Chapter 1 An Introduction to Money and the Financial System

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• ECON 304 Money and Banking
• Instructor Bernard Malamud
• Office BEH 502
• Phone [phone]
• Fax [phone]
• Email bernard.malamud_at_unlv.edu
• Website www.unlv.edu/faculty/bmalamud
• Office hours TR 1130 -1230pm 230 - 330 pm
  and by appointment

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Headline Obama to nominate Bernanke to second
term.
WASHINGTON President Obama on Tuesday will
nominate Ben S. Bernanke to a second term as
chairman of the Federal Reserve, administration
officials said. The announcement is a major
victory for Mr. Bernanke, a Republican who was
appointed by President George W. Bush almost four
years ago and who had briefly served as chairman
of Mr. Bushs Council of Economic Advisers. A top
White House official said Mr. Obama had decided
to keep Mr. Bernanke at the helm of the Fed
because he had been bold and brilliant in his
attempts to combat the financial crisis and the
deep recession. The president thinks that Bens
done a great job as Fed chairman, that he has
helped the economy through one of the worst
experiences since the Great Depression and that
he has essentially been pulling the economy back
from the brink of what would have been the second
Great Depression, the White House chief of
staff, Rahm Emanuel, said Monday night.
When Mr. Obama was elected, many Democrats
considered one of the most likely contenders for
Fed chairman to be Lawrence H. Summers, a former
Treasury secretary under President Bill Clinton
and currently director of the National Economic
Council in Mr. Obamas White House. Other rumored
candidates included Alan S. Blinder, a professor
of economics at Princeton and a former vice
chairman of the Federal Reserve under Alan
Greenspan Janet L. Yellen, president of the
Federal Reserve Bank of San Francisco and Roger
Ferguson, another former vice chairman of the
Federal Reserve who is currently president of
TIAA-CREF, the giant pension fund company.
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• In the spring of 2007, Henry Paulson, the US
  Treasury secretary had told Congress that the
  subprime problem appears to be contained.
  Bernanke, the Federal Reserve governor,
  repeatedly echoed that line. Given the
  fundamental factors in place that should support
  the demand for housing, we believe the effect of
  the troubles in the subprime sector on the
  broader housing market will likely be
  limited.In May, he continued, Importantly, we
  see no serious broader spillover to banks or
  thrift institutions from the problems in the
  subprime market troubled lenders, for the most
  part, have not been institutions with federally
  insured deposits.In early June, after the
  collapse of Bear Stearns funds, Bernanke changed
  his tune slightly. Rising delinquencies and
  foreclosures are creating personal, economic, and
  social distress for many home owners and
  communities problems that likely will get worse
  before they get betterIt seems very far-fetched
  to make any parallels with Japans crisis. The
  key thing to remember is that those loses are not
  just held by American banks, as bad as the loans
  were in Japan, but they are dispersed.

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Money, Banking, and Financial Markets

• The role of money and monetary policy
• TRUST
• How financial markets work
• TRUST
• How financial institutions such as banks and
  insurance companies work
• TRUST
• How the shadow banking system operates
• TRUST?

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• A security (financial instrument) is a claim on
  the issuers future income or assets
• A bond is a debt security that promises to make
  specified payments over time
• An interest rate is the cost of borrowing or the
  price paid for the rental of funds

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Interest Rates on Selected Bonds, 19502008

• Sources Federal Reserve Bulletin
  www.federalreserve.gov/releases/H15/data.htm.

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• A security (financial instrument) is a claim on
  the issuers future income or assets
• A bond is a debt security that promises to make
  specified payments over time
• An interest rate is the cost of borrowing or the
  price paid for the rental of funds
• Common stock represents a share of ownership in a
  corporation
• A share of stock is a claim on the earnings and
  assets of the corporation

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Banking and Financial Institutions

• Financial Intermediariesinstitutions that borrow
  funds from people who have saved and make loans
  to other people and businesses
• Banksaccept deposits and make loans
• Other Financial Institutionsinsurance companies,
  finance companies, pension funds, mutual funds
  and investment banks
• Financial Innovation
• The information age and e-finance
• Derivatives
• Securitization

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From Gillian Tett, Fools Gold

• The sun slipped slowly down the
  cerulean Spanish sky.Several hundred bankers
  stood on the elegant terrace of a futuristic,
  gleaming white hotel, staging a so-called
  champagne salute in celebration of the fact that
  investment banks had just enjoyed their most
  lucrative year in history. The date was June 11,
  2007 and the occasion was the annual meeting of
  the European SecuritisationThe meeting carried a
  lofty title Global Asset Backed Securitization
  Toward a New Dawn. An exuberant crowd including
  smooth talking, white toothed salesmen from large
  American banks, eagerly selling repackaged
  mortgage debt self-deprecating British traders
  and earnest, chain-smoking representatives from
  German insurance companies and banks. Their prey
  included asset managers from Italy, Spain,
  Germany, and GreeceA silent gaggle of Chinese
  and Singaporeans circulated. It was rumored that
  they were furtively buying CDOs to find a home
  for foreign exchange reserves. A few regulators
  could also be spotted, conspicuous in looking
  generally dowdier than the bankers. Some of the
  biggest delegations, though, came from the three
  credit rating agencies that were drawing fat
  profits from the CDO boomLively debate ensued
  about the American mortgage backed bond market,
  the CDO sector, the SIVs, the state of the
  Spanish mortgage market and the outlook for
  Russian ABS. There was even a high-profile
  debate on Islamic finance which some hoped
  would be a hot new growth area for securitization

