Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

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CHAPTER 4

Banks and Central Banking

We have discussed the economy and money; the next logical thing to talk about is banks and the banking system. As grain elevators distribute grain and lumberyards distribute lumber, banks distribute money. They store your spare money and allocate it as capital to others (hopefully) who need it for a good economic reason.

Banks are part of a banking system and, for better or for worse, are interconnected. They are also moderated by a central banking authority, which in the United States is the Federal Reserve. This chapter describes the different kinds of banks, the banking system, the Federal Reserve, and some of the ways we measure bank strength and success.

27. COMMERCIAL BANK

For the most part, when you think of “bank,” you’re thinking of a commercial bank. A commercial bank serves the public—ordinary consumers and “main street” businesses—with an assortment of accounts, savings, checking, and loan services.

What You Should Know

A commercial bank gets funds from customer deposits, including checking and savings accounts, certificates of deposits (CDs), and other time deposits. It may also get funds by selling securities, especially government bonds back to the government, or by short-term borrowings from government or private investors. In turn, it earns income by lending those funds to businesses needing operating capital, and to consumers for a variety of purposes.

While they lend funds for businesses to use, commercial banks are distinguished from investment banks (see #28 Investment Bank) because they do not buy or sell securities for their own part or on behalf of individuals or corporate clients. In fact, huge bank losses on investments prior to the Great Depression led to the failure of many banks (some 20 percent of all banks failed), which then led to legislation, specifically the Glass-Steagall Act of 1933, prohibiting commercial banks from engaging in investment banking activities. That law was repealed in 1999, allowing megabanks like Citigroup and JPMorgan Chase to combine commercial, investment, and many other financial operations into a single holding company.

Arguably, that led to some of the problems seen in the recent global crisis, as the investment banking arms of several big banks put their entire company in jeopardy. The phrase “too big to fail” became part of the common citizen’s vocabulary. Recently, the so-called “Volcker Rule” has reintroduced a ban, with certain exceptions, on commercial banks and their affiliates to engage in “proprietary trading”—that is, trading the markets for their own benefit using what amounts to your funds—but a full-scale reenactment of Glass-Steagall separation of commercial and investment banking activities hasn’t happened. Although much is beyond the scope of our discussion, suffice it to say that commercial and investment banks are subject to different banking laws and capitalization rules.

It should also be noted that at one time there were significant differences between banks and so-called savings and loan, or “thrift,” institutions. Many thrifts were nonprofit, and had regulatory restrictions on the source of their funds and the amount of interest they had to pay on funds acquired. A combination of regulation and poorly thought-out deregulation led to the S&L crisis in the late 1980s. Today, thrifts continue to exist, but are much more like commercial banks than in the early years. Most do not offer the complete array of services that commercial banks do, which now offer investments, business lending and advice, and general financial advice.

Why You Should Care

The banks you generally deal with are commercial banks, unless you’re involved in securities trading, mergers and acquisitions, or in taking companies “public” by selling stock or other securities. Commercial banks are set up to handle your normal banking needs, and are regulated to provide the sort of banking products and safety (insured deposits, for example) that the general public expects.

28. INVESTMENT BANK

Never seen a local branch of Lehman Brothers? Or a Bear Stearns or Goldman Sachs ATM machine? There’s a reason for that. The reason—although not as distinct as it once was—is that these big banking names are investment banks, not commercial banks (see #27 Commercial Bank). These banks are primarily in the securities business, not the general banking business.

What You Should Know

Investment banks are in business primarily to raise capital on behalf of clients, to advise them on mergers and other corporate restructuring, and to make markets for securities. Clients include corporations, governments, pension funds, and large investment companies like mutual funds. In fact, they not only buy and sell securities on behalf of clients, but they also try to make money by dealing in the markets on their own behalf, in an activity known as proprietary trading. While this is once again illegal for commercial banks because of the recently enacted “Volcker Rule” (see #27 Commercial Bank and #39 Dodd-Frank), it is still a big part of what investment banks do.

