 established an Office of Credit Ratings within the Securities and Exchange Commission in order to regulate credit rating agencies. The act also mandated that credit rating agencies establish internal controls to ensure that their process of assigning ratings is more transparent. The agencies must disclose their rating performance over time, and they are to be held accountable if their ratings prove to be inaccurate. The Financial Reform Act also allows investors to sue an agency for issuing credit ratings that the agency should have known were inaccurate.

3-1c Liquidity

Investors prefer securities that are liquid, meaning that they could be easily converted to cash without a loss in value. Thus, if all other characteristics are equal, securities with less liquidity will have to offer a higher yield to attract investors. Debt securities with a short-term maturity or an active secondary market have greater liquidity. Investors that need a high degree of liquidity (because they may need to sell their securities for cash at any moment) prefer liquid securities, even if it means that they will have to accept a lower return on their investment. Investors who will not need their funds until the securities mature are more willing to invest in securities with less liquidity in order to earn a slightly higher return.

3-1d Tax Status

Investors are more concerned with after-tax income than before-tax income earned on securities. If all other characteristics are similar, taxable securities must offer a higher before-tax yield than tax-exempt securities. The extra compensation required on taxable securities depends on the tax rates of individual and institutional investors. Investors in high tax brackets benefit most from tax-exempt securities.

   When assessing the expected yields of various securities with similar risk and maturity, it is common to convert them into an after-tax form, as follows:

Yat = Ybt (1 − T

where

Yat

= after-tax yield

Ybt

= before-tax yield

T

= investor’s marginal tax rate

Investors retain only a percentage (1 − T) of the before-tax yield once taxes are paid.

EXAMPLE

Consider a taxable security that offers a before-tax yield of 8 percent. When converted into aftertax terms, the yield will be reduced by the tax percentage. The precise after-tax yield is dependent on the tax rate T. If the tax rate of the investor is 20 percent, then the after-tax yield will be

Yat

= Ybt (1 − T)

 

= 8% (1 − 0.2)

 

= 16.4%

   

Exhibit 3.2

 presents after-tax yields based on a variety of tax rates and before-tax yields. For example, a taxable security with a before-tax yield of 6 percent will generate an after-tax yield of 5.4 percent to an investor in the 10 percent tax bracket,

5.10

percent to an investor in the

15

percent tax bracket, and so on. This exhibit shows why investors in high tax brackets are attracted to tax-exempt securities.

Exhibit 3.2 After-Tax Yields Based on Various Tax Rates and Before-Tax Yields

BEFORE-TAX YIELD

TAX RATE

6%

8%

10%

12%

14%

10%

5.40%

7.

20%

9.00%

10.80%

12.60%

15 5.10

6.80

8.50

10.20

11.90

25

4.50

6.00

7.50

9.00

10.50

28

4.32

5.76

7.20

8.64

10.08

35

3.90

5.20

6.50

7.80

9.10

Computing the Equivalent Before-Tax Yield
 In some cases, investors wish to determine the before-tax yield necessary to match the after-tax yield of a tax-exempt security that has a similar risk and maturity. This can be done by rearranging the terms of the previous equation:

Ybt

 = 

Yat

	1 − T

For instance, suppose that a firm in the 20 percent tax bracket is aware of a tax-exempt security that is paying a yield of 8 percent. To match this after-tax yield, taxable securities must offer a before-tax yield of

Ybt = 

Yat

1 − T

 = 

8%

1 − 02

 = b

   State taxes should be considered along with federal taxes in determining the after-tax yield. Treasury securities are exempt from state income tax, and municipal securities are sometimes exempt as well. Because states impose different income tax rates, a particular security’s after-tax yield may vary with the location of the investor.

3-1e Term to Maturity

Maturity differs among debt securities and is another reason that debt security yields differ. The 

term structure of interest rates

 defines the relationship between the term to maturity and the annualized yield of debt securities at a specific moment in time while holding other factors, such as risk, constant.

WEB

www.treasury.gov

Treasury yields among different maturities.

EXAMPLE

Assume that, as of today, the annualized yields for federal government securities (which are free from credit risk) of varied maturities are as shown in 

Exhibit 3.3

. The curve created by connecting the points plotted in the exhibit is commonly referred to as a yield curve. Notice that the yield curve exhibits an upward slope.

Exhibit 3.3 Example of Relationship between Maturity and Yield of Treasury Securities (as of March 2013)

   The term structure of interest rates in 
Exhibit 3.3
 shows that securities that are similar in all ways except their term to maturity may offer different yields. Because the demand and supply conditions for securities may vary among maturities, so may the price (and therefore the yield) of securities. A comprehensive explanation of the term structure of interest rates is provided later in this chapter.

WEB

www.bloomberg.com

The section on market interest rates and bonds presents the most recent yield curve.

   Since the yield curve in Exhibit 3.3 is based on Treasury securities, the curve is not influenced by credit risk. The yield curve for AA-rated corporate bonds would typically have a slope similar to that of the Treasury yield curve, but the yield of the corporate issue at any particular term to maturity would be higher to reflect the risk premium.

3-2 EXPLAINING ACRUAL YIELD DIFFERENTIALS

Even small differentials in yield can be relevant to financial institutions that are borrowing or investing millions of dollars. Yield differentials are sometimes measured in basis points; a basis point equals 0.01 percent, so 100 basis points equals 1 percent. If a security offers a yield of 4.3 percent while the a risk-free security offers a yield of 4.0 percent, then the yield differential is 0.30 percent or 30 basis points. Yield differentials are described for money market securities next, followed by differentials for capital market securities.

3-2a Yield Differentials of Money Market Securities

The yields offered on commercial paper (short-term securities offered by creditworthy firms) are typically just slightly higher than Treasury-bill rates, since investors require a slightly higher return (10 to 40 basis points on an annualized basis) to compensate for credit risk and less liquidity. Negotiable certificates of deposit offer slightly higher rates than yields on Treasury bills (“T-bills”) with the same maturity because of their lower degree of liquidity and higher degree of credit risk.

   Market forces cause the yields of all securities to move in the same direction. To illustrate, assume that the budget deficit increases substantially and that the Treasury issues a large number of T-bills to finance the increased deficit. This action creates a large supply of T-bills in the market, placing downward pressure on the price and upward pressure on the T-bill yield. As the yield begins to rise, it approaches the yield of other short-term securities. Businesses and individual investors are now encouraged to purchase T-bills rather than these risky securities because they can achieve about the same yield while avoiding credit risk. The switch to T-bills lowers the demand for risky securities, thereby placing downward pressure on their price and upward pressure on their yields. Thus the risk premium on risky securities would not disappear completely.

3-2b Yield Differentials of Capital Market Securities

Municipal bonds have the lowest before-tax yield, yet their after-tax yield is typically above that of Treasury bonds from the perspective of investors in high tax brackets. Treasury bonds are expected to offer the lowest yield because they are free from credit risk and can easily be liquidated in the secondary market. Investors prefer municipal or corporate bonds over Treasury bonds only if the after-tax yield is sufficiently higher to compensate for the higher credit risk and lower degree of liquidity.

   To illustrate how capital market security yields can vary over time because of credit risk, 

Exhibit 3.4

 shows yields of corporate bonds in two different credit risk classes. The Aaa-rated bonds have very low credit risk, whereas the BAA bonds are perceived to have slightly more risk. Notice that the yield differential between BAA bonds and AAA bonds was relatively large during the recessions (shaded areas), such as in 1991 and in the 2000–2003 period when economic conditions were weak. During these periods, corporations had to pay a relatively high premium if their bonds were rated Baa. The yield differential narrowed during 2004–2007, when economic conditions improved. However, during the credit crisis of 2008–2009, the yield differential increased substantially. At one point during the credit crisis, the yield differential was about 3 percentage points.

Exhibit 3.4 Yield Differentials of Corporate Bonds

   Many corporations whose bonds are rated Baa or below were unwilling to issue bonds because of the high credit risk premium they would have to pay to bondholders. This illustrates why the credit crisis restricted access of corporations to credit.

3-3 ESTIMATING THE APPROPRIATE YIELD

The discussion so far suggests that the appropriate yield to be offered on a debt security is based on the risk-free rate for the corresponding maturity, with adjustments to capture various characteristics. A model that captures this estimate may be specified as follows:

Yn = Rf,n + DP + LP + TA

where

Yn	= yield of an n-day debt security
Rf,n	= yield return of an n-day Treasury risk-free security
DP	= default premium to compensate for credit risk
LP	= liquidity premium to compensate for less liquidity
TA	= adjustment due to the difference in tax status

These are the characteristics identified earlier that explain yield differentials among securities (special provisions applicable to bonds also may be included, as described in 
Chapter 7
). Although maturity is another characteristic that can affect the yield, it is not included here because it is controlled for by matching the maturity of the security with that of a risk-free security.

EXAMPLE

Suppose that the three-month T-bill’s annualized rate is 8 percent and that Elizabeth Company plans to issue 90-day commercial paper. Elizabeth Company must determine the default premium (DP) and liquidity premium (LP) to offer on its commercial paper in order to make it as attractive to investors as a three-month (13-week) T-bill. The federal tax status of commercial paper is the same as for T-bills. However, income earned from investing in commercial paper is subject to state taxes whereas income earned from investing in T-bills is not. Investors may require a premium for this reason alone if they reside in a location where state and (and perhaps local) income taxes apply.

   Assume Elizabeth Company believes that a 0.7 percent default risk premium, a 0.2 percent liquidity premium, and a 0.3 percent tax adjustment are necessary to sell its commercial paper to investors. The appropriate yield to be offered on the commercial paper, Ycp, is then

 

 

Ycp,n		= Rf,n + DP + LP + TA
= 8% + 0.7% + 0.2% + 0.3%
= 9.2%

   The appropriate commercial paper rate will change over time, perhaps because of changes in the risk-free rate and/or the default premium, liquidity premium, and tax adjustment factors.

   Some corporations may postpone plans to issue commercial paper until the economy improves and the required premium for credit risk is reduced. Even then, however, the market rate of commercial paper may increase if interest rates increase.

EXAMPLE

If the default risk premium decreases from 0.7 percent to 0.5 percent but Rf,n increases from 8 percent to 8.7 percent, the appropriate yield to be offered on commercial paper (assuming no change in the previously assumed liquidity and tax adjustment premiums) would be

= Rf,n + DP + LP + TA

 

 

Ycp

= 8.7% + 0.5% + 0.2% + 0.3%

= 9.7%

The strategy of postponing the issuance of commercial paper would backfire in this example. Even though the default premium decreased by 0.2 percent, the general level of interest rates rose by 0.7 percent, so the net change in the commercial paper rate is +0.5 percent.

As this example shows, the increase in a security’s yield over time does not necessarily mean that the default premium has increased. The assessment of yields as described here could also be applied to long-term securities. If, for example, a firm desires to issue a 20-year corporate bond, it will use the yield of a new 20-year Treasury bond as the 20-year risk-free rate and add on the premiums for credit risk, liquidity risk, and so on when determining the yield at which it can sell corporate bonds.

   A simpler and more general relationship is that the yield offered on a debt security is positively related to the prevailing risk-free rate and the security’s risk premium (RP). This risk premium captures any risk characteristics of the security, including credit risk and liquidity risk. A more detailed model for the yield of a debt security could be applied by including additional characteristics that can vary among bonds, such as whether the bond is convertible into stock and whether it contains a call premium. The conversion option is favorable for investors, so it could reduce the yield that needs to be offered on a bond. The call premium is unfavorable for investors, so it could increase the yield that needs to be offered on a bond.

3-4 A CLOSER LOOK AT THE TERM STRUCTURE

Of all the factors that affect the yields offered on debt securities, the one that is most difficult to understand is term to maturity. For this reason, a more comprehensive explanation of the relationship between term to maturity and annualized yield (referred to as the term structure of interest rates) is necessary.

   Various theories have been used to explain the relationship between maturity and annualized yield of securities. These theories include pure expectations theory, liquidity premium theory, and segmented markets theory, and each is explained in this section.

3-4a Pure Expectations Theory

According to pure expectations theory, the term structure of interest rates (as reflected in the shape of the yield curve) is determined solely by expectations of interest rates.

Impact of an Expected Increase in Interest Rates
 To understand how interest rate expectations may influence the yield curve, assume that the annualized yields of short-term and long-term risk-free securities are similar; that is, suppose the yield curve is flat. Then assume that investors begin to believe that interest rates will rise. Investors will respond by investing their funds mostly in the short term so that they can soon reinvest their funds at higher yields after interest rates increase. When investors flood the short-term market and avoid the long-term market, they may cause the yield curve to adjust as shown in Panel A of 

Exhibit 3.5

. The large supply of funds in the short-term markets will force annualized yields down. Meanwhile, the reduced supply of long-term funds forces long-term yields up.

   Even though the annualized short-term yields become lower than annualized long-term yields, investors in short-term funds are satisfied because they expect interest rates to rise. They will make up for the lower short-term yield when the short-term securities mature, and they reinvest at a higher rate (if interest rates rise) at maturity.

   Assuming that the borrowers who plan to issue securities also expect interest rates to increase, they will prefer to lock in the present interest rate over a long period of time. Thus, borrowers will generally prefer to issue long-term securities rather than short-term securities. This results in a relatively small demand for short-term funds. Consequently, there is downward pressure on the yield of short-term funds. There is a corresponding increase in the demand for long-term funds by borrowers, which places upward pressure on long-term funds. Overall, the expectation of higher interest rates changes the demand for funds and the supply of funds in different maturity markets, which forces the original flat yield curve (labeled YC1 in the two rightmost graphs) to pivot upward (counterclockwise) and become upward sloping (YC2).

Impact of an Expected Decline in Interest Rates
 If investors expect interest rates to decrease in the future, they will prefer to invest in long-term funds rather than short-term funds because they could lock in today’s interest rate before interest rates fall. Borrowers will prefer to borrow short-term funds so that they can refinance at a lower interest rate once interest rates decline.

Exhibit 3.5 How Interest Rate Expectations Affect the Yield Curve

   Based on the expectation of lower interest rates in the future, the supply of funds provided by investors will be low for short-term funds and high for long-term funds. This will place upward pressure on short-term yields and downward pressure on long-term yields, as shown in Panel B of 
Exhibit 3.5
. Overall, the expectation of lower interest rates causes the shape of the yield curve to pivot downward (clockwise).

Algebraic Presentation
 Investors monitor the yield curve to determine the rates that exist for securities with various maturities. They can either purchase a security with a maturity that matches their investment horizon or purchase a security with a shorter term and then reinvest the proceeds at maturity. They may select the strategy that they believe will generate a higher return over the entire investment horizon. This could affect the prices and yields of securities with different maturities, so that the expected return over the investment horizon is similar regardless of the strategy used. If investors were indifferent to maturities, the return of any security should equal the compounded yield of consecutive investments in shorter-term securities. That is, a two-year security should offer a return that is similar to the anticipated return from investing in two consecutive one-year securities. A four-year security should offer a return that is competitive with the expected return from investing in two consecutive two-year securities or four consecutive one-year securities, and so on.

EXAMPLE

To illustrate these equalities, consider the relationship between interest rates on a two-year security and a one-year security as follows:

(1 + ti2)2 = (1 + ti1)(1 + t+1r1)

where

ti 2	= known annualized interest rate of a two-year security as of time t
ti 1	= known annualized interest rate of a one-year security as of time t
t+1 r 1	= one-year interest rate that is anticipated as of time t + 1 (one year ahead)

The term i represents a quoted rate, which is therefore known, whereas r represents a rate to be quoted at some point in the future, so its value is uncertain. The left side of the equation represents the compounded yield to investors who purchase a two-year security, and the right side represents the anticipated compounded yield from purchasing a one-year security and reinvesting the proceeds in a new one-year security at the end of one year. If time t is today, then t+1r1 can be estimated by rearranging terms:

The term t+1r1, referred to as the 

forward rate

, is commonly estimated in order to represent the market’s forecast of the future interest rate. Here is a numerical example. Assume that, as of today (time t), the annualized two-year interest rate is 10 percent and the one-year interest rate is 8 percent. The forward rate is then estimated as follows:

This result implies that, one year from now, a one-year interest rate must equal about 12.037 percent in order for consecutive investments in two one-year securities to generate a return similar to that of a two-year investment. If the actual one-year rate beginning one year from now (i.e., at time t + 1) is above 12.037 percent, the return from two consecutive one-year investments will exceed the return on a two-year investment.

   The forward rate is sometimes used as an approximation of the market’s consensus interest rate forecast. The reason is that, if the market had a different perception, the demand and supply of today’s existing two-year and one-year securities would adjust to capitalize on this information. Of course, there is no guarantee that the forward rate will forecast the future interest rate with perfect accuracy.

   The greater the difference between the implied one-year forward rate and today’s one-year interest rate, the greater the expected change in the one-year interest rate. If the term structure of interest rates is solely influenced by expectations of future interest rates, the following relationships hold:

SCENARIO	STRUCTURE OF YIELD CURVE	EXPECTATIONS ABOUT THE FUTURE INTEREST RATE
1. t+1 r 1 >  ti 1	Upward slope	Higher than today’s rate
2. t+1 r 1 =  ti 1	Flat	Same as today’s rate
3. t+1 r 1 <  ti 1	Downward slope	Lower than today’s rate

   Forward rates can be determined for various maturities. The relationships described here can be applied when assessing the change in the interest rate of a security with any particular maturity.

   The previous example can be expanded to solve for other forward rates. The equality specified by the pure expectations theory for a three-year horizon is

All other terms were defined previously. By rearranging terms, we can isolate the forward rate of a one-year security beginning two years from now:

If the one-year forward rate beginning one year from now (t+1r1) has already been estimated, then this estimate can be combined with actual one-year and three-year interest rates to estimate the one-year forward rate two years from now. Recall that our previous example assumed ti1 = 8 percent and estimated t+1r1 to be about 12.037 percent.

EXAMPLE

Assume that a three-year security has an annualized interest rate of 11 percent (i.e., ti3 = 11 percent). Given this information, the one-year forward rate two years from now can be calculated as follows:

Thus, the market anticipates that, two years from now, the one-year interest rate will be 13.02736 percent.

   The yield curve can also be used to forecast annualized interest rates for periods other than one year. For example, the information provided in the last example could be used to determine the two-year forward rate beginning one year from now.

