Commercial Banking

Sessions 7&8 , SIBM-B, June 2017

 Party time for Investors
JPMorgan intends to boost its quarterly common stock
dividend to 56 cents a share, from 50 cents a share at
present. It also announced a share buyback programme
of up to $19.4bn between June 1 2017 and June 30,
2018.

Citigroup plans to boost its quarterly dividend to 32

cents a share and launch a share repurchase program of
up to $15.6bn. Combined, the capital actions total
$18.9bn over the next year.
 More party time..
Wells Fargo said it plans to lift its quarterly dividend by
a penny to 39 cents a share and will launch a $11.5bn
share buyback program.

Morgan Stanley announced a $5bn share buyback and

said it would boost its quarterly dividend to 25 cents a
share, from 20 cents at present.

Bank of Americas board authorised a $12bn share

repurchase plan and plans to lift its dividend by 60 per
cent to 12 cents a share.
Bagehots Dictum for Central
Bankers
lend freely,
at a penalty rate,
against good collateral.

We focus on the role of Governments in Commercial
Banking

Banking problems - and the governments role in either

causing them or alleviating them

Banks play a key role in allocating investment funds,

governments can have a powerful effect on the
evolution of their economies through their
intervention in this sector.
 Discussion Questions
I.What did commercial banks do in the 1920s. Does
this mix of activities make sense? Why do panics
recur.

II.Should Roosevelt agree to deposit insurance?

Why not simply maintain the status quo? Are there
alternatives reforms of the banking system which
are preferable from an economic point of view?
From a political point of view?

III.Why does Glass want to separate commercial

and investment banking? Are his arguments
compelling? Are there other reasons to do it?
 Q1. Do? Panics?
Banks are very leveraged institutions whose liabilities
are both fixed in nominal terms and callable while its
assets are both risky and illiquid.

While all bank assets can presumably be sold at some

price, the lack of good ANALYSIS can imply that the
market value of a particular loan is substantially lower
than the value of this loan to the originating bank .

Normal net withdrawals by depositors are generally

quite low.
 Q1
While the banks assets are individually risky, their
aggregate return is generally sufficient to ensure that
even after bad loans are written off, the book value of
assets is larger than the value of the banks liabilities

In the absence of a panic, depositors thus have

continuous easy access to the funds that they have
deposited.

In effect, banks provide insurance on both sides of

their balance sheet. Lenders pay a slight interest
premium but are allowed to default when their projects
turn sour.
 Q1-Liabilities side
An obvious attraction of demandable deposits is that
people can change their mind as to when they want to
spend their assets.

In effect, these deposits provide insurance to

depositors with respect to changes in the timing of
their desired withdrawals

This insurance is valuable to depositors. Otherwise, it

seems difficult to explain why depositors were willing
to keep large sums in this form even though the
nominal returns were low while there was at least some
chance of losing a great deal in a panic.
 Q1-Asset Side
On the asset side, two things mitigate risk.

First, banks spend considerable resources collecting

information and monitoring their borrowers (in the
case this is illustrated for small banks, but it is
obviously true quite generally).

Second, bank claims tend to be senior and backed by

collateral.
Asset side-What can go wrong?
First, aggregate shocks can reduce the value of bank
assets so that, after proper provision for bad loans, the
book value of a banks net worth turns negative.

Second, depositors can panic and insist on

withdrawing their deposits en masse. Whenever this
occurs the market value of a banks assets is often lower
than the value of its liabilities.

This can be true either because the assets have

genuinely lost value or because their liquidation value
is low.
 Consequently.
In either case, the bank is then unable to meet its
contractual obligation to pay its deposits on demand.

When depositors suspect that a bank may face this

problem, they have an incentive to be first in line in
withdrawing their funds.

Thus, at least in principle, the expectation of a panic

may be enough to create a panic.

Moreover, because the bank must then liquidate assets

it is uniquely qualified to manage, the panic in effect
reduces the value of what depositors receive as a whole.
deposit insurance? maintain
the status quo?
If backed by a government guarantee, deposit
insurance eliminates losses to depositors.