Investment banks assist a company in selling new shares of stock, or bonds, or other securities to raise capital. For corporations, they will advise on mergers, acquisitions, and divestitures, and then do the financial legwork to execute these transactions. As securities dealers, most investment banks act as dealer, buying and selling shares in the open market on their own behalf or on behalf of clients.

The days of separate and individual investment banks are almost over with the 2008 demise of Bear Stearns and Lehman Brothers, two of the last independent investment banks. Most have been combined into larger holding companies as an arm of a larger, combined commercial/investment banking company, like Credit Suisse or Barclays. These so-called “universal banks” took center stage in the 2008 banking crisis, although in the case of JPMorgan Chase and others, well-managed banking diversification has proven beneficial.

Why You Should Care

You will generally not run into investment banks, or the investment-banking arm of larger universal banks, in your ordinary business. Investment banks have traditionally made huge amounts of money facilitating transactions (a quarter or a half percent “crumb” off of a billion-dollar transaction is still a lot of money). It remains to be seen what the future of investment banking is to become, and how much the regulatory environment will change. For most consumers, it may prove to have little effect.

29. CENTRAL BANK

As the name implies, a “central bank” is central to the banking and monetary system of a nation. The central bank plays several key roles in the economy, including setting and carrying out monetary policy, maintaining the stability of the nation’s currency, and supporting and regulating individual banks and the banking system. The Federal Reserve (see #30 Federal Reserve) functions as the central bank in the United States, while the European Central Bank (ECB) is the central bank for the sixteen member states of the so-called Eurozone. Other central banks include the Bank of Japan, the People’s Bank of China, and the Bank of England.

What You Should Know

Central banks control money supply and currency stability through monetary policy (see #56 Monetary Policy). That is done by setting target interest rates (see #31 Target Interest Rates) and more directly through open market operations (see #32 Fed Open Market Operations), where they buy and sell government bonds to inject cash into or remove it from the economy. Central banks also control the amount of currency—paper and coin—in the economy.

Central banks lend money to other banks when needed, and act as a “lender of last resort” during financial crises. The financial crisis that triggered the Great Recession saw the Federal Reserve, in coordination with the U.S. Treasury, take a more activist role in propping up not only banks but also other players in the economy. While the “propping up” scenario is largely past, today’s Fed continues to boost the economy through open market operations—still in mid-2013 buying about $85 billion in bonds every month to infuse more cash into the economy through its “quantitative easing” programs—so-called “QE3” and “QE4.” Central banks may make these operations “public,” declaring them in the media and in their own published minutes to achieve maximum economic effect (in the most recent case, optimism)—and they may also conduct open market operations “under the radar” so as not to affect or disturb the markets. The Fed and other central banks may also project and communicate future activities, as seen with the so-called “tapering” of bond purchases widely prognosticated, also in mid-2013.

Central banks also set and enforce important banking and finance ground rules. These rules and requirements include governing how much capital banks must keep in reserve (see #36 Reserve Requirements), and how much equity stock investors must have in a stock transaction involving borrowing, or margin (see #86 Margin and Buying on Margin). In some countries, like China, central banks actively manage the country’s foreign currency exchange and exchange rates.

Notably, most central banks operate somewhat independently of the nation’s political authority to avoid political gridlock and to be able to do what’s best for the economy on short notice. The U.S. Federal Reserve can create money “with the stroke of a keyboard” without Congressional approval.

Why You Should Care

The health and welfare of any economy is carefully monitored and controlled by a country’s central bank. Observing the central bank’s actions will give you a forward look into what’s ahead for the economy. If the central bank is raising target interest rates, for instance, a slowdown is intended and likely on the horizon. If the central bank is lowering interest rates and injecting money into the system, that signals that the slowdown is at hand and the central bank is acting to reverse a slumping economy. It is also worth listening to comments made by the leaders of the central banks—Ben Bernanke (soon to be Janet Yellen) of the U.S. Federal Reserve and Jean-Claude Trichet of the ECB—for signs of economic health or concern.