   According to pure expectations theory, a one-year investment followed by a two-year investment should offer the same annualized yield over the three-year horizon as a three-year security that could be purchased today. This relation is expressed as follows:

(1 + t+1i3)3 = (1 + ti1)(1 + t + 1r2)2

   where t+1r2 is the annual interest rate of a two-year security anticipated as of time t+1. By rearranging terms, t+1r2 can be isolated:

(1 + t+1r2)2 = 

(1 + ti3)
		1 + ti1

EXAMPLE

Recall that today’s annualized yields for one-year and three-year securities are 8 percent and 11 percent, respectively. With this information, t+1r2 is estimated as follows:

Thus, the market anticipates an annualized interest rate of about 12.53 percent for two-year securities beginning one year from now.

   Pure expectations theory is based on the premise that forward rates are unbiased estimators of future interest rates. If forward rates are biased, investors can attempt to capitalize on the bias.

EXAMPLE

In the previous numerical example, the one-year forward rate beginning one year ahead was estimated to be about 12.037 percent. If the forward rate was thought to contain an upward bias, the expected one-year interest rate beginning one year ahead would actually be less than 12.037 percent. Therefore, investors with funds available for two years would earn a higher yield by purchasing two-year securities rather than purchasing one-year securities for two consecutive years. However, their actions would cause an increase in the price of two-year securities and a decrease in that of one-year securities, and the yields of these securities would move inversely with the price movements. Hence any attempt by investors to capitalize on the forward rate bias would essentially eliminate the bias.

   If forward rates are unbiased estimators of future interest rates, financial market efficiency is supported and the information implied by market rates about the forward rate cannot be used to generate abnormal returns. In response to new information, investor preferences would change, yields would adjust, and the implied forward rate would adjust as well.

   If a long-term rate is expected to equal a geometric average of consecutive short-term rates covering the same time horizon (as is suggested by pure expectations theory), longterm rates would likely be more stable than short-term rates. As expectations about consecutive short-term rates change over time, the average of these rates is less volatile than the individual short-term rates. Thus long-term rates are much more stable than short-term rates.

3-4b Liquidity Premium Theory

Some investors may prefer to own short-term rather than long-term securities because a shorter maturity represents greater liquidity. In this case, they may be willing to hold long-term securities only if compensated by a premium for the lower degree of liquidity. Although long-term securities can be liquidated prior to maturity, their prices are more sensitive to interest rate movements. Short-term securities are normally considered to be more liquid because they are more likely to be converted to cash without a loss in value.

   The preference for the more liquid short-term securities places upward pressure on the slope of a yield curve. Liquidity may be a more critical factor to investors at some times than at others, and the liquidity premium will accordingly change over time. As it does, the yield curve will change also. This is the liquidity premium theory (sometimes referred to as the liquidity preference theory).

   

Exhibit 3.6

 contains three graphs that reflect the existence of both expectations theory and a liquidity premium. Each graph shows different interest rate expectations by the market. Regardless of the interest rate forecast, the yield curve is affected in a similar manner by the liquidity premium.

Exhibit 3.6 Impact of Liquidity Premium on the Yield Curve under Three Different Scenarios

Estimation of the Forward Rate Based on a Liquidity Premium
 When expectations theory is combined with liquidity theory, the yield on a security will not necessarily be equal to the yield from consecutive investments in shorter-term securities over the same investment horizon. For example, the yield on a two-year security is now determined as

(1 + t+1i2)2 = (1 + ti1)(1 + t+1r1 + LP2

where LP2 denotes the liquidity premium on a two-year security. The yield generated from the two-year security should exceed the yield from consecutive investments in one-year securities by a premium that compensates the investor for less liquidity. The relationship between the liquidity premium and term to maturity can be expressed as follows:

0 < LP1 < LP2 < LP3 < ··· < LP20

where the subscripts represent years to maturity. This implies that the liquidity premium would be more influential on the difference between annualized interest rates on one-year and 20-year securities than on the difference between one-year and two-year securities.

   If liquidity influences the yield curve, the forward rate overestimates the market’s expectation of the future interest rate. A more appropriate formula for the forward rate would account for the liquidity premium. By rearranging terms in the previous equation for forward rates, the one-year forward rate can be derived as follows:

t+1r1 = 

1 + ti1

(1 + ti2)2

 − 1 − 

1 + ti1

LP2

EXAMPLE

Reconsider the example where i1 = 8 percent and i2 = 10 percent, and assume that the liquidity premium on a two-year security is 0.5 percent. The one-year forward rate can then be derived from this information as follows:

This estimate of the one-year forward rate is lower than the estimate derived in the previous related example in which the liquidity premium was not considered. The previous estimate (12.037 percent) of the forward rate probably overstates the market’s expected interest rate because it did not account for a liquidity premium. Thus forecasts of future interest rates implied by a yield curve are reduced slightly when accounting for the liquidity premium.

   Even with the existence of a liquidity premium, yield curves could still be used to interpret interest rate expectations. A flat yield curve would be interpreted to mean that the market is expecting a slight decrease in interest rates (without the effect of the liquidity premium, the yield curve would have had a slight downward slope). A slight upward slope would be interpreted as no expected change in interest rates: if the liquidity premium were removed, this yield curve would be flat.

3-4c Segmented Markets Theory

According to the segmented markets theory, investors and borrowers choose securities with maturities that satisfy their forecasted cash needs. Pension funds and life insurance companies may generally prefer long-term investments that coincide with their long-term liabilities. Commercial banks may prefer more short-term investments to coincide with their short-term liabilities. If investors and borrowers participate only in the maturity market that satisfies their particular needs, then markets are segmented. That is, investors (or borrowers) will shift from the long-term market to the short-term market, or vice versa, only if the timing of their cash needs changes. According to segmented markets theory, the choice of long-term versus short-term maturities is determined more by investors’ needs than by their expectations of future interest rates.

EXAMPLE

Assume that most investors have funds available to invest for only a short period of time and therefore desire to invest primarily in short-term securities. Also assume that most borrowers need funds for a long period of time and therefore desire to issue mostly long-term securities. The result will be downward pressure on the yield of short-term securities and upward pressure on the yield of long-term securities. Overall, the scenario described would create an upward-sloping yield curve.

   Now consider the opposite scenario in which most investors wish to invest their funds for a long period of time while most borrowers need funds for only a short period of time. According to segmented markets theory, this situation will cause upward pressure on the yield of short-term securities and downward pressure on the yield of long-term securities. If the supply of funds provided by investors and the demand for funds by borrowers were better balanced between the short-term and long-term markets, the yields of short-and long-term securities would be more similar.

   The preceding example distinguished maturity markets as either short-term or longterm. In reality, several maturity markets may exist. Within the short-term market, some investors may prefer maturities of one month or less whereas others may prefer maturities of one to three months. Regardless of how many maturity markets exist, the yields of securities with various maturities should be influenced in part by the desires of investors and borrowers to participate in the maturity market that best satisfies their needs. A corporation that needs additional funds for 30 days would not consider issuing long-term bonds for such a purpose. Savers with short-term funds would avoid some long-term investments (e.g., 10-year certificates of deposit) that cannot be easily liquidated.

Limitation of the Theory
 A limitation of segmented markets theory is that some borrowers and savers have the flexibility to choose among various maturity markets. Corporations that need long-term funds may initially obtain short-term financing if they expect interest rates to decline, and investors with long-term funds may make short-term investments if they expect interest rates to rise. Moreover, some investors with short-term funds may be willing to purchase long-term securities that have an active secondary market.

   Some financial institutions focus on a particular maturity market, but others are more flexible. Commercial banks obtain most of their funds in short-term markets but spread their investments into short-, medium-, and long-term markets. Savings institutions have historically focused on attracting short-term funds and lending funds for long-term periods. Note that if maturity markets were completely segmented, then an interest rate adjustment in one market would have no impact on other markets. However, there is clear evidence that interest rates among maturity markets move nearly in concert over time. This evidence indicates that there is some interaction among markets, which implies that funds are being transferred across markets. Note also that the theory of segmented markets conflicts with the general presumption of pure expectations theory that maturity markets are perfect substitutes for one another.

Implications
 Although markets are not completely segmented, the preference for particular maturities can affect the prices and yields of securities with different maturities and thereby affect the yield curve’s shape. For this reason, the theory of segmented markets seems to be a partial explanation for the yield curve’s shape but not the sole explanation.

   A more flexible variant of segmented markets theory, known as preferred habitat theory, offers a compromise explanation for the term structure of interest rates. This theory proposes that, although investors and borrowers may normally concentrate on a particular maturity market, certain events may cause them to wander from their “natural” market. For example, commercial banks that obtain mostly short-term funds may select investments with short-term maturities as a natural habitat. However, if they wish to benefit from an anticipated decline in interest rates, they may select medium- and long-term maturities instead. Preferred habitat theory acknowledges that natural maturity markets may influence the yield curve, but it also recognizes that interest rate expectations could entice market participants to stray from their natural, preferred markets.

3-4d Research on Term Structure Theories

Much research has been conducted on the term structure of interest rates and has offered considerable insight into the various theories. Researchers have found that interest rate expectations have a strong influence on the term structure of interest rates. However, the forward rate derived from a yield curve does not accurately predict future interest rates, and this suggests that other factors may be relevant. The liquidity premium, for example, could cause consistent positive forecasting errors, meaning that forward rates tend to overestimate future interest rates. Studies have documented variation in the yield–maturity relationship that cannot be entirely explained by interest rate expectations or liquidity. The variation could therefore be attributed to different supply and demand conditions for particular maturity segments.

General Research Implications
 Although the results of research differ, there is some evidence that expectations theory, liquidity premium theory, and segmented markets theory all have some validity. Thus, if term structure is used to assess the market’s expectations of future interest rates, then investors should first “net out” the liquidity premium and any unique market conditions for various maturity segments.

3-5 INTEGRATING THE THEORIES OF TERM STRUCTURE

In order to understand how all three theories can simultaneously affect the yield curve, first assume the following conditions.

· 1. Investors and borrowers who select security maturities based on anticipated interest rate movements currently expect interest rates to rise.

Exhibit 3.7Effect of Conditions in Example of Yield Curve

· 2. Most borrowers are in need of long-term funds, while most investors have only short-term funds to invest.

· 3. Investors prefer more liquidity to less.

   The first condition, which is related to expectations theory, suggests the existence of an upward-sloping yield curve (other things being equal); see curve E in 

Exhibit 3.7

. The segmented markets information (condition 2) also favors the upward-sloping yield curve. When conditions 1 and 2 are considered simultaneously, the appropriate yield curve may look like curve E + S in the graph. The third condition (regarding liquidity) would then place a higher premium on the longer-term securities because of their lower degree of liquidity. When this condition is included with the first two, the yield may be represented by curve E + S + L.

   In this example, all conditions placed upward pressure on long-term yields relative to short-term yields. In reality, there will sometimes be offsetting conditions: one condition may put downward pressure on the slope of the yield curve while other conditions cause upward pressure. If condition 1 in the example here were revised so that future interest rates were expected to decline, then this condition (by itself) would result in a downward-sloping yield curve. So when combined with the other conditions, which imply an upward-sloping curve, the result would be a partial offsetting effect. The actual yield curve would exhibit a downward slope if the effect of the interest rate expectations dominated the combined effects of segmented markets and a liquidity premium. In contrast, there would be an upward slope if the liquidity premium and segmented markets effects dominated the effects of interest rate expectations.

3-5a Use of the Term Structure

The term structure of interest rates is used to forecast interest rates, to forecast recessions, and to make investment and financing decisions.

Forecasting Interest Rates
 At any point in time, the shape of the yield curve can be used to assess the general expectations of investors and borrowers about future interest rates. Recall from expectations theory that an upward-sloping yield curve generally results from the expectation of higher interest rates whereas a downward-sloping yield curve generally results from the expectation of lower interest rates. Expectations about future interest rates must be interpreted cautiously, however, because liquidity and specific maturity preferences could influence the yield curve’s shape. Still, it is generally believed that interest rate expectations are a major contributing factor to the yield curve’s shape. Thus the curve’s shape should provide a reasonable indication (especially once the liquidity premium effect is accounted for) of the market’s expectations about future interest rates.

   Although they can use the yield curve to interpret the market’s consensus expectation of future interest rates, investors may have their own interest rate projections. By comparing their projections with those implied by the yield curve, they can attempt to capitalize on the difference. For example, if an upward-sloping yield curve exists, investors expecting stable interest rates could benefit from investing in long-term securities. From their perspective, long-term securities are undervalued because they reflect the market’s (presumed incorrect) expectation of higher interest rates. Strategies such as this are effective only if the investor can consistently forecast better than the market.

Forecasting Recessions
 Some analysts believe that flat or inverted yield curves indicate a recession in the near future. The rationale for this belief is that, given a positive liquidity premium, such yield curves reflect the expectation of lower interest rates. This in turn is commonly associated with expectations of a reduced demand for loanable funds, which could be attributed to expectations of a weak economy.

   The yield curve became flat or slightly inverted in 2000. At that time, the shape of the curve indicated expectations of a slower economy, which would result in lower interest rates. In 2001, the economy weakened considerably. And in March 2007, the yield curve exhibited a slight negative slope that caused some market participants to forecast a recession. During the credit crisis in 2008 and in the following two years, yields on Treasury securities with various maturities declined. The short-term interest rates experienced the most pronounced decline, which resulted in an upward-sloping yield curve in 2010.

Making Investment Decisions
 If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term securities even though they have funds to invest for only a short period of time. The secondary market allows investors to implement this strategy, which is known as riding the yield curve. Consider an upward-sloping yield curve such that some one-year securities offer an annualized yield of 7 percent while 10-year bonds offer an annualized yield of 10 percent. An investor with funds available for one year may decide to purchase the bonds and sell them in the secondary market after one year. The investor earns 3 percent more than was possible on the one-year securities, but only if the bonds can be sold (after one year) at the price for which they were purchased. The risk of this strategy is the uncertainty in the price for which the security can be sold in the near future. If the upward-sloping yield is interpreted as the market’s consensus of higher interest rates in the future, then the price of a security would be expected to decrease in the future.

   The yield curve is commonly monitored by financial institutions whose liability maturities are distinctly different from their asset maturities. Consider a bank that obtains much of its funds through short-term deposits and uses the funds to provide long-term loans or purchase long-term securities. An upward-sloping yield curve is favorable to the bank because annualized short-term deposit rates are significantly lower than annualized long-term investment rates. The bank’s spread is higher than it would be if the yield curve were flat. However, if it believes that the upward slope of the yield curve indicates higher interest rates in the future (as predicted by expectations theory), then the bank will expect its cost of liabilities to increase over time because future deposits would be obtained at higher interest rates.

Making Decisions about Financing
 The yield curve is also useful for firms that plan to issue bonds. By assessing the prevailing rates on securities for various maturities, firms can estimate the rates to be paid on bonds with different maturities. This may enable them to determine the maturity of the bonds they issue. If they need funds for a two-year period, but notice from the yield curve that the annualized yield on one-year debt is much lower than that of two-year debt, they may consider borrowing for a one-year period. After one year when they pay off this debt, they will need to borrow funds for another one-year period.

3-5b Why the Slope of the Yield Curve Changes

If interest rates at all maturities were affected in the same manner by existing conditions, then the slope of the yield curve would remain unchanged. However, conditions may cause short-term yields to change in a manner that differs from the change in long-term yields.

EXAMPLE

Suppose that last July the yield curve had a large upward slope, as shown by yield curve YC1 in 

Exhibit 3.8

. Since then, the Treasury decided to restructure its debt by retiring $300 billion of long-term Treasury securities and increasing its offering of short-term Treasury securities. This caused a large increase in the demand for short-term funds and a large decrease in the demand for long-term funds. The increase in the demand for short-term funds caused an increase in short-term interest rates and thereby increased the yields offered on newly issued short-term securities. Conversely, the decline in demand for long-term funds caused a decrease in long-term interest rates and thereby reduced the yields offered on newly issued long-term securities. Today, the yield curve is YC2 and is much flatter than it was last July.

Exhibit 3.8 Potential Impact of Treasury Shift from Long-term to Short-term Financing

3-5c How the Yield Curve Has Changed over Time

Yield curves at various dates are illustrated in 

Exhibit 3.9

. The yield curve is usually upward sloping, but a slight downward slope has sometimes been evident (see the exhibit’s curve for March 21, 2007). Observe that the yield curve for March 18, 2013, is below the other yield curves shown in the exhibit, which means that the yield to maturity was relatively low regardless of the maturity considered. This curve existed during the credit crisis, when economic conditions were extremely weak.

3-5d International Structure of Interest Rates

Because the factors that affect the shape of the yield curve can vary among countries, the yield curve’s shape at any given time also varies among countries. Exhibit 3.10 plots the yield curve for six different countries in July 2013. Each country has a different currency with its own interest rate levels for various maturities, and each country’s interest rates are based on conditions of supply and demand.

   Interest rate movements across countries tend to be positively correlated as a result of internationally integrated financial markets. Nevertheless, the actual interest rates may vary significantly across countries at a given point in time. This implies that the difference in interest rates is attributable primarily to general supply and demand conditions across countries and less so to differences in default risk premiums, liquidity premiums, or other characteristics of the individual securities.

Exhibit 3.9 Yield Curves at Various Points in Time

Exhibit 3.10 Yield Curves among Foreign Countries (as of July 2013)

   Because forward rates (as defined in this chapter) reflect the market’s expectations of future interest rates, the term structure of interest rates for various countries should be monitored for the following reasons. First, with the integration of financial markets, movements in one country’s interest rate can affect interest rates in other countries. Thus some investors may estimate the forward rate in a foreign country to predict the foreign interest rate, which in turn may affect domestic interest rates. Second, foreign securities and some domestic securities are influenced by foreign economies, which are dependent on foreign interest rates. If the foreign forward rates can be used to forecast foreign interest rates, they can enhance forecasts of foreign economies. Because exchange rates are also influenced by foreign interest rates, exchange rate projections may be more accurate when foreign forward rates are used to forecast foreign interest rates.

   If the real interest rate were fixed, inflation rates for future periods could be predicted for any country in which the forward rate could be estimated. Recall from 

Chapter 2

 that the nominal interest rate consists of an expected inflation rate plus a real interest rate. Because the forward rate represents an expected nominal interest rate for a future period, it also represents an expected inflation rate plus a real interest rate in that period. The expected inflation in that period is estimated as the difference between the forward rate and the real interest rate.

