The Financial System, Financial Regulation and Central Bank Policy PDF

 The Financial System, Financial Regulation and Central Bank Policy Traditional money and banking textbooks are long, expensive and full of so much institu- tional and technical modeling detail that students can't understand the big picture. Thomas F. Cargill presents a new alternative: a short, i...

 The Financial System, Financial Regulation and Central Bank Policy Traditional money and banking textbooks are long, expensive and full of so much institu- tional and technical modeling detail that students can't understand the big picture. Thomas F. Cargill presents a new alternative: a short, inexpensive book without the "bells and whis- tles" that teaches students the fundamentals in a clear, narrative form. In an engaging writing style, Cargill explains the three core components of money and banking, and their interac- tions: 1), the financial system; 2), government regulation and supervision; and, 3), central bank policy. Cargill focuses on the interaction between government financial policy and central bank policy and offers a critique of the central bank's role in the economy, the tools it uses, how these tools affect the economy and how effective these policies have been, pro- viding a more balanced perspective of government policy failure versus market failure than traditional textbooks. Professor Thomas F. Cargill has taught and conducted research on financial and mone- tary economics at the University of California, Davis; the University of Hawaii, at both Honolulu and Saigon (Ho Chi Minh City), Vietnam; California State University, Sacra- mento; Purdue University, at West Lafayette, Indiana; and, since 1973, the University of Nevada, Reno. He has written extensively as a single and joint author on U.S. financial and central banking issues and has also conducted similar research on China, South Korea, Japan and Vietnam. His work has been published in The Journal ofEconomic History, Jour- nal of Money, Credit and Banking, The Journal of Finance, Journal of Political Economy, Review ofEconomics and Statistics and International Finance. His work has also been pub- lished by Cambridge University Press, Hoover Institution Press, the MIT Press and Oxford University Press. The Financial System, Financial Regulation and Central Bank Policy THOMAS F. CARGILL University of Nevada, Reno UCAMBRIDGE ~ UNIVERSITY PRESS  CAMBRIDGE UNIVERSITY PRESS University Printing House, Cambridge CB2 8BS, United Kingdom One Liberty Plaza, 20th Floor, New York, NY 10006, USA 477 Williamstown Road, Port Melbourne, VIC 3207, Australia 4843/24, 2nd Floor, Ansari Road, Daryaganj, Delhi- 110002, India 79 Anson Road, #06-04/06, Singapore 079906 Cambridge University Press is part of the University of Cambridge. It furthers the University's mission by disseminating knowledge in the pursuit of education, learning and research at the highest international levels of excellence. www.cambridge.org Information on this title: www.cambridge.org/9781107035676 DOl: 10.1017/9781139565172 ©Thomas F. Cargill2017 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2017 Printed in the United States of America by Sheridan Books, Inc. A catalogue record for this publication is available from the British Library Library of Congress Cataloging-in-Publication data Names: Cargill, Thomas F., author. Title: The financial system, financial regulation and central bank policy I Thomas F. Cargill. Description: New York: Cambridge University Press, 2017. I Includes bibliographical references and index. Identifiers: LCCN 2017001521 I ISBN 9781107035676 (hardback) I ISBN 9781107689763 (paperback) Subjects: LCSH: Banks and banking, Central. I Finance-Government policy. I Banking law. I BISAC: BUSINESS & ECONOMICS I International/ Economics. Classification: LCC HG1811.C373 20171 DDC 332.1/1- Financial Sector (1.1) Assume a given interest rate determined in the financial sector. At this interest rate, the real sector determines the level of output, spending, employment, etc. As part of this process, the real sector determines saving, which, in tum, influences the supply of loanable funds in the financial sector, and spending influences the demand for loanable funds in the financial sector. The real sector thus influences the financial sector (Expression 1.1), but, in tum, the financial sector then feeds back onto the real sector: Financial Sector > Real Sector (1.2) The supply of and demand for loanable funds influence the interest rate we started with in the real sector and change the interest rate. The changed interest rate feeds back onto the real sector by influencing output, spending, employment, prices, etc. in the real sector (Expression 1.2). The influence on the real sector then influences the supply of and demand for loanable funds in the financial sector, which in tum changes the interest rate and feeds back onto the real sector (Expression 1.2), which in tum influences the financial sector (Expression 1.1 ), which in tum influences the real sector (Expression 1.2), and so on. The country's financial and monetary regime is thus part of the financial sector in the broad sense, which in tum influences the real sector, and so on; thus, the financial and monetary regime is an integral part of the overall economy. 