30. FEDERAL RESERVE

The Federal Reserve functions as the U.S. central bank. The Federal Reserve System was created by the Federal Reserve Act of 1913 in response to the Panic of 1907, earlier panics in 1873 and 1893, and an accepted need for a stronger central banking system. Known simply as “the Fed,” the Federal Reserve carries out a broad range of activities to ensure the stability and prosperity of the U.S. economy.

What You Should Know

The Federal Reserve is not a single bank or institution but rather a system of committees, advisory councils, and twelve member banks located through the United States. The details of this structure aren’t important, but you’ll hear about the Board of Governors, of which Ben Bernanke was the chair through February 2014, and the twelve-member Open Market Committee (FOMC), which meets eight times a year and makes policy decisions affecting target interest rates and ultimately, money supply (see #31 Target Interest Rates, #17 Money Supply, and #56 Monetary Policy).

The Federal Reserve was created to address banking panics, but in the modern era has taken on a more active role in managing and moderating the economy. Most visible is the management of money supply through monetary policy, toward the stated and often conflicting goals of maximum employment and stable prices (translation: avoidance of inflation and deflation). The Fed regulates banking and banking institutions and other credit instruments, including the credit rights of consumers. Credit protection regulations are created and enforced by the Fed through laws passed by Congress, including the Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure acts (see #48 Credit Protection). The Fed manages the relationships between the banks and government, banks and consumers, and banks with each other.

The Fed has roles beyond managing the banking system and money supply too numerous to recount here. Among those goals are managing financial stability in times of crisis and improving the financial standing of the United States in the world economy. The Fed played a very active role in preventing systemic meltdown in the 2008–2009 financial crisis, acting as “lender of last resort” in addition to its traditional role in providing financial stimulus. The Fed announced several new programs, or lending “facilities,” like the so-called “TARP,” or Troubled Asset Relief Program, to help banks and other businesses get short-term credit; some of these programs hadn’t been seen since the Great Depression.

Critics contend that the Fed may be playing too active a role in managing the economy; in its zeal to create stability and manage the business cycle, it is making us as a nation more vulnerable to unintended consequences that may have far-reaching and much more serious effects. Through monetary policy and the new lending facilities, the Fed injected huge and unprecedented amounts of money into the economy; many worry about the long-term inflationary effects of this massive injection (see #34 Reflation).

Why You Should Care

What happens in the U.S. economy has always been influenced and to a degree controlled by the Fed. Most recently, the Fed, by necessity and somewhat by choice, has become much more involved in trying to manage and stabilize economic outcomes. You should watch what the Fed says and does, and think through the long-term consequences of its economic policies and actions. It’s also worth understanding the credit and banking protections the Fed has put in place.

31. TARGET INTEREST RATES

Central to the task of the Federal Reserve and other central banks is to manage the nation’s money supply and to stimulate or slow down economic activity to stabilize prices, maintain employment, and foster moderate economic growth. Central banks use target interest rates as well as direct injections of money into the financial system to moderate interest rates and to accomplish these other economic goals.

Interest rates work like a brake or accelerator on an economy. Lower rates make money “cheaper”—that is, cheaper to borrow, and thus more available for economic activity. Conversely, higher interest rates make money more expensive, thus acting as a brake on the economy, which ultimately helps to control inflation.

What You Should Know

Every economy has target interest rates managed through central bank policy. In the United States, the Fed controls the discount rate directly, and manages the federal funds rate, or “Fed funds rate,” through open market operations (see #32 Fed Open Market Operations). In Europe, the LIBOR, or London Interbank Offered Rate, is the primary target interest rate.

The Fed funds rate is more important—and more complicated—than the discount rate, and is a key component of monetary policy. Specifically, it’s the rate that banks charge each other for overnight loans of reserves they hold at the Fed. The Fed does not actually set this rate, but rather influences and controls it by changing the money supply through open market operations. When the Federal Open Market Committee meets, as it does eight times a year, it sets the target for the Fed funds rate, leaving it unchanged, or raising or lowering it, usually in increments of 0.25 or 0.50 percent. Open market operations do the rest. The Fed funds rate is the most important and most closely watched tool in the Fed’s policy arsenal, and it becomes the base for many other interest rates throughout the economy, including the prime rate (see #22 Prime Rate), which is typically about 3 percent above the Fed funds rate.

