Ch10 all macro__lecture_ppt

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Chapter 10 Credit Markets


10 Credit Markets

Chapter Outline

10.1 What Is the Credit Market?

10.2 Banks and Financial Intermediation: Putting Supply and Demand Together

10.3 What Banks Do

EBE How often do banks fail?


10 Credit Markets

Key Ideas

1. The credit market matches borrowers (the source of credit demand) and savers (the source of credit supply).

2. The credit market equilibrium determines the real interest rate.


10 Credit Markets

Key Ideas

3. Banks and other financial intermediaries have three key functions: identifying profitable lending opportunities; using short-run deposits to make long-run investments; and managing the amount and distribution of risk.

4. Banks become insolvent when the value of their liabilities exceeds the value of their assets.



Debtors, or borrowers Economic agents—such as entrepreneurs, businesses, home buyers, college students—who borrow funds.

Credit The amount of funds that the debtor receives.

Interest rate The additional payment, above and beyond the principal (the loan amount), that a borrower makes on a $1 loan.



Nominal interest rate, iThe annual cost of a $1 loan.

Total interest payments = i x $Lwhere $L is the loan amount.



Suppose you borrow $20,000, with a promise to pay it back in one year.

Question: What are your total interest payments?

Total Loan Amount

Nominal Interest Rate

Total Interest

Payments$20,000 1%$20,000 5%$20,000 10% $20,000 50%



Total Loan Amount

Nominal Interest Rate

Total Interest

Payments$20,000 1% $200$20,000 5% $1,000$20,000 10% $2,000$20,000 50% $10,000

Suppose you borrow $20,000, with a promise to pay it back in one year.

Answer:



Real interest rate, rThe annual real or inflation-adjusted cost of a $1 loan:

r = i – π

where r is the real interest ratei is the nominal interest rateπ is the rate of inflation



Suppose that the inflation rate is 2%.

Question: What is the real interest rate?

Nominal Interest

RateRate of Inflation

Real Interest

Rate1% 2%5% 2%

10% 2% 50% 2%



Nominal Interest

RateRate of Inflation

Real Interest

Rate1% 2% –1%5% 2% 3%

10% 2% 8%50% 2% 48%

Suppose that the inflation rate is 2%.

Answer:



Quantity of credit demand The amount of loans that borrowers are willing to borrow at a given real interest rate.

Credit demand schedule A table that reports the quantity of credit demanded at different real interest rates, holding all else equal.

Credit demand curve A curve that plots the quantity of credit demanded at different real interest rates.



Exhibit 10.1 The Credit Demand Curve



Question: Why does the credit demand curve slope downward?

Hint: Think about what is the “price” of credit.

Answer: An increase in the real interest rate will raise the cost of borrowing. As a result, profits will be lower, which in turn will decrease the number of potential borrowers.



The steepness of the credit demand curve tells us the sensitivity of the relationship between the real interest rate and the quantity of credit demanded.



Question: What does a relatively steep credit demand curve imply?



Question: What does a relatively flat credit demand curve imply?



The credit demand curve shifts with changes in any of the following:

1. Perceived business opportunities for firms2. Household preferences or expectations3. Government policy



Question: Which way does the credit demand curve shift for each of the following?

1. Firms buy more capital equipment.2. Households become nervous about their

jobs.3. The U.S. federal government decreases its

budget deficit.



Exhibit 10.2 Shifts in the Credit Demand Curve



Question: What do people save for?

Some answers: 1. Retirement

2. Their kids (bequests)

3. Computer, car, house, or other large purchase

4. To start a business

5. A “rainy day” (insurance)



Question: If the real interest rate were to increase, would you save more or less?

Answer 1: A higher real interest rate implies a higher return to savings. You would save more!

Answer 2: A higher real interest rate implies that you can save less to generate a retirement nest egg of a certain size. You would therefore save less!



Quantity of credit supply The amount of funds that people and firms save at a given real interest rate.

Credit supply schedule A table that reports the quantity of credit supplied at different real interest rates, holding all else equal.

