Question

U82 Assignment

The Federal Reserve can be a short–term source of funds. Discuss how a bank borrows from the Fed and why a bank would borrow from the Fed. Also discuss how the borrowing interest rate is established and include a description of what this rate (that is charged to banks) is called. Include a discussion about how to determine what that rate is today.

● Summarize the most significant uses of the funds banks obtain; include a description of each and the risks involved. Next, discuss why a bank might invest in securities, even though loans typically generate a higher return; discuss risk as a factor. Finally, discuss how a bank might allocate funds to each type of asset and how this helps a bank to manage risk for the bank and its customers.

● Describe what is meant by bank capital and discuss how banks determine the optimal amount of capital to hold. Since a bank’s capital is generally less than 10% of its assets, discuss how this compares to the average capital structure of manufacturing corporations and explain this difference.

Answer 1

1. FEDERAL RESERVE :

• The Federal Reserve System (FRS), also known as the Fed, is the U.S. central bank.
• Its key functions include handling the country's monetary policy and regulating banks, among other things.
• The Federal Reserve payments system, known as the Fedwire, moves trillions of dollars daily between banks.
• The Federal Open Market Committee (FOMC) is the Fed's monetary policy-making body and manages the country's money supply.
• The FOMC adjusts the target for the overnight federal funds rate, which controls short-term interest rates, based on its view of the economy.

2. How the borrowing interest rate is established

The FOMC adjusts the target for the overnight federal funds rate, which controls short-term interest rates, at its meetings based on its view of the strength of the economy. When it wants to stimulate the economy, it reduces the target rate. Conversely, it raises the federal funds rate to slow the economy.

The target rate was lowered to 0.25% in response to the recession in 2008 and stayed there for seven years. On Dec. 15, 2015, the Fed raised the target rate to a range of 0.25% to 0.5%—the first rate hike in almost 10 years. The FOMC increased the rate all the way to 2.25% to 2.5% during the first half of 2019. The rate fell drastically during the first part of 2020, all the way back to the 0% to 0.25% range, where it remains as of April 2020.

3. Why Do Commercial Banks Borrow From the Federal Reserve?

Commercial banks borrow from the Federal Reserve System (FRS) primarily to meet reserve requirements before the end of the business day when their cash on hand is low. Borrowing from the Fed allows banks to get themselves back over the minimum reserve threshold. A bank borrows money from the government's central bank utilizing what is known as the "discount window".

Borrowing via the discount window is convenient because it’s always available. The process includes no negotiation or extensive documentation. The downside, however, is the discount rate—the interest rate at which the Federal Reserve lends to banks—is higher than if borrowing from another bank.

4. Banks Must Meet Reserve Requirements

Prior to the 1930s, the government imposed no regulations on banks as to the amount of cash they had to keep on hand relative to their deposit liabilities. Following the stock market crash of 1929, depositors, fearful of bank collapses, arrived in masses to withdraw their money. This caused many banks to become insolvent, as the amounts requested in withdrawals exceeded the cash they had on hand.

The government responded by implementing reserve requirements that forced banks to keep a percentage of their total deposit liabilities on hand as cash. The previous reserve requirement was 10%, but as of March 26, 2020, the reserve requirement was moved to 0%.

5. Utilizing the Federal Reserve

Occasionally, robust lending activity depletes a commercial bank's cash reserves to where they fall below the government's mandated reserve requirement. At this point, the bank has two options to avoid running afoul of the law. It can borrow from another bank, or it can borrow from the Federal Reserve.

Borrowing from another bank is the cheaper option, but many commercial banks, especially when only taking out an overnight loan to meet reserve requirements, elect to borrow from the discount window because of its simplicity.

6. Banks Can Borrow From Other Banks

But banks can opt to pay a higher interest rate and borrow from another bank. The rate that banks charge each other is known as the federal funds rate. Although this rate is typically 50 basis points below the discount rate, as of April 2020 the two are equal—at 0.25%.

Loans from banks to each other are also done on an overnight basis. Banks use their excess reserve balances to lend to other banks. The Federal Open Market Committee (FOMC) meets eight times a year to set the federal funds rate. The committee sets a target for the rate, although banks don’t have to charge the exact rate. The rate charged is negotiated between the two banks.