In the Great Recession and its aftermath the Fed was so concerned about propping up the economy that it lowered the Fed funds rate to an unprecedented 0.25 percent, and it has ranged between 0 and 0.25 percent ever since. To put that into context, it’s interesting to look at the Fed funds rate over the last fifty-five years:

Figure 4.1 Target Fed Funds Rate, 1954–2009

Source: The Federal Reserve

Figure 4.1 shows pronounced swings in the rate, including a drastic and—in hindsight—somewhat misguided spike in the rate in the early 1980s to mitigate an inflationary spiral that was as much caused by supply constraints (oil) as overheated demand. You can also see the swings over the last twenty-five years as the Fed has tried, with some success, to moderate the business cycle. Finally, although the chart itself has only been updated through 2009, there’s been little reason to update it since, because the effective rate continues to hover near zero.

The discount rate is the rate at which the Fed will lend funds directly to member banks. The Fed sets this rate directly, but sets it usually a percent or so higher than the Fed funds rate to encourage banks to lend to each other instead of borrowing from the Fed.

To understand global credit conditions and interest rates, many now refer to LIBOR, or London Interbank Offered Rate—a composite indicator originating in Europe. LIBOR is similar in effect to the Fed funds rate, but is a composite calculation of rates at which eighteen of the world’s major banks actually do lend to each other, so isn’t a target rate per se. While policy is used to try to influence LIBOR, it is much more a reflection of true lending and credit conditions, and has been adopted worldwide as an indicator. In the fall of 2008, at the height of the banking crisis, LIBOR spiked to stunning highs, showing the world just how bad credit conditions had become.

Why You Should Care

Target interest rates and the Fed funds rate will ultimately influence the interest rates, especially short-term rates, you will pay on loans or receive as income on deposits. Obviously, they will also affect the economy. Changes in the Fed funds rate are closely watched—as are the accompanying statements by the Fed—for signs of current economic stress and future economic direction.

32. FED OPEN MARKET OPERATIONS

The Fed funds rate is the Fed’s most important tool for influencing economic activity and achieving price stability (see #31 Target Interest Rates). As it is a rate used by banks for lending to each other, the Fed does not control the rate directly, but does it instead through open market operations.

What You Should Know

With open market operations, the Fed adds or subtracts money from the economy, influencing the supply and demand balance for money and thus the interest rate, or price for that money. Open market operations are the method used by the Fed to bring the true Fed funds rate in line with the target rate, as well as to more directly moderate the amount of money in the system.

The operations consist of sale and purchase of mostly short-term U.S. government Treasury securities to and from the banks. If the Fed sells bonds, it drains money from the banks; if it buys bonds, that gives the banks money to lend. That additional money, multiplied through leverage (see #33 Fractional Reserve Banking), puts a lot more money into the financial system. The Fed does not mandate which securities to trade or which banks or dealers it will transact with; the market is “open” for banks and dealers to compete on price. Every day the Fed announces its intentions, and bond dealers and bankers mostly located in large Wall Street skyscrapers get to work dealing with the Federal Reserve Bank of New York’s Domestic Trading Desk. The Federal Open Market Committee (FOMC), which also sets the target rates, monitors this activity.

Open market operations are usually very short term, dealing in short-term securities swapped back and forth on an almost overnight basis to fine-tune short-term interest rates. The Fed may also “jawbone” rates in one direction or another by making public statements in combination with actual open market operations. The persistent stimulus accomplished through the quantitative easing (QE3 and QE4) monthly purchase of $85 billion in bonds on the open market—and related publicity—serves as an excellent example.