Credit supply curve A curve that plots the quantity of credit supplied at different real interest rates.



Exhibit 10.3 The Credit Supply Curve



The credit supply curve shifts with changes in either of the following:

1. Saving motives of households2. Saving motives of firms



Question: Which way does the credit supply curve shift for each of the following?

1. Households become nervous about their jobs.

2. Households buy the new Apple iPhone.3. Apple and other firms retain more earnings.



Exhibit 10.4 Shifts in the Credit Supply Curve



The equilibrium in the credit market is the point at which the credit supply curve and the credit demand curve intersect.

This intersection determines both the total quantity of credit in the market (Q*) and the equilibrium real interest rate (r*).



Exhibit 10.5 Credit Market Equilibrium



Question: What happens in the credit market if the U.S. federal government increases its budget deficit?

Hint: Think about how the government finances its budget deficit.



Exhibit 10.6 Effect of a Shift in the Credit Demand Curve on the Real Interest Rate and Credit



The credit market improves the allocation of resources in an economy by enabling savers to lend their excess money to borrowers.

Consider the following thought experiment:



Suppose you have $1,000 set aside for next year.

If there are no credit markets, you would keep the money in a safe box in your house and earn a zero nominal return and a negative real return.

If there are no credit markets, firms would be unlikely to borrow the money and invest in new plant and equipment.



If there are credit markets, you could “lend” the money and earn a positive nominal return and even a positive real return.

If there are credit markets, firms could borrow the money and invest in new plant and equipment.


Banks and financial intermediaries are the organizations that connect savers and borrowers.

10.2 Banks and Financial Intermediation



There are many different types of financial institutions that channel funds from suppliers (savers) to borrowers (users) of financial capital:

• Asset management companies

• Hedge funds

• Private equity funds

• Venture capital funds

• Shadow banking system



A balance sheet records the assets and liabilities of a company, like a bank.

An asset is something owned by a bank. If an asset is sold, the payment goes to the bank.

A liability is something owed to another institution. If a liability is sold, the payment comes from the bank.



Assets of a bank:

• Bank reserves are vault cash and holdings on deposit at the Federal Reserve Bank.

• Cash equivalents are riskless, liquid assets that a bank can immediately access.

• Long-term investments are loans to households and firms and the value of the bank’s properties.



Liabilities of a bank:

• Demand deposits are funds that depositors can access on demand.

• Short-term borrowing consists of loans from other financial institutions that are short in duration.

• Long-term debt is debt that is due to be repaid in one year or more.



Liabilities of a bank:

• Stockholders’ equity is the difference between a bank’s total assets and total liabilities. It is equal to the estimated value of a company if priced “correctly” by the stock market.



Exhibit 10.7 Citibank’s Balance Sheet, June 2013 (billions of dollars)


Banks perform three interrelated functions as financial intermediaries:

1. Identify profitable lending opportunities.

2. Transform short-term liabilities into long-term investments (maturity transformation).

3. Manage risk through diversification.

10.3 What Banks Do


10.3 What Banks Do

1. Banks identify profitable lending opportunities by:

a. Attracting a large number of “would be” depositors.

b. Identifying the best loan applications.


10.3 What Banks Do

2. Banks transform short-maturity liabilities, like deposits, into long-term investments, like business and real estate loans.

This process is called maturity transformation.


10.3 What Banks Do

MaturityThe time until a debt must be repaid.

Demand deposits and short-term borrowing of banks have a 0-year maturity since depositors can take back their money at any time.

Loans and other long-term assets have a maturity ranging from several years to 30 years.


10.3 What Banks Do

Exhibit 10.7 Citibank’s Balance Sheet, June 2013 (billions of dollars)


10.3 What Banks Do

3. Banks manage risk by:

a. Holding a diversified portfolio.b. Transferring risk to stockholders and

ultimately to the U.S. government during a severe financial crisis.


10.3 What Banks Do

Banks hold a diverse set of assets,including mortgages, consumer loans, business loans, loans to other financial institutions, and government debt.

