Intro to Business Chapter 20

Business in Business in Action 8e Action 8e Bovée/ThillBovée/Thill

Developing a Business Mindset

Chapter 20Chapter 20The Money Supply The Money Supply

andandBanking SystemsBanking Systems

Learning Objectives

1. List the four financial functions of money, and define two key measures of the money supply.

2. Explain the major functions of the Federal Reserve System, and identify other key federal financial institutions.

3. Distinguish investment banks from commercial banks, and identify the three major types of investment banks.

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Learning Objectives (cont.)

4. Identify the major types of commercial banks, and outline the impact of banking deregulation over the past three decades.

5. Identify the two major sets of economic forces that triggered the meltdown of 2008 and sent the economy into a global recession.

6. Outline the efforts to reform the banking industry in the wake of the subprime crisis.


The Meaning of Money

• Money Anything generally accepted as a means of

paying for goods and services Serves as a medium of exchange, a unit of

accounting, a store of value, and a standard of deferred value


The Money Supply

• Money supply The amount of money in circulation at any

given point in time


Trends in the Money SupplyExhibit 20.1

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The Federal Reserve System

• Federal Reserve system The central banking system of the United

States Responsible for regulating banks and

implementing monetary policy


The Federal Reserve System (cont.)

• Federal funds rate The interest rate that member banks charge

each other to borrow money overnight from the funds they keep in the Federal Reserve accounts


The Federal Reserve System (cont.)

• Discount rate The interest rate that member banks pay

when they borrow funds from the Fed

• Prime rate The interest rate a bank charges its best loan

customers


Other Government Banking Agencies and Institutions

• Federal Deposit Insurance Corporation (FDIC) The federal agency responsible for protecting

money in customer accounts and managing the transition of assets whenever a bank fails


Other Government Banking Agencies and Institutions (cont.)

• Fannie Mae The government-sponsored enterprise

responsible for guaranteeing and funding home mortgages

• Secondary mortgage market The financial market in which mortgages are

bought and sold, providing much of the funds that are loaned to home buyers


Other Government Banking Agencies and Institutions (cont.)

• Freddie Mac A secondary mortgage institution similar to

Fannie Mae


Investment Banking

• Investment banks Firms that offer a variety of services related to

initial public stock offerings, mergers and acquisitions, and other investment matters


Commercial Banking and OtherFinancial Services

• Commercial banks Financial institutions that accept deposits,

offer various types of checking and savings accounts, and provide loans

• Retail banks Banks that provide financial services to

consumers


Commercial Banking and OtherFinancial Services (cont.)

• Merchant banks Banks that provide financial services to

businesses Can also refer to private equity management

• Thrift banks Banking institutions that offer deposit

accounts and focus on offering home mortgage loans


Commercial Banking and OtherFinancial Services (cont.)

• Credit unions Not-for-profit, member-owned cooperatives

that offer deposit accounts and lending services to consumers and small businesses

• Private banking Banking services for wealthy individuals and

families


Other Financial Services

• Independent mortgage companies Nonbank

companies that use their own funds to offer mortgages

• Mortgage brokers Nonbank

companies that initiate loans on behalf of a mortgage lender in exchange for a fee


Other Financial Services (cont.)

• Finance companies Nonbank institutions

that lend money to consumers and businesses for cars and other vehicles, home improvements, expansion, purchases, and other purposes

• Credit rating agencies Companies that

offer opinions about the creditworthiness of borrowers and of specific investments


Banking and Financial Bubbles

• Bubble A market situation in which frenzied demand

for an asset pushes the price of that asset far beyond its true economic value


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The Housing BubbleExhibit 20.2

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The Housing Bubble

• Subprime mortgages Home loans for borrowers with low credit

scores

• Loan-to-value (LTV) The percentage of an asset’s market value

that a lender is willing to finance when offering a loan

The rest of the purchase price has to be paid by the buyer as a down payment


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Subprime LendingExhibit 20.3

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Changing the Rules in Mortgage Lending

• Adjustable rate mortgage (ARM) A mortgage that

features variable interest rates over the life of the loan

• Option ARM A type of ARM that

lets borrowers choose from several repayment options


The Securitization of Debt

• Securitization A process in which debts such as mortgages

are pooled together and transformed into investments

• Mortgage-backed securities (MBSs) Credit derivatives based on home mortgages


The Meltdown of 2008

• Defaults Situations in which borrowers stop making

payments on their loans

• Foreclosures Situations in which lenders take possession

of homes after borrowers default on their mortgage payments


The Meltdown of 2008 (cont.)

• Liquidity crisis A severe shortage of liquidity throughout a

sector of the economy or the entire economy, during which companies can’t get enough cash to meet their operating needs

• Credit freeze A situation in which credit has become so

scarce that it is virtually unavailable, at any cost, to most potential borrowers


Lessons to Learn from the Subprime Meltdown

• Transferring risk does not reduce or eliminate the risk—and sometimes it can even increase risk.

• Decoupling risk from responsibility leads to risky and irresponsible behavior.

• Individual short-term incentives can overpower logic and collective long-term consequences.


Lessons to Learn from the Subprime Meltdown (cont.)

• Unregulated private contracts can have damaging public consequences.

• If something seems too good to be true, it is.

• Innovation can be dangerous if it outpaces our ability to understand it or control it.


Lessons to Learn from the Subprime Meltdown (cont.)

• Leverage can be dangerous, and massive leverage can be deadly.

• The past is not always a reliable guide to the future.

• Computer models and quantitative analysis must support experience and common sense, not replace them.

• Investors must understand the quality of the information they use to make investment decisions.


Efforts to Prevent Another Banking Crisis

• Dodd-Frank Act Legislation passed in 2010 aimed at

reforming the banking industry and offering consumers greater protection


Dodd-Frank Act: Points of Emphasis

• Monitoring for systemic risk• Protecting consumers• Closer scrutiny of the derivatives market• Ending taxpayer bailouts of companies

deemed “too big to fail”• Tougher regulation of credit rating

agencies


Applying What You’ve Learned

1. List the four financial functions of money, and define two key measures of the money supply.

2. Explain the major functions of the Federal Reserve System, and identify other key federal financial institutions.

3. Distinguish investment banks from commercial banks, and identify the three major types of investment banks.


Applying What You’ve Learned (cont.)

4. Identify the major types of commercial banks, and outline the impact of banking deregulation over the past three decades.

5. Identify the two major sets of economic forces that triggered the meltdown of 2008 and sent the economy into a global recession.

6. Outline the efforts to reform the banking industry in the wake of the subprime crisis.


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