SUMMARY

· ▪ Quoted yields of debt securities at any given time may vary for the following reasons. First, securities with higher credit (default) risk must offer a higher yield. Second, securities that are less liquid must offer a higher yield. Third, taxable securities must offer a higher before-tax yield than tax-exempt securities. Fourth, securities with longer maturities offer a different yield (not consistently higher or lower) than securities with shorter maturities.

· ▪ The appropriate yield for any particular debt security can be estimated by first determining the risk-free yield that is currently offered by a Treasury security with a similar maturity. Then adjustments are made that account for credit risk, liquidity, tax status, and other provisions.

· ▪ The term structure of interest rates can be explained by three theories. The pure expectations theory suggests that the shape of the yield curve is dictated by interest rate expectations. The liquidity premium theory suggests that securities with shorter maturities have greater liquidity and therefore should not have to offer as high a yield as securities with longer terms to maturity. The segmented markets theory suggests that investors and borrowers have different needs that cause the demand and supply conditions to vary across different maturities; in other words, there is a segmented market for each term to maturity, which causes yields to vary among these maturity markets. Consolidating the theories suggests that the term structure of interest rates depends on interest rate expectations, investor preferences for liquidity, and the unique needs of investors and borrowers in each maturity market.

POINT COUNTER-POINT

Should a Yield Curve Influence a Borrower’s Preferred Maturity of a Loan?

Point
 Yes. If there is an upward-sloping yield curve, then a borrower should pursue a short-term loan to capitalize on the lower annualized rate charged for a short-term period. The borrower can obtain a series of short-term loans rather than one loan to match the desired maturity.

Counter-Point
 No. The borrower will face uncertainty regarding the interest rate charged on subsequent

QUESTIONS AND APPLICATIONS

1. Characteristics That Affect Security Yields Identify the relevant characteristics of any security that can affect its yield. 2. Impact of Credit Risk on Yield What effect does a high credit risk have on securities? 3. Impact of Liquidity on Yield Discuss the relationship between the yield and liquidity of securities. 4. Tax Effects on Yields Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? At a given point in time, loans that are needed. An upward-sloping yield curve suggests that interest rates may rise in the future, which will cause the cost of borrowing to increase. Overall, the cost of borrowing may be higher when using a series of loans than when matching the debt maturity to the time period in which funds are needed.

Who Is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Characteristics That Affect Security Yields Identify the relevant characteristics of any security that can affect its yield.

· 2. Impact of Credit Risk on Yield What effect does a high credit risk have on securities?

· 3. Impact of Liquidity on Yield Discuss the relationship between the yield and liquidity of securities.

· 4. Tax Effects on Yields Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? At a given point in time, which offers a higher before-tax yield: municipal bonds or corporate bonds? Why? Which has the higher aftertax yield? If taxes did not exist, would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity? Why?

· 5. Pure Expectations Theory Explain how a yield curve would shift in response to a sudden expectation of rising interest rates, according to the pure expectations theory.

· 6. Forward Rate What is the meaning of the forward rate in the context of the term structure of interest rates? Why might forward rates consistently overestimate future interest rates? How could such a bias be avoided?

· 7. Pure Expectation Theory Assume there is a sudden expectation of lower interest rates in the future. What would be the effect on the shape of the yield curve? Explain.

· 8. Liquidity Premium Theory Explain the liquidity premium theory.

· 9. Impact of Liquidity Premium on Forward Rate Explain how consideration of a liquidity premium affects the estimate of a forward interest rate.

· 10. Segmented Markets Theory If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets?

· 11. Segmented Markets Theory If the segmented markets theory causes an upward-sloping yield curve, what does this imply? If markets are not completely segmented, should we dismiss the segmented markets theory as even a partial explanation for the term structure of interest rates? Explain.

· 12. Preferred Habitat Theory Explain the preferred habitat theory.

· 13. Yield Curve What factors influence the shape of the yield curve? Describe how financial market participants use the yield curve.

Advanced Questions

· 14. Segmented Markets Theory Suppose that the Treasury decides to finance its deficit with mostly longterm funds. How could this decision affect the term structure of interest rates? If short-term and long-term markets were segmented, would the Treasury’s decision have a more or less pronounced impact on the term structure? Explain.

· 15. Yield Curve Assuming that liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market’s perception of future interest rates?

· 16. Global Interaction among Yield Curves Assume that the yield curves in the United States, France, and Japan are flat. If the U.S. yield curve suddenly becomes positively sloped, do you think the yield curves in France and Japan would be affected? If so, how?

· 17. Multiple Effects on the Yield Curve Assume that (1) investors and borrowers expect that the economy will weaken and that inflation will decline, (2) investors require a small liquidity premium, and (3) markets are partially segmented and the Treasury currently has a preference for borrowing in short-term markets. Explain how each of these forces would affect the term structure, holding other factors constant. Then explain the effect on the term structure overall.

· 18. Effect of Crises on the Yield Curve During some crises, investors shift their funds out of the stock market and into money market securities for safety, even if they do not fear rising interest rates. Explain how and why these actions by investors affect the yield curve. Is the shift best explained by expectations theory, liquidity premium theory, or segmented markets theory?

· 19. How the Yield Curve May Respond to Prevailing Conditions Consider how economic conditions affect the default risk premium. Do you think the default risk premium will likely increase or decrease during this semester? How do you think the yield curve will change during this semester? Offer some logic to support your answers.

· 20. Assessing Interest Rate Differentials among Countries In countries experiencing high inflation, the annual interest rate may exceed 50 percent; in other countries, such as the United States and many European countries, annual interest rates are typically less than 10 percent. Do you think such a large difference in interest rates is due primarily to the difference between countries in the risk-free rates or in the credit risk premiums? Explain.

· 21. Applying the Yield Curve to Risky Debt Securities Assume that the yield curve for Treasury bonds has a slight upward slope, starting at 6 percent for a 10-year maturity and slowly rising to 8 percent for a 30-year maturity. Create a yield curve that you believe would exist for A-rated bonds and a corresponding one for B-rated bonds.

· 22. Changes to Credit Rating Process Explain how credit raters have changed their process following criticism of their ratings during the credit crisis.

Interpreting Financial News

Interpret the following comments made by Wall Street analysts and portfolio managers.

· a. “An upward-sloping yield curve persists because many investors stand ready to jump into the stock market.”

· b. “Low-rated bond yields rose as recession fears caused a flight to quality.”

· c. “The shift from an upward-sloping yield curve to a downward-sloping yield curve is sending a warning about a possible recession.”?

Managing in Financial Markets

Monitoring Yield Curve Adjustments As an analyst of a bond rating agency, you have been asked to interpret the implications of the recent shift in the yield curve. Six months ago, the yield curve exhibited a slight downward slope. Over the last six months, long-term yields declined while short-term yields remained the same. Analysts said that the shift was due to revised expectations of interest rates.

· a. Given the shift in the yield curve, does it appear that firms increased or decreased their demand for long-term funds over the last six months?

· b. Interpret what the shift in the yield curve suggests about the market’s changing expectations of future interest rates.

· c. Recently, an analyst argued that the underlying reason for the yield curve shift is that many large U.S. firms anticipate a recession. Explain why an anticipated recession could force the yield curve to shift as it has.

· d. What could the specific shift in the yield curve signal about the ratings of existing corporate bonds? What types of corporations would be most likely to experience a change in their bond ratings as a result of this shift in the yield curve?

PROBLEMS

· 1. Forward Rate

· a. Assume that, as of today, the annualized two-year interest rate is 13 percent and the one-year interest rate is 12 percent. Use this information to estimate the one-year forward rate.

· b. Assume that the liquidity premium on a two-year security is 0.3 percent. Use this information to estimate the one-year forward rate.

· 2. Forward Rate Assume that, as of today, the annualized interest rate on a three-year security is 10 percent and the annualized interest rate on a two-year security is 7 percent. Use this information to estimate the one-year forward rate two years from now.

· 3. Forward Rate If ti1 > ti2, what is the market consensus forecast about the one-year forward rate one year from now? Is this rate above or below today’s one-year interest rate? Explain.

· 4. After-Tax Yield You need to choose between investing in a one-year municipal bond with a 7 percent yield and a one-year corporate bond with an 11 percent yield. If your marginal federal income tax rate is 30 percent and no other differences exist between these two securities, which would you invest in?

· 5. Deriving Current Interest Rates Assume that interest rates for one-year securities are expected to be 2 percent today, 4 percent one year from now, and 6 percent two years from now. Using only pure expectations theory, what are the current interest rates on two-year and three-year securities?

· 6. Commercial Paper Yield

· a. A corporation is planning to sell its 90-day commercial paper to investors by offering an 8.4 percent yield. If the three-month T-bill’s annualized rate is 7 percent, the default risk premium is estimated to be 0.6 percent, and there is a 0.4 percent tax adjustment, then what is the appropriate liquidity premium?

· b. Suppose that, because of unexpected changes in the economy, the default risk premium increases to 0.8 percent. Assuming that no other changes occur, what is the appropriate yield to be offered on the commercial paper?

· 7. Forward Rate

· a. Determine the forward rate for various one-year interest rate scenarios if the two-year interest rate is 8 percent, assuming no liquidity premium. Explain the relationship between the one-year interest rate and the one-year forward rate while holding the two-year interest rate constant.

· b. Determine the one-year forward rate for the same one-year interest rate scenarios described in question (a) while assuming a liquidity premium of 0.4 percent. Does the relationship between the one-year interest rate and the forward rate change when the liquidity premium is considered?

· c. Determine how the one-year forward rate would be affected if the quoted two-year interest rate rises; hold constant the quoted one-year interest rate as well as the liquidity premium. Explain the logic of this relationship.

· d. Determine how the one-year forward rate would be affected if the liquidity premium rises and if the quoted one-year interest rate is held constant. What if the quoted two-year interest rate is held constant? Explain the logic of this relationship.

· 8. After-Tax Yield Determine how the after-tax yield from investing in a corporate bond is affected by higher tax rates, holding the before-tax yield constant. Explain the logic of this relationship.

· 9. Debt Security Yield

· a. Determine how the appropriate yield to be offered on a security is affected by a higher risk-free rate. Explain the logic of this relationship.

· b. Determine how the appropriate yield to be offered on a security is affected by a higher default risk premium. Explain the logic of this relationship.

FLOW OF FUNDS EXERCISE

Influence of the Structure of Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to the six-month Treasury bill rate (and includes a risk premium) and is adjusted every six months. Therefore, Carson’s cost of obtaining funds is sensitive to interest rate movements. The company expects that the U.S. economy will strengthen, so it plans to grow in the future by expanding its business and by making acquisitions. Carson anticipates needing substantial long-term financing to pay for its growth and plans to borrow additional funds, either through loans or by issuing bonds; it is also considering issuing stock to raise funds in the next year.

· a. Assume that the market’s expectations for the economy are similar to Carson’s expectations. Also assume that the yield curve is primarily influenced by interest rate expectations. Would the yield curve be upward sloping or downward sloping? Why?

· b. If Carson could obtain more debt financing for 10- year projects, would it prefer to obtain credit at a longterm fixed interest rate or at a floating rate? Why?

· c. If Carson attempts to obtain funds by issuing 10-year bonds, explain what information would help in estimating the yield it would have to pay on 10-year bonds. That is, what are the key factors that would influence the rate Carson would pay on its 10-year bonds?

· d. If Carson attempts to obtain funds by issuing loans with floating interest rates every six months, explain what information would help in estimating the yield it would have to pay over the next 10 years. That is, what are the key factors that would influence the rate Carson would pay over the 10-year period?

· e. An upward-sloping yield curve suggests that the initial rate financial institutions could charge on a longterm loan to Carson would be higher than the initial rate they could charge on a loan that floats in accordance with short-term interest rates. Does this imply that creditors should prefer offering Carson a fixed-rate loan to offering them a floating-rate loan? Explain why Carson’s expectations of future interest rates are not necessarily the same as those of some financial institutions.

INTERNET/EXCEL EXERCISES

· 1. Assess the shape of the yield curve by using the website 
www.bloomberg.com
. Click on “Market data” and then on “Rates & bonds.” Is the Treasury yield curve upward or downward sloping? What is the yield of a 90-day Treasury bill? What is the yield of a 30-year Treasury bond?

· 2. Based on the various theories attempting to explain the yield curve’s shape, what could explain the difference between the yields of the 90-day Treasury bill and the 30-year Treasury bond? Which theory, in your opinion, is the most reasonable? Why?

WSJ EXERCISE

Interpreting the Structure of Interest Rates

· a. Explaining Yield Differentials Using the most recent issue of the Wall Street Journal, review the yields for the following securities:

10-year

___

10-year

___

10-year

___

TYPE

MATURITY

YIELD

Treasury

10-year

___

Corporate: high-quality

Corporate: medium-quality

Municipal (tax-exempt)

· If credit (default) risk is the only reason for the yield differentials, then what is the default risk premium on the corporate high-quality bonds? On the medium-quality bonds?

·    During a recent recession, high-quality corporate bonds offered a yield of 0.8 percent above Treasury bonds while medium-quality bonds offered a yield of about 3.1 percent above Treasury bonds. How do these yield differentials compare to the differentials today? Explain the reason for any change.

·    Using the information in the previous table, complete the following table. In Column 2, indicate the before-tax yield necessary to achieve the existing after-tax yield of tax-exempt bonds. In Column 3, answer this question: If the tax-exempt bonds have the same risk and other features as high-quality corporate bonds, which type of bond is preferable for investors in each tax bracket?

10%

___

___

___

___

___

___

___

___

___

___

MARGINAL TAX BRACKET OF INVESTORS	EQUIVALENT BEFORE-TAX YIELD	PREFERRED BOND
15%
20%
28%
34%

· b. Examining Recent Adjustments in Credit Risk Using the most recent issue of the Wall Street Journal, review the corporate debt section showing the high-yield issue with the biggest price decrease.

· ▪ Why do you think there was such a large decrease in price?

· ▪ How does this decrease in price affect the expected yield for any investors who buy bonds now?

· c. Determining and Interpreting Today’s Term Structure Using the most recent issue of the Wall Street Journal, review the yield curve to determine the approximate yields for the following maturities:

___

___

___

TERM TO MATURITY	ANNUALIZED YIELD
1 year
2 years
3 years

·    Assuming that the differences in these yields are due solely to interest rate expectations, determine the one-year forward rate as of one year from now and the one-year forward rate as of two years from now.

· d. The Wall Street Journal
 provides a “Treasury Yield Curve.” Use this curve to describe the market’s expectations about future interest rates. If a liquidity premium exists, how would this affect your perception of the market’s expectations?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. credit risk

· 2. credit ratings AND risk

· 3. risk premium

· 4. yield curve

· 5. yield curve AND interest rate

· 6. interest rate AND liquidity premium

· 7. interest rate AND credit risk

· 8. rating agency AND risk

· 9. term structure AND maturity

· 10. yield curve AND financing

PART 1 INTEGRATIVE PROBLEM: Interest Rate Forecasts and Investment Decisions

This problem requires an understanding of how economic conditions affect interest rates and bond yields (

Chapters 1

, 

2

, and 

3

).

Your task is to use information about existing economic conditions to forecast U.S. and Canadian interest rates. The following information is available to you.

· 1. Over the past six months, U.S. interest rates have declined and Canadian interest rates have increased.

· 2. The U.S. economy has weakened over the past year while the Canadian economy has improved.

· 3. The U.S. saving rate (proportion of income saved) is expected to decrease slightly over the next year; the Canadian saving rate will remain stable.

· 4. The U.S. and Canadian central banks are not expected to implement any policy changes that would have a significant impact on interest rates.

· 5. You expect the U.S. economy to strengthen considerably over the next year but still be weaker than it was two years ago. You expect the Canadian economy to remain stable.

· 6. You expect the U.S. annual budget deficit to increase slightly from last year but be significantly less than the average annual budget deficit over the past five years. You expect the Canadian budget deficit to be about the same as last year.

· 7. You expect the U.S. inflation rate to rise slightly but still remain below the relatively high levels of two years ago; you expect the Canadian inflation rate to decline.

· 8. Based on some events last week, most economists and investors around the world (including yourself) expect the U.S. dollar to weaken against the Canadian dollar and against other foreign currencies over the next year. This expectation was already accounted for in your forecasts of inflation and economic growth.

· 9. The yield curve in the United States currently exhibits a consistent downward slope. The yield curve in Canada currently exhibits an upward slope. You believe that the liquidity premium on securities is quite small.

Questions

· 1. Using the information available to you, forecast the direction of U.S. interest rates.

· 2. Using the information available to you, forecast the direction of Canadian interest rates.

· 3. Assume that the perceived risk of corporations in the United States is expected to increase. Explain how the yield of newly issued U.S. corporate bonds will change to a different degree than will the yield of newly issued U.S. Treasury bonds.

2 Determination of Interest Rates

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ apply the loanable funds theory to explain why interest rates change,

· ▪ identify the most relevant factors that affect interest rate movements, and

· ▪ explain how to forecast interest rates.

An interest rate reflects the rate of return that a creditor receives when lending money, or the rate that a borrower pays when borrowing money. Since interest rates change over time, so does the rate earned by creditors who provide loans or the rate paid by borrowers who obtain loans. Interest rate movements have a direct influence on the market values of debt securities, such as money market securities, bonds, and mortgages. They have an indirect influence on equity security values because they can affect the return by investors who invest in equity securities. Thus, participants in financial markets attempt to anticipate interest rate movements when restructuring their investment or loan positions.

   Interest rate movements also affect the value of most financial institutions. They influence the cost of funds to depository institutions and the interest received on some loans by financial institutions. Since many financial institutions invest in securities (such as bonds), the market value of their investments is affected by interest rate movements. Thus managers of financial institutions attempt to anticipate interest rate movements and commonly restructure their assets and liabilities to capitalize on their expectations. Individuals attempt to anticipate interest rate movements so that they can monitor the potential cost of borrowing or the potential return from investing in various debt securities.

2-1 LOANABLE FUNDS THEORY

WEB

www.bloomberg.com

Information on interest rates in recent months.