1.4 Measuring Economic Performance An important premise in this book is that a significant malfunction in the country's financial and monetary regime has an adverse impact on economic activity, and, as such, it is important to be familiar with how economic activity is measured. A coun- try's economic performance can be measured in a variety of ways; however, five variables, most of which are drawn from the real sector, provide a good overview of how well an economy is performing over both the short and long run.  1.4 Measuring Economic Performance 7 These are: actual real gross domestic product, or real GDP; potential real GDP; the unemployment rate; the natural unemployment rate; and the price level. The price level itself is not a real variable but is an important indicator of economic activity and permits us to distinguish between nominal and real values of economic variables where appropriate. Variables that measure the financial sector, such as interest rates, money, credit, etc., are also important, but ultimately it's the overall level of economic performance represented by these five variables that determines the wealth and growth of the nation. Actual and potential real GDP: Real GDP is the final output of goods and ser- vices produced in the country over a period of time, holding prices constant. Real GDP is measured by the spending on final output measured by consumer spending (C), investment spending (I), government spending (G) and net foreign spending [exports of goods and services (X) minus imports of goods and services (M)]: RealGDP= C +I+ G+ (X-M) (1.3) Nominal or market GDP is the final output of goods and services valued at current or market prices and related to real GDP by the following: Real GDP = (Nominal GDP/Price Index) (1.4) where the price index is divided by 100 to convert it from a percent to a real number. While real GDP is what the economy actually produced over a given period of time, the economy's potential real GDP is the level of real output an economy is capable of producing over a period of time utilizing its resources with its given structure and technology. Potential GDP is also referred to as the level of output the economy produces at "full employment"; however, full employment does not mean zero unemployment, because even at "full employment" there is a non-zero level of unemployment determined by the structure of the economy, referred to as natural unemployment. There is nothing special or desirable about potential GDP in that it can be high or low depending on the country's structure, resource base and technology. Potential GDP is simply a base to measure actual economic performance against its potential, but there is nothing optimal about potential output. An economy might have inef- ficiencies that limit a country's potential output. Consider the former command economies of China and the Soviet Union that collapsed in the latter part of the twentieth century. Despite resources and access to technology, the inherent ineffi- ciency of these command economies limited their potential levels compared to the West; that is, the government-controlled structure limited the country's potential output at a given level of resources and technology. This is a major reason why these economies collapsed and/or had so much "deadweight loss" they shifted to more open markets and less government planning. The difference between real and potential GDP indicates whether the economy is operating above or below its potential or natural output path. The GDP gap is 8 Chapter 1. The Financial and Monetary Regime $18,000 -. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Real GOP - - Potential real GOP ~ $12,000 +---------------------~'------------.., 0 ~ ~..,.. $10,000 + - - - - - - - - - - - - - - - - - ----F£-- - - - - - - - - - c ·; -£ $8,000.. 'S c ~ $6,000 iii $2,000 + - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - $0.....,. "".,..,. 0 "'"'.!. "'"'> "'">./::."'"' "..!. ""'> ">./::."" 't;;; "'""...!. """'...!. """> """'> 0 N t"';;; "'.!. "'"'.!. "'""> > 0 N "'.!. ".!. "'>........>./::....."'...."'> ~ "'c. "' ~ ~ ::!: ~ ;;; "' ~ ::!: ~ "' ~ ::!:... ~ 0 "' ~ ~ 0./::... 0 0 0 "' ~ ::!: ~ ;;; "' ~"'c.0.0.0.0.0.0.0.0 ::!: ::J E "' ::!: ::J c E "' ::!: ::J c E E ::J c E E ::!: ::J E E "' ::!: ::J c ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ c. c. 0 c. 0 c. 0 c. -'l -'l z -'l z -'l z -'l Month and year Figure 1.1. Quarterly Real GDP and Potential Real GDP, 1960:1 to 2016:1, in Chained 2009 Dollars. Source: FRED, Federal Reserve Bank of St. Louis (https://fred.stlouisfed.org). the difference between actual real GOP and potential GOP expressed as a ratio of potential GOP: GOP Gap= (Real GOP- Potential GOP)/Potential GOP (1.5) The GOP gap is often expressed in percentage terms by multiplying Expression 1.5 by 100. Figure 1.1 illustrates U.S. quarterly real GOP and potential GOP from the first quarter of 1960 (1960: 1) to the first quarter of 2016 (2016: 1), and, while the U.S. economy has grown over time, actual GOP has moved above and below its poten- tial. These swings in economic activity are more apparent in the GOP gap, illus- trated in Figure 1.2. The GOP gap exhibits definite cyclical movements, which are called business fluctuations or cycles. To highlight the business cycle move- ments, Figure 1.2 highlights periods of recession and expansion established by the National Bureau of Economic Research (NBER). The shaded areas in Figure 1.2 are recessions and the non-shaded areas, by definition, are periods of expansion in the U.S. economy. Notice how the GOP gap is negative during recession periods and positive during expansion periods.  JA Measuring Economic Perfonnance 9 8.00 Recession Gap 6.00 f.l 1--- 4.00 ~I ~l r-- -1 v~ J !'' 2.00 1-- 0.00 ~ N ~w~m j ~ N f ~ ~ 'mo ~ l f1 A b op ~~ggg~~CJ..yt:J; lifi~. 1: J 0'1 0 N M r 0 M ~t!t · '2~'2..--i.--1.... ~ t~ ~ ~E % --. ~ ~ ~ ~ ~..0~ ~0....c~ ~ t ~~~~ 0 1~ lil ~f-1 --.~ ~ ro E::::~ TE TRCE+I TR I TR-CE I S B LI, then lending >borrowing, and, if S lending. If S =I and L = B, the balanced sector provides funds to and obtains funds from the financial system. The advantage of the third perspective is that it emphasizes that balanced units play a role in the financial system even though they are not net lenders or borrowers. Table 3.3 indicates the three different ways to define a surplus, deficit and bal- anced unit. The financial system can then be thought of as a collection of markets and institutions that bring surplus, deficit and balanced units together, though on a net basis the financial system places the surplus unit on the supply side and the deficit unit on the demand side. Of the three perspectives of the surplus, deficit and balanced unit, the third, based on lending and borrowing, is the most useful. Surplus units are net lenders to the financial system, deficit units are net borrow- ers from the financial system and balanced units lend and borrow in equal amounts, but nonetheless are