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Overview of the U.S. Financial System

• This chapter details the financial markets and how they link savers to borrowers.
• Two methods exist for savers to lend to borrowers:
  • Depositing funds into a financial institution, which then lends to borrowers
  • Lending directly to borrowers by investing in financial securities
• Financial markets include spot, derivative, primary, and secondary markets.
• The impact of financial innovation and government regulation on financial markets is examined.
• Common financial instruments are defined.
• The U.S. banking system evolved into a complex structure due to early distrust of large banks, resulting in regulations limiting bank size and increasing their number.
• There are two layers of commercial banks in the U.S.: national and state banks, regulated by federal and/or state agencies.
• Banks have innovated to circumvent government regulations.

Financial Intermediation

• A financial system transfers funds from savers to borrowers, who can be households, businesses, or governments.
• Net savers spend less than their income, while net borrowers spend more.
• Students using loans are net borrowers, becoming net savers as their income rises and they repay loans.
• Many local and state governments are net savers due to balanced budget laws, unlike the U.S. federal government, which has been a net borrower for the last 50 years.
• Transferring funds from savers to borrowers boosts the economy by enabling investments in machinery and equipment, increasing production, creating jobs, rising incomes, and improving living standards.
• The U.S. financial system allows institutions to collect small savings from many people and lend to large companies; for example, 10,000 savers with $200 can enable a $2 million business loan.
• Savers link to borrowers through financial intermediaries and direct finance.
• Financial intermediaries include banks, mutual funds, and insurance companies, existing to earn profits by investing premiums in financial markets and profiting from interest rate differences.
• Direct finance involves savers lending directly to businesses through financial markets using instruments like common stock and bonds.
• Common stock represents ownership in a corporation (equity), granting stockholders voting rights and a share of profits (dividends).
• A bond is a standardized loan to a corporation, promising repayment plus interest, with bondholders having a higher claim on assets during bankruptcy compared to stockholders.
• Bonds and stocks are traded in primary and secondary markets.
• Corporations issue new securities in the primary market.
• Investors trade existing securities in the secondary market, like the New York Stock Exchange.
• Financial intermediaries offer liquidity, specialist information gathering, and risk reduction through diversification.
• Diversification involves lending to various borrowers, such as credit card holders, mortgagees, businesses, and the U.S. government.
• Financial disintermediation occurs when savers withdraw money from intermediaries to invest directly in financial markets, often for higher interest rates or lower default risk (e.g., investing in U.S. Treasury bills).
• With financial disintermediation, governments may obtain loans first, potentially crowding out private investment needed for business development.
• Financial transactions are completed through:
• Cash or spot markets for immediate exchange or
• Derivative markets for future exchanges at a negotiated price and quantity (e.g., buying Treasury bills in six months at a set price).

Financial Instruments

• Every financial instrument, except stock, has a principal, interest, and maturity. Principal: The loan amount Interest: Payments because borrower can utilize funds Maturity: The date the security expires
• Money market: Short-term securities with a maturity of less than one year
• Capital market: Long-term securities with a maturity greater than one year
• The function of securities is one party owes another money plus interest, except stocks, which represent ownership.
• Money market securities maturities are listed below:
  • U.S. Treasury bills (T-bills): Loans to the U.S. government with maturities from 15 days to one year (Example: Buy for $19,000, receive $20,000 six months later)
  • Commercial paper: Short-term loans to well-known banks or corporations, without collateral
  • Banker's Acceptances: Guarantees of payment by a bank in international trade, liquid due to secondary markets
  • Negotiable Bank Certificates of Deposit (CDs): Loans banks sell directly to depositors
  • Repurchase Agreements (repos): Short-term loans where a bank sells T-bills and buys them back the next day at a higher price
  • Federal Funds: Overnight loans between banks at Federal Reserve
  • Eurodollars: U.S. dollars deposited in foreign commercial banks or branches of U.S. banks, even if in Eurozone
• Common types of capital market securities include:
  • U.S. Treasury securities:
    • Treasury Notes (T-notes): Issued for 1 to 10 years
    • Treasury Bonds (or T-bonds): Issued for longer than 10 years
  • Bonds issued by state and local governments are known as municipal bonds and fall into two categories:
    • General-obligation bonds: Bond payment is guaranteed with taxing power
    • Revenue bonds: Secures bond payment by revenues generated
  • Mortgage: a loan on property with a 15-30 year duration
  • Commercial bank loan: Banks lending to businesses
  • Securities from government agencies is used for things like college loans

United States Banking System

• The U.S. has more banks per capita with fewer assets due to government regulations.
• The U.S. has a dual banking system where banks get charters from a state or the U.S. federal government.
  • National banks: Receive charters from the federal government
  • State banks: Receive charters from a state government
• Banks with federal charters are regulated by these government agencies:
  • Comptroller of the Currency: Regulates national banks and grants charters
  • Federal Deposit Insurance Corporation (FDIC): Insures deposits at member banks
  • Federal Reserve System (Fed): Serves as the central bank, lender of last resort, and bank regulator
• State-chartered banks may have fewer regulations and may also join the Fed and/or FDIC.
• Banks have restrictions
  • McFadden Act: Prohibited a bank from opening branches in another state
  • Unit banking: Restricted a bank to a single geographic location
  • Branch banking: Allows a bank to have multiple offices within an area
• Savings institutions and credit unions have their own regulatory agencies and issue charters.
• Federal Home Loan Bank System (FHLBS): U.S. government agency similar to the Federal Reserve
• National Credit Union Administration: Issues credit union charters

Banking System Regulation

• Governments regulate banking systems and financial markets to:
  • Ensure financial system stability
  • Influence inflation, business cycle, and interest rates through monetary policy
  • Promote efficiency in financial intermediation.
  • Provide low-cost financing for homebuyers
  • Make sure borrowers provide accurate info
  • Protect consumers from financial instruments they dont understand.
• The Glass-Steagall Banking Act in 1933 divided investment and commercial banking to prevent risky securities underwriting and monopolies.
• In 1999, the U.S. repealed parts of the Glass-Steagall Act to boost competition.
• Creates the Federal Deposit Insurance Corporation (FDIC).
  • The FDIC insures bank deposits up to $250,000 per depositor.
  • FDIC is funded by insurance premiums paid by member banks.
  • Manages bank failures using two methods:
  • Closing the bank and selling its assets to repay depositors: FDIC pays deficiency
  • Purchasing control of failing bank and searching for buyers: FDIC provides incentives like low-interest loans
• Bank runs and contagion are prevented and reduced by the FDIC
  • A bank run = Too many depositors looking to withdraw funds
  • Contagion = A bank run causes a bank run at another bank
  • Financial panic = A wave of bank runs
• The FDIC charges insurance premiums based on deposit amounts and the depository institutions' risk level.

Financial Innovation

• Financial innovation drives financial market and institutional change.
• Mutual funds are one financial innovation that increases investors' through stock diversification
• Bank holding companies were created as institutions cleverly maneuvered regulations by creating new financial instruments and institutions.
• A bank holding company is when one corporation obtains ownership of multiple independent banks and can do the following:
  • Branch within states
  • buy other non-bank companies
  • raise non-deposit funds
• Nonbank allows banks to circumvent federal and state regulations by specializing in only accepting loans
• Modern computer technology allows bank's customers to receive services, not be subjected branch restrictions.
• Technology innovations lead to rising interest rates and deregulation
• Banks acquire other banks, reducing their number, leading to larger assets
• Consquently, taxpayers indirectly helped the corporations to reduce potential failure.