The 

loanable funds theory

, commonly used to explain interest rate movements, suggests that the market interest rate is determined by factors controlling the supply of and demand for loanable funds. The theory is especially useful for explaining movements in the general level of interest rates for a particular country. Furthermore, it can be used (along with other concepts) to explain why interest rates among some debt securities of a given country vary, which is the focus of the next chapter. The phrase “demand for loanable funds” is widely used in financial markets to refer to the borrowing activities of households, businesses, and governments. This chapter describes the sectors that commonly affect the demand for loanable funds and then describes the sectors that supply loanable funds to the markets. Finally, the demand and supply concepts are integrated to explain interest rate movements.

Exhibit 2.1 Relationship between Interest Rates and Household Demand (Dh) for Loanable Funds at a Given Point in Time

2-1a Household Demand for Loanable Funds

Households commonly demand loanable funds to finance housing expenditures. In addition, they finance the purchases of automobiles and household items, which results in installment debt. As the aggregate level of household income rises, so does installment debt. The level of installment debt as a percentage of disposable income has been increasing over time, although it is generally lower in recessionary periods.

   If households could be surveyed at any given time to indicate the quantity of loanable funds they would demand at various interest rate levels, the results would reveal an inverse relationship between the interest rate and the quantity of loanable funds demanded. This simply means that, at any moment in time, households would demand a greater quantity of loanable funds at lower rates of interest; in other words, they are willing to borrow more money (in aggregate) at lower rates of interest.

EXAMPLE

Consider the household demand-for-loanable-funds schedule (also called the demand curve) in 

Exhibit 2.1

, which shows how the amount of funds that would be demanded is dependent on the interest rate. Various events can cause household borrowing preferences to change and thereby shift the demand curve. For example, if tax rates on household income are expected to decrease significantly in the future, households might believe that they can more easily afford future loan repayments and thus be willing to borrow more funds. For any interest rate, the quantity of loanable funds demanded by households would be greater as a result of the tax rate change. This represents an outward shift (to the right) in the demand curve.

2-1b Business Demand for Loanable Funds

Businesses demand loanable funds to invest in long-term (fixed) and short-term assets. The quantity of funds demanded by businesses depends on the number of business projects to be implemented. Businesses evaluate a project by comparing the present value of its cash flows to its initial investment, as follows:

where

· NPV = net present value of project

· INV = initial investment

·
CF t
 = cash flow in period t

·
k
 = required rate of return on project

Projects with a positive net present value (NPV) are accepted because the present value of their benefits outweighs the costs. The required return to implement a given project will be lower if interest rates are lower because the cost of borrowing funds to support the project will be lower. Hence more projects will have positive NPVs, and businesses will need a greater amount of financing. This implies that, all else being equal, businesses will demand a greater quantity of loanable funds when interest rates are lower; this relation is illustrated in 

Exhibit 2.2

.

   In addition to long-term assets, businesses also need funds to invest in their short-term assets (such as accounts receivable and inventory) in order to support ongoing operations. Any demand for funds resulting from this type of investment is positively related to the number of projects implemented and thus is inversely related to the interest rate. The opportunity cost of investing in short-term assets is higher when interest rates are higher. Therefore, firms generally attempt to support ongoing operations with fewer funds during periods of high interest rates. This is another reason that a firm’s total demand for loanable funds is inversely related to prevailing interest rates. Although the demand for loanable funds by some businesses may be more sensitive to interest rates than others, all businesses are likely to demand more funds when interest rates are lower.

Shifts in the Demand for Loanable Funds
 The business demand-for-loanable funds schedule (as reflected by the demand curve in 
Exhibit 2.2
) can change in reaction to any events that affect business borrowing preferences. If economic conditions become more favorable, the expected cash flows on various proposed projects will increase. More proposed projects will then have expected returns that exceed a particular required rate of return (sometimes called the hurdle rate). Additional projects will be acceptable as a result of more favorable economic forecasts, causing an increased demand for loanable funds. The increase in demand will result in an outward shift (to the right) in the demand curve.

WEB

www.treasurydirect.gov

Information on the U.S. government’s debt.

Exhibit 2.2 Relationship between Interest Rates and Business Demand (Db) for Loanable Funds at a Given Point in Time

2-1c Government Demand for Loanable Funds

Whenever a government’s planned expenditures cannot be completely covered by its incoming revenues from taxes and other sources, it demands loanable funds. Municipal (state and local) governments issue municipal bonds to obtain funds; the federal government and its agencies issue Treasury securities and federal agency securities. These securities constitute government debt.

   The federal government’s expenditure and tax policies are generally thought to be independent of interest rates. Thus the federal government’s demand for funds is referred to as 

interest-inelastic

, or insensitive to interest rates. In contrast, municipal governments sometimes postpone proposed expenditures if the cost of financing is too high, implying that their demand for loanable funds is somewhat sensitive to interest rates.

   Like household and business demand, government demand for loanable funds can shift in response to various events.

EXAMPLE

The federal government’s demand-for-loanable-funds schedule is represented by Dg1 in 

Exhibit 2.3

. If new bills are passed that cause a net increase of $200 billion in the deficit, the federal government’s demand for loanable funds will increase by that amount. In the graph, this new demand schedule is represented by Dg2.

2-1d Foreign Demand for Loanable Funds

The demand for loanable funds in a given market also includes foreign demand by foreign governments or corporations. For example, the British government may obtain financing by issuing British Treasury securities to U.S. investors; this represents British demand for U.S. funds. Because foreign financial transactions are becoming so common, they can have a significant impact on the demand for loanable funds in any given country. A foreign country’s demand for U.S. funds (i.e., preference to borrow U.S. dollars) is influenced by, among other factors, the difference between its own interest rates and U.S. rates. Other things being equal, a larger quantity of U.S. funds will be demanded by foreign governments and corporations if their domestic interest rates are high relative to U.S. rates. As a result, for a given set of foreign interest rates, the quantity of U.S. loanable funds demanded by foreign governments or firms will be inversely related to U.S. interest rates.

WEB

www.bloomberg.com/markets

Interest rate information.

Exhibit 2.3 Impact of Increased Government Deficit on the Government Demand for Loanable Funds

Exhibit 2.4 Impact of Increased Foreign Interest Rates on the Foreign Demand for U.S. Loanable Funds

  The foreign demand curve can shift in response to economic conditions. For example, assume the original foreign demand schedule is represented by Df1 in 

Exhibit 2.4

. If foreign interest rates rise, foreign firms and governments will likely increase their demand for U.S. funds, as represented by the shift from Df1to Df2.

2-1e Aggregate Demand for Loanable Funds

The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors at any given interest rate, as shown in 

Exhibit 2.5

. Because most of these sectors are likely to demand a larger quantity of funds at lower interest rates (other things being equal), it follows that the aggregate demand for loanable funds is inversely related to the prevailing interest rate. If the demand schedule of any sector changes, the aggregate demand schedule will also be affected.

2-1f Supply of Loanable Funds

The term “supply of loanable funds” is commonly used to refer to funds provided to financial markets by savers. The household sector is the largest supplier, but loanable funds are also supplied by some government units that temporarily generate more tax revenues than they spend or by some businesses whose cash inflows exceed outflows. Yet households as a group are a net supplier of loanable funds, whereas governments and businesses are net demanders of loanable funds.

   Suppliers of loanable funds are willing to supply more funds if the interest rate (reward for supplying funds) is higher, other things being equal. This means that the supply-of-loanable-funds schedule (also called the supply curve) is upward sloping, as shown in 

Exhibit 2.6

. A supply of loanable funds exists at even a very low interest rate because some households choose to postpone consumption until later years, even when the reward (interest rate) for saving is low. Foreign households, governments, and businesses commonly supply funds to their domestic markets by purchasing domestic securities. In addition, they have been a major creditor to the U.S. government by purchasing large amounts of Treasury securities. The large foreign supply of funds to the U.S. market is due in part to the high saving rates of foreign households.

Effects of the Fed
 The supply of loanable funds in the United States is also influenced by the monetary policy implemented by the Federal Reserve System. The Fed conducts monetary policy in an effort to control U.S. economic conditions. By affecting the supply of loanable funds, the Fed’s monetary policy affects interest rates (as will be described shortly). By influencing interest rates, the Fed is able to influence the amount of money that corporations and households are willing to borrow and spend.

Exhibit 2.5 Determination of the Aggregate Demand Curve for Loanable Funds

Exhibit 2.6 Aggregate Supply Curve for Loanable Funds

Aggregate Supply of Funds
 The aggregate supply schedule of loanable funds represents the combination of all sector supply schedules along with the supply of funds provided by the Fed’s monetary policy. The steep slope of the aggregate supply curve in 
Exhibit 2.6
 means that it is interest-inelastic. The quantity of loanable funds demanded is normally expected to be more elastic, meaning more sensitive to interest rates, than the quantity of loanable funds supplied.

   The supply curve can shift inward or outward in response to various conditions. For example, if the tax rate on interest income is reduced, then the supply curve will shift outward as households save more funds at each possible interest rate level. Conversely, if the tax rate on interest income is increased, then the supply curve will shift inward as households save fewer funds at each possible interest rate level.

   In this section, minimal attention has been given to financial institutions. Although financial institutions play a critical intermediary role in channeling funds, they are not the ultimate suppliers of funds. Any change in a financial institution’s supply of funds results only from a change in habits of the households, businesses, or governments that supply those funds.

2-1g Equilibrium Interest Rate

An understanding of equilibrium interest rates is necessary to assess how various events can affect interest rates. In reality, there are several different interest rates because some borrowers pay a higher rate than others. At this point, however, the focus is on the forces that cause the general level of interest rates to change, since interest rates across borrowers tend to change in the same direction. The determination of an equilibrium interest rate is presented first from an algebraic perspective and then from a graphical perspective. Following this presentation, several examples are offered to reinforce the concept.

Algebraic Presentation
 The equilibrium interest rate is the rate that equates the aggregate demand for funds with the aggregate supply of loanable funds. The aggregate demand for funds (DA) can be written as

DA = Dh + Db + Dg Dm + Df

where

·
Dh
 = household demand for loanable funds

·
Db
 = business demand for loanable funds

·
Dg
 = federal government demand for loanable funds

·
Dm
 = municipal government demand for loanable funds

·
Df
 = foreign demand for loanable funds

The aggregate supply of funds (SA) can likewise be written as

SA = Sh + Sb + Sg + Sm + Sf

where

·
Sh
 =household supply of loanable funds

·
Sb
 =business supply of loanable funds

·
Sg
 =federal government supply of loanable funds

·
Sm
 =municipal government supply of loanable funds

·
Sf
 =foreign supply of loanable funds

   In equilibrium, DA = SA. If the aggregate demand for loanable funds increases without a corresponding increase in aggregate supply, there will be a shortage of loanable funds. In this case, interest rates will rise until an additional supply of loanable funds is available to accommodate the excess demand. Conversely, an increase in the aggregate supply of loanable funds without a corresponding increase in aggregate demand will result in a surplus of loanable funds. In this case, interest rates will fall until the quantity of funds supplied no longer exceeds the quantity of funds demanded.

   In many cases, both supply and demand for loanable funds are changing. Given an initial equilibrium situation, the equilibrium interest rate should rise when DA > SA and fall when DASA.

Graphical Presentation
 By combining the aggregate demand and aggregate supply curves of loanable funds (refer to 

Exhibits 2.5

 and 

2.6

), it is possible to compare the total amount of funds that would be demanded to the total amount of funds that would be supplied at any particular interest rate. 

Exhibit 2.7

 illustrates the combined demand and supply schedules. At the equilibrium interest rate of i, the supply of loanable funds is equal to the demand for loanable funds.

   At any interest rate above i, there is a surplus of loanable funds. Some potential suppliers of funds will be unable to successfully supply their funds at the prevailing interest rate. Once the market interest rate decreases to i, the quantity of funds supplied is sufficiently reduced and the quantity of funds demanded is sufficiently increased such that there is no longer a surplus of funds. When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved.

   If the prevailing interest rate is below i, there will be a shortage of loanable funds; borrowers will not be able to obtain all the funds that they desire at that rate. The shortage of funds will cause the interest rate to increase, resulting in two reactions. First, more savers will enter the market to supply loanable funds because the reward (interest rate) is now higher. Second, some potential borrowers will decide not to demand loanable funds at the higher interest rate. Once the interest rate rises to i, the quantity of loanable funds supplied has increased and the quantity of loanable funds demanded has decreased to the extent that a shortage no longer exists. Thus an equilibrium position is achieved once again.

Exhibit 2.7 Interest Rate Equilibrium

2-2 FACTORS THAT AFFECT INTEREST RATES

Although it is useful to identify those who supply or demand loanable funds, it is also necessary to recognize the underlying economic forces that cause a change in either the supply of or the demand for loanable funds. The following economic factors influence this supply and demand and thereby influence interest rates.

2-2a Impact of Economic Growth on Interest Rates

Changes in economic conditions cause a shift in the demand curve for loanable funds, which affects the equilibrium interest rate.

EXAMPLE

When businesses anticipate that economic conditions will improve, they revise upward the cash flows expected for various projects under consideration. Consequently, businesses identify more projects that are worth pursuing, and they are willing to borrow more funds. Their willingness to borrow more funds at any given interest rate reflects an outward shift (to the right) in the demand curve.

   The supply-of-loanable-funds schedule may also change in response to economic growth, but it is difficult to know in which direction it will shift. It is possible that the increased expansion by businesses will lead to more income for construction crews and others who service the expansion. In this case, the quantity of savings (loanable funds supplied) could increase regardless of the interest rate, causing an outward shift in the supply schedule. However, there is no assurance that the volume of savings will actually increase. Even if such a shift does occur, it will likely be of smaller magnitude than the shift in the demand schedule.

   Overall, the expected impact of the increased expansion by businesses is an outward shift in the demand curve but no obvious change in the supply schedule; see 

Exhibit 2.8

. Note that the shift in the aggregate demand curve to DA2 causes an increase in the equilibrium interest rate to i2.

   Just as economic growth puts upward pressure on interest rates, an economic slowdown puts downward pressure on the equilibrium interest rate.

EXAMPLE

A slowdown in the economy will cause the demand curve to shift inward (to the left), reflecting less demand for loanable funds at any given interest rate. The supply curve may shift a little, but the direction of its shift is uncertain. One could argue that a slowdown should cause increased saving (regardless of the interest rate) as households prepare for possible layoffs. At the same time, the gradual reduction in labor income that occurs during an economic slowdown could reduce households’ ability to save. Historical data support this latter expectation. Once again, any shift that does occur will likely be minor relative to the shift in the demand schedule. The equilibrium interest rate is therefore expected to decrease, as illustrated in 

Exhibit 2.9

.

Exhibit 2.8 Impact of Increased Expansion by Firms

2-2b Impact of Inflation on Interest Rates

Changes in inflationary expectations can affect interest rates by affecting the amount of spending by households or businesses. Decisions to spend affect the amount saved (supply of funds) and the amount borrowed (demand for funds).

EXAMPLE

Assume the U.S. inflation rate is expected to increase. Households that supply funds may reduce their savings at any interest rate level so that they can make more purchases now before prices rise. This shift in behavior is reflected by an inward shift (to the left) in the supply curve of loanable funds. In addition, households and businesses may be willing to borrow more funds at any interest rate level so that they can purchase products now before prices increase. This is reflected by an outward shift (to the right) in the demand curve for loanable funds. These shifts are illustrated in 

Exhibit 2.10

. The new equilibrium interest rate is higher because of these shifts in saving and borrowing behavior.

Exhibit 2.9 Impact of an Economic Slowdown

Exhibit 2.10 Impact of an Increase in Inflationary Expectations on Interest Rates

Fisher Effect
 More than 70 years ago, Irving Fisher proposed a theory of interest rate determination that is still widely used today. It does not contradict the loanable funds theory but simply offers an additional explanation for interest rate movements. Fisher proposed that nominal interest payments compensate savers in two ways. First, they compensate for a saver’s reduced purchasing power. Second, they provide an additional premium to savers for forgoing present consumption. Savers are willing to forgo consumption only if they receive a premium on their savings above the anticipated rate of inflation, as shown in the following equation:

i = E(INF) + iR

where

·
i
 = nominal or quoted rate of interest

·
E(INF) = expected inflation rate

·
iR
 = real interest rate

This relationship between interest rates and expected inflation is often referred to as the Fisher effect. The difference between the nominal interest rate and the expected inflation rate is the real return to a saver after adjusting for the reduced purchasing power over the time period of concern. It is referred to as the 

real interest rate

 because, unlike the nominal rate of interest, it adjusts for the expected rate of inflation. The preceding equation can be rearranged to express the real interest rate as

iR = i − E(INF)

When the inflation rate is higher than anticipated, the real interest rate is relatively low. Borrowers benefit because they were able to borrow at a lower nominal interest rate than would have been offered if inflation had been accurately forecasted. When the inflation rate is lower than anticipated, the real interest rate is relatively high and borrowers are adversely affected.

WEB

www.federalreserve.gov/monetarypolicy/fomc.htm

Information on how the Fed controls the money supply.

   Throughout the text, the term “interest rate” will be used to represent the nominal, or quoted, rate of interest. Keep in mind, however, that inflation may prevent purchasing power from increasing during periods of rising interest rates.

2-2c Impact of Monetary Policy on Interest Rates

The Federal Reserve can affect the supply of loanable funds by increasing or reducing the total amount of deposits held at commercial banks or other depository institutions. The process by which the Fed adjusts the money supply is described in 

Chapter 4

. When the Fed increases the money supply, it increases the supply of loanable funds and this places downward pressure on interest rates.

EXAMPLE

The credit crisis intensified during the fall of 2008, and economic conditions weakened. The Fed increased the money supply in the banking system as a means of ensuring that funds were available for households or businesses that wanted to borrow funds. Consequently, financial institutions had more funds available that they could lend. The increase in the supply of loanable funds placed downward pressure on interest rates. Because the demand for loanable funds decreased during this period (as explained previously), the downward pressure on interest rates was even more pronounced. Interest rates declined substantially in the fall of 2008 in response to these two forces.

   Since the economy remained weak even after the credit crisis, the Fed continued its policy of injecting funds into the banking system during the 2009–2013 period in order to keep interest rates (the cost of borrowing) low. Its policy was intended to encourage corporations and households to borrow and spend money, in order to stimulate the economy.