serviced by the financial system. The net lender/net borrower perspective is important for constructing a flow of funds matrix of the economy; however, the financial system can also be illustrated as lenders on one side supply- ing funds and borrowers on the other side demanding funds. Table 3.4 illustrates the financial system in terms of lenders on the side supply- ing funds and borrowers on the other side demanding funds. Note that each sector shows up on both sides of the financial system. Based on the fundamental flow of funds equation in Expression 3.3, a lender may be a surplus unit (S > I and L > B), a deficit unit (S < I and L < B) or a balanced unit (S =I and L =B). In all three cases, lending takes place. Likewise, a borrower may be a surplus unit (S > I and L > B), a deficit unit (S < I and L < B) or a balanced unit (S = I and L = B). In all three cases, borrowing takes place. Table 3.4 also illustrates the two channels of finance discussed in the next section. 3.5 Two Channels of Finance: Direct and Indirect Finance Irrespective of how we characterize the financial system, any financial transaction involves an act of supplying funds and an act of demanding funds. Funds can be  3.5 Two Channels of Finance: Direct and Indirect Finance 65 Table 3.4. Financial System in Terms of Lenders and Borrowers Nonfinancial lenders Nonfinancial borrowers Households Households Businesses Businesses Federal government Federal government Local and state governments Local and state governments Foreign Foreign Direct finance Lenders supply funds directly to borrowers through money and capital markets. The lender purchases a promise to pay instrument issued by the borrower. The promise to pay instrument becomes an asset held by the lender and a liability of the borrower to the lender. Indirect finance Lenders supply funds to a financial institution by purchasing promises to pay issued by the financial institution (deposits, insurance policies, pension policies), which become an asset held by the lender and a liability of the financial institution. The financial institution then lends the funds received from the lender by purchasing promises to pay issued by the borrower. The borrower's promise to pay becomes an asset held by the financial institution and a liability of the borrower to the financial institution. supplied and demanded through financial markets or financial institutions. We can think of the supply of funds as purchasing a financial asset or promise to pay and the demand for funds as selling a financial asset or promise to pay. Direct finance: Direct finance occurs when the lender deals directly with the bor- rower on an "eye-to-eye" basis or through an agent or broker. The key element of direct finance is that the lender accepts the borrower's promise to pay and assumes whatever risk and other conditions are embedded in the promise to pay. Direct finance takes place through financial markets in which promises to pay or financial instruments are purchased by lenders and sold by borrowers. The purchased finan- cial instrument becomes an asset to the lender and the sold financial instrument becomes a liability to the borrower; for example, when the U.S. government sells a bond in the bond market, the government is the borrower and the bond becomes a liability on the government's balance sheet, while the purchaser of the bond is the lender and the bond becomes a financial asset on the lender's balance sheet. Finan- cial markets in the United States are the broadest, deepest and most diversified in the world. Table 3.5lists the most important financial instruments used in direct U.S. finan- cial markets bifurcated by maturity. Financial instruments up to one year in matu- rity are money market instruments and those longer than one year in maturity are capital market instruments. Table 3.4 also indicates whether the instrument has default risk and a secondary market. Default risk is the probability that the issuer of the financial instrument will not service the debt by not paying the interest, the 66 Chapter 3. The Financial System and the Country's Flow of Funds Table 3.5. Money and Capital Market Instruments Used in Direct Finance Financial Degree of Secondary instrument Description default risk market Money market instruments Treasury bills Issued by the federal government in None Active (T-bills) maturities up to one year; they pay no interest coupon and, hence, are sold at a discount - sold at a price lower than the face value of the Treasury bill. Large certificates Issued by large banks in denominations Amounts Modest of deposits of $100,000 or larger and are legally above (CDs) negotiable; that is, they can be sold $250,000 to another entity before maturity and issued in a range of maturities. Commercial Short-term debt issued by banks and Yes Modest paper nonfinancial business entities with maturities up to nine months. Repurchase Banks, nonfinancial entities or any Determined None agreements entity that holds securities used as by default (repos) collateral for the repo. The issuer risk of uses securities such as T-bills for securities collateral. The issuer sells the repo with a promise to repurchase it in a short period of time, usually "overnight" or less than two weeks. Federal funds "Overnight" loans of reserve balances Depends on None held by a bank at the Federal default Reserve to another bank with a risk of deposit account at the Federal bank Reserve. Federal funds are not loans by the federal government or Federal Reserve. The name comes from the fact that funds are transferred from the lending bank to the borrowing bank via the Federal Reserve's wire transfer facility. The interest rate on federal funds, called the federal funds rate, is a key variable in the conduct of monetary policy. Capital market instruments Equities or stock Issued by financial and nonfinancial Yes Active corporations without any maturity. Corporate bonds Issued by financial and nonfinancial Yes Active corporations in a wide range of maturities up to 20 and 30 years. Treasury notes Issued by the federal government in No Active (T-notes) maturities up to ten years.  