Banks and Financial Institutions

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Introduction

Definitions and Basics

    Federal Reserve System, from the Concise Encyclopedia of Economics
    The Original Federal Reserve System. Several monetary institutions appeared in the United States prior to the formation of the Federal Reserve System, or Fed. These were, in order: the constitutional gold (and bimetallic) standard, the First and Second Banks of the United States, the Independent Treasury, the National Banking System, clearinghouse associations, and the National Reserve Association. The Fed was the last such institution founded. Although it has endured, the present-day Fed would be unrecognizable to its founders....

    The original Federal Reserve Act became law in December 1913. The "Federal" in the title implied that the law applied to the whole country, and "Reserve" emphasized the new institution's role as a reserve holder and reserve supplier for the commercial banking system....
    Financial Regulation, from the Concise Encyclopedia of Economics
    Financial institutions serve various purposes. Depository institutions (banks, savings and loans [S&Ls], and credit unions) transform liquid liabilities (checking accounts, savings accounts, and certificates of deposit that can be cashed in prior to maturity) into relatively illiquid assets, such as home mortgages, car loans, loans to finance business inventories and accounts receivable, and credit card balances. Depository institutions also operate the payments system where bank balances are shifted between parties through checks, wire transfers, and credit and debit card transactions. Insurance companies fall into two broad categories--life and health insurers, whose policies provide financial protection against death, disability, and medical bills; and property and casualty insurers, whose policies protect policyholders against losses arising from fire, natural disasters, accidents, fraud, and other calamities. Stockbrokers and related investment banking firms are central players in the capital markets where businesses raise capital and where individuals and institutional investors buy and sell shares of stock in business enterprises....
    Glossary, at the Federal Reserve Bank of Minneapolis.
    Terms related to the Federal Reserve, banking and economics....

In the News and Examples

    Calomiris on Capital Requirements, Leverage, and Financial Regulation, podcast at EconTalk. March 5, 2012.
    Charles Calomiris of Columbia University talks with EconTalk host Russ Roberts about corporate debt, capital requirements, and financial regulation. This is an in-depth conversation about how debt works on a firm's balance sheet and the risks that debt vs. equity pose for the survival of the firm. Calomiris applies these insights to financial regulation--how it works in practice and the firm's choices in responding to various interventions including bailouts and capital requirements. The conversation closes with a discussion of some of the government interventions in the financial crisis.
    Allan Meltzer on the Fed, Money, and Gold, podcast at EconTalk
    Allan Meltzer of Carnegie Mellon University talks with host Russ Roberts about what the Fed really does and the political pressures facing the Chair of the Fed. He describes and analyzes some fascinating episodes in U.S. monetary history, discusses the advantages and disadvantages of the gold standard and ends the conversation with some insights into recent Fed moves to intervene with investment banks. This is a wonderful introduction to the political economy of the money supply and central banks.
    Admati on Financial Regulation, podcast at EconTalk. August 1, 2011
    Anat Admati of Stanford University talks with EconTalk host Russ Roberts about ways to make the financial system more stable. In particular, Admati explores the implications of higher capital requirements. She argues that current policies subsidize leverage--high levels of debt relative to equity--and that current levels of leverage increase the vulnerability of the system to swings in asset prices. She then gives her response to criticisms of higher equity levels. The conversation concludes with a discussion of the role of academic economists and finance professors as advocates for various policies.
    William Black on Financial Fraud, podcast at EconTalk. February 6, 2012.
    William Black of University of Missouri-Kansas City and author of The Best Way to Rob a Bank Is to Own One, talks with EconTalk host Russ Roberts about financial fraud, starting with the Savings and Loan debacle up through the current financial crisis. Black explains how bank executives can use fraudulent loans to inflate the size of their bank in order to justify large compensation packages. He argues that "liar loans" were a major part of the crisis and that policy changes made it easy to generate such loans without criminal repercussions.
    William Black on Financial Fraud, podcast at EconTalk. February 6, 2012.
    William Black of University of Missouri-Kansas City and author of The Best Way to Rob a Bank Is to Own One, talks with EconTalk host Russ Roberts about financial fraud, starting with the Savings and Loan debacle up through the current financial crisis. Black explains how bank executives can use fraudulent loans to inflate the size of their bank in order to justify large compensation packages. He argues that "liar loans" were a major part of the crisis and that policy changes made it easy to generate such loans without criminal repercussions.