   If the Fed reduces the money supply, it reduces the supply of loanable funds. Assuming no change in demand, this action places upward pressure on interest rates.

2-2d Impact of the Budget Deficit on Interest Rates

When the federal government enacts fiscal policies that result in more expenditures than tax revenue, the budget deficit is increased. Because of large budget deficits in recent years, the U.S. government is a major participant in the demand for loanable funds. A higher federal government deficit increases the quantity of loanable funds demanded at any prevailing interest rate, which causes an outward shift in the demand curve. Assuming that all other factors are held constant, interest rates will rise. Given a finite amount of loanable funds supplied to the market (through savings), excessive government demand for these funds tends to “crowd out” the private demand (by consumers and corporations) for funds. The federal government may be willing to pay whatever is necessary to borrow these funds, but the private sector may not. This impact is known as the 

crowding-out effect

. 

Exhibit 2.11

 illustrates the flow of funds between the federal government and the private sector.

   There is a counterargument that the supply curve might shift outward if the government creates more jobs by spending more funds than it collects from the public (this is what causes the deficit in the first place). If this were to occur, then the deficit might not place upward pressure on interest rates. Much research has investigated this issue and has generally shown that, when holding other factors constant, higher budget deficits place upward pressure on interest rates.

2-2e Impact of Foreign Flows of Funds on Interest Rates

The interest rate for a specific currency is determined by the demand for funds denominated in that currency and the supply of funds available in that currency.

EXAMPLE

The supply and demand curves for the U.S. dollar and for Brazil’s currency, the real, are compared for a given point in time in 

Exhibit 2.12

. Although the demand curve for loanable funds should be downward sloping for every currency and the supply schedule should be upward sloping, the actual positions of these curves vary among currencies. First, notice that the demand and supply curves are farther to the right for the dollar than for the Brazilian real. The amount of U.S. dollar-denominated loanable funds supplied and demanded is much greater than the amount of Brazilian real-denominated loanable funds because the U.S. economy is much larger than Brazil’s economy.

Exhibit 2.11 Flow of Funds between the Federal Government and the Private Sector

Exhibit 2.12 Demand and Supply Curves for Loanable Funds Denominated in U.S. Dollars and Brazilian Real

   Observe also that the positions of the demand and supply curves for loanable funds are much higher for the Brazilian real than for the dollar. The supply schedule for loanable funds denominated in Brazilian real shows that hardly any amount of savings would be supplied at low interest rate levels because the relatively high inflation in Brazil encourages households to spend more of their disposable income before prices increase. This discourages households from saving unless the interest rate is sufficiently high. In addition, the demand for loanable funds denominated in Brazilian real shows that borrowers are willing to borrow even at relatively high rates of interest because they want to make purchases now before prices increase. Firms are willing to pay 15 percent interest on a loan to purchase machines whose prices may increase 20 percent by the following year.

   Because of the different positions of the demand and supply curves for the two currencies shown in 
Exhibit 2.12
, the equilibrium interest rate is much higher for the Brazilian real than for the dollar. As the demand and supply schedules change over time for a specific currency, so will the equilibrium interest rate. For example, if Brazil’s government could substantially reduce local inflation, then the supply curve of loanable funds denominated in the Brazilian real would shift out (to the right) while the demand schedule of loanable funds would shift in (to the left). The result would be a lower equilibrium interest rate.

   In recent years, massive flows of funds have shifted between countries, causing abrupt adjustments in the supply of funds available in each country and thereby affecting interest rates. In general, the shifts are driven by large institutional investors seeking a high return on their investments. These investors commonly attempt to invest funds in debt securities in countries where interest rates are high. However, many countries that typically have relatively high interest rates also tend to have high inflation, which can weaken their local currencies. Since the depreciation (decline in value) of a currency can more than offset a high interest rate in some cases, investors tend to avoid investing in countries with high interest rates if the threat of inflation is very high.

2-2f Summary of Forces That Affect Interest Rates

In general, economic conditions are the primary forces behind a change in the supply of savings provided by households or a change in the demand for funds by households, businesses, or the government. The saving behavior of the households that supply funds in the United States is partially influenced by U.S. fiscal policy, which determines the taxes paid by U.S. households and thus determines the level of disposable income. The Federal Reserve’s monetary policy also affects the supply of funds in the United States because it determines the U.S. money supply. The supply of funds provided to the United States by foreign investors is influenced by foreign economic conditions, including foreign interest rates.

WEB

http://research.stlouisfed.org/fred2

Time series of various interest rates provided by the Federal Reserve Economic Databank.

   The demand for funds in the United States is indirectly affected by U.S. monetary and fiscal policies because these policies influence economic growth and inflation, which in turn affect business demand for funds. Fiscal policy determines the budget deficit and therefore determines the federal government demand for funds.

EXAMPLE

Exhibit 2.13

 plots U.S. interest rates over recent decades and illustrates how they are affected by the forces of monetary and fiscal policy. From 2000 to the beginning of 2003, the U.S. economy was very weak, which reduced the business and household demand for loanable funds and caused interest rates to decline. During the period 2005-2007, U.S. economic growth increased and interest rates rose.

   However, the credit crisis that began in 2008 caused the economy to weaken substantially, and interest rates declined to extremely low levels. During the crisis, the federal government experienced a huge budget deficit as it bailed out some firms and increased its spending in various ways to stimulate the economy. Although the large government demand for funds placed upward pressure on interest rates, this pressure was offset by a weak demand for funds by firms (as businesses canceled their plans to expand). In addition, the Federal Reserve increased the money supply at this time in order to push interest rates lower in an attempt to encourage businesses and households to borrow and spend money. The weak economy and the Fed’s monetary policy continued during the next four years, which allowed interest rates to remain at very low levels. The Fed’s monetary policy had more influence on U.S. interest rates than any other factor during the 2008-2013 period. In some other periods, the monetary policy is not as pronounced, and other factors have more influence on interest rates.

Exhibit 2.13 Interest Rate Movements over Time

Exhibit 2.14 Framework for Forecasting Interest Rates

   This summary does not cover every possible interaction among the forces that can affect interest rate movements, but it does illustrate how some key factors have an influence on interest rates over time. Because the prices of some securities are influenced by interest rate movements, those prices are affected by the factors discussed here, as explained more fully in subsequent chapters.

2-3 FORECASTING INTEREST RATES

WEB

http://research.stlouisfed.org/fred2

Quotations of current interest rates and trends of historical interest rates for various debt securities.

Exhibit 2.14

 summarizes the key factors that are evaluated when forecasting interest rates. With an understanding of how each factor affects interest rates, it is possible to forecast how interest rates may change in the future. When forecasting household demand for loanable funds, it may be necessary to assess consumer credit data to determine the borrowing capacity of households. The potential supply of loanable funds provided by households may be determined in a similar manner by assessing factors that affect the earning power of households.

   Business demand for loanable funds can be forecast by assessing future plans for corporate expansion and the future state of the economy. Federal government demand for loanable funds could be influenced by the economy’s future state because it affects tax revenues to be received and the amount of unemployment compensation to be paid out, factors that affect the size of the government deficit. The Federal Reserve System’s money supply targets may be assessed by reviewing public statements about the Fed’s future objectives, although those statements are rather vague.

   To forecast future interest rates, the net demand for funds (ND) should be forecast:

ND = DA − SA = (Dh + Db + Dg + Dm + Df) − (Sh + Sb + Sg + Sm + Sf)

If the forecasted level of ND is positive or negative, then a disequilibrium will exist temporarily. If ND is positive, the disequilibrium will be corrected by an upward adjustment in interest rates; if ND is negative, the disequilibrium will be corrected by a downward adjustment. The larger the forecasted magnitude of ND, the larger the adjustment in interest rates.

   Some analysts focus more on changes in DA and SA than on estimating their aggregate levels. For example, assume that today the equilibrium interest rate is 7 percent. This interest rate will change only if DA and SA change to create a temporary disequilibrium. If the government demand for funds (Dg) is expected to increase substantially and if no other components are expected to change, DA will exceed SA, placing upward pressure on interest rates. Thus the forecast of future interest rates can be derived without estimating every component comprised by DA and SA.

SUMMARY

· ▪ The loanable funds framework shows how the equilibrium interest rate depends on the aggregate supply of available funds and the aggregate demand for funds. As conditions cause the aggregate supply or demand schedules to change, interest rates gravitate toward a new equilibrium.

· ▪ The relevant factors that affect interest rate movements include changes in economic growth, inflation, the budget deficit, foreign interest rates, and the money supply. These factors can have a strong impact on the aggregate supply of funds and/or the aggregate demand for funds and can thereby affect the equilibrium interest rate. In particular, economic growth has a strong influence on the demand for loanable funds, and changes in the money supply have a strong impact on the supply of loanable funds.

· ▪ Given that the equilibrium interest rate is determined by supply and demand conditions, changes in the interest rate can be forecasted by forecasting changes in the supply of and the demand for loanable funds. Thus, the factors that influence the supply of funds and the demand for funds must be forecast in order to forecast interest rates.

POINT COUNTER-POINT

Does a Large Fiscal Budget Deficit Result in Higher Interest Rates?

Point
 No. In some years (such as 2008), the fiscal budget deficit was large but interest rates were very low.

Counter-Point
 Yes. When the federal government borrows large amounts of funds, it can crowd out other potential borrowers, and the interest rates are bid up by the deficit units.

Who Is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Interest Rate Movements Explain why interest rates changed as they did over the past year.

· 2. Interest Elasticity Explain what is meant by interest elasticity. Would you expect the federal government’s demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

· 3. Impact of Government Spending If the federal government planned to expand the space program, how might this affect interest rates?

· 4. Impact of a Recession Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they reacted to recessionary periods. Explain this reaction.

· 5. Impact of the Economy Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.

· 6. Impact of the Money Supply Should increasing money supply growth place upward or downward pressure on interest rates?

· 7. Impact of Exchange Rates on Interest Rates Assume that if the U.S. dollar strengthens it can place downward pressure on U.S. inflation. Based on this information, how might expectations of a strong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is there any reason to think that expectations of a strong dollar could also affect the supply of loanable funds? Explain.

· 8. Nominal versus Real Interest Rate What is the difference between the nominal interest rate and the real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

· 9. Real Interest Rate Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.

· 10. Forecasting Interest Rates Why do forecasts of interest rates differ among experts?

Advanced Questions

· 11. Impact of Stock Market Crises During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.

· 12. Impact of Expected Inflation How might expectations of higher oil prices affect the demand for loanable funds, the supply of loanable funds, and interest rates in the United States? Will the interest rates of other countries be affected in the same way? Explain.

· 13. Global Interaction of Interest Rates Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years?

· 14. Impact of War War tends to cause significant reactions in financial markets. Why would a war in Iraq place upward pressure on U.S. interest rates? Why might some investors expect a war like this to place downward pressure on U.S. interest rates?

· 15. Impact of September 11 Offer an argument for why the terrorist attack on the United States on September 11, 2001, could have placed downward pressure on U.S. interest rates. Offer an argument for why that attack could have placed upward pressure on U.S. interest rates.

· 16. Impact of Government Spending Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that, although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, Jayhawk believed that the deficit’s impact would more than offset the effects of other factors, so it forecast interest rates to increase by 2 percentage points. Comment on Jayhawk’s logic.

· 17. Decomposing Interest Rate Movements The interest rate on a one-year loan can be decomposed into a one-year, risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is normally affected by changing economic conditions to a greater degree than is the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury and (b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation? Why?

· 18. Forecasting Interest Rates Based on Prevailing Conditions Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on these conditions, do you think interest rates will likely increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the greatest impact on interest rates?

· 19. Impact of Economic Crises on Interest Rates When economic crises in countries are due to a weak economy, local interest rates tend to be very low. However, if the crisis was caused by an unusually high rate of inflation, interest rates tend to be very high. Explain why.

· 20. U.S. Interest Rates during the Credit Crisis During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should result in a higher number of feasible projects, which should encourage businesses to borrow more money and expand. Yet many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, thereby discouraging businesses from expanding?

· 21. Political Influence on Interest Rates Offer an argument for why a political regime that favors a large government will cause interest rates to be higher. Offer at least one example of why a political regime that favors a large government will cause interest rates to be lower. [Hint: Recognize that the government intervention in the economy can influence other factors that affect interstates.]

· 22. Impact of Stock Market Uncertainty Consider a period in which stock prices are very high, such that investors begin to think that stocks are overvalued and their valuations are very uncertain. If investors decide to move their money into much safer investments, how do you think this would affect general interest rate levels? In your answer, use the loanable funds framework by explaining how the supply or demand for loanable funds would be affected by the investor actions, and how this force would affect interest rates.

· 23. Impact of the European Economy In 2012, some economists suggested that U.S. interest rates are dictated by the weak economic conditions in Europe. Use the loanable funds framework to explain how European economic conditions might affect U.S. interest rates.

Interpreting Financial News

Interpret the following comments made by Wall Street analysts and portfolio managers.

· a. “The flight of funds from bank deposits to U.S. stocks will pressure interest rates.”

· b. “Since Japanese interest rates have recently declined to very low levels, expect a reduction in U.S. interest rates.”

· c. “The cost of borrowing by U.S. firms is dictated by the degree to which the federal government spends more than it taxes.”

Managing in Financial Markets

Forecasting Interest Rates As the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. You plan to borrow funds and may use the forecast of interest rates to determine whether you should obtain a loan with a fixed interest rate or a floating interest rate. The following information can be considered when assessing the future direction of interest rates.

· ▪ Economic growth has been high over the last two years, but you expect that it will be stagnant over the next year.

· ▪ Inflation has been 3 percent over each of the last few years, and you expect that it will be about the same over the next year.

· ▪ The federal government has announced major cuts in its spending, which should have a major impact on the budget deficit.

· ▪ The Federal Reserve is not expected to affect the existing supply of loanable funds over the next year.

· ▪ The overall level of savings by households is not expected to change.

· a. Given the preceding information, assess how the demand for and the supply of loanable funds would be affected, if at all, and predict the future direction of interest rates.

· b. You can obtain a one-year loan at a fixed rate of 8 percent or a floating-rate loan that is currently at 8 percent but would be revised every month in accordance with general interest rate movements. Which type of loan is more appropriate based on the information provided?

· c. Assume that Canadian interest rates have abruptly risen just as you have completed your forecast of future U.S. interest rates. Consequently, Canadian interest rates are now 2 percentage points above U.S. interest rates. How might this specific situation place pressure on U.S. interest rates? Considering this situation along with the other information provided, would you change your forecast of the future direction of U.S. interest rates?

PROBLEMS

· 1. Nominal Rate of Interest Suppose the real interest rate is 6 percent and the expected inflation rate is 2 percent. What would you expect the nominal rate of interest to be?

· 2. Real Interest Rate Suppose that Treasury bills are currently paying 9 percent and the expected inflation rate is 3 percent. What is the real interest rate?

FLOW OF FUNDS EXERCISE

How the Flow of Funds Affects Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. Given its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding and by making acquisitions. Carson expects that it will need substantial long-term financing to pay for this growth, and it plans to borrow additional funds either through existing loans or by issuing bonds. The company is also considering the possibility of issuing stock to raise funds in the next year.

· a. Explain why Carson should be very interested in future interest rate movements.

· b. Given Carson’s expectations, do you think the company anticipates that interest rates will increase or decrease in the future? Explain.

· c. If Carson’s expectations of future interest rates are correct, how would this affect its cost of borrowing on its existing loans and on its future loans?

· d. Explain why Carson’s expectations about future interest rates may affect its decision about when to borrow funds and whether to obtain floating-rate or fixed-rate loans.

INTERNET/EXCEL EXERCISES

· 1. Go to 
http://research.stlouisfed.org/fred2
. Under “Categories,” select “Interest rates” and then select the three-month Treasury-bill series (secondary market). Describe how this rate has changed in recent months. Using the information in this chapter, explain why the interest rate changed as it did.

· 2. Using the same website, retrieve data at the beginning of the last 20 quarters for interest rates (based on the three-month Treasury-bill rate) and the producer price index for all commodities and place the data in two columns of an Excel spreadsheet. Derive the change in interest rates on a quarterly basis. Then derive the percentage change in the producer price index on a quarterly basis, which serves as a measure of inflation. Apply regression analysis in which the change in interest rates is the dependent variable and inflation is the independent variable (see Appendix B for information about applying regression analysis). Explain the relationship that you find. Does it appear that inflation and interest rate movements are positively related?

WSJ EXERCISE

Forecasting Interest Rates

Review information about the credit markets in a recent issue of the Wall Street Journal. Identify the factors that are given attention because they may affect future interest rate movements. Then create your own forecasts as to whether interest rates will increase or decrease from now until the end of the school term, based on your assessment of any factors that affect interest rates. Explain your forecast.

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. budget deficit AND interest rate

· 2. flow of funds AND interest rate

· 3. Federal Reserve AND interest rate

· 4. economic growth AND interest rate

· 5. inflation AND interest rate

· 6. monetary policy AND interest rate

· 7. supply of savings AND interest rate

· 8. business expansion AND interest rate

· 9. demand for credit AND interest rate

· 10. interest rate AND forecast

1 Role of Financial Markets and Institutions

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the types of financial markets that facilitate the flow of funds,

· ▪ describe the types of securities traded within financial markets,

· ▪ describe the role of financial institutions within financial markets, and

· ▪ explain how financial institutions were exposed to the credit crisis.

A 

financial market

 is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. This chapter provides some background on financial markets and on the financial institutions that participate in them.

1-1 ROLE OF FINANCIAL MARKETS

Financial markets transfer funds from those who have excess funds to those who need funds. They enable college students to obtain student loans, families to obtain mortgages, businesses to finance their growth, and governments to finance many of their expenditures. Many households and businesses with excess funds are willing to supply funds to financial markets because they earn a return on their investment. If funds were not supplied, the financial markets would not be able to transfer funds to those who need them.

   Those participants who receive more money than they spend are referred to as 

surplus units

 (or investors). They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as 

deficit units

. They access funds from financial markets so that they can spend more money than they receive. Many individuals provide funds to financial markets in some periods and access funds in other periods.