A diversified portfolio is usefulin that assets are unlikely to underperform all at the same time.


10.3 What Banks Do

Diversification by itself is insufficient to manage risk because a large fraction of a diverse set of assets can still underperform.

In 2007–2009, 12% of all mortgages entered some form of delinquency (non-payment). As a result, the return on average assets for all U.S. banks became negative.


10.3 What Banks Do


10.3 What Banks Do

Depositors of a bank remain safe because banks transfer risk to stockholders and, ultimately, the U.S. government.

Why? The deposits are insured, so the losses in the assets must be met by losses in stockholders’ equity.


10.3 What Banks Do

Bank A starts with the following balance sheet:

Exhibit 10.8 Illustrative Balance Sheet, Panel (a)


10.3 What Banks Do

Scenario 1: Bank A suffers a 10% reduction in the value of its long-term assets.


10.3 What Banks Do

The deposits are fully insured by FDIC insurance, so stockholders must absorb the full loss.

Exhibit 10.8 Illustrative Balance Sheet, Panel (b)


10.3 What Banks Do

Scenario 2: Bank A suffers a 30% reduction in the value of its long-term assets:

Assets Liabilities

Reserves & cash 1 Demand deposits 9Long-term invest 10–3 = 7 Total liabilities 9

Stockholders’ equity 2

Total assets 11–3 = 8 Total liabilities 11


10.3 What Banks Do

Scenario 2: Bank A suffers a 30% reduction in the value of its long-term assets.

Assets Liabilities

Reserves & cash 1 Demand deposits 9Long-term invest 10‒3 = 7 Total liabilities 9

Stockholders’ equity 2‒2 = 0

Total assets 11‒3 = 8 Total liabilities 11‒2 = 9


10.3 What Banks Do

Scenario 2: Stockholders’ equity goes to zero, and Bank A is insolvent, with assets valued less than liabilities.

The Federal Deposit Insurance Corporation (FDIC) and quite often U.S. taxpayers must make up the difference.


10.3 What Banks Do

The FDIC will either:

1. Shut down the bank’s operations and make payments to depositors up to $250,000.

2. Transfer the bank to new ownership, where all depositors are protected.


10.3 What Banks Do

Maturity and risk transformation create risks because the bank’s assets are illiquid, and the bank’s liabilities are liquid.

The bank is effectively locking up money in its assets that are payable to depositors and other creditors on short notice.


10.3 What Banks Do

If there is a concern that a bank may run out of liquid assets, a bank run may occur.


10.3 What Banks Do

A substantial number of depositors may try to withdraw their deposits at the same time.

This initial panic may lead other depositors to withdraw before the liquid assets are gone.

The bank may be forced to sell its illiquid assets in “fire sales,” where it receives lower prices.


Evidence-Based Economics Example

Question: How often do banks fail?

Data: Historical banking data for 1892 to present from the Federal Reserve and the FDIC.

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There have been four waves of bank failures in the United States.

The first wave was the 1919–1928 decade, when 6,000 banks, mainly rural, failed.

The second wave was the 1929–1939 decade (the Great Depression), when 9,000 banks failed.

10 Credit Markets


The third wave was the 1986–1995 saving and loan crisis, when 3,000 banks, mainly small, failed.

The fourth wave was the 2007–2009 financial crisis, when several (nonbank) financial institutions, like Lehman Brothers, collapsed.

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Exhibit 10.9 Annual Rate of Bank Failures in the United States (1892–2013)


Evidence-Based Economics Example

Question: How often do banks fail?

Answer: Although there have been long periods of calm, four waves of banks failures have occurred, resulting in around 20,000 total failures.

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Caveat: Counting bank failures may be misleading in that the failure of one large bank like Lehman Brothers may be more destructive than the failure of hundreds of small banks.

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The collapse of Lehman Brothers has led to the regulation of systemically important financial institutions (SIFIs) that are considered “too big to fail.”

1. A SIFI now must submit a “living will,” explaining how it would sell off its assets.

2. A SIFI is required to take on less risk and hold more stockholders’ equity.

10 Credit Markets