3.5 Two Channels of Finance: Direct and Indirect Finance 67 Table 3.5 (continued) Financial Degree of Secondary instrument Description default risk market Treasury bonds Issued by the federal government in No Active (T-bonds) maturities greater than ten years and up to 30 years. Municipals Bonds issued by local, regional and Yes Moderate state governments of up to 30 years in maturity. u.s. Issued by agencies supported by Technically, Active government government, but not guaranteed by yes; but agency government. Prominent agencies have built in securities or are: Student Loan Marketing an implicit u.s. Association (Sallie Mae); Federal government government- National Mortgage Association guarantee sponsored (Fannie Mae); Federal Home Loan enterprise Mortgage Corporation (Freddie (GSE) Mac); Government National securities Mortgage Association (Ginnie Mae); the 11 Federal Home Loan banks; Federal Farm Credit banks. GSEs issue bonds of up to 30 years in maturity to obtain funds and then loan the funds to selected sectors of the economy. Mortgages and Mortgages are long-term loans issued Yes Active mortgage- by banks, S&Ls, savings banks, backed credit unions and mortgage brokers. bonds The mortgages are then sold, in many cases to mortgage-related GSEs, which hold the mortgages or bundle them into a mortgage-backed bond to sell in the capital market. principal or both. Federal government debt is regarded as default-free because the central government has the ability to issue more debt to service or pay off maturing debt; increase tax revenue; or increase the money supply through the central bank. History shows, however, this may not always be the case. In August 2011 Standard & Poor made a slight downward credit rating of U.S. government debt, from AAA to AA +; however, the other rating agencies, Moody's Investor Service and Fitch Ratings, did not follow suit. Despite this rating change, U.S. government debt, including currency and coin, has zero default risk. At the same time, governments have defaulted on their debt, and the slight downgrade of U.S. debt is a reminder of that fact. In contrast to federal debt, debt instruments issued by local, regional or state governments possess some degree of default risk because the issuers of these instruments do not have the same ability as the federal 68 Chapter 3. The Financial System and the Country's Flow of Funds government to issue new debt to service old debt; nor do they have the same degree of power to raise taxes. All private financial instruments in Table 3.4, with the exception of that portion of large CDs issued by banks up to $250,000, possess some degree of default risk. Limitations of direct financial markets: Financial markets in the United States represent about 30 percent of the flow of funds at any time. They are national and international in scope. However, direct finance presents limitations for small lenders and borrowers. First, financial instruments are issued with a fixed face value and, hence, require a coincidence of denomination; second, financial instruments with the exception of stocks are issued with fixed maturity and, hence, require a coincidence of matu- rity; third, financial instruments require some degree of technical knowledge to sell and purchase, which is not a common denominator among smaller lenders and borrowers; fourth, small lenders lack the ability to evaluate and monitor the cred- itworthiness of borrowers; fifth, small lenders are not able to diversify because of insufficient funds; and, sixth, small lenders and borrowers lack the resources and the ability to obtain and provide information to evaluate credit risk and monitor credit. These restrictions create a fundamental problem for small lenders and borrowers in direct markets. The small borrower has difficulty borrowing in direct markets because the minimum denomination of instruments is large and the small borrower lacks the resources to provide financial disclosure to the potential lenders in the direct market so that they can evaluate risk. Small lenders have a different problem, in that the risk-return tradeoff of the small lender is likely incompatible with any borrower, small or large. This can be illustrated with the risk-return tradeoff curves illustrated in Figure 3.1. The risk-return tradeoff is an upward-sloping curve for a given level of utility for different portfolios of expected return and risk. The lender's utility is a positive function of the expected return of the portfolio and an inverse function of the risk of the portfolio. A risk-return curve closer to the vertical axis implies a more risk- averse lender and, for any given curve, the steeper the curve, the more risk-averse the lender. In Figure 3.1 the risk-return curve RRl is the base curve for a large lender, indicating the lender's tradeoff between return and risk. RRl indicates that the lender will incur risk only if compensated by a higher expected return. There are special exceptions to the tradeoff illustrated by RRl, but they are not important for the normal operation of the financial system. RR2 is closer to the origin and steeper and represents the risk-return tradeoff of a small lender relative to the base lender. Since RR2 is closer to the vertical axis, the lender will demand a higher expected return for the same level of risk as illustrated with RRl. RR2 is not only closer to the vertical axis but steeper than RRl, because, for this lender, an increase in risk must be compensated with a larger increase in expected return than for the base lender.  