A Little History: Primary Sources and References

    A History of Central Banking in the United States, at the Federal Reserve Bank of Minneapolis.
    Nearly every country around the world, and certainly every developed industrial nation, has a central bank. Most serve one or more of the following functions: acting as a bank for bankers, issuing a common currency, clearing payments, regulating banks and acting as a "lender of last resort" for banks in financial trouble. The one thing they all do is serve as banker to their own governments.

    But even though these central banks have common functions, each still operates in distinct ways, and those distinctions largely stem from the banks' historical foundations. If you want to understand the nature of a modern central bank, you have to study its history and relationship to commerce and government. This is especially true of the United States, where the Federal Reserve System's unique structure has been shaped by this country's earlier experiments with central banking, and by the political response to those experiments. Indeed, the Federal Reserve itself has changed in profound ways since it was signed into law in 1913....
    Bank Runs, from the Concise Encyclopedia of Economics
    A run on a bank occurs when a large number of depositors, fearing that their bank will be unable to repay their deposits in full and on time, simultaneously try to withdraw their funds immediately. This may create a problem because banks keep only a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets such as government securities. When a run comes, a bank must quickly increase its cash to meet depositors' demands. It does so primarily by selling assets, often hastily and at fire-sale prices. As banks hold little capital and are highly leveraged, losses on these sales can drive a bank into insolvency....
    Savings and Loan Crisis, from the Concise Encyclopedia of Economics
    Years later, the extraordinary cost of the 1980s S&L crisis still astounds many taxpayers, depositors, and policymakers. The cost of bailing out the Federal Savings and Loan Insurance Corporation (FSLIC), which insured the deposits in failed S&Ls, may eventually exceed $160 billion. At the end of 2004, the direct cost of the S&L crisis to taxpayers was $124 billion, according to financial statements published by the Federal Deposit Insurance Corporation (FDIC), the successor to the FSLIC.

    The bankruptcy of the FSLIC did not occur overnight; the FSLIC was a disaster waiting to happen for many years. Numerous public policies, some dating back to the 1930s, created the disaster.

    Regulation Q, under which the Federal Reserve since 1933 had limited the interest rates banks could pay on their deposits, was extended to S&Ls in 1966. Regulation Q was price fixing, and like most efforts to fix prices,...
    Great Depression, from the Concise Encyclopedia of Economics
    The second major policy change was in monetary policy. Following the end of the contraction, banks, as a precaution against bank runs, had begun to hold large excess reserves. Officials at the Federal Reserve System knew that if banks used a large percentage of those excess reserves to increase lending, the money supply would quickly expand and price inflation would follow. Their studies suggested that the excess reserves were distributed widely across banks, and they assumed that these reserves were due to the low level of loan demand. Because banks were not borrowing at the discount window and the Fed had no bonds to sell on the open market, its only tool to reduce excess reserves was the new one of varying reserve requirements....
    Evolution of Central Banks and Federal Reserve Bank structure: Lombard Street: A Description of the Money Market, by Walter Bagehot

Advanced Resources

    Eugene White on Bank Regulation, podcast at EconTalk
    Eugene White of Rutgers University talks with EconTalk host Russ Roberts about the regulation of banks and financial crises. White argues that most regulation tries to limit the choices of banks to restrain them from making choices that create instability or fragility. A better approach, White argues, is to change the incentives facing bankers so that they would be encouraged to make prudent choices without the need for top-down monitoring. He shows how in the 19th century various regulations and market results encouraged stability and prudence while some regulations made the system more fragile. White discusses the lessons for the current crisis and what might be done to improve the current state of regulation.
    George Selgin on Free Banking, podcast at EconTalk
    George Selgin of West Virginia University talks with EconTalk host Russ Roberts about free banking, where government treats banks as no different from other firms in the economy. Rather than rely on government guarantees to protect depositors (coupled with regulation), banks would compete with each other in offering security and return on deposits. Selgin draws on historical episodes of free banking, particularly in Scotland, to show that such a world need not be unduly hazardous or filled with bank runs. He also talks about Gresham's Law and an episode in British history when banks successfully issued their own currency.

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