Why You Should Care

Aside from the resulting influence on market interest rates, open market operations don’t affect you directly. That said, if you were borrowing to buy a house or refinancing between 2011 and 2013, the well-communicated monthly bond-buying activities worked quite well to drive mortgage rates down to fifty-year lows. It’s interesting to realize just how much goes on behind the scenes at the Fed and within the government in general to keep the economy moving in a favorable direction, and to smooth out the bumps. Without these operations we’d be looking at painful economic gyrations between inflation and deflation, or boom and bust, as seen in Figure 3.1.

33. FRACTIONAL RESERVE BANKING

Want to turn $100 into $500? Who wouldn’t? And the architects and designers of the worldwide banking system have found just a way to do that—through so-called fractional reserve banking. Fractional reserve banking is a fundamental principle in modern-day banking whereby banks keep a fraction of their deposits in reserve and lend out the rest. Fractional reserve banking allows banks to stay in existence to make a profit on funds lent out. More importantly, in the aggregate, fractional reserve banking effectively creates more money for the economy.

What You Should Know

Unless governed by the terms of a certificate of deposit, the money people have deposited in a bank can be withdrawn at any time. So how can a bank lend out money to others and earn a profit if it might have to return money to its depositors at a moment’s notice? Fractional reserve banking works on the theory that in all but the biggest crises, only a small fraction of depositors will want their money back.

This idea then turns banks loose to lend out the rest—directly to customers or to each other. When banks lend money to each other, the borrowing bank can keep a fraction of that loan and lend to still others—customers or banks—and the cycle repeats. By keeping only a fraction of the money in reserve, banks can lend the same money many times over, effectively increasing the supply of money through leverage. In aggregate, the supply of money is thus a multiple of the “base” money created by deposits—or by injections from a central bank. In practice, the amount of money in circulation can be five, ten, or even twenty times the amount injected into the banking system by the Fed or individual depositors.

This practice sounds risky, and indeed it can be, for if depositors see a crisis and demand all their money at once, it pulls the rug out from under the layers of leveraged loans. The Fed imposes a reserve requirement (see #36 Reserve Requirements) to mandate that banks keep at least a certain percentage of their deposits or funds in reserve to protect against bank runs.

But in the 2008 banking crisis, depositors became worried about their deposits in banks and withdrew in greater numbers, forcing a rapid contraction in reserves and in money to loan. The fear and contraction of lendable reserves fed on itself in a cycle of deleveraging (see #9 Deleveraging). Further, bank reserves were hit hard by bad investments, loan write-offs, and contracting asset values. The result was very restricted, or “tight,” credit, and the banking system nearly ground to a standstill. The Fed and the U.S. Treasury had to step in to create money and bolster bank reserves through TARP, the Troubled Asset Relief Program. These problems were amplified by the leverage created through fractional reserve banking.

This is not to say that fractional reserve banking is a bad thing—it is really a good thing when managed properly. It puts more money in circulation, makes credit easier to obtain, and fosters economic growth. The problems occur when banks get careless in how they lend money; when that happens the multiplicative effect occurs in reverse.

Why You Should Care

Fractional reserve banking occurs largely in the background; under normal circumstances it won’t affect your household finances or what you can pull from an ATM machine. But especially in the aftermath of the 2008–2009 banking crisis, it helps to understand what makes banks succeed or fail. Healthy banks lend money to you on favorable terms and keep the economy going. What happened during that period is a helpful reminder of the risks of using leverage to expand purchasing power.

34. REFLATION

Reflation is a term used somewhat informally in economics to refer to combined government efforts to stimulate an economy, particularly one hard hit by recession, deflation (see #19 Deflation), or an enduring decline in asset prices. The term is relevant in the aftermath of the Great Recession, as many economists felt that governments and the Fed in particular were engaging in deliberate actions to “reflate” the economy at the risk of creating runaway inflation later.