3.5 Two Channels of Finance: Direct and Indirect Finance 69 Expected return RR2 RRI Risk Figure 3.1. Risk-Return Tradeoff for Small Lender versus Base Lender Shows Small Lender Will Require Higher Expected Return for a Given Level of Risk. What accounts for the difference? The small lender is unable to diversify and thus forced to put more eggs in one basket than the base lender. The small lender is unable to spend the same resources as the base lender to evaluate and monitor credit. The small lender lacks the detailed knowledge of the technicalities of direct finance of the base lender. As a result, the small lender in direct finance will have a tradeoff curve closer to the vertical axis and steeper than that of the base lender. To illustrate how small lenders are at a disadvantage in direct finance, assume that a lender is contemplating making a loan for $50,000 to a borrower for five years; thus, there is no problem with a coincidence of denomination and maturity. But, given the lender's degree of risk aversion, the lender requires an expected rate of return of 20 percent. Assume the borrower is a business that wants to use the $50,000 over the five-year period to expand plant and equipment to generate more revenue. The borrower analyzes the cost and revenue flow of the expansion, then computes an internal rate of return that equalizes the present value of the revenue and cost stream to determine how much interest he/she can afford to render the expansion profitable. Assume the internal rate of return is 10 percent; that is, the investment is profitable if the borrower can borrow $50,000 at less than 10 percent. The lender, however, is unwilling to lend the $50,000 at any rate less than 10 per- cent. As a result, there is an incompatibility between the risk-return tradeoff of the lender and the default risk of the borrower, and no lending and borrowing will take place. 70 Chapter 3. The Financial System and the Country's Flow of Funds The risk-return tradeoff of the small lender is incompatible with the require- ments of the borrower. No financial transaction will take place. The small borrower also is restricted in the direct markets because of a lack of resources to provide information for the lender to evaluate risk. In contrast, large lenders and borrowers, because of the amount of funds they are willing to loan and borrow, respectively, have the resources and knowledge to evaluate and monitor credit, in the case of the lender, and to provide financial disclosure, in the case of the borrower. Most importantly, the large lender can diversify the loan portfolio and reduce systemic risk. Thus, small lenders and borrowers are not welcomed in the direct financial markets. Indirect or intermediation finance provides increased access to the financial sys- tem: The problems of direct finance for small lenders and borrowers are resolved by indirect or intermediation finance. In indirect finance a financial institutions is placed between the lender and borrower and fundamentally changes the relation- ship between them. In direct finance, the lender assumes all of the risk and other characteristics of the promise to pay offered by the borrower, and for many small lenders and small borrowers this excludes them from the market. Indirect finance eliminates this problem, as well as other restrictions, such as the need for a coinci- dence of maturity and denomination. The role of the financial institution in the financial system can be illustrated with the fundamental flow of funds equation (Expression 3.3) for the financial institu- tions sector. There are two major differences between Expression 3.3 for a financial institution and the other sectors of the economy. First, a financial institution, by def- inition, is a firm primarily focused on collecting funds and distributing those funds in the form of loans and investments, and, as a result, I and S are relatively small parts of Expression 3.3 compared to Band L. Second, financial institutions, by def- inition, largely distribute what they collect since they are required to pay interest or offer other services to obtain funds to lend, and, as a result, financial institutions are essentially balanced budget entities. Not only are I and S relatively small compared to B and L, but I = S and B = L. Take the example of a depository financial institution. The institution borrows by offering deposits, which are insured up to $250,000; deposits are offered in small to large denominations and deposits are offered in short to long maturities. The lenders to a depository institution thus in most cases have zero default risk, retain flexibility in the denomination and maturity of their lending to the depository intuition and still earn an interest rate. In addition, the promise to pay can be used as money. The depository institution uses the accumulated funds to lend. Because the depository institution specializes in credit evaluation and credit monitoring, it can evaluate default risk better than any small lender. Because the depository institution can make loans to many borrowers and thus put its eggs in many baskets, the overall risk of the loan portfolio is far less than for any small lender. As a result, the depository institution can lend to riskier borrowers than could any small lender.  3.5 Two Channels of Finance: Direct and Indirect Finance 71 Table 3.6. Important Financial Institutions that Constitute Indirect Finance Borrowing (sources of funds) Lending (uses of funds) Depository financial institutions Commercial banks Checking, saving and time Consumer and business loans; deposits, and large CDs mortgages; Treasury securities; and municipal securities S&Ls Checking, saving and time Mostly mortgage loans, but also deposits consumer loans Savings banks Checking, saving and time Mostly mortgage loans, but also deposits consumer loans Credit unions Checking, saving and time Mostly consumer loans, but also deposits mortgage loans Nondepository financial institutions Contractual savings institutions Life insurance Life insurance policies Corporate bonds, equity and companies mortgages Casualty insurance Casualty insurance policies Corporate bonds, equity and companies mortgages Pension funds Retirement policies - Corporate bonds and equity employer and employee contributions Investment institutions Finance companies Finance paper, bonds and Consumer and business loans equities Money market funds Shares Money market instruments Mutual funds Shares Bonds and equities Financial institutions are divided into two types depending primarily on their borrowing or sources of funds: depository and nondepository financial institu- tions. Nondepository institutions are further divided into contractual saving and