EXAMPLE

College students are typically deficit units, as they often borrow from financial markets to support their education. After they obtain their degree, they earn more income than they spend and thus become surplus units by investing their excess funds. A few years later, they may become deficit units again by purchasing a home. At this stage, they may provide funds to and access funds from financial markets simultaneously. That is, they may periodically deposit savings in a financial institution while also borrowing a large amount of money from a financial institution to buy a home.

   Many deficit units such as firms and government agencies access funds from financial markets by issuing 

securities

, which represent a claim on the issuer. 

Debt securities

 represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units that issue the debt securities are borrowers. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis (such as every six months). Debt securities have a maturity date, at which time the surplus units can redeem the securities in order to receive the principal (face value) from the deficit units that issued them.

   

Equity securities

 (also called stocks) represent equity or ownership in the firm. Some large businesses prefer to issue equity securities rather than debt securities when they need funds but might not be financially capable of making the periodic interest payments required for debt securities.

1-1a Accommodating Corporate Finance Needs

A key role of financial markets is to accommodate corporate finance activity. Corporate finance (also called financial management) involves corporate decisions such as how much funding to obtain and what types of securities to issue when financing operations. The financial markets serve as the mechanism whereby corporations (acting as deficit units) can obtain funds from investors (acting as surplus units).

1-1b Accommodating Investment Needs

Another key role of financial markets is accommodating surplus units who want to invest in either debt or equity securities. Investment management involves decisions by investors regarding how to invest their funds. The financial markets offer investors access to a wide variety of investment opportunities, including securities issued by the U.S. Treasury and government agencies as well as securities issued by corporations.

   Financial institutions (discussed later in this chapter) serve as intermediaries within the financial markets. They channel funds from surplus units to deficit units. For example, they channel funds received from individuals to corporations. Thus they connect the investment management activity with the corporate finance activity, as shown in 
Exhibit 1.1
. They also commonly serve as investors and channel their own funds to corporations.

WEB

www.nyse.com

New York Stock Exchange market summary, quotes, financial statistics, and more.

www.nasdaq.com

Comprehensive historic and current data on all Nasdaq transactions.

1-1c Primary versus Secondary Markets

Primary markets

 facilitate the issuance of new securities. 

Secondary markets

 facilitate the trading of existing securities, which allows for a change in the ownership of the securities. Many types of debt securities have a secondary market, so that investors who initially purchased them in the primary market do not have to hold them until maturity. Primary market transactions provide funds to the initial issuer of securities; secondary market transactions do not.

EXAMPLE

Last year, Riverto Co. had excess funds and invested in newly issued Treasury debt securities with a 10-year maturity. This year, it will need $15 million to expand its operations. The company decided to sell its holdings of Treasury debt securities in the secondary market even though those securities will not mature for nine more years. It received $5 million from the sale. In also issued its own debt securities in the primary market today in order to obtain an additional $10 million. Riverto’s debt securities have a 10-year maturity, so investors that purchase them can redeem them at maturity (in 10 years) or sell them before that time to other investors in the secondary market.

Exhibit 1.1 How Financial Markets Facilitate Corporate Finance and Investment Management

   An important characteristic of securities that are traded in secondary markets is 

liquidity

, which is the degree to which securities can easily be liquidated (sold) without a loss of value. Some securities have an active secondary market, meaning that there are many willing buyers and sellers of the security at a given moment in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.

   Treasury securities are liquid because they are frequently issued by the Treasury, and there are many investors at any point in time who want to invest in them. Conversely, debt securities issued by a small firm may be illiquid, as there are not many investors who may want to invest in them. Thus investors who purchase these securities in the primary market may not be able to easily sell them in the secondary market.

1-2 SECURITIES TRADED IN FINANCIAL MARKETS

Securities can be classified as money market securities, capital market securities, or derivative securities.

1-2a Money Market Securities

Money markets

 facilitate the sale of short-term debt securities by deficit units to surplus units. The securities traded in this market are referred to as 

money market securities

, which are debt securities that have a maturity of one year or less. These generally have a relatively high degree of liquidity, not only because of their short-term maturity but also because they are desirable to many investors and therefore commonly have an active secondary market. Money market securities tend to have a low expected return but also a low degree of credit (default) risk. Common types of money market securities include Treasury bills (issued by the U.S. Treasury), commercial paper (issued by corporations), and negotiable certificates of deposit (issued by depository institutions).

1-2b Capital Market Securities

Capital markets facilitate the sale of long-term securities by deficit units to surplus units. The securities traded in this market are referred to as 

capital market securities

. Capital market securities are commonly issued to finance the purchase of capital assets, such as buildings, equipment, or machinery. Three common types of capital market securities are bonds, mortgages, and stocks, which are described in turn.

WEB

www.investinginbonds.com

Data and other information about bonds.

Bonds
 Bonds are long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations. They provide a return to investors in the form of interest income (coupon payments) every six months. Since bonds represent debt, they specify the amount and timing of interest and principal payments to investors who purchase them. At maturity, investors holding the debt securities are paid the principal. Bonds commonly have maturities of between 10 and 20 years.

   Treasury bonds are perceived to be free from default risk because they are issued by the U.S. Treasury. In contrast, bonds issued by corporations are subject to default risk because the issuer could default on its obligation to repay the debt. These bonds must offer a higher expected return than Treasury bonds in order to compensate investors for that default risk.

   Bonds can be sold in the secondary market if investors do not want to hold them until maturity. Because the prices of debt securities change over time, they may be worthless when sold in the secondary market than when they were purchased.

Mortgages
 Mortgages are long-term debt obligations created to finance the purchase of real estate. Residential mortgages are obtained by individuals and families to purchase homes. Financial institutions serve as lenders by providing residential mortgages in their role as a financial intermediary. They can pool deposits received from surplus units, and lend those funds to an individual who wants to purchase a home. Before granting mortgages, they assess the likelihood that the borrower will repay the loan based on certain criteria such as the borrower’s income level relative to the value of the home. They offer prime mortgages to borrowers who qualify based on these criteria. The home serves as collateral in the event that the borrower is not able to make the mortgage payments.

   Subprime mortgages are offered to some borrowers who do not have sufficient income to qualify for prime mortgages or who are unable to make a down payment. Subprime mortgages exhibit a higher risk of default, thus the lenders providing these mortgages charge a higher interest rate (and additional up-front fees) to compensate. Subprime mortgages received much attention in 2008 because of their high default rates, which led to the credit crisis. Many lenders are no longer willing to provide subprime mortgages, and recent regulations (described later in this chapter) raise the minimum qualifications necessary to obtain a mortgage.

   Commercial mortgages are long-term debt obligations created to finance the purchase of commercial property. Real estate developers rely on commercial mortgages so they can build shopping centers, office buildings, or other facilities. Financial institutions serve as lenders by providing commercial mortgages. By channeling funds from surplus units (depositors) to real estate developers, they serve as a financial intermediary and facilitate the development of commercial real estate.

Mortgage-Backed Securities
 Mortgage-backed securities are debt obligations representing claims on a package of mortgages. There are many forms of mortgage-backed securities. In their simplest form, the investors who purchase these securities receive monthly payments that are made by the homeowners on the mortgages backing the securities.

EXAMPLE

Mountain Savings Bank originates 100 residential mortgages for home buyers and will service the mortgages by processing the monthly payments. However, the bank does not want to use its own funds to finance the mortgages. It issues mortgage-backed securities that represent this package of mortgages to eight financial institutions that are willing to purchase all of these securities. Each month, when Mountain Savings Bank receives interest and principal payments on the mortgages, it passes those payments on to the eight financial institutions that purchased the mortgage-backed securities and thereby provided the financing to the homeowners. If some of the homeowners default on their payments, the payments, and thus the return on investment earned by the financial institutions that purchased the mortgage-backed securities, will be reduced. The securities they purchased are backed (collateralized) by the mortgages.

   In many cases, the financial institution that originates the mortgage is not accustomed to the process of issuing mortgage-backed securities. If Mountain Savings Bank is unfamiliar with the process, another financial institution may participate by bundling Mountain’s 100 mortgages with mortgages originated by other institutions. Then the financial institution issues mortgage-backed securities that represent all the mortgages in the bundle. Thus any investor that purchases these mortgage-backed securities is partially financing the 100 mortgages at Mountain Savings Bank and all the other mortgages in the bundle that are backing these securities.

   As housing prices increased in the 2004–2006 period, many financial institutions used their funds to purchase mortgage-backed securities, some of which represented bundles of subprime mortgages. These financial institutions incorrectly presumed that the homes would serve as sufficient collateral if the mortgages defaulted. In 2008, many subprime mortgages defaulted and home prices plummeted, which meant that the collateral was not adequate to cover the credit provided. Consequently, the values of mortgage-backed securities also plummeted, and the financial institutions holding these securities experienced major losses.

Stocks
 Stocks (or equity securities) represent partial ownership in the corporations that issue them. They are classified as capital market securities because they have no maturity and therefore serve as a long-term source of funds. Investors who purchase stocks (referred to as stockholders) issued by a corporation in the primary market can sell the stocks to other investors at any time in the secondary market. However, stocks of some corporations are more liquid than stocks of others. More than a million shares of stocks of large corporations are traded in the secondary market on any given day, as there are many investors who are willing to buy them. Stocks of small corporations are less liquid, because the secondary market is not as active.

   Some corporations provide income to their stockholders by distributing a portion of their quarterly earnings in the form of dividends. Other corporations retain and reinvest all of their earnings in their operations, which increase their growth potential.

   As corporations grow and increase in value, the value of their stock increases; investors can then earn a capital gain from selling the stock for a higher price than they paid for it. Thus, investors can earn a return from stocks in the form of periodic dividends (if there are any) and in the form a capital gain when they sell the stock. However, stocks are subject to risk because their future prices are uncertain. Their prices commonly decline when the firm performs poorly, resulting in negative returns to investors.

1-2c Derivative Securities

In addition to money market and capital market securities, derivative securities are also traded in financial markets. 

Derivative securities

 are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management.

WEB

www.cboe.com

Information about derivative securities.

Speculation
 Derivative securities allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets. Some derivative securities allow investors to benefit from an increase in the value of the underlying assets, whereas others allow investors to benefit from a decrease in the assets’ value. Investors who speculate in derivative contracts can achieve higher returns than if they had speculated in the underlying assets, but they are also exposed to higher risk.

Risk Management
 Derivative securities can be used in a manner that will generate gains if the value of the underlying assets declines. Consequently, financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities. If a firm maintains investments in bonds, it can take specific positions in derivative securities that will generate gains if bond values decline. In this way, derivative securities can be used to reduce a firm’s risk. The loss on the bonds is offset by the gains on these derivative securities.

1-2d Valuation of Securities

Each type of security generates a unique stream of expected cash flows to investors. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows.

   Debt securities are easier to value because they promise to investors specific payments (interest and principal) until they mature. The stream of cash flows generated by stocks is more difficult to estimate because some stocks do not pay dividends, and so investors receive cash flow only when they sell the stock. All investors sell the stock at different times. Thus some investors choose to value a stock by valuing the company and then dividing that value by the number of shares of stock.

Impact of Information on Valuation
 Investors can attempt to estimate the future cash flows that they will receive by obtaining information that may influence a security’s future cash flows. The valuation process is illustrated in 

Exhibit 1.2

.

   Some investors rely mostly on economic or industry information to value a security, whereas others rely more on published opinions about the firm’s management. When investors receive new information about a security that clearly indicates the likelihood of higher cash flows or less uncertainty surrounding the cash flows, they revise their valuations of that security upward. As a result, investors increase the demand for the security. In addition, investors that previously purchased that security and were planning to sell the security in the secondary market may decide not to sell. This results in a smaller supply of that security for sale (by investors who had previously purchased it) in the secondary market. Thus the market price of the security rises to a new equilibrium level.

   Conversely, when investors receive unfavorable information, they reduce the expected cash flows or increase the discount rate used in valuation. The valuations of the security are revised downward, which results in a lower demand and an increase in the supply of that security for sale in the secondary market. Consequently, there is a decline in the equilibrium price.

Exhibit 1.2 Use of Information to Make Investment Decisions

   In an 

efficient market

, securities are rationally priced. If a security is clearly undervalued based on public information, some investors will capitalize on the discrepancy by purchasing that security. This strong demand for the security will push the security’s price higher until the discrepancy no longer exists. The investors who recognized the discrepancy will be rewarded with higher returns on their investment. Their actions to capitalize on valuation discrepancies typically push security prices toward their proper price levels, based on the information that is available.

Impact of the Internet on Valuation
 The Internet has improved the valuation of securities in several ways. Prices of securities are quoted online and can be obtained at any given moment by investors. For some securities, investors can track the actual sequence of transactions. Because much more information about the firms that issue securities is available online, securities can be priced more accurately. Furthermore, orders to buy or sell many types of securities can be submitted online, which expedites the adjustment in security prices to new information.

WEB

finance.yahoo.com

Market quotations and overview of financial market activity.

Impact of Behavioral Finance on Valuation
 In some cases, a security may be mispriced because of the psychology involved in the decision making. 

Behavioral finance

 is the application of psychology to make financial decisions. It offers a reason why markets are not always efficient.

EXAMPLE

When Facebook issued stock to the public in May 2012, many critics suggested that the initial high stock price was influenced by market hype rather than fundamentals (such as its expected cash flows). Some of Facebook’s customers may invest in Facebook’s stock because they commonly use Facebook’s services, without really considering whether the stock price was appropriate. Facebook’s stock price declined by about 50 percent in a few months as the hype in the stock market wore off.

   Behavioral finance can sometimes explain the movements of a security’s price or even of the entire stock market. In some periods, investors seem to be excessively optimistic, and their stock-buying frenzy can push the prices of the entire stock market higher. This leads to a stock price bubble that bursts once investors consider fundamental characteristics (such as a firm’s cash flows) rather than hype when valuing a stock.

Uncertainty Surrounding Valuation of Securities
 Even if markets are efficient, the valuation of a firm’s security is subject to much uncertainty because investors have limited information available to value that security. Furthermore, the return from investing in a security over a particular period is typically uncertain because the cash flows to be received by investors over that period is uncertain. The higher the degree of uncertainty, the higher is the risk from investing in that security. From the perspective of an investor who purchases a security, risk represents the potential deviation of the security’s actual return from what was expected. For any given type of security, risk levels among the issuers of that security can vary.

EXAMPLE

Nike stock provides cash flows to investors in the form of quarterly dividends and when an investor sells the stock. Both the future dividends and the future stock price are uncertain. Thus the cash flows that Nike stock will provide to investors over a future period are uncertain, which means that the return from investing in Nike stock over that period is uncertain.

   Yet the cash flow provided by Nike’s stock is less uncertain than that provided by a small, young, publicly traded technology company. Because the return on the technology stock over a particular period is more uncertain than the return on Nike stock, the technology stock has more risk.

1-2e Securities Regulations

Much of the information that investors use to value securities issued by firms is provided in the form of financial statements by those firms. In particular, investors rely on accounting reports of a firm’s revenue and expenses as a basis for estimating its future cash flows. Although firms with publicly traded stock are required to disclose financial information and financial statements, a firm’s managers still possess information about its financial condition that is not necessarily available to investors. This situation is referred to as asymmetric information. Even when information is disclosed, an asymmetric information problem may still exist if some of the information provided by the firm’s managers is intentionally misleading in order to exaggerate the firm’s performance.

Required Disclosure
 Many regulations exist that attempt to ensure that businesses disclose accurate financial information. Similarly, when information is disclosed to only a small set of investors, those investors have a major advantage over other investors. Thus another regulatory goal is to provide all investors with equal access to disclosures by firms. The Securities Act of 1933 was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.

WEB

www.sec.gov

Background on the Securities and Exchange Commission, and news releases about financial regulations.

   The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared illegal a variety of deceptive practices, such as misleading financial statements and trading strategies designed to manipulate the market price. In addition, it established the Securities and Exchange Commission (SEC) to oversee the securities markets, and the SEC has implemented additional regulations over time. Securities laws do not prevent investors from making poor investment decisions; they seek only to ensure full disclosure of information and thereby protect against fraud.

Regulatory Response to Financial Reporting Scandals
 Financial scandals that occurred in the 2001–2002 period proved that the existing regulations were not sufficient to prevent fraud. Several well-known companies such as Enron and WorldCom misled investors by exaggerating their earnings. They also failed to disclose relevant information that would have adversely affected the prices of their stock and debt securities. Firms that have issued stock and debt securities must hire independent auditors to verify that their financial information is accurate. However, in some cases, the auditors who were hired to ensure accuracy were not meeting their responsibility.

   In response to the financial scandals, the Sarbanes-Oxley Act (discussed throughout this text) was passed to require that firms provide more complete and accurate financial information. It also imposed restrictions to ensure proper auditing by auditors and proper oversight by the firm’s board of directors. These rules were intended to regain the trust of investors who supply the funds to the financial markets. Through these measures, regulators tried to eliminate or at least reduce the asymmetric information problem.

   However, the Sarbanes-Oxley Act did not completely eliminate questionable accounting methods. In 2011 and 2012, Groupon Inc. used accounting methods that inflated its reported earnings. As these accounting methods were criticized by the financial media during 2012, the stock price of Groupon declined by about 85 percent.

1-2f International Securities Transactions

Financial markets are continuously being developed throughout the world to improve the transfer of securities between surplus units and deficit units. The financial markets are much more developed in some countries than in others, and they also vary in terms of the volumes of funds transferred from surplus to deficit units. Some countries have more developed financial markets for specific securities, and other countries (in Eastern Europe and Asia, for example) have established financial markets recently.

   Under favorable economic conditions, the international integration of securities markets allows governments and corporations easier access to funding from creditors or investors in other countries to support their growth. In addition, investors and creditors in any country can benefit from the investment opportunities in other countries. Yet, under unfavorable economic conditions, the international integration of securities markets allows one country’s financial problems to adversely affect other countries. The U.S. financial markets allow foreign investors to pursue investment opportunities in the United States, but during the U.S. financial crisis, many foreign investors who invested in U.S. securities experienced severe losses. Thus the U.S. financial crisis spread beyond the United States.

   Many European governments borrow funds from creditors in many different countries, but as the governments of Greece, Portugal, and Spain struggled to repay their loans, they caused financial problems for some creditors in other countries. Economic conditions are more closely connected because of the international integration of securities markets, and this causes each country to be more exposed to the economic conditions of other countries.