What You Should Know

When a government or central bank reflates an economy, it uses a combination of strong monetary stimulus (see #56 Monetary Policy and #17 Money Supply) and fiscal stimulus (see #55 Fiscal Policy) to radically encourage demand, and ultimately boost asset prices. In the aftermath of the crash of the real estate bubble, microscopic interest rates, trillions of dollars in direct capital infusions, bailouts, and tax rebates were all put into play to essentially inflate the prices of assets other than real estate. Those price increases could ultimately make real estate relatively more attractive and affordable, especially if expanded economic activity also increased incomes. That, in theory, would stop the slide in real estate prices, halt the deleveraging, and bring back a stable banking system and economy. As we’ve seen, to a large degree these policies have worked.

The problem recognized by many economists is that once such policy is enacted, it is hard to “turn it off.” The resulting inflation becomes a matter of expectation, and that makes it difficult to eliminate. (Note the fear and uncertainty in the markets in mid-2013 as the Fed announced “tapering” of its quantitative easing bond-buying activities.) Further, the excessive supply of money, or “liquidity,” is hard to “mop up,” especially if it becomes invested in longer-term real estate assets. Reflation may help save jobs and protect asset values for people vulnerable to a bust, but it may carry asset price distortions into the future, while making an economy more vulnerable to strong inflationary pressure later on. During the reflation period, for example, the prices of gold and bonds surged to new highs many thought to be excessive, and the prices of both have dropped to well off their peaks, although not everyone is calling it a “bubble” or a “crash”—at least so far.

Why You Should Care

Excessive inflation is an enemy to everyone except those who are in debt and can pay those debts later in cheaper dollars. Reflation policies can lead to excessive inflation; furthermore, they encourage more borrowing, which may put us back into the same position that caused Great Recession in the first place. When you see the government pull out all the stops to save an economy or to preserve the prices of overpriced assets, it’s a sign of bad times now and greater economic risk in the future. Likewise, when you see the prices of certain assets like gold rise to new heights because of reflationary policies, look out, especially if the policy changes and you’re still invested in these assets.

Many economists and investment professionals follow and recommend what they call the reflation trade. If rampant inflation is expected in a moderately growing economy, investors might want to avoid mainstream economies like the U.S. economy, where dollar depreciation and economic malaise will cripple the value of their investments. Since China is the world’s premier growing economy at this point and must buy most of its resources overseas, it has been felt by many that Australian and Canadian currencies and companies might fare well in a reflation scenario. Their governments aren’t forced to print money at this point, and they sell resources needed by the resource-hungry China and Asian world. Investments can be made in pure currencies or resource exporters, or simply local businesses like utilities paying dividends in local currency. Most recently, however, this investing “idea” has diminished in popularity, as China’s growth for an assortment of reasons has slowed. It goes to show that overseas investing isn’t for everyone, but this discussion shows the complicated, far-reaching, and international consequences of reflation, and how to prepare for it.

35. PARADOX OF THRIFT

The “paradox of thrift,” more often referred to today as the “paradox of saving,” was originally described by the famed economist John Maynard Keynes. It’s a simple paradox: if more people save more money in a bad economy, that leads to a fall in aggregate demand, which makes the recession worse. This concept would have been easy to ignore—except that it became a big part of the story of the Great Recession.

What You Should Know

The paradox of thrift is something of a prisoner’s dilemma—increased saving, which may be good for an individual, is bad for the economy as a whole. Clearly part of what caused the last bust was overspending and an overextension of credit, while personal savings rates dropped below zero (see #3 Saving and Investment). The natural reaction of people to the fear of losing assets or income, and a widespread new aversion to risk, was to stop spending and start saving. Savings rates jumped almost immediately to 5 percent before falling off to a more moderate 3 percent.

The paradox of thrift served to blunt the effects of economic stimulation and reflation (see #34 Reflation) because, as the Fed injected money into the economy, people just saved it for a “rainier” day. It didn’t stimulate demand; thus it didn’t stimulate production, and few were better off. The lesson: people spend and invest when they perceive opportunity worth the risk, not just when they have money available to spend. The lesson for policymakers is to fix what’s causing the risk and let asset prices adjust; then the system is back in balance, and people won’t hoard money out of fear.