investment institutions. The most important financial institutions are described in Table 3.6. Depository institutions consist of banks, S&Ls, savings banks and credit unions. S&Ls, savings banks and credit unions are collectively referred to as thrifts. The term "thrift" evolved decades ago, when these nonbank depository institutions did not offer checking accounts, only saving and time deposits; however, they now function much like banks in many respects, but the term "thrift" is still used even though not accurate. Depository institutions offer a promise to pay in the form of checking deposits, and saving and time deposits. Of the three, banks are the largest in number and size. There are about 6,500 banks, compared to about 800 S&Ls and savings banks and 7,500 credit unions. Banks are the most diversified of all financial institutions, deal with the largest number oflenders and borrowers and are at the center of the nation's financial and monetary regime. While S&Ls, savings banks and credit unions play a 72 Chapter 3. The Financial System and the Country's Flow of Funds smaller role in the financial system, they have become more similar to banks during the past few decades but still tend to specialize to a greater extent than banks. Nondepository financial institutions are fundamentally the same as depository institutions in terms of their role in the flow of funds; however, their promises to pay (borrowing in Expression 3.3) are less liquid and, as a result, not part of the money supply, with the exception of retail money market funds. However, their promises to pay offer important financial services and, because their sources of funds are less liquid, they can make a wider range of loans with longer maturity than depository institutions. Life insurance companies illustrate this point. Life insurance compa- nies offer life insurance policies as a means of obtaining funds (B in Expression 3.3), which, even though not very liquid, provide important services to the insured. Likewise, because their sources of funds are long-term in nature, life insurance companies can make long-term loans. Nondepository financial institutions are usually divided into two groups: con- tractual savings institutions (life insurance companies, casualty insurance com- panies, and private and government pension funds) and investment institutions (finance companies, money market funds that invest in money market instruments, and mutual funds that invest in capital market instruments). Interaction between direct and indirect finance: The two channels of finance are analytically different, but they are closely interrelated as a result of extensive inno- vations in the financial system over the past several decades. Many loans, especially mortgage loans, generated in indirect finance are bundled into a security that is then sold in the direct markets. Treasury securities and municipal securities are held by financial institutions, as are commercial paper, corporate bonds and even equities to varying degrees. Hence, the distinction between the two channels is real, but in many ways the two channels overlap. 3.6 Bringing It Together: A Flow of Funds Matrix of the Economy The financial system can now be summarized by a simple flow of funds matrix of the economy based on the actual matrix published by the Federal Reserve; in fact, most central banks of the world compute and publish detailed flow of funds statistics that highlight the role of the financial system in the economy, indicate who is lending and who is borrowing, indicate who the net suppliers and demanders of funds are and indicate the amounts of finance that go through direct and indirect channels. Table 3.7 is based on dividing the economy into three real sectors and a financial institutions sector. Again, there is no sector for direct finance, since direct finance exists only for the time it takes to exchange funds for a promise to pay. A funda- mental flow of funds equation is constructed for each sector. The top two rows of Table 3.7 indicateS and I for each sector. The household sector is a surplus sector, with S exceeding I by $11 0,000; that is, the household sector is a net lender to the financial system. How did the household sector distribute the surplus or be a net  3.6 Bringing It Together: A Flow of Funds Matrix of the Economy 73 Table 3.7. Flow of Funds Matrix of the Financial System Fundamental flow Financial of funds equation Household Business Government institutions Total Investment $20,000 $100,000 $5,000 $125,000 Saving $130,000 $50,000 -$60,000 $5,000 $125,000 Surplus(+), deficit(-) $110,000 -$50,000 -$60,000 $0 $0 or balance (0) Borrowing (net change -$10,000 $60,000 $60,000 $60,000 $170,000 in liabilities) Checking deposits $40,000 $40,000 Saving and time $20,000 $20,000 deposits Loans -$10,000 $20,000 $10,000 Treasury securities $60,000 $60,000 Corporate securities $40,000 $40,000 Lending (net change in $100,000 $10,000 $0 $60,000 $170,000 financial assets) Checking deposits $30,000 $10,000 $40,000 Saving and time $20,000 $20,000 deposits Loans $0 $10,000 $10,000 Treasury securities $30,000 $30,000 $60,000 Corporate securities $20,000 $20,000 $40,000 Net lender $110,000 Net borrower $50,000 $60,000 Balanced entity $0 $0 lender? The household sector reduced its borrowing by $10,000 by paying off a loan owed to the financial institutions sector. The household sector increased its lend- ing by increasing its holdings of promises to pay in four ways: increased checking deposits ($30,000); increased saving and time deposits ($20,000); increased Trea- sury securities ($30,000); and increased corporate securities ($20,000). The nonfinancial business sector is a deficit unit, with I exceeding S by $50,000, and thus has a net demand of funds from the financial system. How did the business sector finance its deficit of $50,000? The business sector borrowed $60,000 by sell- ing $40,000 in corporate securities and taking a loan of $20,000 from the financial institutions sector. The business sector sold $20,000 of securities to the household sector and $20,000 of securities to the financial institutions sector. The