Financial Crisis Paper DRAFT

Financial Crisis Paper DRAFT - The Financial Crisis Part I:...

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The Financial Crisis Part I: The Purpose of Financial Institutions Financial Institutions are the bridges that connect savers and borrowers, which in turn form the financial markets. The purpose of a traditional bank is to take deposits and make loans. Banks exist to help facilitate the allocation of economic resources, lower transaction costs, provide liquidity, diversify risk, and reduce problems related with information asymmetries. In order to explain how banks function, it is necessary to look into a bank balance sheet. Assets are the uses of funds, while liabilities show the sources of funds. The difference between assets and liabilities, which is called bank capital, represents the value of the bank to its owners 1 . A bank’s major sources of funds come from deposits and borrowings. Banks can borrow from the Federal Reserve, from other banks, or through a repurchase agreement. The majority of the funds raised are then used to make loans. Banks also have cash reserve as well as investments in securities. In United States, banks are only allowed to hold bonds. Shadow banks provide services that compete with or substitute for those supplied by traditional banks. However, unlike traditional banks, shadow banks do not accept deposits, which is why they are less regulated by the government. Shadow banks also don’t have access to FDIC deposit insurance. In contrast to normal banks which get money from deposits, shadow banks get money from uninsured short-term funding, such as interbank borrowing and commercial paper. The lack of transparency among shadow banks encourages risk-taking activities and therefore creates greater problems during economic downturns 2 . To illustrate how competition might increase risk and why shadow banks have become so popular, it is necessary to discuss the roles of “return on assets” (ROA) and “return on equity” 1 S. Cecchetti and K. Schoenholtz. “Money, Banking, and Financial Markets, 3E.” (McGraw-Hill, 2011) P.233. 2 Paul McCulley. “The Shadow Banking System and Hyman Minsky’s Economic Journey.” PIMCO . May 2009.
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(ROE). ROA equals net profit over total bank assets, while ROE equals net profit over bank capital. They are both important measurements for evaluating the performance of a bank. However, for two banks with the same ROA, their ROE can be very different. When the economy is doing well and assets are appreciating, a bank will have a higher ROE if it adopts a capital structure with more debt and less equity. Before the financial crisis began in 2008, the economy of the United States had been performing very well. This led many banks to become increasingly leveraged. Although banks have potential to make high profits, they also face liquidity risk, credit risk, interest-rate risk and trading risk. Liquidity risk refers to a sudden demand of liquid funds, while credit risk refers to the risk that a bank’s loans will not be repaid. These two risks appeared frequently after the financial crisis began. Banks normally handle liquidity risk by holding
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This note was uploaded on 03/30/2012 for the course MANEC 453 taught by Professor Jerrynelson during the Fall '10 term at BYU.

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Financial Crisis Paper DRAFT - The Financial Crisis Part I:...

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