Since depositors are sure to get their money back, they

do not have any reason to panic and runs are avoided.

The question of why the government ought to be

concerned about runs is a good one!

Losses may not be large in financial terms, but , social

costs are large
 continued
The collapse of the payments system to such an extent
that people resort to barter seems like a strong motive
for preventive intervention.

In addition, of course, lack of liquidity during the run

may lead people to sell assets that they are particularly
efficient at managing.

From an economic point of view, the case for stopping

runs is particularly strong if one views bank runs as
occurring even in situations were the underlying
quality of bank assets is high. In this case, fear of runs
can easily distort the banks asset allocations and lead
them to remain excessively liquid.
 Why was there a crisis in
1933?
fundamental reason why bank balance sheets were
particularly weak in 1933. These include high default
rates caused by low output and high unemployment as
well as poor supervision

consequence of poor economic conditions ?

 Exhibits Analysis
Even after Roosevelt reopened banks in March 1933,
the loan to deposit ratio (exhibit 2) remained quite
low. This can be seen as evidence that banks are
lending less than is socially desirable because they are
particularly afraid of runs.

The ratio of loans to GNP (using exhibit 1) is not

particularly low, and the absence of a significant
decline in this ratio might be seen as evidence that
loans have not fallen excessively.
 Analysis paralysis
The fear of bank runs.. As motivating individuals to
hold too few of their assets on deposit at banks.

Certainly, deposits declined substantially. But again,

their decline from 1929 to 1930 (28.5%) is
substantially smaller than the decline in nominal GNP.

Somewhat more compelling evidence that people are

not trusting banks is provided by the fairly significant
increases in currency held by the public and the
deposits at Postal Savings banks.
The moral hazard arguments
against deposit insurance
Two variants

First, there is the fact that a bank with insured deposits

would be willing to gamble for resurrection if its
equity becomes low.

If this strategy succeeds, it would keep the profits. If it

fails, the government is saddled with the losses.

Banks whose true equity value is close to zero would

tend to raise the price of risky projects (as they are
eager to finance them) ( Big Short examples??)
 Guardian Example
Even without deposit insurance banks would behave in
this way if depositors did not effectively monitor them.

The activities of Guardian certainly suggest a

willingness to take risks (lending with own stock as
collateral is a way to increase risk by raising leverage)
even before deposit insurance.
Alternatives to the depo plan
Bagehots advice to simply lend freely, at penalty
interest, on good collateral during panics.

Banking Crisis of 1933 shows some of the difficulties

encountered by this scheme.

High-grade collateral disappeared from banks assets in

the Great Depression, the Feds loans to banks actually
fell (exhibit 5).

Similarly, the RFC was simply unable to find adequate

collateral in the Guardian banks that precipitated the
crisis.
 Alternatives
Lending money to a bank that is effectively bankrupt
makes equity-holders better off (they end up with a
claim that has positive value if the bank recovers).

Thus, these loans are treated as bailouts and are

politically charged.

This is particularly true when, as inevitably occurs,

some of the practices of the failed bank are not above
reproach.
 Alt
The Guardian groups experience illustrates this.

It also shows that, failing banks may see the

government as quite eager to lend in order to save the
financial system.

Such a bank may thus be unwilling to make many

concessions.

The result is brinkmanship that can end in disaster.

 Capital Requirements
An alternative approach is increase capital
requirements further while limiting the risk of assets
that can be held with funds provided by depositors.

The extreme version of such requirements involves the

imposition of narrow banking which the Banking
Act of 1863 imposed on note-issuers.

The obvious advantages of this are that the FDIC

would never lose any money and that panics would be
costless (since banks would have access to the necessary
funds).
 Double Liability
is a scheme that seeks to increase the effective capital
base of banks while also allowing loans to be financed
by deposits.

The clever part of this scheme is that equity-holders do

not have to put down the extra money initially.

This is also its undoing since the most equity-holders

that are best able to monitor the bank can then find a
way out of the obligation.