business sector also was a lender because it increased its checking deposits by $10,000. Hence, the business sector is a net demander of funds of $50,000. All government expenditures are considered current expenditures, so that any deficit, surplus or balance in the budget is indicated by negative, positive or zero S. In Table 3.7 the government sector is operating with a deficit of $60,000, which is financed by selling $60,000 of Treasury securities. The household and financial institutions sectors each purchased $30,000. The financial institutions sector is a balanced entity, since S = I, and a financial entity, since its real transactions - represented by S and I - are small compared to 74 Chapter 3. The Financial System and the Country's Flow of Funds its borrowing and lending. The funds or borrowing come from issuing checking deposits to the household sector ($30,000) and business sector ($10,000) and issu- ing saving and time deposits to the household sector ($20,000). In addition, the financial sector received a payment of $10,000 for an outstanding loan to the house- hold sector, which is netted against lending of $20,000 to the business sector. The financial sector loaned a net of $10,000 - a $20,000 loan to the business sector and a -$10,000 loan to the household sector. Table 3.7 indicates five important aspects of the financial system. First, the financial system is a collection of deficit, surplus and balanced units engaged in lending and borrowing to support their real transactions, represented by saving and investment. Second, lending and borrowing take place through direct and indirect finance. Direct finance occurs when the household and financial institutions sectors pur- chase government securities in the open market and when the household sector purchases corporate securities in the open market. The securities are purchased in a market with the assistance of an agent or broker; that is, they show up on the balance sheets of the household, business, government and financial institutions sectors only since the broker facilitates the transfer for a fee. Indirect finance, how- ever, does manifest itself on the balance sheet of financial institutions. Third, while direct and indirect finance are fundamentally different, they are interrelated; for example, the financial institutions sector not only provides loans to households and businesses but is also a participant in the direct financial markets. In Table 3.7 the financial institutions sector purchased directly from the business and government sectors promises to pay with funds obtained from deposits held by the household and business sectors. Fourth, lending and borrowing are not necessarily equal for each sector, but, when all sectors are combined, lending equals borrowing because every act oflend- ing is an act of borrowing. Lending equals borrowing and saving equals investment for the entire economy even though they can be unequal for individual sectors. Fifth, financial institutions are fundamentally different from the three real sec- tors because their real transactions pale in comparison to their lending and borrow- ing and, by and large, their lending and borrowing are equal because that is their nature - they are an institutional conduit to transfer funds from one group to another.  Chapter4 Interest Rates in the Financial System 4.1 Introduction Interest rates are key variables in the nation's economy and determined by the inter- action of lenders and borrowers in the financial system. Interest rates and changes in interest rates impact virtually every type of private and public spending, the finan- cial health of private and public enterprises, the value of wealth of individuals and the nation, and the economic and financial relationship a country has with the rest of the world. Not only are interest rates a key variable in every lending and borrow- ing transaction, they are the focal point of monetary policy. Virtually every central bank conducts policy by setting an interest rate target and then uses its tools of monetary policy to achieve that target. The interest rate target indicates the direc- tion of monetary policy. Lacking basic knowledge about interest rates is clearly dangerous to your own economic health, aside from the more general problem of being clueless about monetary policy and the financial system in general. This and the next two chapters discuss interest rates from three perspectives. In this chapter, the following basic concepts needed to understand interest rates are discussed: the essential nature of the interest rate; the distinction between interest rates in indirect and direct finance; efforts by government to regulate interest rates; and basic technical aspects of interest rates. In the next chapter, the determinants of the level of interest rates in terms of the flow of funds framework are outlined. This framework can then explain why interest rates change over time. In that discussion, we lump all interest rates together into just one interest rate to focus on the basic determinants of the level of the interest rate, which can then be applied to any one of the many interest rates in the financial system. In the chapter after next, the assumption of one interest rate is dropped to focus on the structure of interest rates. The structure of interest rates explains how different interest rates are related to each other and how key elements of the relationship are used to measure risk in the financial system; indicate changes in the public's expected inflation; and 75 76 Chapter 4. Interest Rates in the Financial System indicate the probability the economy will expand in the future or the probability the economy will contract in the future. 