Foreign Exchange Market
 International financial transactions normally require the exchange of currencies. The 

foreign exchange market

 facilitates this exchange. Many commercial banks and other financial institutions serve as intermediaries in the foreign exchange market by matching up participants who want to exchange one currency for another. Some of these financial institutions also serve as dealers by taking positions in currencies to accommodate foreign exchange requests.

   Like securities, most currencies have a market-determined price (exchange rate) that changes in response to supply and demand. If there is a sudden shift in the aggregate demand by corporations, government agencies, and individuals for a given currency, or a shift in the aggregate supply of that currency for sale (to be exchanged for another currency), the price of the currency (exchange rate) will change.

1-2g Government Intervention in Financial Markets

In recent years, the government has increased its role in financial markets. Consider the following examples.

· 1. During the credit crisis, the Federal Reserve purchased various types of debt securities. The intervention was intended to ensure more liquidity in the debt securities markets, and therefore encourage investors to purchase debt securities.

· 2. New government regulations changed the manner by which the credit risk of bonds were assessed. The new regulations occurred because of criticisms about the previous process used for rating bonds that did not effectively warn investors about the credit risk of bonds during the credit crisis.

· 3. The government increased its monitoring of stock trading, and prosecuted cases in which investors traded based on inside information about firms that was not available to other investors. The increased government efforts were intended to ensure that no investor had an unfair advantage when trading in financial markets.

These examples illustrate how the government has increased its efforts to ensure fair and orderly financial markets, which could encourage more investors to participate in the markets, and therefore could increase liquidity.

1-3 ROLE OF FINANCIAL INSTITUTIONS

Because financial markets are imperfect, securities buyers and sellers do not have full access to information. Individuals with available funds are not normally capable of identifying credit worthy borrowers to whom they could lend those funds. In addition, they do not have the expertise to assess the creditworthiness of potential borrowers. Financial institutions are needed to resolve the limitations caused by market imperfections. They accept funds from surplus units and channel the funds to deficit units. Without financial institutions, the information and transaction costs of financial market transactions would be excessive. Financial institutions can be classified as depository and nondepository institutions.

1-3a Role of Depository Institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities. They are popular financial institutions for the following reasons.

· ▪ They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units.

· ▪ They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units.

· ▪ They accept the risk on loans provided.

· ▪ They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units.

· ▪ They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could.

   To appreciate these advantages, consider the flow of funds from surplus units to deficit units if depository institutions did not exist. Each surplus unit would have to identify a deficit unit desiring to borrow the precise amount of funds available for the precise time period in which funds would be available. Furthermore, each surplus unit would have to perform the credit evaluation and incur the risk of default. Under these conditions, many surplus units would likely hold their funds rather than channel them to deficit units. Hence, the flow of funds from surplus units to deficit units would be disrupted.

   When a depository institution offers a loan, it is acting as a creditor, just as if it had purchased a debt security. The more personalized loan agreement is less marketable in the secondary market than a debt security, however, because the loan agreement contains detailed provisions that can differ significantly among loans. Potential investors would need to review all provisions before purchasing loans in the secondary market.

   A more specific description of each depository institution’s role in the financial markets follows.

Commercial Banks
 In aggregate, commercial banks are the most dominant depository institution. They serve surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by providing direct loans or purchasing debt securities. Commercial bank operations are exposed to risk because their loans and many of their investments in debt securities are subject to the risk of default by the borrowers.

   

Commercial banks

serve both the private and public sectors; their deposit and lending services are utilized by households, businesses, and government agencies. Some commercial banks (including Bank of America, J.P. Morgan Chase, Citigroup, and Sun Trust Banks) have more than $100 billion in assets.

   Some commercial banks receive more funds from deposits than they need to make loans or invest in securities. Other commercial banks need more funds to accommodate customer requests than the amount of funds that they receive from deposits. The 

federal funds market

 facilitates the flow of funds between depository institutions (including banks). A bank that has excess funds can lend to a bank with deficient funds for a short-term period, such as one to five days. In this way, the federal funds market facilitates the flow of funds from banks that have excess funds to banks that are in need of funds.

WEB

www.fdic.gov

Information and news about banks and savings institutions.

   Commercial banks are subject to regulations that are intended to limit their exposure to the risk of failure. In particular, banks are required to maintain a minimum level of capital, relative to their size, so that they have a cushion to absorb possible losses from defaults on some loans provided to households or businesses. The Federal Reserve (“the Fed”) serves as a regulator of banks.

Savings Institutions
 

Savings institutions

, which are sometimes referred to as thrift institutions, are another type of depository institution. Savings institutions include savings and loan associations (S&Ls) and savings banks. Like commercial banks, savings institutions offer deposit accounts to surplus units and then channel these deposits to deficit units. Savings banks are similar to S&Ls except that they have more diversified uses of funds. Over time, however, this difference has narrowed. Savings institutions can be owned by shareholders, but most are mutual (depositor owned). Like commercial banks, savings institutions rely on the federal funds market to lend their excess funds or to borrow funds on a short-term basis.

   Whereas commercial banks concentrate on commercial (business) loans, savings institutions concentrate on residential mortgage loans. Normally, mortgage loans are perceived to exhibit a relatively low level of risk, but many mortgages defaulted in 2008 and 2009. This led to the credit crisis and caused financial problems for many savings institutions.

Credit Unions
 

Credit unions

differ from commercial banks and savings institutions in that they (1) are nonprofit and (2) restrict their business to credit union members, who share a common bond (such as a common employer or union). Like savings institutions, they are sometimes classified as thrift institutions in order to distinguish them from commercial banks. Because of the “common bond” characteristic, credit unions tend to be much smaller than other depository institutions. They use most of their funds to provide loans to their members. Some of the largest credit unions (e.g., the Navy Federal Credit Union, the State Employees Credit Union of North Carolina, the Pentagon Federal Credit Union) have assets of more than $5 billion.

1-3b Role of Nondepository Financial Institutions

Nondepository institutions generate funds from sources other than deposits but also play a major role in financial intermediation. These institutions are briefly described here and are covered in more detail in Part 7.

Finance Companies
 Most finance companies obtain funds by issuing securities and then lend the funds to individuals and small businesses. The functions of finance companies and depository institutions overlap, although each type of institution concentrates on a particular segment of the financial markets (explained in the chapters devoted to these institutions).

Mutual Funds
 

Mutual funds

sell shares to surplus units and use the funds received to purchase a portfolio of securities. They are the dominant nondepository financial institution when measured in total assets. Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds. Others, known as 

money market mutual funds

, concentrate in money market securities. Typically, mutual funds purchase securities in minimum denominations that are larger than the savings of an individual surplus unit. By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds.

WEB

finance.yahoo.com/funds

Information about mutual funds.

Securities Firms
 Securities firms provide a wide variety of functions in financial markets. Some securities firms act as a 

broker

, executing securities transactions between two parties. The broker fee for executing a transaction is reflected in the difference (or 

spread

) between the 

bid quote

 and the 

ask quote

. The markup as a percentage of the transaction amount will likely be higher for less common transactions, since more time is needed to match up buyers and sellers. The markup will also likely be higher for transactions involving relatively small amounts so that the broker will be adequately compensated for the time required to execute the transaction.

   Furthermore, securities firms often act as 

dealers

, making a market in specific securities by maintaining an inventory of securities. Although a broker’s income is mostly based on the markup, the dealer’s income is influenced by the performance of the security portfolio maintained. Some dealers also provide brokerage services and therefore earn income from both types of activities.

   In addition to brokerage and dealer services, securities firms also provide underwriting and advising services. The underwriting and advising services are commonly referred to as investment banking, and the securities firms that specialize in these services are sometimes referred to as investment banks. Some securities firms place newly issued securities for corporations and government agencies; this task differs from traditional brokerage activities because it involves the primary market. When securities firms 

underwrite

 newly issued securities, they may sell the securities for a client at a guaranteed price or may simply sell the securities at the best price they can get for their client.

   Some securities firms offer advisory services on mergers and other forms of corporate restructuring. In addition to helping a company plan its restructuring, the securities firm also executes the change in the client’s capital structure by placing the securities issued by the company.

Insurance Companies
 

Insurance companies

provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property. These companies charge premiums in exchange for the insurance that they provide. They invest the funds received in the form of premiums until the funds are needed to cover insurance claims. Insurance companies commonly invest these funds in stocks or bonds issued by corporations or in bonds issued by the government. In this way, they finance the needs of deficit units and thus serve as important financial intermediaries. Their overall performance is linked to the performance of the stocks and bonds in which they invest. Large insurance companies include State Farm Group, Allstate Insurance, Travelers Group, CNA Insurance, and Liberty Mutual.

Pension Funds
 Many corporations and government agencies offer pension plans to their employees. The employees and their employers (or both) periodically contribute funds to the plan.

Pension funds

provide an efficient way for individuals to save for their retirement. The pension funds manage the money until the individuals with draw the funds from their retirement accounts. The money that is contributed to individual retirement accounts is commonly invested by the pension funds in stocks or bonds issued by corporations or in bonds issued by the government. Thus pension funds are important financial intermediaries that finance the needs of deficit units.

1-3c Comparison of Roles among Financial Institutions

The role of financial institutions in facilitating the flow of funds from individual surplus units (investors) to deficit units is illustrated in 

Exhibit 1.3

. Surplus units are shown on the left side of the exhibit, and deficit units are shown on the right. Three different flows of funds from surplus units to deficit units are shown in the exhibit. One set of flows represents deposits from surplus units that are transformed by depository institutions into loans for deficit units. A second set of flows represents purchases of securities (commercial paper) issued by finance companies that are transformed into finance company loans for deficit units. A third set of flows reflects the purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and equity securities of deficit units.

   The deficit units also receive funding from insurance companies and pension funds. Because insurance companies and pension funds purchase massive amounts of stocks and bonds, they finance much of the expenditures made by large deficit units, such as corporations and government agencies. Financial institutions such as commercial banks, insurance companies, mutual funds, and pension funds serve the role of investing funds that they have received from surplus units, so they are often referred to as institutional investors.

   Securities firms are not shown in 
Exhibit 1.3
, but they play an important role in facilitating the flow of funds. Many of the transactions between the financial institutions and deficit units are executed by securities firms. Furthermore, some funds flow directly from surplus units to deficit units as a result of security transactions, with securities firms serving as brokers.

Exhibit 1.3 Comparison of Roles among Financial Institutions

Institutional Role as a Monitor of Publicly Traded Firms
 In addition to the roles of financial institutions described in 
Exhibit 1.3
, financial institutions also serve as monitors of publicly traded firms. Because insurance companies, pension funds, and some mutual funds are major investors in stocks, they can influence the management of publicly traded firms. In recent years, many large institutional investors have publicly criticized the management of specific firms, which has resulted in corporate restructuring or even the firing of executives in some cases. Thus institutional investors not only provide financial support to companies but also exercise some degree of corporate control over them. By serving as activist shareholders, they can help ensure that managers of publicly held corporations are making decisions that are in the best interests of the shareholders.

1-3d How the Internet Facilitates Roles of Financial Institutions

The Internet has also enabled financial institutions to perform their roles more efficiently. Some commercial banks have been created solely as online entities. Because they have lower costs, they can offer higher interest rates on deposits and lower rates on loans. Other banks and depository institutions also offer online services, which can reduce costs, increase efficiency, and intensify competition. Many mutual funds allow their shareholders to execute buy or sell transactions online. Some insurance companies conduct much of their business online, which reduces their operating costs and forces other insurance companies to price their services competitively. Some brokerage firms conduct much of their business online, which reduces their operating costs; because these firms can lower the fees they charge, they force other brokerage firms to price their services competitively.

1-3e Relative Importance of Financial Institutions

Together, all of these financial institutions hold assets equal to about $45 trillion. Commercial banks hold the most assets of any depository institution, with about $12 trillion in aggregate. Mutual funds hold the largest amount of assets of any nondepository institution, with about $11 trillion in aggregate.

   

Exhibit 1.4

 summarizes the main sources and uses of funds for each type of financial institution. Households with savings are served by depository institutions. Households with deficient funds are served by depository institutions and finance companies. Large corporations and governments that issue securities obtain financing from all types of financial institutions. Several agencies regulate the various types of financial institutions, and the various regulations may give some financial institutions a comparative advantage over others.

1-3f Consolidation of Financial Institutions

In recent years, commercial banks have acquired other commercial banks so that a given infrastructure can generate and support a higher volume of business. By increasing the volume of services produced, the average cost of providing the services (such as loans) can be reduced. Savings institutions have consolidated to achieve economies of scale for their mortgage lending business. Insurance companies have consolidated so that they can reduce the average cost of providing insurance services.

Exhibit 1.4 Summary of Institutional Sources and Uses of Funds

Deposits from households, businesses, and government agencies

Shares sold to households, businesses, and government agencies

Purchases of long-term government and corporate securities

Purchases of long-term government and corporate securities

FINANCIAL INSTITUTIONS	MAIN SOURCES OF FUNDS	MAIN USES OF FUNDS
Commercial banks		Deposits from households, businesses, and government agencies	Purchases of government and corporate securities; loans to businesses and households
Savings institutions	Purchases of government and corporate securities; mortgages and other loans to households; some loans to businesses
Credit unions	Deposits from credit union members	Loans to credit union members
Finance companies	Securities sold to households and businesses	Loans to households and businesses
Mutual funds		Shares sold to households, businesses, and government agencies			Purchases of long-term government and corporate securities
Money market funds	Purchases of short-term government and corporate securities
Insurance companies	Insurance premiums and earnings from investments
Pension funds	Employer/employee contributions

   During the last 10 years, different types of financial institutions were allowed by regulators to expand the types of services they offer and capitalize on economies of scope. Commercial banks merged with savings institutions, securities firms, finance companies, mutual funds, and insurance companies. Although the operations of each type of financial institution are commonly managed separately, a financial conglomerate offers advantages to customers who prefer to obtain all of their financial services from a single financial institution. Because a financial conglomerate is more diversified, it may be less exposed to a possible decline in customer demand for any single financial service.

EXAMPLE

Wells Fargo is a classic example of the evolution in financial services. It originally focused on commercial banking but has expanded its nonbank services to include mortgages, small business loans, consumer loans, real estate, brokerage, investment banking, online financial services, and insurance. In a recent annual report, Wells Fargo stated: “Our diversity in businesses makes us much more than a bank. We’re a diversified financial services company. We’re competing in a highly fragmented and fast growing industry: Financial Services. This helps us weather downturns that inevitably affect anyone segment of our industry.”

Typical Structure of a Financial Conglomerate
 A typical organizational structure of a financial conglomerate is shown in 

Exhibit 1.5

. Historically, each of the financial services (such as banking, mortgages, brokerage, and insurance) had significant barriers to entry, so only a limited number of firms competed in that industry. The barriers prevented most firms from offering a wide variety of these services. In recent years, the barriers to entry have been reduced, allowing firms that had specialized in one service to expand more easily into other financial services. Many firms expanded by acquiring other financial services firms. Thus many financial conglomerates are composed of various financial institutions that were originally independent but are now units (or subsidiaries) of the conglomerate.

Exhibit 1.5 Organizational Structure of a Financial Conglomerate

Impact of Consolidation on Competition
 As financial institutions spread into other financial services, the competition for customers desiring the various types of financial services increased. Prices of financial services declined in response to the competition. In addition, consolidation has provided more convenience. Individual customers can rely on the financial conglomerate for convenient access to life and health insurance, brokerage, mutual funds, investment advice and financial planning, bank deposits, and personal loans. A corporate customer can turn to the financial conglomerate for property and casualty insurance, health insurance plans for employees, business loans, advice on restructuring its businesses, issuing new debt or equity securities, and management of its pension plan.

Global Consolidation of Financial Institutions
 Many financial institutions have expanded internationally to capitalize on their expertise. Commercial banks, insurance companies, and securities firms have expanded through international mergers. An international merger between financial institutions enables the merged company to offer the services of both entities to its entire customer base. For example, a U.S. commercial bank may specialize in lending while a European securities firm specializes in services such as underwriting securities. A merger between the two entities allows the U.S. bank to provide its services to the European customer base (clients of the European securities firm) and allows the European securities firm to offer its services to the U.S. customer base. By combining specialized skills and customer bases, the merged financial institutions can offer more services to clients and have an international customer base.

   The adoption of the euro by 17 European countries has increased business between those countries and created a more competitive environment in Europe. European financial institutions, which had primarily competed with other financial institutions based in their own country, recognized that they would now face more competition from financial institutions in other countries.

   Many financial institutions have attempted to benefit from opportunities in emerging markets. For example, some large securities firms have expanded into many countries to offer underwriting services for firms and government agencies. The need for this service has increased most dramatically in countries where businesses have been privatized. In addition, commercial banks have expanded into emerging markets to provide loans. Although this allows them to capitalize on opportunities in these countries, it also exposes them to financial problems in these countries.

1-4 CREDIT CRISIS FOR FINANCIAL INSTITUTIONS

Following the abrupt increase in home prices in the 2004–2006 period, many financial institutions increased their holdings of mortgages and mortgage-backed securities, whose performance was based on the timely mortgage payments made by homeowners. Some financial institutions (especially commercial banks and savings institutions) aggressively attempted to expand their mortgage business in order to capitalize on the strong housing market. They commonly applied liberal standards when originating new mortgages and often failed to verify the applicant’s job status, income level, or credit history. Home prices were expected to continue rising over time, so financial institutions presumed (incorrectly) that the underlying value of the homes would provide adequate collateral to back the mortgage if homeowners could not make their mortgage payments.

   In the 2007–2009 period, mortgage defaults increased, and there was an excess of unoccupied homes as homeowners who could not pay the mortgage left their homes. As a result, home prices plummeted, and the value of the property collateral backing many mortgages was less than the outstanding mortgage amount. By January 2009, at least 10 percent of all American homeowners were either behind on their mortgage payments or had defaulted on their mortgage. Many of the financial institutions that originated mortgages suffered major losses.

1-4a Systemic Risk during the Credit Crisis

The credit crisis illustrated how financial problems of some financial institutions spread to others. 

