Week one notes
Note: These notes are not a substitute to the textbook. They merely highlight important points and add some needed information to the assigned text.
The title of this course is Management of Financial Institutions. This is a very broad and a far reaching topic. To make it possible, the course will concentrate on Bank management. Many of the concepts we will learn in course are transferable to other financial institutions.
To begin the discussion, let us define banks. What is a bank? What do Banks do? A bank is a chartered financial institution that accepts savings deposits and makes commercial loans. This is the most basic definition of a bank. However, if you look at ...view middle of the document...
The number of banks in the US peaked at 15,000 just before the great depression in 1928 ~ 1929. To put this information into perspective, the US has more banks than the other 200 countries in the world combined. So, does this mean that the banking industry in the US is competitive? Yes, it does. The banking industry in the US is very competitive.
How important are banks to the economy? Providing credit makes banks a vital part of the economy. If you look at the sub-prime mortgage, you will see that it took only 3 to 4 weeks for the economy to collapse after banks stopped providing credit. Without credit, business would not be able to invest in fixed assets, finance inventories, or support their customers financially. Without credit, consumers will not be able to make large purchases. This is exactly what happened in the sub-prime mortgage problem.
The sub-prime mortgage problem
The steps that caused it
As you will see later in the course, banks have to maintain a minimum legal capital. This capital is made up of a bank’s owners’ equity, known as net worth, and a small part of non-deposit borrowing. Any losses due unpaid loans have to be credited against the bank’s capital. Once the bank’s capital drops below the legal minimum requirement, the bank can no longer legally provide credit.
When a large enough number of banks lost their ability to lend, the economy in the US and in the world collapsed. We are still feeling these effects. The following is a more detailed analysis of the sub-prime mortgage industry problem.
Consider a house that costs about a $1 million to buy. Such a house would have a monthly payment of about $7,000 and about $1,200 in property taxes and insurance; the total monthly mortgage impounds would be $8,200. Only a small number of individuals or families can afford such a burden. In the sub-prime market, such a house was offered with a negative amortization 1% 1/1 ARM and an APR of 8%. What do these numbers mean? The owner would pay 1% interest for one year and, since the APR is 8%, the loan will increase by 7% during the first year. With a 1% interest, the payment was about a $1,000 plus the $1,200 in taxes and insurance for a monthly total of $2,200. Many people thought that they can afford that. After the first year, the monthly payment increased to $8,200 and defaults resulted.
The increasing number of defaults depleted the capital of many financial companies and they started to fail. Interestingly enough, small banks avoided the sub-prime market because the details of the transactions did not make sense to them. The banks that suffered the most were big banks with supposedly superior management skills.
The US Government reaction to the problem
Before we start the discussion, note that this is not a political issue, it is an economic issue. A Republican president, George W Bush, and a Democratic president, Barak Obama, handled the situation the same way. After the failure of several large financial...