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Innovation Alphabet Soup
ABCP asset backed commercial paper ABS asset
backed security CD credit derivative, e.g.,
CDS CDO collateralized debt obligation CDO2 a
CDO backed by CDOs CDS credit default swap SIV
structured investment vehicle SPV special
purpose vehicle
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Money Growth (M2 Annual Rate) and the Business
Cycle in the United States, 19502008

• Note Shaded areas represent recessions.
• Source Federal Reserve Bulletin, p. A4, Table
  1.10 www.federalreserve.gov/releases/h6/hist/h6hi
  st1.txt.

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Money and Inflation

• The aggregate price level is an average price of
  goods and services in an economy
• A continual rise in the price level (inflation)
  affects all economic players

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Money Growth (M2 Annual Rate) and Interest Rates
(Long-Term U.S. Treasury Bonds), 19502008

• Sources Federal Reserve Bulletin, p. A4, Table
  1.10 www.federalreserve.gov/releases/h6/hist/h6hi
  st1.txt.

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Monetary and Fiscal Policies

• Monetary policy is the management of the money
  supply and interest rates
• Conducted by the Federal Reserve Bank (Fed)
• Fiscal policy is government spending and taxation
  
• Any deficit must be financed by borrowing
  government borrowing affects interest rates

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Bernankes Focus

• Survival Lender of last resort responsibility
• Inflation Targeting
• Adjust real rate of interest with eye on
  pre-announced target rate of inflation
• Wiggle room for other objectives/emergencies
• Transparency and accountability
• Joined by Mishkin on Board of Governors for while
• Other Governors
• www.federalreserve.gov/bios
• Oppose Deflation
• Great Depression and clogged credit channel

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Core Principles of Money and Banking

• Time has Value ? Interest rate
• Risk Requires Compensation
• Financial decisions are based on Information and
  on TRUST
• Markets set prices and allocate resources
• Stability reduces risk and spurs enterprise

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Where to Find the Numbers

• http//research.stlouisfed.org/fred2/
• www.federalreserve.gov/releases/
• www.economist.com
• www.bea.doc.gov
• http//www.gpoaccess.gov/eop/

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Functions of Financial Markets 101

• Channel funds from those who have saved surplus
  to those who need to borrow
• Win - Win
• Promotes economic efficiency by producing an
  efficient allocation of capital
• increases production
• Improves consumer well-being
• allows them to time purchases better

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Structure of Financial MarketsAddress adverse
selection moral hazard problems

• Debt and Equity Markets
• Short-term (maturitylt1yr) /intermediate
  term/long-term (gt10yrs)
• Primary and Secondary Markets
• Investment Banks underwrite securities in primary
  markets
• Are any investment banks left?
• Brokers and dealers work in secondary markets ?
  liquidity
• Exchanges and Over-the-Counter (OTC) Markets
• Money and Capital Markets
• Money markets ?short-term debt instruments
• Capital markets ?longer-term debt and equities
  (stocks)

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Principal Money Market Instruments
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Principal Capital Market Instruments
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Internationalization of Financial Markets

• Foreign Bondssold in a foreign country and
  denominated in that countrys currency bonds
  in UK
• Eurobondbond denominated in a currency other
  than that of the country in which it is sold
  bond in UK
• Eurocurrenciesforeign currencies deposited in
  banks outside the home country
• EurodollarsU.S. dollars deposited in foreign
  banks outside the U.S. or in foreign branches of
  U.S. banks
• Euroeuro euros deposited in a British bank
• World Stock Markets
• Indexes US?SP 500/UK?FTSE 100/German?DAX/Japan?N
  ikkei

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Function of Financial Intermediaries Indirect
Finance

• Lower transaction costs
• Economies of scale
• Liquidity services
• Reduce Risk
• Risk Sharing (Asset Transformation Risky ? less
  risky)
• Diversification
• Asymmetric Information in Finance
• Adverse Selection (before the transaction)more
  likely to select risky borrower
• Moral Hazard (after the transaction)less likely
  borrower will repay loan

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Principal Financial Intermediaries and Value of
Their Assets
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Regulation of the Financial System

• To increase the information available to
  investors
• Reduce adverse selection and moral hazard
  problems
• Reduce insider trading
• To ensure the soundness of financial
  intermediaries
• Restrictions on entry upstanding citizens with
  impeccable credentials and lots of capital
  upfront
• Disclosure
• Restrictions on Assets and Activities ? SIVs as
  end-run
• Deposit Insurance
• Limits on Competition/branching regulation as
  history
• Restrictions on Interest Rates/Regulation Q as
  history
• ? Disintermediation

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