Systemic risk

 is defined as the spread of financial problems among financial institutions and across financial markets that could cause a collapse in the financial system. It exists because financial institutions invest their funds in similar types of securities and therefore have similar exposure to large declines in the prices of these securities. In this case, mortgage defaults affected financial institutions in several ways. First, many financial institutions that originated mortgages shortly before the crisis sold them to other financial institutions (i.e., commercial banks, savings institutions, mutual funds, insurance companies, securities firms, and pension funds); hence even financial institutions that were not involved in the mortgage origination process experienced large losses because they purchased the mortgages originated by other financial institutions.

   Second, many other financial institutions that invested in mortgage-backed securities and promised payments on mortgages were exposed to the crisis. Third, some financial institutions (especially securities firms) relied heavily on short-term debt to finance their operations and used their holdings of mortgage-backed securities as collateral. But when the prices of mortgage-backed securities plummeted, large securities firms such as Bear Stearns and Lehman Brothers could not issue new short-term debt to pay off the principal on maturing debt.

   Furthermore, the decline in home building activity caused a decrease in the demand for many related businesses, such as air-conditioning services, roofing, and landscaping. In addition, the loss of income by workers in these industries caused a decline in spending in a wide variety of industries. The weak economy also created more concerns about the potential default on debt securities, causing further declines in bond prices. The financial markets were filled with sellers who wanted to dump debt securities, but there were not many buyers willing to buy securities. Consequently, the prices of debt securities plunged.

   Systemic risk was a major concern during the credit crisis because the prices of most equity securities declined substantially, since the operating performance of most firms declined when the economy weakened. Thus most financial institutions experienced large losses on their investments during the credit crisis even if they invested solely inequity securities.

1-4b Government Response to the Credit Crisis

The government intervened in order to correct some of the economic problems caused by the credit crisis.

Emergency Economic Stabilization
 Act On October 3, 2008, Congress enacted the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act), which was intended to resolve the liquidity problems of financial institutions and to restore the confidence of the investors who invest in them. The act directed the Treasury to inject $700 billion into the financial system, primarily by investing money into the banking system by purchasing the preferred stock of financial institutions. In this way, the Treasury provided large commercial banks with capital to cushion their losses, thereby reducing the likelihood that the banks would fail.

Federal Reserve Actions
 In 2008, some large securities firms such as Bear Stearns and Lehman Brothers experienced severe financial problems. The Federal Reserve rescued Bear Stearns by financing its acquisition by a commercial bank (J.P. Morgan Chase) in order to calm the financial markets. However, when Lehman Brothers was failing six months later, it was not rescued by the government, and this caused much paranoia in financial markets.

   At this time, the Fed also provided emergency loans to many other securities firms that were not subject to its regulation. Some major securities firms (such as Merrill Lynch) were acquired by commercial banks, while others (Goldman Sachs and Morgan Stanley) were converted into commercial banks. These actions resulted in the consolidation of financial institutions and also subjected more financial institutions to Federal Reserve regulations.

Financial Reform Act of 2010
 On July 21, 2010, President Obama signed the Financial Reform Act (also referred to as the Wall Street Reform Act or Consumer Protection Act), which was intended to prevent some of the problems that caused the credit crisis. The provisions of the act are frequently discussed in this text when they apply to specific financial markets or financial institutions.

   One of the key provisions of the Financial Reform Act of 2010 is that mortgage lenders verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy.

   In addition, the Financial Reform Act called for the creation of the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the United States and makes regulatory recommendations that could reduce any risks to the financial system. The council consists of 10 members who represent the heads of regulatory agencies that regulate key components of the financial system, including the housing industry, securities trading, depository institutions, mutual funds, and insurance companies.

   Furthermore, the act established the Consumer Financial Protection Bureau (housed within the Federal Reserve) to regulate specific financial services for consumers, including online banking, checking accounts, credit cards, and student loans. This bureau can set rules to ensure that information regarding endorsements of specific financial products is accurate and to prevent deceptive practices.

1-4c Conclusion about Government Response to the Credit Crisis

In general, the government response to the credit crisis was intended to enhance the safety of financial institutions. Since financial institutions serve as intermediaries for financial markets, the tougher regulations on financial institutions can stabilize the financial markets and encourage more participation by surplus and deficit units in these markets.

SUMMARY

· ▪ Financial markets facilitate the transfer of funds from surplus units to deficit units. Because funding needs vary among deficit units, various financial markets have been established. The primary market allows for the issuance of new securities, and the secondary market allows for the sale of existing securities.

· ▪ Securities can be classified as money market (short-term) securities or capital market (long-term) securities. Common capital market securities include bonds, mortgages, mortgage-backed securities, and stocks. The valuation of a security represents the present value of future cash flows that it is expected to generate. New information that indicates a change in expected cash flows or degree of uncertainty affects prices of securities in financial markets.

· ▪ Depository and nondepository institutions help to finance the needs of deficit units. The main depository institutions are commercial banks, savings institutions, and credit unions. The main nondepository institutions are finance companies, mutual funds, pension funds, and insurance companies. Many financial institutions have been consolidated (due to mergers) into financial conglomerates, where they serve as subsidiaries of the conglomerate while conducting their specialized services. Thus, some financial conglomerates are able to provide all types of financial services. Consolidation allows for economies of scale and scope, which can enhance cash flows and increase the financial institution’s value. In addition, consolidation can diversify the institution’s services and increase its value through the reduction in risk.

· ▪ The credit crisis in 2008 and 2009 had a profound effect on financial institutions. Those institutions that were heavily involved in originating or investing in mortgages suffered major losses. Many investors were concerned that the institutions might fail and therefore avoided them, which disrupted the ability of financial institutions to facilitate the flow of funds. The credit crisis led to concerns about systemic risk, as financial problems spread among financial institutions that were heavily exposed to mortgages.

POINT COUNTER-POINT

Will Computer Technology Cause Financial Intermediaries to Become Extinct?

Point
 Yes. Financial intermediaries benefit from access to information. As information becomes more accessible, individuals will have the information they need before investing or borrowing funds. They will not need financial intermediaries to make their decisions.

Counter-Point
 No. Individuals rely not only on information but also on expertise. Some financial intermediaries specialize in credit analysis so that they can make loans. Surplus units will continue to provide funds to financial intermediaries, rather than make direct loans, because they are not capable of credit analysis even if more information about prospective borrowers is available. Some financial intermediaries no longer have physical buildings for customer service, but they still require agents who have the expertise to assess the creditworthiness of prospective borrowers.

Who Is Correct?
 Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Surplus and Deficit Units Explain the meaning of surplus units and deficit units. Provide an example of each. Which types of financial institutions do you deal with? Explain whether you are acting as a surplus unit or a deficit unit in your relationship with each financial institution.

· 2. Types of Markets Distinguish between primary and secondary markets. Distinguish between money and capital markets.

· 3. Imperfect Markets Distinguish between perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries.

· 4. Efficient Markets Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain.

· 5. Securities Laws What was the purpose of the Securities Act of 1933? What was the purpose of the Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment decisions? Explain.

· 6. International Barriers If barriers to international securities markets are reduced, will a country’s interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.

· 7. International Flow of Funds In what way could the international flow of funds cause a decline in interest rates?

· 8. Securities Firms What are the functions of securities firms? Many securities firms employ brokers and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how each is compensated.

· 9. Standardized Securities Why do you think securities are commonly standardized? Explain why some financial flows of funds cannot occur through the sale of standardized securities. If securities were not standardized, how would this affect the volume of financial transactions conducted by brokers?

· 10. Marketability Commercial banks use some funds to purchase securities and other funds to make loans. Why are the securities more marketable than loans in the secondary market?

· 11. Depository Institutions Explain the primary use of funds by commercial banks versus savings institutions.

· 12. Credit Unions With regard to the profit motive, how are credit unions different from other financial institutions?

· 13. Nondepository Institutions Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds.

· 14. Mutual Funds What is the function of a mutual fund? Why are mutual funds popular among investors? How does a money market mutual fund differ from a stock or bond mutual fund?

· 15. Impact of Privatization on Financial Markets Explain how the privatization of companies in Europe can lead to the development of new securities markets.

Advanced Questions

· 16. Comparing Financial Institutions Classify the types of financial institutions mentioned in this chapter as either depository or nondepository. Explain the general difference between depository and nondepository institution sources of funds. It is often said that all types of financial institutions have begun to offer services that were previously offered only by certain types. Consequently, the operations of many financial institutions are becoming more similar. Nevertheless, performance levels still differ significantly among types of financial institutions. Why?

· 17. Financial Intermediation Look in a business periodical for news about a recent financial transaction involving two financial institutions. For this transaction, determine the following:

· a. How will each institution’s balance sheet be affected?

· b. Will either institution receive immediate income from the transaction?

· c. Who is the ultimate user of funds?

· d. Who is the ultimate source of funds?

· 18. Role of Accounting in Financial Markets Integrate the roles of accounting, regulation, and financial market participation. That is, explain how financial market participants rely on accounting and why regulatory oversight of the accounting process is necessary.

· 19. Impact of Credit Crisis on Liquidity Explain why the credit crisis caused a lack of liquidity in the secondary markets for many types of debt securities. Explain how such a lack of liquidity would affect the prices of the debt securities in the secondary markets.

· 20. Impact of Credit Crisis on Institutions Explain why mortgage defaults during the credit crisis adversely affected financial institutions that did not originate the mortgages. What role did these institutions play in financing the mortgages?

· 21. Regulation of Financial Institutions Financial institutions are subject to regulation to ensure that they do not take excessive risk and can safely facilitate the flow of funds through financial markets. Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to facilitate their financial transactions. Why do you think the existing regulations were ineffective at ensuring a safe financial system?

· 22. Impact of the Greece Debt Crisis European debt markets have become integrated over time, so that institutional investors (such as commercial banks) commonly purchase debt issued in other European countries. When the government of Greece experienced problems in meeting its debt obligations in 2010, some investors became concerned that the crisis would spread to other European countries. Explain why integrated European financial markets might allow a debt crisis in one European country to spread to other countries in Europe.

· 23. Global Financial Market Regulations Assume that countries A and B are of similar size, that they have similar economies, and that the government debt levels of both countries are within reasonable limits. Assume that the regulations in country A require complete disclosure of financial reporting by issuers of debt in that country but that regulations in country B do not require much disclosure of financial reporting. Explain why the government of country A is able to issue debt at a lower cost than the government of country B.

· 24. Influence of Financial Markets Some countries do not have well-established markets for debt securities or equity securities. Why do you think this can limit the development of the country, business expansion, and growth in national income in these countries?

· 25. Impact of Systemic Risk Different types of financial institutions commonly interact. They provide loans to each other, and take opposite positions on many different types of financial agreements, whereby one will owe the other based on a specific financial outcome. Explain why their relationships cause concerns about systemic risk.

Interpreting Financial News

“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street analysts and portfolio managers who participate in the financial markets. Interpret the following statements.

· a. “The price of IBM stock will not be affected by the announcement that its earnings have increased as expected.”

· b. “The lending operations at Bank of America should benefit from strong economic growth.”

· c. “The brokerage and underwriting performance at Goldman Sachs should benefit from strong economic growth.”

Managing in Financial Markets

Utilizing Financial Markets As a financial manager of a large firm, you plan to borrow $70 million over the next year.

· a. What are the most likely ways in which you can borrow $70 million?

· b. Assuming that you decide to issue debt securities, describe the types of financial institutions that may purchase these securities.

· c. How do individuals indirectly provide the financing for your firm when they maintain deposits at depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?

FLOW OF FUNDS EXERCISE

Roles of Financial Markets and Institutions

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that requires the application of concepts presented in the chapter as they relate to the flow of funds.

   Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and 10 other individuals. Over time, Carson Company obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs additional funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

   Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and by making more acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. It is also considering issuing stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

· a. In what way is Carson a surplus unit?

· b. In what way is Carson a deficit unit?

· c. How might finance companies facilitate Carson’s expansion?

· d. How might commercial banks facilitate Carson’s expansion?

· e. Why might Carson have limited access to additional debt financing during its growth phase?

· f. How might securities firms facilitate Carson’s expansion?

· g. How might Carson use the primary market to facilitate its expansion?

· h. How might it use the secondary market?

· i. If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

· j. The loans that Carson has obtained from commercial banks stipulate that Carson must receive the bank’s approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?

INTERNET/EXCEL EXERCISES

· 1. Review the information for the common stock of IBM, using the website 
finance.yahoo.com
. Insert the ticker symbol “IBM” in the box and click on “Get Quotes.” The main goal at this point is to become familiar with the information that you can obtain at this website. Review the data that are shown for IBM stock. Compare the price of IBM based on its last trade with the price range for the year. Is the price near its high or low price? What is the total value of IBM stock (market capitalization)? What is the average daily trading volume (Avg Vol) of IBM stock? Click on “5y”just below the stock price chart to see IBM’s stock price movements over the last five years. Describe the trend in IBM’s stock over this period. At what points was the stock price the highest and lowest?

· 2. Repeat the questions in exercise 1 for the Children’s Place Retail Stores (symbol PLCE). Explain how the market capitalization and trading volume for PLCE differ from that for IBM.

WSJ EXERCISE

Differentiating between Primary and Secondary Markets

Review the different tables relating to stock markets and bond markets that appear in Section C of the Wall Street Journal. Explain whether each of these tables is focused on the primary or secondary markets.

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. secondary market AND liquidity

· 2. secondary market AND offering

· 3. money market

· 4. bond offering

· 5. stock offering

· 6. valuation AND stock

· 7. market efficiency

· 8. financial AND regulation

· 9. financial institution AND operations

· 10. financial institution AND governance

Term Paper on the Credit Crisis

Write a term paper on one of the following topics or on a topic assigned by your professor. Details such as the due date and the length of the paper will be provided by your professor.

   Each of the topics listed below can be easily researched because considerable media attention has been devoted to the subject. Although this text offers a brief summary of each topic, much more information is available at online sources that you can find by using a search engine and inserting a few key terms or phrases.

· 1. Impact of Lehman Brothers’ Bankruptcy on Individual Wealth Explain how the bankruptcy of Lehman Brothers (the largest bankruptcy ever) affected the wealth and income of many different types of individuals whose money was invested by institutional investors (such as pension funds) in Lehman Brothers’ debt.

· 2. Impact of the Credit Crisis on Financial Market Liquidity Explain the link between the credit crisis and the lack of liquidity in the debt markets. Offer some insight as to why the debt markets became inactive. How were interest rates affected? What happened to initial public offering (IPO) activity during the credit crisis? Why?

· 3. Transparency of Financial Institutions during the Credit Crisis Select a financial institution that had serious financial problems as a result of the credit crisis. Review the media stories about this institution during the six months before its financial problems were publicized. Were there any clues that the financial institution was having problems? At what point do you think that the institution recognized that it was having financial difficulties? Did its previous annual report indicate serious problems? Did it announce its problems, or did another media source reveal the problems?

· 4. Cause of Problems for Financial Institutions during the Credit Crisis Select a financial institution that had serious financial problems as a result of the credit crisis. Determine the main underlying causes of the problems experienced by that financial institution. Explain how these problems might have been avoided.

· 5. Mortgage-Backed Securities and Risk Taking by Financial Institutions Do you think that institutional investors that purchased mortgage-backed securities containing subprime mortgages were following reasonable investment guidelines? Address this issue for various types of financial institutions such as pension funds, commercial banks, insurance companies, and mutual funds (your answer might differ with the type of institutional investor). If financial institutions are taking on too much risk, how should regulations be changed to limit such excessive risk taking?

· 6. Pension Fund Investments in Lehman Brothers’ Debt At the time that Lehman Brothers filed for bankruptcy, financial institutions serving municipalities in California were holding more than $300 billion in debt issued by Lehman. Do you think that municipal pension funds that purchased commercial paper and other debt securities issued by Lehman Brothers were following reasonable investment guidelines? If a pension fund is taking on too much risk, how should regulations be changed to limit such excessive risk taking?

· 7. Future Valuation of Mortgage-Backed Securities Commercial banks must periodically “mark to market” their assets in order to determine the capital they need. Identify some advantages and disadvantages of this method, and propose a solution that would be fair to both commercial banks and regulators.

· 8. Future Structure of Fannie Mae Fannie Mae plays an important role in the mortgage market, but it suffered major problems during the credit crisis. Discuss the underlying causes of the problems at Fannie Mae beyond what has been discussed in the text. Should Fannie Mae be owned completely by the government? Should it be privatized? Offer your opinion on a structure for Fannie Mae that would avoid its previous problems and enable it to serve the mortgage market.

· 9. Future Structure of Ratings Agencies Rating agencies rated the so-called tranches of mortgage-backed securities that were sold to institutional investors. Explain why the performance of these agencies was criticized, and then defend against this criticism on behalf of the agencies. Was the criticism of the agencies justified? How could rating agencies be structured or regulated in a different manner in order to prevent the problems that occurred during the credit crisis?

· 10. Future Structure of Credit Default Swaps Explain how credit default swaps maybe partially responsible for the credit crisis. Offer a proposal for how they could be structured in the future to ensure that they are used to enhance the safety of the financial system.

· 11. Sale of Bear Stearns Review the arguments that have been made for the government-orchestrated sale of Bear Stearns. If Bear Stearns had been allowed to fail, what types of financial institutions would have been adversely affected? In other words, who benefited from the government’s action to prevent the failure of Bear Stearns? Do you think Bear Stearns should have been allowed to fail? Explain your opinion.

· 12. Bailout of AIG Review the arguments that have been made for the bailout of American International Group (AIG). If AIG had been allowed to fail, what types of financial institutions would have been adversely affected? That is, who benefited from the bailout of AIG? Do you think AIG should have been allowed to fail? Explain your opinion.

·

13. Executive Compensation at Financial Institutions Discuss the compensation received by executives at some financial institutions that experienced financial problems (e.g., AIG, Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual). Should these executives be allowed to retain the bonuses that they received in the 2007-2008 period? Should executive compensation at financial institutions be capped?

· 14. Impact of the Credit Crisis on Commercial Banks versus Securities Firms Both commercial banks and securities firms were adversely affected by the credit crisis, but for different reasons. Discuss the reasons for the adverse effects on commercial banks and securities firms and explain why the reasons were different.

· 15. Role of the Treasury and the Fed in the Credit Crisis Summarize the various ways in which the U.S. Treasury and the Federal Reserve intervened to resolve the credit crisis. Discuss the pros and cons of their interventions. Offer your own opinion regarding whether they should have intervened.