4.2 Interest Rates Connect the Present to the Future, and Vice Versa The interest rate is a key element of the transfer of funds from lender to borrower in any financial transaction, whether lending funds indirectly to borrowers through indirect finance (financial institutions) or directly through direct finance (money and capital markets). The interest rate is the return to the lender for providing the funds and the cost of the funds to the borrower. Interest rates relate the present to the future; that is, the interest rate ties the present to the future and the future to the present. This is illustrated by the concept of future and present value. The future value of A dollars loaned at the start of the first period earning r percent per period for m periods is (4.1) where At is the amount of dollars loaned at the start of the first period; r is the interest rate expressed as a fraction - that is, r is the interest rate in percentage terms divided by 100 (5.0% is expressed as 0.05); and Am is the future amount of the At dollars invested at the start of the first period for m periods. Expression 4.1 indicates the future or appreciated amount of A dollars earning r for any period. Assume At = $100 and r = 0.10; then Am is $110 form= 1 [$100 (1 +.10)t]; $161.05 form= 5 [$100 (1 +.10)5 ]; and $259.37 form= 10 [$100 (1 +.10) 10 ]. Because interest rates are positive, the future value of A dollars is always larger than the value of A dollars at the start of the first period. The present value of A future dollars at the end of m periods is equal to the amount of dollars invested at the start of the first period earning r percent. Expression 4.1 can be reversed to illustrate the value of any future amount in terms of today's value or the present value of the future amount (4.2) where At represents today's value at the start of the first period or present value of the future value of Am dollars at the end of period m. In terms of the above example, the present value of $110 received at the end of the first period (m = 1) is $100 if the interest rate is 0.10; the present value of $161.05 received at the end of the fifth period (m = 5) is $100 if the interest rate is 0.10; and the present value of $259.37 received at the end of the tenth period (m = 10) is $100 if the interest rate is 0.10. Hence, the interest rate ties the present to the future, and vice versa. In a lending-borrowing relationship, the lender is willing to give up liquidity for a return that satisfies their risk-return tradeoff; that is, lenders will not lend funds they could use today for some purpose unless they are paid for giving up that liquidity. The borrower needs liquidity today and is willing to pay a return on the  4.3 Interest Rates in Indirect and Direct Finance 77 borrowed funds. The interest rate is the market's balance between the wants of the lender and the borrower; that is, if the interest rate is r percent, the lender is willing to lend A 1 dollars today for m periods in exchange for Am dollars at the end of the mth period and the borrower is willing to pay Am dollars at the end of the mth period for A 1 dollars today. Interest rates as connecting the present and future are the same in all markets, but market forces play a different role in the determination of interest rates whether we are considering interest rates in indirect finance or direct finance. 4.3 Interest Rates in Indirect and Direct Finance Interest rates in the indirect markets are administered but market-sensitive interest rates. That is, the interest rate on deposits and loans is set by some administra- tive process that adjusts the interest rate from time to time depending on market conditions or ties the interest rate via a formula to another interest rate, usually a market-determined interest rate. Deposit rates on checkable accounts, saving and regular time deposits are usually constant for some period of time, such as a week or longer, until the depository institutions initiate a change in response to changes in market conditions. The same is true for loan rates. The commercial bank prime interest rate and the adjustable-rate mortgage (ARM) illustrate the two types of administered rates on loans. The prime interest rate is the rate charged by banks to their most creditwor- thy customers and is set through a consensus process among major banks. When conditions warrant a change in the prime rate, one or more banks will change its prime and, if the others agree the change is warranted by the market, other banks will set their prime rate to the new level. If not, the initiating bank(s) will return their prime to the consensus prime. The prime rate remains constant for a period that sometimes can be long; for example, the prime rate since the financial cri- sis of 2008/2009 through 2015 was unchanged (Figure 4.1). The interest rate for an ARM is another example of an administered interest rate, but, instead of being determined by an administrative process, the ARM interest rate is tied by a formula to a base rate, such as the five-year Treasury security rate, but remains constant for, say, a six-month period and then is automatically adjusted to the current five-year Treasury security rate according to the formula. The behavior of an administered rate versus a market rate is illustrated in Figure 4.1, which presents the weekly prime rate and five-year constant maturity Trea- sury security rate from January 2000 to May 2016. Notice that the prime rate is constant for periods of time, especially starting late 2009, while the Treasury secu- rity rate fluctuates. The Treasury security rate is market-determined, rather than administered. The administered rate follows the market rate, but, while the mar- ket rate varies from week to week, the prime rate remains constant for periods of time. Administered interest rates, whether set by an administrator of some type 78 Chapter 4. Interest Rates in the Financial System 10.00 - - Prime rate - - Five·yea r Treasury rate n 9.00 v \ r-----\ 8.00 7.00 \ I \ ~·\\ ~ I 6.00 5.00 I I \ I \ 4.00 '''.~ I , I 1\ /, ,. ,, '''"/I \. \ I 3.00 I I I \I a.,.I J " I I \ \ 'I I 1" \1 I \ 2.00 o/ I I\ / 11 \.. li' \I I l\."''",1'1\.. I 1.00 ' ,_, 0.00 ~ ~ ~ ~ ~ ~ ~ n ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ?~?~?~~???~~??~~~?~?~? ~~ \~ ~ C> N '' 0. c:: $14,000 ~ iii $13,000 $12,000 $11,000 $10,000 ,.._ ,.._ ,.._ co co co.............,..,..,......"'....:>."'....~...."'...."':>.........."'...."':>..........'"'""....'":>."'"....'"~"...."'...."':>...... "'"'c:-...."'"':>....."'....."' 0 0 0 "' "' "'.!. N N N