7. What is the Optimal Level of Bank Capital?

Bank capital requirements come with important benefits and important costs. Higher capital requirements help to reduce the likelihood of future financial crises which—as we observed in 2008-2009—are extraordinarily costly in terms not only of wealth destroyed, but more importantly, households strained by unemployment. But higher capital requirements also make it costlier for banks to provide loans to businesses and households at all times; the resulting reduction in the availability of credit reduces economic output. Several academic studies have estimated the level of bank capital requirements that best trades off these benefits and costs.[1] The studies have generally followed the approach used by the Bank for International Settlements (BIS) in a 2010 paper that was an important input to the calibration of the Basel III standard for bank regulation.

First, the BIS estimated the annual probability of a financial crisis at different levels of bank capital requirements. Those estimates, combined with estimates of the cost of a crisis drawn from the academic literature, enabled the BIS to estimate the social benefit of the amount of capital available in the banking sector in terms of financial crises avoided. The BIS found that a one percentage point increase in capital requirements from pre-crisis levels reduced the annual probability of a financial crisis by about 1.5 percentage points while a similar increase from current levels reduces the probability by about 0.1 percentage points.

Second, the BIS estimated the impact on lending spreads and on GDP at different levels of capital requirements. The BIS found that, at any initial level of capital requirements, each percentage point increase in capital requirements raised loan rates 13 basis points and permanently reduced the level (not the growth) of GDP by 9 basis points.

Combining these estimates of costs and benefits, the BIS estimated the optimal level of capital requirements to be about 9 to 11 percent under their baseline set of assumption about the cost of a financial crisis.[2] Under different assumptions, the study puts the optimal level of Tier 1 capital requirements between about 8 and 13 percent.

Following a similar approach but using different estimates, two more recent studies came up with different ranges. A 2015 paper by Bank of England (BoE) economists (Brooke et al.) estimated the optimal range for Tier 1 capital requirements to be between 10 and 14 percent. A 2017 paper by Federal Reserve Economists (Firestone et al.) put the optimal range at 13 to 26 percent. As explained in a BPI blog post (see here), one important difference between the two estimates is that the BoE paper takes into account the impact of other post-crisis financial reforms on the probability and cost of a financial crisis. Most notably, the largest banks are now funded in part with debt that can be converted into equity if needed to recapitalize the institution as part of a resolution. The introduction of a credible resolution regime lowers both the probability and the cost of a financial crisis. Another important difference is that the Firestone et al. paper uses the estimated coefficients of a model that finds a statistically insignificant benefit to higher levels of capital. Thus, under this model specification higher levels of capital have a small impact reducing the probability of a crisis occurring. When those results are excluded, the upper bound of their estimated optimal range declines by about 4 percentage points.[3] Thus, the Firestone et al. would have likely yielded an optimal range that is similar to the one provided in the Brooke et al. paper if they had (1) taken into account other relevant post-crisis regulatory requirements and (2) excluded the model specification for which capital is not correlated with the probability of a financial crisis.

A 2016 paper by IMF economists took a different approach. Rather than estimating the social cost and benefit of capital regulations, Dagher et al. estimate the amount of bank capital that would have been necessary to avoid imposing costs on bank creditors or bank bailouts in past banking crises. They find that capital of 15 to 23 percent would have been necessary to absorb losses in most bank crises. As they note, the range can be interpreted as including not just equity, but also long-term —“bail in” — debt that banks have issued post-crisis pursuant to the FSB’s total loss absorbing capital (TLAC) requirement. Their estimates are determined by the losses experienced in banking crises in a wide range of countries, from Greece to Slovenia to Iceland. They estimate that about 6 percentage points of capital relative to risk-weighted assets would have been necessary to cover the losses of U.S. commercial banks in the 2007-2009 financial crisis.

Judging by these estimates, U.S. banks currently hold slightly more capital than optimal. The estimates by the BIS and BoE studies put the optimal range for tier 1 capital at about 10 to 14 percent of risk-weighted assets. The aggregate Tier 1 capital ratio of U.S. banks is about 13.5 percent; for the largest banks the figure is 13.8 percent, and both are higher than the 12 percent (mid-point of the optimal range). The largest banks also have long-term debt outstanding equal to about 10 percent of risk-weighted assets for a total loss-absorbing cushion of 24 percent, above the range the IMF study reports is necessary for banks to comfortably weather a banking crisis.